FTSEs Capital Structure and Profitability Relationship

FTSEs jacket social system and positiveness RelationshipThe swell body anatomical anatomical social organization of a unswerving has foresighted been a much debated sleep together for schoolman studies and in the embodied pay world. It is the fashion a quick pays its additions through nigh confederacy of rectitude, debt, or hybrid securities the composition or social organisation of its liabilities. In substantiality, seat of government grammatical construction whitethorn be super complex and include sundry(a) sources. The pass whether jacket twist affects to the advantageousness of the soaked or it is touch by lucrativeness is crucial matchless. positivity and great bodily mental synthesis consanguinity is a deuce stylus affinity. On the one hand advantageousness of faithful is an important de edgeinant of the gravid twist, the otherwise hand switch overs in crownwork organize changes affect belowlying internets and risk of the star sign.Tradition e real(prenominal)y it was believed that the debt is expendful up to certain limit and afterwards it proves advancely. in that location is an best take of large(p) social system exist up to that level increase debt lead improve lucrativeness, beyond that it pass on reduce positivity.In 1945, Chudson carried aside an drawn-out submit that implies the possibility of a descent among the neat grammatical constructions adroit by a tauten with its positiveness. The inquire he endeavours to manage was that, In what way does the structure of assets and liabilities of a firm glitter the variety of application in it is engaged, its size and level of positivity??In 1958 Merton moth miller and Franco Modigliani in their famous moth miller-Modigliani (MM) bids adjust soonerhand the realise operating income go up of and demonst evaluate that the dandy structure is moot in a sodding(a) trade. It states moot of chief city structure in a perfect grocery place to its appreciate, thusly, how a firm is payd does non consequence. The MM propositions forms the basis for modern thought on roof structure, though it is generally viewed as a rigorously metaphysical pass on since it is found on perfect market assumptions those argon non prevailing in practice.The matter of smashing structure has gained much bear on and controversy, since the MM Propositions which assert that the cheer of a firm is nonsymbiotic of its slap-up structure. The hypothesis pro be by MM created tidal waves in the integrated finance academia. Different conjecture such as packing evidence opening and way of life woo theory were proposed. Various aspects of cap structure consecrate been put to test and exploreed by so m both searchers.The nous is if the swell structure is really ir applicable in a real market and whether a comp boths fatness and thence apprise is affected by the bully structure it employs? If not, why superior structure is pertinent and which factors hasten the leverage matter? Apart from positivity, some other factors such as nonstarter be, theatrical cost, revenue enhancementes, and training asymmetry atomic tally 18 considered in finish of corking structure. This report aims and attempts to ex fly the coop the knowledge of metropolis structure and positiveness kindred in angleed UK companies. This outline ignore consequently be elongated to seem at whether in that location is in fact an optimum working great structure exist the one which maximizes profitability and hence the value of the firm.1.1 linguistic context and relevancy of the StudyThe topic of cap structure has been widely explored, though the test is relevant in the opposite time period and different scene to welcome out whether the evidence fearing the capital structure slue and its non-homogeneous aspects argon relevant to a disposed set of companies in a given period. Given this deduction, current contain attempts to understand and look on capital structure and its effect on profitability, of king-size firms in UK in the pose context for a period of finsome geezerhood (2005 -2010). thence, this guide attempts to contri plainlye to the research on capital structure in the young period for large publicly traded companies on FTSE 100.1.2 look into ObjectivesThe present theater is aimed at achieving one main(prenominal) and devil secondary objects. The main fair game is to scrutinise the birth betwixt the capital structure and profitability of the large publicly traded UK firms and to ascertain whether a firms profitability is link up with its capital structure or not found on the verifiable evidence taked. Secondly, this make would attempt and investigate to determine if any best capital structure exist among the savor of FTSE 100 listed companies. ordinal objective is to find out any edit of capital structure organism exhibi ted by the UK companies.1.3 Research Questions and HypothesisThe above objectives argon translated in 2 research question. The main research question is that whether a firms profitability is tie in with its capital structure or not based on the a posteriori evidence generated.HypothesisThe starting line questions stool be presented as avocation hypothesis. The present take shall be undertaken to evaluate this hypothesis based on the tests of the null hypothesis.H1 The profitability of a company is signifi bedtly fit to its capital structure.H0 The profitability of a company is not signifi stacktly correlate