Project Proposal

on

An Investigation on Determinants of Capital Structure and its Impact on Firm Value: A

Comparative Study on Selected Firms of Textile and Engineering Industry

Project Code:

Submitted To:

The Director

SUST Research Centre

Shahjalal University of Science and Technology

Submitted By:

(Dr. Syed Mohammad Khaled Rahman)

Associate Professor
Department of Business Administration

and

Shahjalal University of Science and Technology Sylhet.

1. Project title:

An Investigation on Determinants of Capital Structure and its Impact on Firm Value: A

Comparative Study on Selected Firms of Textile and Engineering Industry

2. Type of research: Empirical

3. Field of research: Business

4. Background of the study and Statement of the problem:

Optimal capital structure and its role in maximizing firm value has been an issue of debate in
the field of corporate finance for several decades now. Several attempts were made to reduce
the gap and create a bridge between the academic study and the practical arena. For example,
in 1958, Modigliani and Miller showed that the value of a firm does not depend on the capital
structure in a perfect capital market. However, in 1963, they addressed taxes to their theory
and argued that a 100% debt financing would maximize the firm value. After the irrelevance
theory of capital structure by Modigliani and Miller (1958), much of the research were
focused to test the implications of the three major theories of capital structure: the trade-off
theory, where firms follow a capital structure that balances the costs and the benefits of debt
capital; the agency-costs theory, in which firms add the agency costs to the costs of debt
while comparing with the benefits; the pecking-order theory, where firms follow a financing
hierarchy considering the adverse costs related to various financing options. However, other
researches were conducted to specify the determinants of capital structure of a firm. But most
of these researches were dominated by dataset from developed countries. And prior empirical
works provide abundant evidence that capital structure choices are influenced by firm-
specific as well as country-specific factors (Rajan and Zingales, 1995; La Porta et al., 1998;
Claessens et al., 2001; Booth et al., 2001; Fan et al., 2013). Therefore, developing countries
such as Bangladesh require additional attention in this field. Nevertheless, Haque (1989),
Chowdhury (2004) made the initial attempt from Bangladesh to add to the capital structure
debate and after a few more attempts (Sayeed, 2011; Siddiqui, 2012; Hossain and Ali, 2012),
a lot of questions still remain unanswered.

The global financial crisis that has hit the world economy during year 2007-08 has
brought the most significant economic recession. Many giant corporations went bankrupt
during this period and a significant reason behind the bankruptcy was excessive use of debt
capital or borrowing. According to Allen (1983), two important questions related to financial
decision regarding maximization of owners’ wealth is –how should the company finance its
investment and how should the company distribute its revenue. Gitman (2007) stated that the
amount of debt capital in a firm’s capital structure affect return and risk which ultimately
changes firm value. Often the decision regarding financial leverage or capital structure is a
formidable task due to its short and long term impact on profitability, financial risk and value.
The difficulty is compounded as there are both benefits and drawbacks of having more debt
or equity capital. Every company is supposed to maintain their optimum capital structure
although its measurement is very difficult. Ross, Westerfield and Jaffe (2005) stated, “As
financial distress costs cannot be expressed in a precise way, no formula has yet been
developed to determine a firm’s optimal debt level exactly.” Value of company maximizes at
optimum capital structure. To gain advantages of tax shield and higher earnings per share
(hereafter EPS) many companies raise too much debt capital, which is detrimental to their
good performance and survival. Excessive use of debt capital leads to financial distress and
excessive use of equity capital leads to poor financial performance and low company value.

There have always been controversies among finance scholars when it comes to the
subject of capital structure. So far, researchers have not yet reached a consensus on the
optimal capital structure of firms by simultaneously dealing with the agency problem. Allen
(1983), stated that no definite conclusion can be reached about the existence and nature of an
optimum capital structure. He considers capital structure as a ‘slippery’ concept with a
number of possible definitions and measures. According to him, financial markets are
imperfect and the exact status of company financial decisions in imperfect markets are
inconclusive due to formidable difficulties in statistical and economic work in this area.
Capital structure is very important decision for firms so that they can maximize returns to
their various stakeholders. Moreover, an appropriate capital structure is also important for
firms as it will help in dealing with the competitive environment within which the firm
operates. Trade off theory argues that an optimal capital structure exists when the risk of
going bankrupt is offset by the tax savings of debt. Once this optimal capital structure is
established, a firm would be able to maximize returns to its stakeholders and these returns
would be higher than returns obtained by a firm whose capital is made up of equity only (all
equity firm). On the other hand, pecking order theory states that a firm should use internal
financing rather than external financing. It ignores target capital structure, which contradicts
with tradeoff theory. It can be argued that leverage is used to discipline mangers but it can
lead to the demise of the firm.
5. Rationale of the study:

i) Relationship of the objectives to existing relevant knowledge on the research field:

