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The impact of capital-structurechoice on firm performance:

empirical evidence from EgyptIbrahim 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 structurechoice on firm performance in Egypt as one of emerging or transition economies.

Design/methodology/approach Multiple regression analysis is used in the study in estimatingthe relationship between the leverage level and firms performance.

Findings Using three of accounting-based measures of financial performance (i.e. return on equity(ROE), return on assets (ROA), and gross profit margin), and based on a sample of non-financialEgyptian listed firms from 1997 to 2005 the results reveal that capital structure choice decision, ingeneral terms, has a weak-to-no impact on firms performance.

Originality/value This is the first study that examines the relationship between leverage level andfirm performance in Egypt.

Keywords Capital structure, Business performance, Accounting, Egypt

Paper type Research paper

1. Introduction

The theory of capital structure and its relationship with a firms value and performancehas been a puzzling issue in corporate finance and accounting literature since theseminal work of Modigliani and Miller (1958) (MM-1958). MM-1958 argue that undervery restrictive assumptions of perfect capital markets, investors homogenousexpectations, tax-free economy, and no transactions costs, capital structure is irrelevantin determining firm value. According to this proposition, a firms value is determinedby its real assets, not by the mix of securities it issues. If this proposition does not holdthen arbitrage mechanisms will take place, investor will buy the shares of theundervalued firm and sell the shares of the overvalued firm in such a way that identicalincome streams are obtained. As investors exploit these arbitrage opportunities, theprice of overvalued shares will fall and that of the undervalued shares will rise, untilboth prices are equal.

However, these restrictive assumptions do not hold in the real world, which ledmany researchers to introduce additional rationalization for this proposition and itsunderling assumptions showing that capital structure affects firms value andperformance, especially after the seminal paper of Jensen and Meckling (1976) whichdemonstrate that the amount of leverage in a firms capital structure affects the agencyconflicts between managers and shareholders by constraining or encouragingmanagers to act more in the interest of shareholders and, thus, can alter managersbehaviors and operating decisions, which means that the amount of leverage in capital

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Impact of capital-structure choice

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The Journal of Risk Finance

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pp. 477-487

q Emerald Group Publishing Limited

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DOI 10.1108/15265940911001385

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structure affects firm 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 capitalstructure influence on firm performance, several researchers have followed this

extension and conducted numerous studies that aim to examine the relationshipbetween financial leverage and firm performance over the last decades. However,empirical evidence regarding this relationship is contradictory and mixed. While apositive relationship between leverage level and firm performance had beendocumented in some of these studies (Taub, 1975; Roden and Lewellen, 1995;Champion, 1999; Ghosh et al., 2000; Hadlock and James, 2002). Other studies document anegative relationship between leverage level and firm performance (Fama and French,1998; Gleason et al., 2000; Simerly and Li, 2000).

While the literature examining the performance implications of capital structurechoices is immense in developed markets (e.g. USA and Europe), little is empiricallyknown about such implications in emerging or transition economies such Egypt. Insuch a country as Eldomiaty (2007) argued capital market is less efficient andincomplete and suffers from higher level of information asymmetry than capitalmarkets in developed countries. This environment of the market may cause financingdecisions 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 afirms performance in Egypt as an example of emerging economies.

The main aim of this paper is to empirically examine the relationship between debtlevel and financial performance of companies listed on Egyptian stock exchangeduring the period 1997-2005 using three of Accounting-based measures of firmperformance: return on assets (ROA), return on equity (ROE), and gross profit margin(GM). The paper documents several finding: first, there is a negatively significantinfluence of short-term debt (STD )and total debt (TTD) on financial performance

measured by ROA, but no significant relationship founded between long-term debt(LTD) and this measure of financial performance. Second, the study finds that there isno significant influence of debt (STD, LTD, and TTD) on financial performancemeasured by both of ROE and GM. These results may indicate, in general terms, thatcapital structure choice has a weak-to-no impact on firms performance in Egypt.

The remainder of this paper is organized as follows: the following section gives asummary review of the related literature. The next section describes the researchmethod. The subsequent section presents the analysis and results of empirical work.