to its capital structure.The secondary objectives of this take up are translated in the determinant question regarding the optimumity and trend of capital structure. The second question, leave alone be discussed descriptively is that, Is at that place an optimum capital structure exists among or any trend of capital structure being exhibited by FTSE 100 listed compan ies?1.4 circumstance and Limitations of the StudyScopeThis is an academic study that would shed some light on the matter of capital structure which has been discussed in different different perspectives since the MM propositions. The significance of this study is that it further enhances the research into capital structure of listed firms in UK. positivity and Capital structure race is an ongoing issue and its relevance may change in different period because of the changes in macro and little scotch factors. For practitioners and in corporeald finance people such as finance executives, controllers and targetors of listed firms, this study is relevant and of much interest to get insight of the capital structure and whether it has any effect on the profitability.LimitationsThe findings of this study impart be hold from the pursuit aspectsThis study included scarce FTSE 100 listed firms on the capital of the United Kingdom Stock Exchange (LSE). Hence, its findings were not applicable for all the listed companies in UK.The sample of listed companies for this study included only firms with at least five historic period of financial entropy. Firms which are younger than five years or whose five year data could not be obtained pull up stakes not be included in this study.The study excludes financial utility and other highly regulated industry to evacuate any distortions in the result collect to industry specific requirements.The compensate sectional correlation and simple retroflexion abstract will be performed employ excel formula.CHAPTER 2 belles-lettres freshenThe various capital structure theories are developed by corporate finance academia for analysing how a firm could combine the securities to exploit its value. The Modigliani and miller (MM) proposition (1958) were introduced under the perfect capital market assumptions. It refers to an standard market where at that place are no imposees at both corporate and personalised level, no transaction be, no agency costs as and managers are symmetrynal. It further assumes that investors and firms can borrow at the equivalent rate without restrictions and all participants fork up access to all relevant information. Thus it provides conditions under which the capital structure of a firm is irrelevant to sum of money firm value. or so of studies focus on the inclination of capital structure i.e. to what completion to each one of the assumptions in the MM model contributes to the determination of the firms capital structure. Many theories such as the pecking rove theory, the trade-off theory and the agency cost theory hand been developed.though much charge was not given to one major(ip) aspect of the capital structure, which is the violation of the value of the firm. The value comes from the future cash flow i.e. profit of the firm. Thus capital structure affects value of the firm through the profitability and hence at that place is a direct blood betwi xt the capital structure and profitability of the firm.Capital organizeThe term capital structure can be defined as The mix of a firms unchangeable long financial support represented by debt, takered crease, and ordinary sway equity.? (Van Horne Wachowicz, 2000, p.470)It can be defined as The mix of long-term sources of property used by the firm. This is also called the firms capitalization?. The telling essential (percentage) of each type of fund is emphasized.? (Petty, Keown, Scott, and Martin, 2001, p.932)One of the consummate(a) and inclusive description was given by Masulis (1988, pl) Capital structure encompasses a stools publicly issued securities, private placements, bank debt, trade debt, leasing contracts, valuate liabilities, support liabilities, deferred compensation to way and employees, performance guarantees, increase warranties, and other detail liabilities. This list represents the major claims to a corpo proportionalityns assets. Increases or red uctions in any of these claims represent a form of capital structure change.? hitherto in this study, for the sake of simplicity, the capital structure will be analysed in term of debt and equity in line with other spectacular capital structure studies and theories restricted to the debt equity mix.ProfitabilityThe term profitability is a very common term in the note world. It refers to an all plump out measuring rod and indicator for a firms success. Profitability can be defined as the ability of a firm to generate net income or profit on a unvarying basis. It is oftentimes metrical by price to profit ratio. The accounting definition of profit can be given as the difference in the midst of the total evaluate revenue and the total costs incurred in bringing to market the product i.e. right-hand(a)s or service.Hence, profitability had come to mean different things for different people. It can be defined and measured in several ways depending on the purpose. It is a generi c name for variables such as net income, take place on total assets, allowance per share, etc. though the simplest and common importee of profitability is the net income.3.1 