LITERTUREREVIEW The studyshows effectiveness of financial leverage on capital structure and onperformance of firms.
The finance management get or gather the funds veryhardly. Therefore, the maximum benefit which is obtained by using of thesefunds is also very difficult for financial mangers. Generally, some financemanagers get benefit from the use of financial resources, while some cannot getoptimal benefits from utilization of financial resources. The corporateperformance provides sources of investment which is based on financial debt andstockholder equity. The short- term and long-term benefits are obtained throughthe design of capital structure (Horne, 2002).
The Leverage can be explained asthe use of borrowed money to make an investment and return on that investment. Afirm which has a high ratio of financial leverage it is uncertain for theperformance of firm. The financial leverage can be defined as the ratio oftotal debts to total assets. In other words it is the residual claim of financers.However, the financial leverage may be a healthy indicator in terms ofidentifying the performance firms in near future. There are many variables in acapital structure that’s used to measure the performance of firms and periodsof debt maturity will also be affected performance of firms. Debt maturity willinfluence a company’s decision in investing activities. Furthermore, financialleverage will also affect company’s performance through tax rate.
In the caseof examine the impact of financial leverage base on company’s performance willpresent prove for a company’s performance due to the effect of capitalstructure. Akhtar, etAl. had investigated the impact of financial leverage on shareholders return.In their paper Relationship between Financial leverage and FinancialPerformance: Evidence from Fuel & Energy Sector of Pakistan, they verifiedthat financial leverage has got a positive relationship with financialperformance (2012).
Therefore, the companies in the fuel and energy sector mayenhance their financial performance and can play their role for the growth ofthe shareholder wealth while improving at their optimal capital structures. In their research they used a sample of20 listed firms from Fuel and Energy industry which are listed at Karachi StockExchange (KSE) Pakistan. The objective of this study to explained the relationshipbetween financial leverage and the financial performance. To test thehypothesis, the main variables used in the study consist of a dependentvariable which is used as performance of firms and an independent variablefinancial leverage in fuel and energy sectorThe relationshipbetween financial leverage and firm performance in the construction and developmentcompanies of Hong Kong is examined by Hung et.
Al (2002). The result shows thatcapital structure is significantly positively related with assets and negativelyassociated with income. The financial decisionaffected the financial performance firms. A study had been done by Abor (2005) on theinfluence of financial leverage on profitability of listed companies on theGhana Stock Exchange for a five-year period. He found out that there issignificant positively interrelated between SDA and ROE and shows that firmswhich get a lot use more short-term debt to finance their business. In otherwords, short-term debt is an important source of financing in favor of Ghanaiancompanies, by representing short term debts as 85 percent of total debtfinancing.
However, the results showed the negative relation between LDA andROE. The regression result showed that there is positive relationship betweenDA and ROE which measure the relationship between total debt andprofitability,. This indicates that firms which earn a lot are depending ondebt as their key financing decision. Obradovichand Gill (2013), had researched on the Impact of Financial Leverage on theValue of American Firms. For this purpose they take the data as a sample of 333 firms listed on New York StockExchange (NYSE) for a period of 3 years from 2009-2011 was selected. Theco-relational and non experimental research design was used to conduct thisstudy by taking firm value as independent variable and CEO Duality, Board Size andFinancial Leverage as dependent variable. The purpose of this study was to findthe impact of financial leverage on corporate governance and on the value ofAmerican firms. Overall results show that larger board size negatively impactsthe value of American firms and CEO duality, financial leverage, firm size,return on assets and insider holdings positively impact the value of AmericanfirmsFirms to be diversified is more, as they can getfunds from the capital market easily, may benefit from the higher creditratings for issue of debt in the capital structure and lower cost offinance on financial leverage.
It showsthat financial leverage may increase the profit after tax due to lower interestrates and in the end the higher financial performance and due to that resultsfinancial debts affected the EPS positively. The dividend policy which maychange the performance of firms, If the additional profits as the result oflower cost of finance and tax shields are retained for the company’s growth, itmay affected the company’s value in long term and may lead towards the achievedthe purpose of wealth maximization for which the real investor invest. The researchers investigated the relationship ofcapital structure and firm performance in financial markets of Japan. Theyfound that the performance of the firm improve monotonically when mangers’ownership has increased. They also found a important positive relationshipbetween firm value and ownership of block shareholders.
However, Domsetz andVillalonga (2001) suggested that there is no systematic relationship betweenfirm performance and capital structure to be expected. They have treatedownership as endogenous variable. They have found that ownership structure isinsignificant in explaining the firm performance.In Pakistani financial market, Hasan and Butt(2009) examined the impact of ownership structure and corporate governance oncapital structure of Pakistani listed companies covering the period of (2002,2005) for 58 non financial firms listed at Karachi Stock Exchange.