Modigliani and Miller (1958) (MM) were among the firsts to examine the relationship of
capital structure with firm value. They addressed certain conditions of perfect capital markets
(zero transactions and bankruptcy costs, zero tax, risk-free interest rate, information
symmetry etc.), and stated that capital structure decisions do not affect firm value. However,
a few years later, MM (1963) proposed another theory where they considered taxes and
admitted that capital structure has impact on firm value. As firms enjoy tax benefit on interest
payments, MM (1963) argued that a 100% debt financing would be the optimal capital
structure. Even though both the theories proposed by MM (1958) (1963) were found
questionable by various researchers because of their impracticability in real business territory,
they provided the basis for further research in this area.

Kraus and Litzenberger (1973) proposed another theory where they considered the
trade-off between tax benefits and bankruptcy costs. They demonstrated that a firm has to
choose between higher after-tax operating income deriving from tax benefits, and costs of
bankruptcy deriving from failure to meet fixed payments to debt holders. However, the
optimal capital structure was still an issue of debate. Additionally, failure of firms had always
invited the attention of researchers to consider other qualitative factors such as agency costs,
asymmetric information etc. In 1976, Jensen and Meckling advanced the agency costs theory
in which they established the costs of conflicts between shareholders and bondholders, and
between managers and shareholders. They showed agency costs as a determinant of capital
structure, which were supported by Stulz (1990), Harris and Raviv (1991). Pecking order
theory, originally proposed by Donaldson (1961), was developed by Myers and Majluf
(1984), where it has been showed that firm managers consider a financing hierarchy based on
priorities. First, they consider retained earnings for new investments, then go for debt and
finally, equity as the last option. They showed the relationship between firm value and capital
structure is concerned with asymmetric information between investors and firm managers.
Issuance of new securities may mean revaluing the firm, and as managers know more about
the firm’s value than the outside investors, they prefer not to issue equity when their firms
can be undervalued. However, asymmetric information issue gets resolved when a firm
doesn’t issue any new securities and relies only on internal funds (retained earnings) (Myers
and Majluf, 1984).
 Several other researches were conducted to analyze various determinants of capital
structure. Ross (1977) showed a positive relation between profitability and firm leverage, and
argued that, for investor, higher leverage signals a more stable income, high future cash
inflows and confidence of firm managers about their firms’ performance. This theory is
known as the signaling theory. Titman and Wessels (1988) found transaction costs as an
important determinant of capital structure. They also found negative relation between
uniqueness of a firm and debt level. Rajan and Zingales (1995), analyzing US companies
found size, growth, profitability and tangible assets as important determinants of capital
structure. Champion (1999), Hadlock and James (2002) also found that firms with high
profitability uses high level of leverage. However, according to Bevan and Danbolt (2000), in
contrast to smaller companies, larger UK companies with high opportunities of growth used
less debt. In India, Kakani and Reddy (1998) found firm size as insignificant but capital
intensity and profitability as significant and negatively related to capital structure. In contrast
to Titman and Wessels (1988), uniqueness of the firms was found significant determinant
factor of firms’ total and short-term debt. In other researches, size, profitability, growth,
tangibility were found as important determinants of capital structure by Pandey (2001),
Huang and Song (2002), Shah and Hijazi (2004).

Bangladeshi researchers also have contribution to this literature. Chowdhury (2004)

did a cross-sectional analysis between Bangladeshi and Japanese firms and found
profitability, growth, agency cost of debt, operational leverage and bankruptcy risk to be
important determinant factors to both countries firms. Additionally, size, growth rate,
tangibility, operating leverage were also found to determine capital structure of Bangladeshi
firms (Sayeed, 2011; Siddiqui, 2012; Hossain and Ali, 2012). In other recent researches on
Bangladeshi firms, Hossain and Hossain (2015) found managerial ownership to be positively
related to leverage ratios but profitability, growth rate, non-debt tax shields, free cash flow to
firm, debt-service coverage ratio, financial costs, agency costs and dividend payment to be
negatively related to leverage ratios.

In our study, we hypothesize that Bangladesh, having limited access to external

financing because of its developing nature, may display a diverse capital structure. Therefore,
this study attempts to add to the previous literatures by analyzing the determinants of capital
structure and the impact of those determinants on firm value, taking leverage ratio as
mediating variable. Furthermore, we compare the results between two industries –
engineering and textile of the Dhaka Stock Exchange.
ii. Significance of the proposed study:

Capital structure is one of the most important decisions of a firm. Failure to make an efficient
decision may lead to a financial distress. Moreover, an optimal capital structure is supposed
to cost a firm the least. So, the farther a firm is from its optimal capital structure, the more
costly it gets for the firm to finance an investment. Additionally, a firm enjoys tax benefits
from debt financing which is, however, limited by the bankruptcy costs that come alongside
those benefits. Therefore, a firm has to maintain a perfect balance between its debt and equity
capital. The financial structure of a firm is very important since it is related to the ability of
the firm to meet the needs of its stakeholders. Funding decisions should be carried out
effectively and efficiently to improve shareholders’ or owners’ welfare. Shareholders’
welfare is shown from increasing firm value or share price or return, as a reflection of
funding decisions. High firm value indicates owner high level welfare.