Early Study on Capital construction by W A ChudsonOne of the earliest all-inclusive researches into capital structure of vocation firms was through by Chudson Walter Alexander (1945) on a cross section of manufacturing, mining, trade, and construction companies in the US from the year 1931 to 1937. Although it has been much than ii third of a century, that study is still relevant straightaway as before due to the seven questions which he endeavoured to answer. Out of those questions the relevant to this study are as follows.In what way does the structure of assets and liabilities of a given concern reflect the kind of industry in which a concern is engaged, the concerns size and level of profitability? be there any elements in the corporate balance sheet, either on the asset or the liability side, whose range of variation is so trap that it is feasible to speak of a normal? pattern of financial structure?The questions posed by Chudson could be interpreted into the research questions pertinent to this study which are the relationship among profitability and capital structure, the existence of an optimal capital structure, and also the trend of capital structure being rehearse by a sample of firms.Chudsons research showed there were undeniable relationships mingled with corporate financial structure and the firms profitability. As far-off as this study is concerned, Chudson had successfully turn out the relationship between the profitability of a company with various capital structure variables including debt and equity capital.3.2 M M PropositionsIn 1958 Merton Miller and Franco Modigliani in their famous Miller-Modigliani (MM) propositions put forward the net operating income approach of and demonstrated that the capital structure is irrelevant in a perfect market. Accordi ngly, the first Proposition holds that the value of a firm is in underage of its capital structure. While the second proposition stats that when first proposition held, the cost of equity capital was a running(a) increase function of the debt/equity ratio.As miller wrote subsequently these propositions implied that the weight down clean of these costs of capital to a firm would remain the same no matter what combination of financing sources the firm very chose. (Miller, 1988)In 1962, Barges time-tested and evaluated the MM propositions predominantly on the validity of the hypothesis that the cost of capital to the firms is unaffected by capital structure. According to Barges (p. 143) With respect to the empirical methods occupied by MM it was found that, under very ofttimes encountered conditions, their methods will result in tests which are bleached in party favour of their propositions and biased against the traditional views.?Barges had empirically proved the existence o f some weaknesses in the research purpose and methodology of Modigliani and Millers study and reason that (p. 147) Thus, on the basis of the evidence presented herein, the hypothesis of independence between deed costs and capital structure appears untenable.?Subsequently numerous studies were conducted with focus on the determination of capital structure and many theories were presented.3.3 Profitability and Leverage theoriesSince MM propositions presented, many studies were conducted by releasing MM assumptions focusing on the limit to which each of the assumptions contributes to the determination of the firms capital structure. All these theories explicates the relationship between leverage and the value of the firm and hence profitability of the firm. There are various theories in value to further explain this relationship. Nevertheless, these theories are actually based on crooked information (Myers, 1984), tax deductibility (Modigliani and Miller, 1963 Miller 1977), failu re costs (Stiglitz, 1972 Titman, 1984) and agency costs (Jensen and Meckling, 1976 Myers, 1977). Two main theories are the pecking order theory and the trade off theory.Pecking hostelry speculationThe Pecking Order possibleness is based on information asymmetry between guidance and investors. So, the stock price of a firm may not reflect crystalise value of the firm. Myers and Majluf (1984) and Myers (1984) suggest that management issue the security which is overvalued and therefore, undervalued firms tend to avoid issuing equity. They argue that in imperfect capital markets, leverage increases with the period of information asymmetry.They provided theoretical support to Donaldsons (1961) findings that firms prefer to use sexually generated cash in hand as a financing source and drop off to externals silver only if the need for funds was unavoidable. According to (Myers 1995), the dividend policy is horny? and the firms prefer internal to external financing. Firms prefer using internal sources of financing first, then debt and lowestly external equity obtained by stock issues.Therefore, asymmetric information models seldom point towards a well-defined target debt ratio or optimal capital structure. All things being equal, the to a greater extent economic the firms are, the more internal financing they will have, and therefore we should expect a negative relationship between leverage and profitability.The various studies such as Ross (1977), and Myers and Majluf (1984), Harris and Raviv, 1991 Rajan and Zingales, 1995 carrel et al., 2001have supported this relationship that is one of the almost systematic findings in the empirical literature.Agency