Profitability of
Zero Leverage and Leveraged Companies
1.0 Introduction
This research is doing
on the profitability of zero leverage and leverage companies in the cement
industry in Pakistan. Leverage means borrowing money (Loan) from financial
institute / banks for the purpose of investing in the firm .There are two terms
zero leverage and leveraged. Zero leverage is that “the company is totally
based on equity finance” In other words zero leverage is the low leverage as
compare the others. The leverage means that the company capital structure is
based on the debt or long term debt and equity. It may be 20% equity and 80%
long term debt in the cement industry
these companies are based on the leveraged. The Lucky Cement Pakistan Ltd,
Attock Cement Pakistan Ltd and Dewan Cement Pakistan are the highly leveraged
companies in the Pakistan and few cement industries are zero leverage or low
leverage industries in Pakistan. As that the profitability of leverage
companies is less than the profitability of the zero or low leverage companies.
These Cement Company have long term debt. The long term debt is most important
part of the balance sheet; the companies are borrowing from the banks and paid
the interest on that debt to the bank. The companies borrowing for the
purchasing of Asset, the assets are more important for the every company .The
assets of Cement Company are very costly for that cement companies always
borrowing long term debt from the bank.
The profitability of zero leverage companies
is more than the leveraged companies but the zero leverage companies paid the
tax more than the leveraged companies. The leveraged companies paid
the
interest on debt or Loan after the EBIT (Earning Before Interest and Tax ) or
Operating income. After that the company paid the tax on the amount, which is EBT
(Earning before Tax) this amount is lowest because the company paid there huge
interest to the bank .it means company save their tax. In Pakistan the ratio
leveraged companies is more than the zero leverage. Cement companies takes loan
from bank for the continuously paid the interest on the loan.
In cement industry
there are many companies are highly leveraged but lowest (zero) leverage
companies are few. The followings are the highly leveraged cement companies in
Pakistan.
·
Lucky Cement ltd
·
Dewan Cement Ltd
·
D. G Khan Cement Ltd
The followings are zero
leveraged (Lowest) leveraged companies in Pakistan.
- Attock Cement ltd
- Best Way Cement Ltd
- Kohat Cement Ltd.
The above companies are listed in the KSE (Karachi
Stock Exchange) the zero leverage companies are totally equity financed based.
1.1
Theoretical Back ground
In finance,
capital structure refers to the way a corporation
finances its assets
through some combination of equity, debt, or securities. A firm's capital structure is then
the composition or 'structure' of its liabilities. The Modigliani-Miller theorem, proposed by Franco
Modigliani and Merton Miller, forms the basis for modern
thinking on capital structure, though it is generally viewed as a purely
theoretical result since it regards many important factors in the capital
structure decision. The theorem states that, in a perfect market, how a firm is
financed is irrelevant to its value. This result provides the base with which
to examine real world reasons why capital structure is relevant, that is, a
company's value is affected by the capital structure it employs. Some other
reasons include bankruptcy costs, agency costs,
taxes,
and information asymmetry. This analysis can
then be extended to look at whether there is in fact an optimal capital
structure: the one which maximizes the value of the firm In the capital
Structure theory of Miller Modigliani (1977) is that the company profitability
is depend upon the capital structure of the company the some company used the
long term debt and few companies are used low (zero) debt.
1.2 Problem Definition The
main problem of this research report is that the profitability of firm and its
capital structure. The capital structure should be debt based or equity based,
but the main focus on the profitability of the firm, and capital Structure. The
capital Structure may be 100% debt or 100% equity. Some companies take only 60%
debt and 40% equity. Some companies use the leverage or some avoid the
leveraged. Either Leveraged reduced the profitability of the companies,
Leveraged means borrowing from bank for capital use and paid the interest to
the bank. In the cement industry of Pakistan some companies have a leveraged
and some have zero leverage (Low leverage).. Although different capital
structure theories are based on different assumptions and hence different
predictions, in the presence of market frictions they all point to a
relationship between leverage and firm value. Most important, the relationship
between firm value and leverage is influenced by the benefits of financial
leverage due to the tax deductibility of interest expenses and a variety of
conflicts of interests between shareholders, bondholders and managers .In this
research the most important
variable will profitability of firm
which show that the firm total earning in the year .
