The Effect of Capital Structure on Profitability Assignment

Assignment Task

1. Introduction

One of the most crucial choices a financial management may make, especially during times of economic crisis, in a developed country like the UK is the choice of capital structure. Every Chief Financial Officer's principal goal is to raise the company's worth and produce wealth for its owners. By being aware of the variables that affect borrowing decisions, finance managers can decide on borrowing capacity as well as the benefits and drawbacks to the company. The capital structure of a business refers to the exact debt ratio it employs to finance all elements of its operations and growth. Debt comes from borrowing while equity comes from equity investments. In general, companies with a more leveraged capital structure pose a higher risk to investors and the company itself, with the worst-case scenario being bankruptcy. However, these uncertainties could also be a key source for business expansion. Therefore, establishing a suitable capital structure is vital for the business. One of the many considerations that organisations consider when choosing the best capital structure is profitability, which was one of the aspects this study looked at. This study primarily examines the impact of capital structure on the profitability of non-financial companies listed on the London Stock Exchange with a focus on the FTSE100 indices.

1.2 Research Problem

This study will highlight the effect of capital structure on profitability in relation to the FTSE100, top 50 companies. The capital structure of the company has an effect on its profitability and value since using debt results in current tax savings that increase the firm's worth. First, it would mean that companies would have to use all of their debt to increase their value. The company's financial situation is uncertain as it affects its ability to be competitive and obtain a good return on investment. Capital structure is of great importance to many stakeholders in an industry. It might be difficult for analysts to identify the ideal debt -to-equity ratio for a particular company. In order for the entrepreneur to maximize his profit, it is in everyone's interest to keep the cost of debt as low as possible. Financial managers have historically sought to maximize three factors: cost, profit and market value. Combining loan and equity financing lowers the cost of capital, strengthens the business's financial condition, and enhances profit margins. The best capital structure cannot yet be determined by corporate management in any way.

1.3 Research Background

The financial structure a company chooses has a significant impact on its capacity to find and invest in businesses that produce the highest profits. The company's ability to be competitive in a very difficult market environment will depend on the investments made. A company's capital structure consists of a variety of securities in various ratios. In general, a company has a range of options to choose from for its capital structure, and a company can issue a significant amount of debt (Ngoc et al., 2021). Banks and other financial institutions,

according to Kwan (2009), are specialised businesses whose capital structures are influenced by a range of financial sector characteristics, such as regulatory constraints and access to federal government security instruments, such deposit insurance.

A company may also gear up to use lease finance, warrants, convertible bonds, forward contracts, or bond swap trading. It can also issue a range of securities that can be connected in various ways; however, it strives to identify the precise combination that will allow it to maximize total market value. It's a crucial decision because the profits are to be used elsewhere in the business and because it determines how successful a business will be able to manage its competitive environment. In such a situation, the business environment is full of dangers and uncertainties, and deciding a company's plan of action is one of the most difficult aspects of determining the direction of the future. Companies can finance the acquisition of their assets in two ways: by taking on new debt or by using their existing cash reserves. A financing structure that combines loans and equity is ideal. Entrepreneurs wouldn't care whether their business was financed by debt or equity if the interest payments weren't tax deductible. Conversely, they would not be able to use any form of debt financing to rise the value of their business if the interest payments were not tax deductible. A measure called cumulative productivity can be used to identify which elements of a monetary policy are working well and which need improvement. The management of any business is the group of people who are ultimately responsible for choosing the course of action that will bring in the maximum amount of money for the business. Companies even set goals for how much money they want to make and occasionally raise the CEO's pay if those goals are met. Despite this, companies still have goals that go beyond simple earnings (Pisano et al., 2017).

1.4 Research Aim and Objectives

The investigation's goal is to learn how the capital structure of FTSE 100 firms impacts their profitability. The following goals have been established in order to fulfil this purpose:

• Understand the overview of the capital structure of companies
• Identify the impact of capital structure on profitability
• Make recommendations regarding the capital structure
• Determine the type of relationship between capital structure and corporate performance
• Examine how capital structure affects business performance.

1.5 Research Questions

• What is the summary of the company capital structure?
• How does capital structure affect profitability?
• What are some suggestions are there to strengthen a company's capital structure?

2. Literature Review

2.1 Capital Structure and Firm Value

According to Alnori & Alqahtani (2019), the terms 'goodwill', 'shareholder value', 'shareholder wealth' and 'profitability' are all interchangeable as they all show how shareholder money grows. In earlier study, the inherent relationship between capital composition and company performance was also discussed (Smith & Watts, 1992). For example, profitable companies tend to benefit more from shareholders than from losses. The maximisation of current equity's market value is the aim of all financial choices. As a result, the market value of equities is subsequently increased by wise financial decisions while decreased by unwise ones. Because the present value of the tax savings from the use of leverage improves firm value, capital structure decisions have an impact on profitability and business value. First, it would mean that companies would have to use all of their debt to increase their value. However, this research shows that if a company takes on too much debt, its value may decrease because there is a higher risk of financial problems and the creditworthiness of the company may decrease (Ngoc et al., 2021). If an organization is highly leveraged, it means that debt rather than equity forms a larger part of the capital structure (Rujiin & Sukirman. 2020).