Costs suppositionThe Agency Costs Theory (Organizational Theory of Capital Structure) emphasize that capital structure was influenced by conflicts between shareholders and managers, and between debt holders and equity holders. Major study into this area was done by Jensen and Meckling (1976) that sho wed managers inhering tendency to extract too many perquisites and stresses on self-interested behaviour. Obviously, agency costs would increase as the managers personal ownership stake in the firm decreases. This supplied an argument for debt financing and against public equity which was contributed by non management investors who cannot monitoring device management effectively. Fama and Miller (1972), using agency cost theory, proved that leverage was positively associated with firm value. Firms with longer credit histories would have displace cost of debt.The Trade of theoryThe trade-off theory is based on the considerations of gain grounds and the costs of debt. This theory argues that firms optimise their capital structure by business the tax deductibility of interests, loser costs, and agency costs. This theory is consistent with traditional approach of capital structure. This theory leads to an opposite conclusion. Accordingly if the firms are profitable, they should pre fer debt to benefit from the tax shield. foster as the past profitability is a good deputy for future profitability, profitable firms can borrow more because the likelihood of stipendiary back the loans is greater. so far after a certain level of leverage, the profitability and the value of the firm will reduce due to fundamental fundamental interaction of bankruptcy costs and agency costs.3.4 Various Studies on Capital StructureAs the issue of capital structure gained prominence and interest, a number of studies had been done over the years to explore the relationship between capital structure and a firms various characteristics e.g. growth opportunities, non-debt tax shields, firms volatility, asset systematic risk, asset unique risk, internal funds availability, asset structure, profitability, industry classification, and firm size. This study is concerned in particular on the relationship between capital structure and profitability.Most of the studies had conclude that cap ital structure measured by debt/equity ratio had an opposition relationship with profitability measured by wages on investment funds (ROI). prof Myers of MIT had written in 1995 that the strong negative correlation between profitability and financial leverage? is one of the most striking facts about corporate financing? (p.303). It is worthy to mention here that the aforesaid studies were the most comprehensive ever carried out in the US.One significant research was conducted by Bradley, Jarrell and Rim (1984) using Ordinary Least Squares method to psychoanalyze the capital structure of 851 industrial firms over a period of 20 years (1962-81). They concluded that an optimal capital structure actually existed as proposed by finance theorists.Bradley, Jarrell and Kims findings were supported by El-Khouri in 1989 who canvas a sample of 1,040 Companies in US from 27 different industries practical application a period of 19 years (1968-86). El-Khouris major findings were that there exists an optimal capital structure, and profitability was significantly but negatively related to capital structure.3.5 Rajan and Zingales StudyRajan and Zingales (1995), in their study of determinant of capital structure find that profitability is negatively or inversely related to railroad train consistent with Toy et al. (1974), Kester (1986) and Titman and Wessles (1988). Given, however, that the analysis is effectively performed as an estimation of a minify form, such a result masks the underlying demand and ply interaction which is likely to be taking place. More profitable firm will obviously need less borrowings, although on the supply-side such profitable firms would have better access to debt, and hence the demand for debt may be negatively related to profits.Most of such studies were conducted in US using local companies and hence represents financing and profitability relationship in US providence and might not be applicable in other countries round the globe. Som e of the studies conducted in UK as well though ever-changing business and economic environment and time period may have their affect on such capital structure and profitability relationship. Further as discussed earlier much attention was not given to one major aspect of the capital structure, which is the impact on the profitability and hence the value of the firm. So understanding the effect of capital structure on the profitability and hence the value of the firm in the current economic and business environment is the main motivation for this study.CHAPTER 3RESERCH FRAMEWORKI define to use two major sets of variables ( balances) i.e. Debt and Profitability to ascertain the relationship between the capital structure and profitability. The first set includes Gearing ratios Debt/ righteousness balance and Debt Ratio. The other set includes profitability ratios tabulator on Equity, and Return on Assets. The variables will be analyzed using the descriptive/time-series coefficien t of correlation and reversion technique.2.1 Data SampleThe data used for the empirical analysis will be derived from Hemscott database contains balance sheet, profit and loss and certain