1.3
Scope of Research
This research project
is conduct on the Cement Industry it is very useful for the cement companies,
this research is doing on the capital structure of company and its
profitability , in this project I am going to find out the company capital
structure which may be debt or totally
equity finance it depend upon the company . This Research will done on the
cement companies as Attock Cement Company, Lucky Cement Company, Dewan Cement
Company and etc .This research is very important for the cement companies,
which used leveraged and zero leverage company, Because the nowadays in
Pakistan it most important part of every company is financing, it means company
capital structure which is done on the totally equity finance based or debt
based. From this research the cement companies can get more knowledge, as for
that they used leveraged or zero leverage. And also can assume that the company
profitability will increase or reduced, if company use the leverage and zero leverage.
Basically the main purpose of this research
project is that find out the relationship between zero leverage and leverage of
the cement companies, and also find out the relationship between interest and profitability.
In this research I want to find out the main impact of capital structure on
Profitability of Company In Cement Company’s
proportion of short and long-term debt is considered when analyzing capital
structure. When people refer to capital structure they are most likely
referring to a firm's debt-to-equity ratio, which provides insight into how
risky a company is. Usually a company more heavily
financed by debt poses greater risk, as this firm is relatively highly
levered.
1.4
Limitations
The
possible limitations are:
·
Data which will be collected based on
the annual or financial reports of the companies.
·
The focus is only on the financial
statements of Cement Companies.
·
The model testing is based on the
historical data.
·
Only 5-6 years data will be collected
for testing a theory.
·
The time duration for making this thesis
is limited.
·
At least 4 Companies Data should be use
1.5 Variables
The
followings are the main variables of the research project.
Variables Nature
V1 Profitability
V2 Long
Term Debt
V3 EBIT
(Earning Before Interest & Tax)
V4 Finance
Cost (Interest)
V5 Debt
Tax Shield
V6 EPS
(Earning per Share)
V1= Profitability of
the Company: This variable used for
the profitability of company, In Zero leverage and Leverage Company’s
profitability shows by the V1. Profitability is Return on Assets (ROA) and
Return on Equity (ROE). This variable is used on both company Zero leverage and
Leveraged. This is very important Variables in this research and main variable
of research. V2= Long term Debt: This variable used for the long term
financing which take from bank / financial Institute for particular period for
that we used V2. This variable only used for the leveraged firm.
V3=EBIT (Earning Before
Interest & Tax): This Variable is used for operating income on
this variable the leveraged Company paid the interest to the bank than paid the
Tax. This variable used for the both companies Leveraged and Zero Leverage.
V4= Finance Cost
(Interest): This variable is used for the Interest
which paid by the leverage firm on the EBIT (Operating Income). Interest paid
only by the Leverage Company because the leverage companies take a long term
loan from bank/ Financial Institute.
V5= Debt Tax Shield: Debt Tax Shield means companies save the tax
due to the debt because the company paid the interest, this variable shows that
the company how much % company save their tax and paid interest to bank. This
variable only us for the leverage company.
V6= EPS (Earning per
Share) this variable show that earning of the
company on the per share this variables will be used as net income and total
outstanding shares. This variable also used on the leveraged and zero leverage.
1.6 Method for Solving
In
this Research I will use the Regression Method
for the solving problem and find out the relation between the profitability
and leveraged. The zero leverage and
leveraged companies data use in this research report the last 5 years data will
be use, in cement Industry there are few companies which are zero leverage (lowest
leverage) and leveraged.
1.7 Regression Method Justification
The
regression model is most important in this research because the variables are
depended and independent as the profitability is depended variable and other
are independent for that I choose this model for research. The result of this
research will get from use of this model it is perfect for the result finding.
This method will show the profitability and other variables as long term Debt,
EBIT (Earning Before interest & Tax), EPS (Earning per Share) and Debt Tax
Shield.