Capital structure or financial leverage decisions are of the strategic importance to the
organizations. The foremost objective of the organizations is stockholders' wealth
maximization, which translates into maximizing the price of the firm’s common stock.
Financial structure decisions have direct impact on firm value and return to stockholders.
Management appointed by the board of directors-representatives of the stockholders, is
supposed to operate in the best interests of the stockholders. Due to great deal of autonomy,
managers of large organizations may pursue goals other than stock price maximization.
Appropriate decision about leverage can mitigate this problem. Financial structure control all
the subsequent decisions of the management and these decisions affect firm-value or stock
prices through the mechanisms, like the change in level of leverage, change in financial risk
of the firm, change in return on common stocks and change in flexibility for subsequent
financial decisions as well as decisions related to operations and other functional areas.

All financial functions can be broadly categorized into two classes; raising funds and
investing funds. Utilization of different sources for raising funds determines financial
structure, which represents certain level of leverage that devises financial risk of the firm and
cost of the raised capital. On the other hand, decisions relate to investment of funds involves
application of specialized techniques of capital budgeting. Viability of the available
opportunities and resulted returns largely depends upon the financial structure and cost of
capital to the firm, which is one basic determinant of price of common stocks.
 Financial structure is one of the most complex areas of financial decision making
because of its interrelationship with other financial decision variables. According to Gitman
(2007), poor capital structure decisions can result in a high cost of capital, thereby lowering
the Net Present Values of projects and making more of them unacceptable. Effective capital
structure decisions can lower the cost of capital, resulting in higher NPVs and more
acceptable projects- and thereby increasing the value of the firm. If the return on investments
remains equal, a rise in the cost of capital will cause a decrease in the company’s profitability
and in shareholders’ wealth. The financial manager has to take into consideration the effect
on the financial structure when any financing decision is evaluated. Once a financial need
arises from the planning activity, the financial manager should simulate what impact a debt or
equity issue may have on the overall company. This activity enables the financial manager to
quantify the effects of financing alternatives in terms of the firm’s cost of capital and
financial riskiness. It is very essential for finance professionals to know about the nitty-gritty
of capital structure they have suggested to the management. Accurate analysis of capital
structure can help a company to save cost of capital and hence to improve profitability for the
shareholders.

iii. Research gap / Motivation:

Bangladesh has a very little contribution to the literature of capital structure. Majority of the
prior empirical works mainly focused on developed countries. Nevertheless, several
researches were conducted in Bangladesh. But most of them attempted to explain the
relationship between capital structure and firm value or firm performance (Amin and Jamil,
2015; Siddik, Kabiraj and Joghee, 2017). However, determinants of capital structure were
also examined by a few researchers. But older panel data were used in most of these previous
studies. Additionally, Impact of capital structure determinants on firm value is not explored
much on Bangladeshi context. Nevertheless, cross sectional analysis of capital structure was
conducted between banking and non-banking financial institutions in Bangladesh by Akter,
Parvin and Easmin (2015). However, other diversified industries seek attention in exploring
and contrasting between those. Henceforth, this study attempts to analyze capital structure
determinants and impact of those industry specific determinants on firm value, taking
leverage ratio as mediating variable. Moreover, the results of the study are compared for
engineering and textile industry in Bangladesh.
6. Objective of the study:

The main objective of the study is to explore the determinants of capital structure and its
impact on the value of sample firms. The specific objectives are:
i. To find out the significant determinants of the capital structure of textile and
engineering industry in Bangladesh
ii. To analyze the effect of the financial leverage on firm value of both textile and
engineering industry
iii. To compare and contrast the results between the textile and engineering industry in
Bangladesh

7. Methodology:
7.1 Data and sample:
This empirical study will be conducted with a quantitative research approach. Annual data for
the period of 2003-2017 (15 years) of 50 firms listed under engineering and textile industry in
the Dhaka Stock Exchange (DSE) will be gathered. For the purpose of the study, we
eliminated firms whose accounting and financial data are not available for the study period.
Proportionality is also maintained between engineering and textile industry while choosing
sample firms. We used simple random sampling technique through random number table to
select the sample firms. Eventually, the final sample of our study consists of 750 number of
firm-year observations. Table 1 shows a summary of the population and sample of this study.