2. Literature reviewKinsman and Newman (1999) state that examination of the relationship between capitalstructure choice (i.e. debt level) and firms performance is very important for many

reasons. Among these reasons: first, mean firm debt level have risen substantially overthe last periods, requiring an explanation of the impact of debt level on firmsperformance, so that appropriate debt level decisions can be made in a particular firm.Second, since managers and investors may have different emphases, the relativestrengths of any specific effects of debt on firms performance must be known. Final,and most important, reason for studying debt level and firms performance is to examinethe association between debt level and shareholders wealth, since shareholders wealthmaximization is a primary goal of firms managers.

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The capital structure of the firm could be explained, in general terms, by twodominant theories: the trade-off and pecking order theories. According to trade-offtheory, optimal capital structure could be determined by balancing the different benefitsand costs associated with debt financing. Debt benefits include tax shields (saving)

induced by the deductibility of interest expenses from pre-tax income of the firm(Modigliani and Miller, 1963), reduction of agency costs through the threat of liquidationwhich causes personal losses to managers of salaries, reputation, perquisites, andthrough the need to generate cash flow to pay interest payment (Grossman and Hart,1982; Williams, 1987). High leverage can also enhance the firms performance bymitigating conflicts between shareholders and managers concerning the free cash flow(Jensen, 1986), optimal investment strategy (Myers, 1977), the amount of risk to beundertake (Jensen and Meckling, 1976). On the other hand, debt costs include direct andindirect bankruptcy costs, debt financing brings with it commitment for future cashoutflows in terms of periodic interest and the principal borrowed, and thesecommitments increase the likelihood of firms financial default and bankruptcy.However, several studies suggest that bankruptcy costs do exist but they are reasonablysmall relative to tax saving associated with debt (Miller, 1977; Warner, 1977).Thus, according to trade-off theory more profitable firms have higher income to shieldand 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 firmsperformance (i.e. profitability). A number of studies provide empirical evidencesupporting this positive relationship between debt level and firms 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 informationasymmetry between managers and investors about the firms investment opportunities,

the market may undervalue a firms new shares relative to the value that would beassessed if managers information about their firms investment opportunities wererevealed to the market. Thus, issuing new shares may harm existing shareholdersthrough value transfer from old to new shareholders. So, managers will prefer financingnew investments by internal sources (i.e. retained earnings) first, if this source is notenough then managers seeks for external sources from debt as second and equity as last.Thus, according to the pecking order theory firms that are profitable and, therefore,generate high earnings to be retained are expected to use less debt in their capitalstructure than those do not generate high earnings, since they are able to finance theirinvestment opportunities with retained earning. Consequently, negative relationshipcould be expected between debt level and firms performance (i.e. profitability).A number of studies provide empirical evidence supporting this negative relationship

between debt level and firms performance or profitability (Kester, 1986; Friend andLang, 1988; Titman and Wessels, 1988;Rajan and Zingales, 1995;Wald, 1999; Booth etal.,2001; Fama and French, 2002).

Based on the above analysis, one may argue that firms financing decisionis influenced by many factors, and explaining that decision by one theory (trade-offor 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 notoffer a complete explanation of financial 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 empiricallytested the predictions of these theories (i.e. relationship between leverage and firmsprofitability). Jermias (2008) argue that prior studies have examined only the direct effect

of financial leverage on performance wheres this leverage-performance relationshipmay be contingent upon some factors such as competitive intensity and businessstrategy, he provides empirical evidence that the effect of leverage on performance ismore negative for firms attempting to be differentiators than those attempting to be costleaders, also competitive intensity negatively affects the leverage-performancerelationship.