2.0
Literature Review
In
this literature review I am giving here some research which also done in the
past years related with the zero leverage and leverage firms followings are the
studies which are done by the researcher, The capital structure of cement
companies are mostly based on leverage the are the few cement companies which
are lowest debt based .
These studies help me in this research
This research which is
done on the Zero leverage (ZL) and ultra level leverage or lowest leverage
firms this study done in the U.K firms .In this research the researcher observe
that the firms complete their capital structure i.e. firm go for debt the main
point of this research is the zero leverage. This study done on the U.K firms
which were using very lowest level of Leverage. Researcher got result that the
20% firm have zero leverage and 35 % firms have low leverage 45% firms have
zero debt totally equity based firms .The researcher used these variables growth,
investment, size of the firm, cash flow, debt, dividend, and tax .the
researcher used the linear regression and get result that the firms which have
zero debts those firms continuously exist in the market a long period and those
firms which used long term debt they paid low tax and get more profit, the
researcher used the few theories in this study i.e. Miller and Modigliani,
Trade off Theory and Agency theory .The researcher used more than 900 firms
data collected .There is mixed evidence on the financial flexibility hypothesis
that firms choose to have low leverage to stockpile debt capacity that is used
to fund large capital expenditures in the future. Researcher shown that firms
no debt does build up cash reserves and financial slack. However, the decision
to raise more debt is not driven by an increasing future investment spending as
predicted by the financial flexibility hypothesis, but rather by dynamic
trade-off models. Zero-leverage and ultra-low leverage firms Undertake
adjustment and revert back to a less conservative debt policy when they become
sufficiently under-leveraged. (Dang, 2006)
The research which is
the Mystery of Zero Leverage firm, the research don on the U.S. Large public
companies which follow the zero leverage the data used on the period of 1963 to
2003. Using the COMPSTAT data and find out the result which is that more than 60%
companies using the zero leverage and 15% firms are used the low leverage. The researcher also compares the leverage
ratios between companies. Particularly surprising evidence is the presences of
a large number of zero leverage firm who pay to dividend, and some companies
pay higher taxes and higher cash flows, in this research he used the few
variables as quasi market leverage ratio, book leverage. Consumer price index,
long size, and EBIT (Earning before Interest and Tax), market book value ratio,
and some other variables he also found the relationship between the variables.
The researcher used the t test to find out the relationship between zero
leverage or leverage companies that zero leverage firms saved their tax shield.
the 27 companies used the zero leverage another result is that the dividend
payers and zero dividend, also find the size of leverage and zero leverage and
the main result of the research is that the performance of firms and zero leverage.
The researcher finds out the equity issue and he used the liner regression. (Yang,
2005).
This research done on
the zero leverage and leveraged firm profitability and impact of leverage
on the profitability of default the
result on the financial distress, firms save there taxes benefit. Researcher also find that the stronger
leverage effect on ratings is less evident firms are engaged in hedging
activities and when firms are financially constrained. On the other hand, the
impact of leverage on ratings is even stronger when firms are less likely to
hedge and when firms are financially unconstrained. Researcher used the data of
1983-11997. Researcher find out that
leverage negatively affects debt ratings up to three times more than it use the
stronger impact of leverage on ratings to translate an increase in the use of
debt into a rating downgrade, and then into an increase in default
probabilities. This increase in the firm’s probability of default is multiplied
by the ex-post financial distress .The Researcher used the variables as
profitability, zero leverage (ZL), Leveraged. (Malina, 2002).
The
leverage and growth are two terms but in this research the researcher used the
variables leverage, Growth and they applied the method of Regression and find
out the link between leverage and growth of firms in the period 1993–2005. We
find that the negative relationship of leverage on growth reduced significantly
during this period. And also examine the relationship between leverage and
growth in focused and diversified firms, we find that the negative coefficient
on book leverage in the case of focused segment firms is twice as large as
compared to diversified. (Bill Francis, Ifthakhar Hassan, 2001)
The
financial constrains and international zero- leverage Phenomenon by Wolfgang,
This research is done on the international level of zero leverage phenomenons,
the researcher use the few variables and used the Descript statistics. In this
Research the research examines very surprising questions is that the why the
firms used the debt policy and they choice to the zero leverage for the firm.
