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The impact of capital-structure choice on rm performance: empirical evidence from Egypt

Ibrahim El-Sayed Ebaid
Department of Accounting, Faculty of Commerce, Tanta University, Tanta, Egypt
Abstract
Purpose The purpose of this paper is to empirically investigate the impact of capital structure choice on rm performance in Egypt as one of emerging or transition economies. Design/methodology/approach Multiple regression analysis is used in the study in estimating the relationship between the leverage level and rms performance. Findings Using three of accounting-based measures of nancial performance (i.e. return on equity (ROE), return on assets (ROA), and gross prot margin), and based on a sample of non-nancial Egyptian listed rms from 1997 to 2005 the results reveal that capital structure choice decision, in general terms, has a weak-to-no impact on rms performance. Originality/value This is the rst study that examines the relationship between leverage level and rm performance in Egypt. Keywords Capital structure, Business performance, Accounting, Egypt Paper type Research paper

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1. Introduction The theory of capital structure and its relationship with a rms value and performance has been a puzzling issue in corporate nance and accounting literature since the seminal work of Modigliani and Miller (1958) (MM-1958). MM-1958 argue that under very restrictive assumptions of perfect capital markets, investors homogenous expectations, tax-free economy, and no transactions costs, capital structure is irrelevant in determining rm value. According to this proposition, a rms value is determined by its real assets, not by the mix of securities it issues. If this proposition does not hold then arbitrage mechanisms will take place, investor will buy the shares of the undervalued rm and sell the shares of the overvalued rm in such a way that identical income streams are obtained. As investors exploit these arbitrage opportunities, the price of overvalued shares will fall and that of the undervalued shares will rise, until both prices are equal. However, these restrictive assumptions do not hold in the real world, which led many researchers to introduce additional rationalization for this proposition and its underling assumptions showing that capital structure affects rms value and performance, especially after the seminal paper of Jensen and Meckling (1976) which demonstrate that the amount of leverage in a rms capital structure affects the agency conicts between managers and shareholders by constraining or encouraging managers to act more in the interest of shareholders and, thus, can alter managers behaviors and operating decisions, which means that the amount of leverage in capital

The Journal of Risk Finance Vol. 10 No. 5, 2009 pp. 477-487 q Emerald Group Publishing Limited 1526-5943 DOI 10.1108/15265940911001385

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structure affects rm performance (Harris and Raviv, 1991; Graham and Harvey, 2001; Brav et al., 2005, for overviews). Since, Jensen and Meckling (1976) argument regarding the possibility of capital structure inuence on rm performance, several researchers have followed this extension and conducted numerous studies that aim to examine the relationship between nancial leverage and rm performance over the last decades. However, empirical evidence regarding this relationship is contradictory and mixed. While a positive relationship between leverage level and rm performance had been documented in some of these studies (Taub, 1975; Roden and Lewellen, 1995; Champion, 1999; Ghosh et al., 2000; Hadlock and James, 2002). Other studies document a negative relationship between leverage level and rm performance (Fama and French, 1998; Gleason et al., 2000; Simerly and Li, 2000). While the literature examining the performance implications of capital structure choices is immense in developed markets (e.g. USA and Europe), little is empirically known about such implications in emerging or transition economies such Egypt. In such a country as Eldomiaty (2007) argued capital market is less efcient and incomplete and suffers from higher level of information asymmetry than capital markets in developed countries. This environment of the market may cause nancing decisions to be incomplete and subject to a considerable degree of irregularity. It is, therefore, necessary to examine the validity of corporate leverage levels impact on a rms performance in Egypt as an example of emerging economies. The main aim of this paper is to empirically examine the relationship between debt level and nancial performance of companies listed on Egyptian stock exchange during the period 1997-2005 using three of Accounting-based measures of rm performance: return on assets (ROA), return on equity (ROE), and gross prot margin (GM). The paper documents several nding: rst, there is a negatively signicant inuence of short-term debt (STD )and total debt (TTD) on nancial performance measured by ROA, but no signicant relationship founded between long-term debt (LTD) and this measure of nancial performance. Second, the study nds that there is no signicant inuence of debt (STD, LTD, and TTD) on nancial performance measured by both of ROE and GM. These results may indicate, in general terms, that capital structure choice has a weak-to-no impact on rms performance in Egypt. The remainder of this paper is organized as follows: the following section gives a summary review of the related literature. The next section describes the research method. The subsequent section presents the analysis and results of empirical work. 2. Literature review Kinsman and Newman (1999) state that examination of the relationship between capital structure choice (i.e. debt level) and rms performance is very important for many reasons. Among these reasons: rst, mean rm debt level have risen substantially over the last periods, requiring an explanation of the impact of debt level on rms performance, so that appropriate debt level decisions can be made in a particular rm. Second, since managers and investors may have different emphases, the relative strengths of any specic effects of debt on rms performance must be known. Final, and most important, reason for studying debt level and rms performance is to examine the association between debt level and shareholders wealth, since shareholders wealth maximization is a primary goal of rms managers.