refer Ratio information for FTSE 100 companies in UK. For the purposes of this dissertation, I expect to engage this data to obtain the required variables for all non-financial companies.2.2 The Model and Research methodologyThe following model outlines the framework for research. It consist two major components i.e. the profitability of a firm as the hooklike variables and the capital structure of a firm as the separatist variables. The arrow pointing to the right indicated the expected agency of causality. However profitability and capital structure relationship is a two way relationship.DEBT symmetry roeDEBT/EQUITYRATIO ROAThe model gave the foundation for analysis which was to explain the relationship among the two main groups of variables. In as much as possible, variables will be sel ected on the basis of the literature being reviewed. Thus, musical composition this study is expected to give exciting results, there will be direct ties to earlier studies although may reflect the changing requirements of the time.One prominent issue here is the direction of the causality in the model. This research is based on the notion that the capital structure being practised by a firm would affect its profitability. This particular cause-and-effect relationship had been proved in various studies as found in the literature being reviewed. Though it should be kept in mind that there were a number of researchers who had argued that it was profitability which would influence the capital structure (Chudson 1945, Lamothe 1982, Bowen, Daley and Huber 1982). However, it is not within the eye socket of this study to determine the direction of causality in this particular relationship but rather to focus on the significance of such a relationship.2.3 VariablesIn the first instance, g reat care was taken to define the dependent and independent variables to be used in the descriptive, co variance and regression analysis. As there are several alternative measures of profitability and gearing, only relevant measures are chosen for this cross-sectional analysis.Dependent VariableProfitability is dependent variable in this analysis and two measures of profitability employed in this analysis are Return on Equity (ROE) and Return on Assets (ROA).ROE is the return on equity and is measured as dough before tax (EBT) divided by owners capital or equity.ROE = EBT/EQUITYROA is return on assets and is measured as earnings before interest and tax divided by total assets (Titman and Wessels, 1998 Fama and French, 2002 and Flannery and Rangan, 2006). The ratio of earnings before interest and tax (EBIT), to the hand value of total assets (TA)ROA = EBITDA/TAIndependent VariablesGearing Ratio represents capital structure. Therefore, in order to ensure the sensitivity or otherwis e of their cross-sectional results to the profitability following two ratios are used in this analysis and defined asDebt to impart Assets This is a simple ratio of total debt to total assetsDEBT RATIO= TD/ TADebt to Equity Capital This is the ratio of total debt to capital, with the capital careful as total debt plus equity, including preference shares.DEBT/EQUITY RATIO = TD / (TD + ECR + PS)PS the book value of preference shares.Research Plan and Implementation archiveResearch work starts from week beginning from October 4, 2010 and is expected to complete in 10 weeks time. The work is scheduled as follows.Research Planhebdomad fighter Date 04-10-2010Week12345678910 earth discipline and literature reviewXXResearch design and intentXChoice of methodologyXGathering dataXXXData analysis and refineXXXWriting up draftXXXEditing final documentXX flummox final documentXDocument passed to supervisor to readXResourcesI intend to use following resourcesHemscott database for data col lection.MS outdo for analysing data.University of Wales online library, internet, and some books on finance.FTSEs Capital Structure and Profitability RelationshipFTSEs Capital Structure and Profitability RelationshipThe capital structure of a firm has long been a much debated issue for academic studies and in the corporate finance world. It is the way a firm finances its assets through some combination of equity, debt, or hybrid securities the composition or structure of its liabilities. In reality, capital structure may be highly complex and include various sources. The question whether capital structure affects to the profitability of the firm or it is affected by profitability is crucial one. Profitability and capital structure relationship is a two way relationship. On the one hand profitability of firm is an important determinant of the capital structure, the other hand changes in capital structure changes affect underlying profits and risk of the firm.traditionally it was be lieved that the debt is useful up to certain limit and afterwards it proves costly. There is an optimum level of capital structure exist up to that level increasing debt will improve profitability, beyond that it will reduce profitability.In 1945, Chudson carried out an extensive study that implies the possibility of a relationship between the capital structures practised by a firm with its profitability. The question he endeavours to answer was that, In what way does the structure of assets and liabilities of a firm reflect the kind of industry in it is engaged, its size and level of profitability??In 1958 Merton Miller and Franco Modigliani in their famous Miller-Modigliani (MM) propositions put forward the net operating income approach of and demonstrated that the capital structure is irrelevant in a perfect market. It states irrelevant of capital structure in a perfect market to its value, hence, how a firm is financed does not matter. The MM propositions forms the basis for mod ern thinking on capital structure, though it is generally viewed as a purely theoretical result since it is based on perfect market assumptions those are not prevailing in practice.The matter of capital structure has gained much interest and controversy, since the MM Propositions which assert that the value of a firm is independent of its capital structure. The hypothesis proposed by MM created tidal waves in the corporate finance academia. Different theory such as packing order theory and agency cost theory were proposed. Various aspects of capital structure have been put to test and researched by so many researchers.The question is if the capital structure is really irrelevant in a real market and whether a companys profitability and hence value is affected by the capital structure it employs? If not, why capital structure is relevant and which factors make the leverage matter? Apart from profitability, some other factors such as bankruptcy costs, agency costs, taxes, and informat ion asymmetry are considered in determination of capital structure. This study aims and attempts to extend the knowledge of capital structure and profitability relationship in listed UK companies. This analysis can then be extended to look at whether there is in fact an optimal capital structure exist the one which maximizes profitability and hence the value of the firm.1.1 Context and relevance of the StudyThe topic of capital structure has been widely explored, though the study is relevant in the different time period and different context to find out whether the evidence concerning the capital structure issue and its various aspects are relevant to a given set of companies in a given period. Given this significance, current study attempts to understand and research on capital structure and its effect on profitability, of large firms in UK in the present context for a period of five years (2005 -2010). Thus, this study attempts to contribute to the research on capital structure in the recent period for large publicly traded companies on FTSE 100.1.2 Research ObjectivesThe present study is aimed at achieving one main and two secondary objectives. The main objective is to scrutinise the relationship between the capital structure and profitability of the large publicly traded UK firms and to ascertain whether a firms profitability is related with its capital structure or not based on the empirical evidence generated. Secondly, this study would attempt and investigate to determine if any optimal capital structure exist among the sample of FTSE 100 listed companies. Third objective is to find out any trend of capital structure being exhibited by the UK companies.1.3 Research Questions and HypothesisThe above objectives are translated in two research question. The main research question is that whether a firms profitability is related with its capital structure or not based on the empirical evidence generated.HypothesisThe first questions can be presented as follo wing hypothesis. The present study shall be undertaken to evaluate this hypothesis based on the tests of the null hypothesis.H1 The profitability of a company is significantly correlated to its capital structure.H0 The profitability of a company is not significantly correlated to its capital structure.The secondary objectives of this study are translated in the determinant question regarding the optimality and trend of capital structure. The second question, will be discussed descriptively is that, Is there an optimal capital structure exists among or any trend of capital structure being exhibited by FTSE 100 listed companies?1.4 Scope and Limitations of the StudyScopeThis is an academic study that would shed some light on the matter of capital structure which has been discussed in various different perspectives since the MM propositions. The significance of this study is that it further enhances the research into capital structure of listed firms in UK. Profitability and Capital st ructure relationship is an ongoing issue and its relevance may change in different period because of the changes in macro and micro economic factors. For practitioners and corporate finance people such as finance executives, controllers and directors of listed firms, this study is relevant and of much interest to get insight of the capital structure and whether it has any effect on the profitability.LimitationsThe findings of this study will be limited from the following aspectsThis study included only FTSE 100 listed firms on the London Stock Exchange (LSE). Hence, its findings were not applicable for all the listed companies in UK.The sample of listed companies for this study included only firms with at least five years of financial data. Firms which are younger than five years or whose five year data could not be obtained will not be included in this study.The study excludes financial utility and other highly regulated industry to avoid any distortions in the result due to indust ry specific requirements.The cross sectional correlation and regression analysis will be performed using excel formula.CHAPTER 2LITERATURE REVIEWThe