Table 1: Population and sample size

Engineering Industry Textile Industry Total

No. of listed firms 36 53 89
No. of selected firms 20 30 50
No. of years studied 15 15 15
No. of observations 300 450 750

7.2 Variables description:

Explanatory variables of the study were selected based on variant theories of capital structure
and prior empirical works. We used profitability, firm growth, assets tangibility and firm size
as independent variables of the study. And capital structure is used as the mediating variable,
while firm value is considered as the dependent variables of the study. Furthermore, both
book value and market value of the firms are used as measures of firm value. The proxies for
the variables used in this study were identified from prior works (Chen and Chen, 2011;
Hossain and Hossain, 2015). The measurements of the variables are presented in Table 2.
Table 2: Measurements of the variables

Variable Variable Measurements

Indicators Name (Proxies)
PROF Profitability EBIT / Total Assets
GROW Sales Growth Sales – Salest-1 / Salest-1
TANG Assets Tangibility Fixed Assets / Total Assets
SIZE Firm Size Log(Assets)
DEBT Debt Ratio Total Debt / Total assets
BVAL Book Value per Share (Total assets – Total debt) / No. of Shares
MVAL Market Value Market price of per share at the end of
year

7.3 Data analysis procedure/ Statistical tools:

Descriptive statistics and correlation matrix will be used to study the relationship among the
variables. We used the “t” test to test the hypotheses. SPSS-20 version, Gretl and MS-Excel
will be used for the analysis.

8. Expected Outcome:

After completion of the study, the researcher expected that-

(i) There are significant differences in capital structure of textile and engineering industry

(ii) Operating and financial performances are significant determinant of capital structure

(iii) Debt-equity ratio depends on some firm specific factors

(iv) There would be significant relationship between financial leverage and firm value

(v) There are significant differences in average firm value of textile and engineering industry

(vi) Some policy suggestions will come forth for improvement of firm value in Bangladesh.
9. Work Plan of the Project:

Activities 1 2 3 4 5 6 7 8 9 10 11 12

Review books, journals, laws

and regulations
Development of sustainable
guideline
Collection of annual reports
of sampled companies
Data input from the annual
reports as per guideline
Analysis and interpretation of
data
Report writing and
submission

10. Budget:
Summery Budget

SL Expenditure Heads Amount in (Tk.)

1. Honorarium of Principal Investigator(PI) and co Investigator (C.I) 87,500
2. Allowances for Research Student (Tk. 400 per day per student but 68,000
not more than 30% of the total budget)
3. Travel Expenditure for the field work (Data collection) and 1,00,000
purchase of reports
4. Stationeries (Not more than 10% of the total budget) 35,000
5. Report preparation 21,000
6. Publication cost 8,500
7. Miscellaneous (Consultancy and other cost) 30,000
6. Total (Tk. Three Lac Fifty thousand only) 3,50,000
 Detailed Budget

Sl. Item of Expenditure Unit Quantity Cost Total

No per unit (in Tk.)
(In Tk.)
1 a. Honorarium of Principal PR 15% 52,500 52,500
Investigator of Co Investigator
b. Honorarium PR 10% 35,000 35,000
2 Allowances for research students for M/day 170 400 68000
data gathering and input
3 a. Travel Expenditure for the field Round 4 8000 32,000
work trip
b. Purchase of Reports PC 150 400 60000
c. Allowance for data analysis with M/month 2 4000 8,000
STATA and SPSS
4 a. Stationeries LS LS 15000 15000
b. Purchase of books LS LS 20000 20000
5 Report Printing and binding LS LS 21000 21000
6 Publication cost LS LS 8,500 8,500
7 Miscellaneous
a. Consultancy 20000 20000
b. Other cost 10000 10000
Total (Tk. Three Lac fifty thousand only) 3,50,000

PR: Percentage; LS: lump sum; M/day= Man day; PC= Per copy; M/month= Monthly per
man

11. List of Existing Research Facilities in the Department:

(i) Some books are available. (ii) Statistical software is available;

(iii) Research assistants are available;

12. Name of current research projects under by Principal and Co-Investigator:

Project name: An Investigation on Profitability and Efficiency of Leasing Companies-A

Study on Selected Firms through Data Envelopment Analysis

Project ID: BUS/2018/1/02

Project period: 2018-19

Funding authority: University

Amount: 1,26,000 BDT

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Signature of principal investigator, co-investigator

Principal Investigator Co-investigator

(Dr. Syed Mohammad Khaled Rahman) (Dr. Fazle Elahi Md. Faisal)
Associate Professor Associate Professor
Department of Business Administration Department of Business Administration