The capital structure of the rm could be explained, in general terms, by two dominant theories: the trade-off and pecking order theories. According to trade-off theory, optimal capital structure could be determined by balancing the different benets and costs associated with debt nancing. Debt benets include tax shields (saving) induced by the deductibility of interest expenses from pre-tax income of the rm (Modigliani and Miller, 1963), reduction of agency costs through the threat of liquidation which causes personal losses to managers of salaries, reputation, perquisites, and through the need to generate cash ow to pay interest payment (Grossman and Hart, 1982; Williams, 1987). High leverage can also enhance the rms performance by mitigating conicts between shareholders and managers concerning the free cash ow (Jensen, 1986), optimal investment strategy (Myers, 1977), the amount of risk to be undertake (Jensen and Meckling, 1976). On the other hand, debt costs include direct and indirect bankruptcy costs, debt nancing brings with it commitment for future cash outows in terms of periodic interest and the principal borrowed, and these commitments increase the likelihood of rms nancial default and bankruptcy. However, several studies suggest that bankruptcy costs do exist but they are reasonably small relative to tax saving associated with debt (Miller, 1977; Warner, 1977). Thus, according to trade-off theory more protable rms have higher income to shield and thus should borrow more to take tax advantages (i.e. operate with higher leverage). Consequently, a positive relationship could be expected between debt level and rms performance (i.e. protability). A number of studies provide empirical evidence supporting this positive relationship between debt level and rms performance (Taub, 1975; Roden and Lewellen, 1995; Champion, 1999; Ghosh et al., 2000; Hadlock and James, 2002; Berger and Bonaccorsi di Patti, 2006). The second theory of capital structure is pecking order theory developed by Myers (1984) and Myers and Majluf (1984). This theory points out that because of information asymmetry between managers and investors about the rms investment opportunities, the market may undervalue a rms new shares relative to the value that would be assessed if managers information about their rms investment opportunities were revealed to the market. Thus, issuing new shares may harm existing shareholders through value transfer from old to new shareholders. So, managers will prefer nancing new investments by internal sources (i.e. retained earnings) rst, if this source is not enough then managers seeks for external sources from debt as second and equity as last. Thus, according to the pecking order theory rms that are protable and, therefore, generate high earnings to be retained are expected to use less debt in their capital structure than those do not generate high earnings, since they are able to nance their investment opportunities with retained earning. Consequently, negative relationship could be expected between debt level and rms performance (i.e. protability). A number of studies provide empirical evidence supporting this negative relationship between debt level and rms performance or protability (Kester, 1986; Friend and Lang, 1988; Titman and Wessels, 1988; Rajan and Zingales, 1995; Wald, 1999; Booth et al., 2001; Fama and French, 2002). Based on the above analysis, one may argue that rms nancing decision is inuenced by many factors, and explaining that decision by one theory (trade-off or pecking order) may be short of providing a complete diagnosis of that decision. In fact, each capital structure theory works under its own assumptions and so does not offer a complete explanation of nancial decisions. This means that searching for