From the cited empirical studies above, it is clear that most of the researchconcerning the relationship between capital structure and firms performance wasconducted in developed countries and markets. A few studies empirically examined thisrelationship in emerging (transition) economies. For instance, Majumdar and Chhibber(1999) examine the relationship between capital structure and performance of Indianfirms showing that debt level is negatively related with performance (i.e. return on networth). Chiang et al. (2002) examine the relationship between capital structure andperformance of firms in property and construction sector in Hong Kong showing thathigh gearing is negativity related with performance (i.e. profit margin). Abor (2005)investigates the relationship between capital structure and profitability of listed firms inGhana showing that STD and TTD are positively related with firms profitability (i.e.ROE), whereas LTD is negatively related with firms profitability (i.e. ROE).Kyereboah-Coleman (2007) examines the relationship between capital structure andperformance of microfinance institutions in sub-Saharan Africa showing that highleverage is positively related with performance (i.e. ROA and ROE). Zeitun and Tian(2007) examine the relationship between capital structure and performance of Jordanfirms showing that debt level is negatively related with performance (both the

accounting and market measures). Finally, Abor (2007) examines the relationshipbetween debt policy (capital structure) and performance of small and medium-sizedenterprises in Ghana and South Africa showing that capital structure, especiallylong-term and total debt level, is negatively related with performance (both theaccounting and market measures).

In summary, empirical studies regarding the relationship between capital structureand firms performance in developed countries provided mixed and contradictoryevidence, on the other hand there is a few studies empirically examine this relationshipin emerging (transition) economies. The present study extends the literature onthe impact of capital structure on firms performance by empirically examining therelationship between capital structure and firms performance in Egypt. In fact, Egypt isa unique case for tow reasons, first, although Egypt has transformed its economic

system into capitalism and open market, the managerial decision making may stillconstrained by old school of government support to economic entities which couldexplain the high level of financial leverage of Egyptian firms, especially, those firms thatbelonged 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 efficient and incomplete and suffers from higherlevel of information asymmetry than capital markets in developed countries. Also, thecapital market in Egypt is still to now an equity market, the debt market structure is still

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very immature. This environment of the market may cause financing decisions to beincomplete and subject to a considerable degree of irregularity. It is important, therefore,to explore the validity of debt financing firms performance relationship under theseunique economic settings.

3. Research method3.1 Sample and dataGiven the thinness of the Egyptian capital market, this study uses all publicly tradedfirms on Egyptian stock exchange during the period of 1997-2005. Misr InformationServices & Trading is a data base agency that keeps records of financial statementsand market data of all Egyptian firms that are listed on Egyptian stock exchange, andthat are subject to the regulations by the Capital Market Authority in Egypt. Listedfirms were then screened against several factors; financial services institutions (banksand insurance firms) were deleted from sample, and remaining firms were then testedfor availability of financial data during the test period (1997-2005). This screeningyielded a final sample of 64 firms. The firms included in the sample cover ten ofnon-financial industries. Table I provides the distribution of the sample by industry.

3.2 Variables measurement3.2.1 Performance. Literature uses a number of different measures of firmsperformance, these measures include accounting-based measures calculated fromfirms financial 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 (Zeitunand Tian, 2007), Both accounting-based and Tobins Qmeasures (e.g. Abor, 2007), andother measures such as profit efficiency, i.e. frontier efficiency computed using a profitfunction (Berger and Bonaccorsi di Patti, 2006). This study uses three of common

accounting-based performance measures to evaluate the firms performance, thesemeasures are: ROE) which computed as the ratio of net profit to average total equity,ROA which computed as the ratio of net profit to average total assets; and GM whichcomputed as the ratio of gross profit to sales.

3.2.2 Financial leverage. Similar to previous literature (Abor, 2005; Abor, 2007)financial leverage was measured in the study by three ratios:

Industry name Number of firms

Pharmaceutical 6Fertilizer and chemicals 10

Flour and mills 8Foods 7Construction and housing 8Cement and construction materials 12Manufacturing 4Ginning and textiles 4Transportation 2Communication 3Total 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 firms size may influence itsperformance, larger firms have a greater variety of capabilities and can enjoyeconomies of scale, which may influence the results and the inferences (Ramaswamy,2001; Frank and Goyal, 2003; Jermias, 2008). Therefore, this study controls thedifferences in firms operating environment by including the size variable in the model.Size is measured by the log of total assets of the firm and included in the model tocontrol for effects of firm size on dependent variable (i.e. performance).