According to this idea, a company's market value is determined by two factors: the potential earnings it can generate and the degree of risk connected with its core beliefs. This theory suggests that the usage of leverage within a capital structure can be advantageous in determining the appropriate one to use, taking into account the fact that interest payments can raise a company's overall tax burden. Explaining why the majority of enterprises are financed partially by debt and partially by equity is one of the fundamental purposes of arbitrage theory, which also aims to accomplish many of its other goals. Singhania & Mehta (2017) asserted that companies are more likely to use their funds, such as, retained earnings or excess cash, as opposed to financing from external sources. If there are insufficient funds in a company's bank account to cover a potential investment opportunity, the company may seek funding from other sources but will choose which outside sources to use in order to minimize costs. The concept of "market timing," which proposes that companies schedule their stock offerings to issue new shares once the current share price is too high and to buy back existing shares when the current share price is too low, is also a part of the capital structure.Changes in stock prices can affect how a company finances itself. When it comes to financing, a business usually doesn't care where the money comes from debt or equity. Instead, they choose to pursue the type of financing that capital markets seem to value most at the time (Alnori & Alqahtani, 2019). The subject of capital structure

has received a lot of attention from academics, particularly since Modigliani and Miller (1958). In their view, the issuing of debt by a corporation has no bearing on its market value in some situations, such as those involving unfettered arbitrage, the absence of insolvency, and the payment of corporate taxes (Habibniya et al., 2022).

2.2 Modigliani and Miller (m+m) Theories

The irrelevance theory of capital structure was presented by Modigliani and Miller (m+m) in 1958. In the absence of taxes, brokerage charges, solvency costs, and symmetric information between internal and external parties, the m+m irrelevance theory contends that a company's value has no bearing on how it is financed. As a result, the worth of a company is purely based on how smoothly its actual operations perform. A tax-protected benefit of debt financing, according to m+m's 1963 modification of one of their initial assumptions for the capital structure irrelevance thesis, the absence of taxes, would cause the value of an effect firm's leveraged business to differ from a non-leveraged business. As a company's leverage increases, the weighted average cost of capital (WACC) decreases and the amount of profits exempt from corporation tax increases. The amount of debt increases a firm's worth, and at the ideal debt ratio, the value of the company is highest.

However, critics contend that m+m overlooked the financial burden brought on by growing capital structure leverage as well as the direct and indirect costs of bankruptcy, indicating that businesses cannot perpetually borrow (Watson and Head, 2013). Alternative theories to explain the factors that determine capital structure have been created in response to these criticisms. These theories are the trade-off theory and agency theory, which are covered below.

2.3 Trade-off theory

One of the earliest ideas produced in reaction to the m+m studies of 1958 and 1963 was the trade-off theory by Kraus and Litzebnerger (1973). Trade-off theory gives the business advice on how much debt and equity to take on based on how the costs and benefits balance. This theory states that the value of a levered firm should be increased by the value of the existing interest tax shields and, the value of an unlevered firm. However, high debt usage increases the risk of insolvency (Shoaib & Siddiqui, 2020). There were two types of bankruptcy costs that seemed extremely dire due to the potential financial hardship caused by high leverage. Both direct and indirect costs have to be managed. The expenses incurred by the business in order to operate make up the direct cost. If the business is large, these costs will only be a small fraction of the total. Consequently, for a small business, these fixed costs make up a larger portion and are considered an active part of the business. Indirect costs are the result of a change in the company's investment policy, which can cause the company to lose money. The industry is trying to compensate for this loss through research and development. To reduce systemic risk, landlords have tried to avoid borrowing money in

this way (Pisano et al., 2017). According to this idea, the best capital structure is obtained when there is a trade-off (an offsetting scenario) between the possibility of bankruptcy or financial crisis and the tax-deductible benefits of debt (a tax shield). To put it another way, a company's capital structure is optimal when the advantages and disadvantages of debt are equal (Rashid, 2020).

2.4 Agency Theory

Agency theory is another approach to determining the best organizational structure. This approach presupposes two different kinds of conflicts of interest: those between shareholders and bondholders and managers and shareholders (Amjad et al., 2013). According to this theory, managers should behave in the best interests of shareholders as they are agents of their clients; however, this is not always the case, which can cause conflict. In order to assure that managers behave in their best interests, shareholders must install pricey control tools (Ellili and Farouk, 2011, Ho-Yin Yue, 2011). Increasing firm's leverage is a way to reduce this conflict of interest (Jensen, 1986, Jucá et al., 2012). This study shows that the pursuit of different objectives can lead to circumstances that can be analyzed to determine the most efficient way to organize the capital structure. Due to the agency problem, managers who have sufficient funds tend to spend them without much thought. Because of the agency problem, it is obvious that debt contracts should be the primary means of distributing capital to investors. This could be due to avoiding unnecessary expenses, which would result in more money being returned to shareholders (Rashid, 2020).

3. Research Methodology

3.1 Methodology, Sample Size and Data Collection Technique

The study uses secondary data from magazine articles, the Financial Times, Companies House, and financial reports from companies listed on the London Stock Exchange. The data covers 50 non-financial companies included in the FTSE100 index for a ten (10) year period from 2011 to 2022. As the financial sector has a high ratio of debt to assets, this data would not be comparable to those of other sectors. The nature of the survey and the ease with which the general public can obtain companies' financial records led to the selection of secondary data.

Since report information is only available from secondary sources, secondary data is used. When performing a secondary data analysis, a researcher uses information that has already been collected for another study. Secondary data analysis is used by researcher to review the original subject of a prior study or to try to address a new research question. The researcher might start collecting the data instead of spending time making the data suitable for analysis because the data from a secondary data collection is frequently already cleansed and kept in an electronic format.

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