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an optimal capital structure is not one-way to go (Myers, 2001; Eldomiaty, 2007). This could explain the mixed and contradictory results of the studies that empirically tested the predictions of these theories (i.e. relationship between leverage and rms protability). Jermias (2008) argue that prior studies have examined only the direct effect of nancial leverage on performance wheres this leverage-performance relationship may be contingent upon some factors such as competitive intensity and business strategy, he provides empirical evidence that the effect of leverage on performance is more negative for rms attempting to be differentiators than those attempting to be cost leaders, also competitive intensity negatively affects the leverage-performance relationship. From the cited empirical studies above, it is clear that most of the research concerning the relationship between capital structure and rms performance was conducted in developed countries and markets. A few studies empirically examined this relationship in emerging (transition) economies. For instance, Majumdar and Chhibber (1999) examine the relationship between capital structure and performance of Indian rms showing that debt level is negatively related with performance (i.e. return on net worth). Chiang et al. (2002) examine the relationship between capital structure and performance of rms in property and construction sector in Hong Kong showing that high gearing is negativity related with performance (i.e. prot margin). Abor (2005) investigates the relationship between capital structure and protability of listed rms in Ghana showing that STD and TTD are positively related with rms protability (i.e. ROE), whereas LTD is negatively related with rms protability (i.e. ROE). Kyereboah-Coleman (2007) examines the relationship between capital structure and performance of micronance institutions in sub-Saharan Africa showing that high leverage is positively related with performance (i.e. ROA and ROE). Zeitun and Tian (2007) examine the relationship between capital structure and performance of Jordan rms showing that debt level is negatively related with performance (both the accounting and market measures). Finally, Abor (2007) examines the relationship between debt policy (capital structure) and performance of small and medium-sized enterprises in Ghana and South Africa showing that capital structure, especially long-term and total debt level, is negatively related with performance (both the accounting and market measures). In summary, empirical studies regarding the relationship between capital structure and rms performance in developed countries provided mixed and contradictory evidence, on the other hand there is a few studies empirically examine this relationship in emerging (transition) economies. The present study extends the literature on the impact of capital structure on rms performance by empirically examining the relationship between capital structure and rms performance in Egypt. In fact, Egypt is a unique case for tow reasons, rst, although Egypt has transformed its economic system into capitalism and open market, the managerial decision making may still constrained by old school of government support to economic entities which could explain the high level of nancial leverage of Egyptian rms, especially, those rms that belonged to public sector before the mid-1990s and gone to private (fully or partially) through the privatization policy adopted by Egyptian government by the mid-1990s, Second, capital market in Egypt is less efcient and incomplete and suffers from higher level of information asymmetry than capital markets in developed countries. Also, the capital market in Egypt is still to now an equity market, the debt market structure is still

very immature. This environment of the market may cause nancing decisions to be incomplete and subject to a considerable degree of irregularity. It is important, therefore, to explore the validity of debt nancing rms performance relationship under these unique economic settings. 3. Research method 3.1 Sample and data Given the thinness of the Egyptian capital market, this study uses all publicly traded rms on Egyptian stock exchange during the period of 1997-2005. Misr Information Services & Trading is a data base agency that keeps records of nancial statements and market data of all Egyptian rms that are listed on Egyptian stock exchange, and that are subject to the regulations by the Capital Market Authority in Egypt. Listed rms were then screened against several factors; nancial services institutions (banks and insurance rms) were deleted from sample, and remaining rms were then tested for availability of nancial data during the test period (1997-2005). This screening yielded a nal sample of 64 rms. The rms included in the sample cover ten of non-nancial industries. Table I provides the distribution of the sample by industry. 3.2 Variables measurement 3.2.1 Performance. Literature uses a number of different measures of rms performance, these measures include accounting-based measures calculated from rms nancial statements such as ROE, ROA, and GM (e.g. Majumdar and Chhibber, 1999; Abor, 2005) market based measures such as stock returns and volatility (Welch, 2004), Tobins Q measure which mixes market values with accounting values (Zeitun and Tian, 2007), Both accounting-based and Tobins Q measures (e.g. Abor, 2007), and other measures such as prot efciency, i.e. frontier efciency computed using a prot function (Berger and Bonaccorsi di Patti, 2006). This study uses three of common accounting-based performance measures to evaluate the rms performance, these measures are: ROE) which computed as the ratio of net prot to average total equity, ROA which computed as the ratio of net prot to average total assets; and GM which computed as the ratio of gross prot to sales. 3.2.2 Financial leverage. Similar to previous literature (Abor, 2005; Abor, 2007) nancial leverage was measured in the study by three ratios:

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Industry name Pharmaceutical Fertilizer and chemicals Flour and mills Foods Construction and housing Cement and construction materials Manufacturing Ginning and textiles Transportation Communication Total