Researcher examines the zero-leverage phenomenon using a comprehensive sample of
firms from the G7 countries. In fact, extreme debt conservatism is a
cross-country observation that has strongly increased during our sample period.
While only about 5% of all firms in our sample followed a zero-leverage policy
in 1988, this fraction increased to roughly 15% by 2008. However, firms adopt a
zero-leverage policy over a medium period of time. Only 20% of the firms did
not switch to a less conservative debt policy after five years. (Drobetz,
2011).
The
research which is don on the impact on the leverage on the firm investment
decisions which shows that the company decision making is depend upon the firms
leverage if the firm increase the profitability that needs the high level of
leverage . In this research the variables are used the cash flow, profitability
(ROA) Sales, Liquidity. The researcher used estimate a reduced form of
investment equation to examine the effect of leverage on investment the
specification is similar to AivazianGe and Qiu (2005). The researcher get the
result is that the present result for the small size, medium size and larger
sized firm is classified based on the size. The smaller size is obtained by
subtracting mean from standard deviation of total asset and larger size is
obtained by adding mean value of asset to standard deviation. The median sized
firms are those firms which are not belong to both categories of the firm. The
econometric result for the sample firms is showed the pooled estimates; random
effect estimates and fixed effect estimates on the T values are shown in the
parenthesis. Two statistics are used in order to identify, which methodology is
appropriate to establish the relationship between leverage and investment.
First we compare the pooled estimates and random effect estimate (John, 2010)
The
liquidity and leverage are more important for every organization .In this
research the researcher used the main two industry. One is commercial banks and
second is non financial firm. Researcher used the variables total investment of
firm, total assets of firm (Securities). He takes the data from balance sheet
of two industries. Finally he got the result that Aggregate liquidity can be
understood as the rate of growth of the aggregate financial sector balance
sheet. When asset prices increase, financial intermediaries’ balance sheets
generally become stronger, and–without adjusting asset holdings–their leverage
tends to be too low. The financial intermediaries then hold surplus capital,
and they will attempt to find ways in which their surplus capital. In analogy
with manufacturing firms, we may see the financial system as having “surplus
capacity”. For such surplus capacity to be utilized, the intermediaries must
expand their balance sheets. On the liability side, they take on more
short-term debt. On the asset side, they search for potential borrowers. Aggregate
liquidity is intimately tied to how hard the financial intermediaries search
for borrowers. In the sub-prime mortgage market in the United States researcher
have seen that when balance sheets are expanding fast enough, even borrowers that
do not have the means to repay are granted credit so intense is the urge to
surplus capital. The seeds of the subsequent downturn in the credit cycle are
thus sown. (Adrian, 2004)
There
are many benefits of the leverage as the company save their tax this research
don on the benefits of the leverage the researcher focus on the firms tax which is very
important for the leveraged companies In this research the variables are
capital of company and borrow the loan (debt ) ratio and the capital zero leveraged companies The finally the result of the leverage
benefits is that The net benefits to debt financing are identified from the
market values and betas of corporate debt and equity. Two assumptions are
necessary: (i) Firms within an industry have the same (unlevered) asset beta,
and (ii) the ex-ante net benefits to leverage are a function of observable
variables. Net benefits are increasing in leverage for low debt firms but
decrease as leverage becomes very high, implying the existence of an optimal
capital structure. For the median Firm in the sample, net benefits can be as
high as 5.5% of firms value. Unlike the cross-sectional regressions used in
prior research, the results on optimal capital structure in this paper are not
accepected by firm deviating from their optimal capital structure. Contrary to
prior empirical evidence but consistent with theoretical predictions, that
optimal leverage is increasing in profitability and decreasing in company size.
An important feature is that it does not require Firm to be optimally levered,
not even on average. (Arthur, 2007)
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