They foundthat board size and managerial shareholding have a significant negativecorrelation with financial leverage to equity ratio. Their results also showedthat the corporate financing behavior has no significant effect of the presenceof non-executive directors on board and chair duality. They recommended thatcorporate governance factors such as ownership structure, size of the board ofdirectors and managerial shareholding are important in determining the capitalstructure of the firms. In this study we consider thepeculiarity between the long-term regular impact and short-term, more immediateeffects of using leverage in private equity real estate investment funds. Wespecifically draw on the argument, put forward in the corporate finance literaturethat financing decisions are informed by the state of the market, allowing amanager to issue debt when the economic environment is most favorablerecommended by Baker and Wurgler (2002). However, not only does a firm’s level of leverageaffect corporate performance and failure but also its debt repayment structure.Schiantarelli and Sembenelli investigated the effects of firms’ debt maturity structure onprofitability for Italy and the United Kingdom (1999). They proved a positiverelationship between initial debt maturity and average performance.
A study byBarclay and Smith provides empiricalevidence that large firms and firms with low growth rates prefer to issuelong-term debt. Another study by Stohs and Mauer found that larger and lessrisky firms usually make greater use of long-term debt (1996). They also foundthat debt repayment period is negatively affected to company tax, the firm’srisk and net income.
In other words, the selection of debt structure could havea effect on both corporate performance and failure risk. Furthermore, there areother factors, besides capital structure, that may influence firm performancesuch as firm, age, growth, firm size, risk, rate of taxation, factors specificto the sector of financial activity, and factors specific to macroeconomicenvironment of the country. These variables will be measured in this stud Performanceof firms based on Effectiveness on financial or operational activities. Profitmaximization, wealth maximization of shareholder, and maximizing return onassets are examples of financial effectiveness measures. Increase in sales,growth in the value of market share, and sales per employee are examples ofoperational effectiveness actions.
Kotha and Nair (1995) found that theusefulness of a measure of effectiveness may be impacted by the objectives of aparticular national culture. For example, U.S.
firms generally focus onfinancial measures of effectiveness, while, in general, Japanese firms focus onoperational measures. For these reasons, any cross cultural study shouldconsider both financial and operational measures of performance. Therefore indifferent cultures, in different industries, the standard to measure theperformance of firms are dependent on the adverse factors of capital structure. Mohammad Fawzi Shubita, the authors given a result of a strong negativerelationship of financial leverage and profitability of firms by analyzing adata of 39 Industrial Jordanian companies. Based on the result, it was statedthat performance of companies tend to depend more on equity financing ratherthan debt financing, thus these companies should look for an optimal structureof capital to gain more quality of profitability (2012). The concept of performance is a controversialproblem in finance mostly due to its different dimensional meanings.
Research on firm performance emanatesfrom organization theory and planned management (Murphy et al., 1996).Performance measures are also financial or organizational. Financialperformance such as profit maximization, maximizing return on assets, andmaximizing stockholders’ wealth are at the core of the firm’s effectiveness(Chakravarthy, 1986).
Operational performance measures, such as increase insales and growth in market price of share. The effectiveness of a measure ofperformance may be affected by the objective of a firm that could affect itschoice of performance measure and the development of the stock and capitalmarket. Performance of firms based on the performance of stock market if thestock market is not highly developed and active then the market performanceresults will not provide a good result. The most commonly used variables tomeasure the performance of firms are return on assets (ROA) and return onequity (ROE) or return on investment (ROI). These accounting measures representingthe financial ratios from balance sheet and income statements have been used bymany researchers ( Gorton and Rosen, 1995, Mehran, 1995, and Ang, Cole andLine, 2000, Demsetz and Lehn, 1985). However,there are other procedures of performance called market performance measures,such as market value of equity to bookvalue of equity (MBVR), price per share to the earnings per share (P/E) (AbdelShahid, 2003), and Tobin Q.
Tobin’s Q mixes market value with accounting valueand is used to measure the firm’s value in many studies ( McConnel and Serveas,1990, and Zhou, 2001). The performance measure ROA is commonly regarded as themost useful measure to exanimate firm performance. Return on assets ROA andReturn on equity ROE, two accounting measures are used as proxy measures forcorporate performance, and three market performance measures, P/E, MBVR. Thestock market efficiency and other economic and political factors could affect afirm’s performance and its reliability ( Abdel Shahid, 2003).