Number of rms 6 10 8 7 8 12 4 4 2 3 64

Table I. Industry distribution of the sample

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(1) STD to total assets; (2) LTD to total assets; and (3) TTD to total assets. 3.2.3 Control variable. Prior research suggest that rms size may inuence its performance, larger rms have a greater variety of capabilities and can enjoy economies of scale, which may inuence the results and the inferences (Ramaswamy, 2001; Frank and Goyal, 2003; Jermias, 2008). Therefore, this study controls the differences in rms operating environment by including the size variable in the model. Size is measured by the log of total assets of the rm and included in the model to control for effects of rm size on dependent variable (i.e. performance). 3.3 Model The relationship between leverage and a rms performance was tested by the following regression models: PerformanceI ; t b0 b1 STDI ; t b2 log S I ; t eiI ; t PerformanceI ; t b0 b1 LTDI ; t b2 log S I ; t eiI ; t PerformanceI ; t b0 b1 TTDI ; t b2 log S I ; t eiI ; t where: STDI, t LTDI, t short-term debt to total assets for rm I in year t. long-term debt to total assets for rm I in year t. 1 2 3

482

TTDI, t total debt to total assets for rm I in year t. Log SI, t logarithm of total assets for rm I in year t. eiI, t the error term.

4. Analysis and results 4.1 Descriptive statistics Table II presents a summary of descriptive statistics of the dependent and independent variables used in the study. Descriptive statistics shown in Table II refer to two important indicators. First, the mean (median) of ROA, ROE, and GM are 0.0724 (0.0762), 0.2137 (0.2117), and 0.2449 (0.2006), respectively. These results suggest that Egyptian listed rms have relatively poor performance during the test period (1997-2005) with respect to ROA, ROE, and GM. This is may be because most of listed rms in Egypt belonged to public sector before the mid-1990s and gone to private (fully or partially) through the privatization policy adopted by Egyptian government by the mid-1990s, so these rms may still suffer from some of the public sectors problems in Egypt such as increased amounts of obsolete xed assets and inventories in their total assets, lack of managerial skills, excess number of employees, these problems may impact negatively on rms performance. Second, as shown in Table II the mean (median) value of ratio of TTD to total assets is 0.6022 (0.6026); this result suggests that about 60 percent of total assets of Egyptian listed rms are nanced by debt, this is consequently suggests that Egyptian listed

rms operate with high level of nancial leverage. The mean (median) of ratio of STD to total assets and ratio of LTD to total assets are 0.4922 (0.4764) and 0.1125 (0.0456), respectively; these results suggest that Egyptian listed rms depend on STD for nancing their operation more largely than LTD. The considerable dependence on STD by Egyptian listed rms rather than LTD could be a result of the absence of an established public debt market, so the only long-term source of nancing available to Egyptian listed rms is direct borrowing from banks, but this source is difcult to attained in light of very restrictive debt covenants faced by these rms. 4.2 Regression results Tables III-V present the results of ordinary least squares regression used in testing the relationship between capital structure and rms performance. Table III presents the results of testing the relationship between capital structure measured by ratio of STD to total assets (Model 1), ratio of LTD to total assets (Model 2), ratio of TD to total assets (Model 3), and rms performance measured by ROA. As shown in this table, the results indicate a signicant negative relationship between STD and ROA; the coefcient of STD in Model 1 is negative and statistically signicant at level of condence of 99 percent, which suggests that an increase in STD associated with decrease in (ROA). Also the results indicate a signicant negative relationship between TTD and ROA; the coefcient of TTD in Model 3 is negative and statistically signicant at level of condence of 99 percent, which suggests that an increase in associated with decrease in ROA. This may be due to considerable amount of in capital structure of Egyptian rms is STD. On the other hand, as shown in Table III, LTD has no signicant relationship with ROA; the coefcient of LTD in Model 2 is not statistically signicant at level of
Variable ROA ROE GM STD LTD TTD Log S Mean 0.0724 0.2137 0.2449 0.4922 0.1125 0.6022 2.70 STD 0.0746 0.1441 0.1760 0.2224 0.1378 0.2233 0.66 Minimum 2 0.2600 2 0.0928 2 0.1111 0.0687 0.0000 0.1193 1.65 Median 0.0762 0.2117 0.2006 0.4764 0.0456 0.6026 2.55 Maximum 0.2049 0.8086 0.8532 1.7210 0.4850 1.7294 5.23

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Table II. Descriptive statistics

Variable Constant STD LTD TTD Log S R2 F Sig.