3.3 ModelThe relationship between leverage and a firms performance was tested by thefollowing regression models:

PerformanceI; t b0 b1STDI; t b2log SI; t eiI; t 1

PerformanceI; t b0 b1LTDI; t b2log SI; t eiI; t 2

PerformanceI; t b0 b1TTDI; t b2log SI; t eiI; t 3

where:

STDI, t short-term debt to total assets for firm I in year t.

LTDI, t long-term debt to total assets for firm I in year t.

TTDI, t total debt to total assets for firm I in year t.

Log SI,t logarithm of total assets for firm I in year t.

eiI, t the error term.

4. Analysis and results4.1 Descriptive statisticsTable II presents a summary of descriptive statistics of the dependent and independentvariables used in the study. Descriptive statistics shown in Table II refer to twoimportant 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 thatEgyptian listed firms have relatively poor performance during the test period(1997-2005) with respect to ROA, ROE, and GM. This is may be because most of listedfirms in Egypt belonged to public sector before the mid-1990s and gone to private(fully or partially) through the privatization policy adopted by Egyptian governmentby the mid-1990s, so these firms may still suffer from some of the public sectorsproblems in Egypt such as increased amounts of obsolete fixed assets and inventoriesin their total assets, lack of managerial skills, excess number of employees, theseproblems may impact negatively on firms performance.

Second, as shown in Table II the mean (median) value of ratio of TTD to total assetsis 0.6022 (0.6026); this result suggests that about 60 percent of total assets of Egyptianlisted firms are financed by debt, this is consequently suggests that Egyptian listed

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firms operate with high level of financial leverage. The mean (median) of ratio of STDto 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 firms depend on STD forfinancing their operation more largely than LTD. The considerable dependence on

STD by Egyptian listed firms rather than LTD could be a result of the absence of anestablished public debt market, so the only long-term source of financing available toEgyptian listed firms is direct borrowing from banks, but this source is difficult toattained in light of very restrictive debt covenants faced by these firms.

4.2 Regression resultsTables III-V present the results of ordinary least squares regression used in testing therelationship between capital structure and firms performance. Table III presents theresults of testing the relationship between capital structure measured by ratio of STD tototal assets (Model 1), ratio of LTD to total assets (Model 2), ratio of TD to total assets(Model 3), and firms performance measured by ROA. As shown in this table, the resultsindicate a significant negative relationship between STD and ROA; the coefficient ofSTD in Model 1 is negative and statistically significant at level of confidence of 99percent, which suggests that an increase in STD associated with decrease in (ROA). Alsothe results indicate a significant negative relationship between TTD and ROA; thecoefficient of TTD in Model 3 is negative and statistically significant at level ofconfidence of 99 percent, which suggests that an increase in associated with decrease inROA. This may be due to considerable amount of in capital structure of Egyptian firmsis STD. On the other hand, as shown in Table III, LTD has no significant relationshipwith ROA; the coefficient of LTD in Model 2 is not statistically significant at level of

Variable Mean STD Minimum Median Maximum

ROA 0.0724 0.0746 20.2600 0.0762 0.2049ROE 0.2137 0.1441 20.0928 0.2117 0.8086GM 0.2449 0.1760 20.1111 0.2006 0.8532STD 0.4922 0.2224 0.0687 0.4764 1.7210LTD 0.1125 0.1378 0.0000 0.0456 0.4850TTD 0.6022 0.2233 0.1193 0.6026 1.7294Log S 2.70 0.66 1.65 2.55 5.23

Table II.Descriptive statistics

Performance (ROA)Variable Model 1 Model 2 Model 3

Constant 18.810 5.695 18.179STD 20.171 (0.000)LTD 20.136 (0.075)TTD 20.207 (0.000)Log S 21.174 (0.360) 1.142 (0.469) 0.572 (0.618)

R2 0.250 0.051 0.382F 10.191 1.648 18.829Sig. 0.000 0.201 0.000

Table III.Capital structure and

performance measuredby ROA


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confidence of 99 percent. Finally, the results show that firm performance (ROA) has alsono significant relationship with control variable (firm size).

