Procesos Cognitivos en la Escritura Dramática

Modigliani and Miller (1958) believed that the value of a firm is determined by its real assets and not by the amount of debt and equity available as part of its capital structure. Many studies have been undertaken to examine the determinants of capital structure and the choice between equity and debt financial instruments. However, the question remains whether the choice between debt and equity has any effect on a firm’s performance. Studies of the determinants of capital structure mix have provided some evidence that

Business Environment  Labour market  Capital market  Product market - Suppliers - Customers - Competitors

 Business regulations Business Activities  Operating activities  Investment activities  Financing activities Business Strategy  Scope of business - Degree of diversification - Type of diversification  Competitive positioning - Cost leadership - Differentiation  Key success factors and

risks Accounting System  Measure and report economic consequences of business activities Financial Statements

 Managers’ superior information on business activities

 Estimation errors

 Distortions from managers’ accounting choices

Accounting Strategy

 Choice of accounting policies  Choice of accounting

estimates

 Choice of reporting format  Choice of supplementary

disclosures Accounting Environment

 Capital market structure  Contracting and governance  Accounting conventions and

regulations

 Tax and financial accounting linkages

 Third-party auditing  Legal system for accounting

could be used as an indicator of the relationship between capital structure mix and firm performance. This section will highlight studies that have examined the effect of debt and equity choice on the financial performance and profitability of a company.

Since Modigliani and Miller’s (1958) landmark paper, the cost of capital, corporate finance, the theory of investment, and the theory of capital structure and its effect on firm value and financial performance have remained confusing issues (Ebaid 2009). Some theories consider the roles of managers to maximise a firm’s value and subsequently shareholders’ benefits. This is central to a firm’s effectiveness (Chakravarthy 1986). The importance of shareholders emerges from the degree to which they form the capital structure of the firm issuing the shares. However, debt holders can also influence a firm’s value, depending on debt benefits. In this study, capital structure refers to the way that firms finance their activities by using a mix of debt and equity.

The trade-off theory suggests that there is an optimal capital mix that can help maximise a firm’s market value by considering both the costs of bankruptcy and the tax-shield advantage of debt capital (Adeyem & Oboh 2011). This theory predicts a positive relationship between a firm’s choice of capital structure and its market value. According to Miller (1977), by using debt, tax savings appear large and certain while the bankruptcy cost appears negligible, thus implying that many firms are more highly leveraged than they actually are. Myers (1984) argued that if this theory was valid, then tax indicators should provide an important hint about the optimum capital structure decision that should increase the value of the firm.

According to Adeyem and Oboh (2011), the static-order hypothesis also suggests that more profitable firms carry more debt in order to be able to get tax deduction over their profit. However, Myers (1984), Titman and Wessels (1988) and Fama and French (2002) criticised this suggestion. For example, Myers (1984) suggested that managers will issue equity if they notice that the company price is increased in the equity market, which in this case will increase equity over debt. The trade-off theory suggests that larger and more mature firms, which are expected to have a high equity price, use more debt than equity in their capital structure.

Reducing agency costs is one of the issues associated with high leverage levels. Jensen and Meckling (1976) and Jensen (1986) argued that high leverage can help a firm’s performance by reducing conflicts among shareholders and managers concerning FCF. Jensen (1986) stated that firms with high FCF and low growth opportunities are expected to have high debt levels. He further argued that firm managers tend to use internal funds (FCF) to avoid shareholder control. However, shareholders tend to avoid this by reducing cash flow by raising debt.

Since Jensen and Meckling (1976) and Jensen (1986) argued that capital structure influences firm performance, several researchers have conducted studies to examine the relationship between financial leverage and firm performance. In India, a study by Majumdar and Chhibber (1999) found a negative relationship between capital structure (debt level) and firm performance. Likewise, Chiang, Chang and Hui (2002) found a negative relationship between high leverage (high gearing) and firm performance, such as profit margin, in the Hong Kong property and construction sectors. Abor (2005) found a positive relationship between short-term debt and total-term debt and firm profitability in Ghana; however, he also found that long-term debt was negatively related to firm profitability. Korteweg (2004) found a negative relationship between leverage and returns. He tested MM Proposition II, which states that firms can benefit from tax shields when using debt because using more debt will reduce the tax that needs to be paid. In their study about the relationship between capital structure and firm performance, Bistrova, Lace and Peleckiene (2011) found evidence that supports the pecking order theory. Their study showed a negative relationship between the level of debt and capital profitability. Hence, firms should avoid using external funds if they can use internal funds.

There have been a few studies examining the relationship between leverage levels and the financial performance of firms in the Middle East, particularly in Saudi Arabia. The studies that have been undertaken offer mixed results about the relationship between leverage levels and financial indicators. For example, Abdullah and Elsiddiq (2002) concluded that the total debt ratio is negatively related to profitability, liquidity and growth opportunity in Saudi Arabian firms. AL-Sakran (2001) found a negative relationship between the total debt ratio and growth opportunities, as well as profit margin and ROA.

Al-Dohaiman (2008) conducted a study about the determinants of capital structure of Saudi Arabian listed and unlisted companies. The main objective of this study was to extend prior research by investigating both listed and unlisted companies in Saudi Arabia, where many cultural and institutional features can affect financing decisions in a different manner to those in developed countries. The results showed that companies in Saudi Arabia generally have substantially lower levels of debt and lower agency cost levels. He argued that this finding was related to the low tax regime and other environmental characteristics. He found that the unlisted firms had more short-term debt and less long- term debt than the listed firms, as has been found in other countries.

Some studies have considered debt and equity as tools to reduce FCF problems (Harris & Raviv 1991; Jensen 1986). Firms’ managers can use FCF to finance projects with negative NPV and to expand a firm beyond its optimal size (Jensen 1986). Using higher debt levels can reduce the ability of managers to use FCF. Managers of Saudi Arabian firms have more power than do shareholders. This leads to the assumption that equities are the first and best choice for Saudi Arabia’s firms, with debt considered the last choice.

Ebaid (2009) concluded that leverage levels have a negligible effect on firm performance. Zeitun and Tian (2007) concluded that a firm’s capital structure has a significantly negative effect on performance measures. However, they also found that a firm’s short-term debt to total assets level has a significantly positive effect on the market performance measure (Tobin’s q)5_{. Moreover, in his study of the relationship between debt maturity and specific}

characteristics of firms, Abdullah (2005) found no statistically significant evidence for the relationship between debt and profitability. However, he found that total debt is negatively and significantly related to liquidity and asset structure. By examining these studies, it can be concluded that a negative relationship exists between the level of leverage and financial performance of firms in Saudi Arabia.

Leverage has significant information content that can be used to explain stock returns, which can be used to explain a firm’s performance. Artikis and Nifora’s (2012) study found evidence of the effects of capital structure (leverage) on stock return. They found that

5_{Tobin’s q is a performance measurement developed by Tobin (1969). It is the ratio between the}

market value and replacement value of the same physical asset.

leverage and value risk factors have a negative and statistically significant relationship with equity returns. Thus, in order to obtain high ROE, leverage needs to be decreased. Using more equity in the capital structure mix can increase the potential equity return, which has a positive effect on firms’ profitability and performance. This finding aligned with other studies’ findings, such as those by Arditti (1967); Fama and French (1992, 1996, 1999, 2002); Dimitrov and Jain (2008); George and Hwang (2010); Penman, Richardson and Tuna (2007) and Garlappi and Yan (2011). Together, these findings offer an indication of the effect of leverage levels on firm performance.