Model 1 18.810 2 0.171 (0.000) 2 1.174 (0.360) 0.250 10.191 0.000

Performance (ROA) Model 2 5.695 2 0.136 (0.075) 1.142 (0.469) 0.051 1.648 0.201

Model 3 18.179 2 0.207 (0.000) 0.572 (0.618) 0.382 18.829 0.000

Table III. Capital structure and performance measured by ROA

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condence of 99 percent. Finally, the results show that rm performance (ROA) has also no signicant relationship with control variable (rm size). Table IV presents the results of testing the relationship between capital structure measured by ratio of STD to total assets (Model 1), ratio of LTD to total assets (Model 2), ratio of total debt to total assets (Model 3), and rms performance measured by ROE. As shown in this table, the results indicate to neither STD, LTD, nor TTD has a signicant relationship with rms performance measured by ROE; the coefcient of STD in Model 1, the coefcient of LTD in Model 2, and the coefcient of TTD in Model 3 are not statistically signicant at level of condence of 99 percent. The results also indicate that the control variable (rm size) has no signicant effect on rms performance. As in Table IV, the results shown in Table V also indicate that neither STD, LTD, nor TTD has a signicant relationship with rms performance measured by GM; the coefcient of STD in Model 1, the coefcient of LTD in Model 2, and the coefcient of TTD in Model 3 are not statistically signicant at level of condence of 99 percent. Again, the control variable (rm size) has no signicant effect on rm performance measured by GM. In summary, the results shown in Tables III-V indicate that capital structure choice, in general terms, has a weak-to-no signicant impact on Egyptian listed rms performance. These results contradict with ndings of previous literature either in developed or transition economies which document a signicant impact of capital structure on rms performance either positively (Gosh et al., 2000; Abor, 2005; Kyereboah-Coleman, 2007) or negatively (Balakrishnan and Fox, 1993; Majumdar and Chibber, 1999; Gleason et al., 2000; Zeitun and Tian, 2007; Abor, 2007).
Performance (ROE) Model 2 20.051 2 0.264 (0.074) 0.216 (0.937) 0.069 2.265 0.112 1.590 (0.602) 0.053 1.702 0.191 0.096 (0.244) 2 1.167 (0.675) 0.024 0.739 0.482

Variable Constant STD LTD TTD Log S R2 F Sig.

Model 1 12.349 0.171(0.039)

Model 3 18.710

Table IV. Capital structure and performance measured by ROE

Variable Constant STD LTD TTD Log S R2 F Sig.

Model 1 23.228 2 0.080 (0.435) 1.932 (0.576) 0.018 0.567 0.570

Performance (GM) Model 2 17.796 2 0.010 (0.955) 2.524 (0.507) 0.008 0.257 0.774

Model 3 22.209 2 0.083 (0.410) 2.706 (0.428) 0.019 0.603 0.550

Table V. Capital structure and rm performance measured by GM

5. Conclusions A vast literature investigates the implications of capital structure choice on rms value and performance since the seminal work of Modigliani and Miller (1958). Most of these studies investigate these implications in the developed countries, very little is empirically known about such implications in emerging or transition economies such Egypt. The study investigates the impact of capital structure choice on performance of listed rms in Egypt as one of emerging or transition economies. Based on a sample of Egyptian listed rms and using three of accounting-based measures of nancial performance (ROA, ROE, and GM), the empirical tests indicate that capital structure (especially, STD and TTD) impacts negatively the rms performance measured by ROA. On the other hand capital structure (STD, LTD, and TTD) has no signicant impact on rms performance measured by ROE or measured by GM. These results lead the study to conclude that capital structure choice, in general terms, has weak-to-no inuence on the nancial performance of listed rms in Egypt. However, issues relating to capital structure still remain contentious and a puzzle especially in emerging or transition markets such Egypt. Further research could examine the determinants of capital structure of Egyptian rms such as size, growth, business risk, etc. and compare results with those reached in developed markets. The relationship between nancial leverage and Egyptian rms value also need to be empirically examined. The results of the study reveal that STD impacts negatively the rm performance measured by ROA, so, further research could examine the relationship between maturity structure of the rms debt and its decisions and performance. Finally, further research could examine the joint impact of both capital structure and ownership structure on rms performance since a large number of Egyptian rms are family rms.
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