Table IV presents the results of testing the relationship between capital structuremeasured 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 firms performance measured by ROE. Asshown in this table, the results indicate to neither STD, LTD, nor TTD has a significantrelationship with firms performance measured by ROE; the coefficient of STD in Model1, the coefficient of LTD in Model 2, and the coefficient of TTD in Model 3 are notstatistically significant at level of confidence of 99 percent. The results also indicate thatthe control variable (firm size) has no significant effect on firms performance.

As in Table IV, the results shown in Table V also indicate that neither STD, LTD,nor TTD has a significant relationship with firms performance measured by GM;the coefficient of STD in Model 1, the coefficient of LTD in Model 2, and the coefficientof TTD in Model 3 are not statistically significant at level of confidence of 99 percent.Again, the control variable (firm size) has no significant effect on firm performancemeasured by GM.

In summary, the results shown in Tables III-V indicate that capital structure choice,in general terms, has a weak-to-no significant impact on Egyptian listed firmsperformance. These results contradict with findings of previous literature either indeveloped or transition economies which document a significant impact of capitalstructure on firms performance either positively (Gosh et al., 2000; Abor, 2005;Kyereboah-Coleman, 2007) or negatively (Balakrishnan and Fox, 1993; Majumdar andChibber, 1999; Gleason et al., 2000; Zeitun and Tian, 2007; Abor, 2007).

Performance (ROE)Variable Model 1 Model 2 Model 3

Constant 12.349 20.051 18.710STD 0.171(0.039)LTD 20.264 (0.074)TTD 0.096 (0.244)Log S 0.216 (0.937) 1.590 (0.602) 21.167 (0.675)

R2 0.069 0.053 0.024F 2.265 1.702 0.739Sig. 0.112 0.191 0.482

Table IV.Capital structure andperformance measuredby ROE

Performance (GM)Variable Model 1 Model 2 Model 3

Constant 23.228 17.796 22.209STD 20.080 (0.435)LTD 20.010 (0.955)TTD 20.083 (0.410)Log S 1.932 (0.576) 2.524 (0.507) 2.706 (0.428)

R2 0.018 0.008 0.019F 0.567 0.257 0.603Sig. 0.570 0.774 0.550

Table V.Capital structure and firmperformance measuredby GM

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5. ConclusionsA vast literature investigates the implications of capital structure choice on firmsvalue and performance since the seminal work of Modigliani and Miller (1958). Most ofthese studies investigate these implications in the developed countries, very little is

empirically known about such implications in emerging or transition economies suchEgypt. The study investigates the impact of capital structure choice on performance oflisted firms in Egypt as one of emerging or transition economies. Based on a sample ofEgyptian listed firms and using three of accounting-based measures of financialperformance (ROA, ROE, and GM), the empirical tests indicate that capital structure(especially, STD and TTD) impacts negatively the firms performance measured byROA. On the other hand capital structure (STD, LTD, and TTD) has no significantimpact on firms performance measured by ROE or measured by GM. These resultslead the study to conclude that capital structure choice, in general terms, hasweak-to-no influence on the financial performance of listed firms in Egypt.

However, issues relating to capital structure still remain contentious and a puzzleespecially in emerging or transition markets such Egypt. Further research couldexamine the determinants of capital structure of Egyptian firms such as size, growth,business risk, etc. and compare results with those reached in developed markets.The relationship between financial leverage and Egyptian firms value also need to beempirically examined. The results of the study reveal that STD impacts negatively thefirm performance measured by ROA, so, further research could examine therelationship between maturity structure of the firms debt and its decisions andperformance. Finally, further research could examine the joint impact of both capitalstructure and ownership structure on firms performance since a large number ofEgyptian firms are family firms.

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Corresponding authorIbrahim El-Sayed Ebaid can be contacted at: [email protected]


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