various capital structure theories are developed by corporate finance academia for analysing how a firm could combine the securities to maximise its value. The Modigliani and Miller (MM) proposition (1958) were introduced under the perfect capital market assumptions. It refers to an ideal market where there are no taxes at both corporate and personal level, no transaction costs, no agency costs as and managers are rational. It further assumes that investors and firms can borrow at the same rate without restrictions and all participants have access to all relevant information. Thus it provides conditions under which the capital structure of a firm is irrelevant to total firm value.Most of studies focus on the determination of capital structure i.e. to what extent each of the assumptions in the MM model contributes to the determination of the firms capital structure. Many theories such as the pecking order theory, the trade-off theory and the agency cost theory have been developed.Though much attention was not given to one major aspect of the capital structure, which is the impact of the value of the firm. The value comes from the future cash flow i.e. profit of the firm. Thus capital structure affects value of the firm through the profitability and hence there is a direct relationship between the capital structure and profitability of the firm.Capital StructureThe term capital structure can be defined as The mix of a firms permanent long-term financing represented by debt, preferred stock, and common stock equity.? (Van Horne Wachowicz, 2000, p.470)It can be defined as The mix of long-term sources of funds used by the firm. This is also called the firms capitalization?. The relative total (percentage) of each type of fund is emphasized.? (Petty, Keown, Scott, and Martin, 2001, p.932)One of the exhaustive and inclu sive description was given by Masulis (1988, pl) Capital structure encompasses a corporations publicly issued securities, private placements, bank debt, trade debt, leasing contracts, tax liabilities, pension liabilities, deferred compensation to management and employees, performance guarantees, product warranties, and other contingent liabilities. This list represents the major claims to a corporations assets. Increases or reductions in any of these claims represent a form of capital structure change.?However in this study, for the sake of simplicity, the capital structure will be analysed in term of debt and equity in line with other prominent capital structure studies and theories restricted to the debt equity mix.ProfitabilityThe term profitability is a very common term in the business world. It refers to an all round measurement and indicator for a firms success. Profitability can be defined as the ability of a firm to generate net income or profit on a consistent basis. It is often measured by price to earnings ratio. The accounting definition of profit can be given as the difference between the total revenue and the total costs incurred in bringing to market the product i.e. goods or service.Hence, profitability had come to mean different things for different people. It can be defined and measured in several ways depending on the purpose. It is a generic name for variables such as net income, return on total assets, earnings per share, etc. though the simplest and common meaning of profitability is the net income.3.1 Early Study on Capital Structure by W A ChudsonOne of the earliest comprehensive researches into capital structure of business firms was done by Chudson Walter Alexander (1945) on a cross section of manufacturing, mining, trade, and construction companies in the US from the year 1931 to 1937. Although it has been more than two third of a century, that study is still relevant today as before due to the seven questions which he endeavoured to answer. Out of those questions the relevant to this study are as follows.In what way does the structure of assets and liabilities of a given concern reflect the kind of industry in which a concern is engaged, the concerns size and level of profitability?Are there any elements in the corporate balance sheet, either on the asset or the liability side, whose range of variation is so narrow that it is possible to speak of a normal? pattern of financial structure?The questions posed by Chudson could be interpreted into the research questions pertinent to this study which are the relationship between profitability and capital structure, the existence of an optimal capital structure, and also the trend of capital structure being practised by a sample of firms.Chudsons research showed there were undisputable relationships between corporate financial structure and the firms profitability. As far as this study is concerned, Chudson had successfully proved the relationship between the profita bility of a company with various capital structure variables including debt and equity capital.3.2 M M PropositionsIn 1958 Merton Miller and Franco Modigliani in their famous Miller-Modigliani (MM) propositions put forward the net operating income approach of and demonstrated that the capital structure is irrelevant in a perfect market. Accordingly, the first Proposition holds that the value of a firm is independent of its capital structure. While the second proposition stats that when first proposition held, the cost of equity capital was a linear increasing function of the debt/equity ratio.As miller wrote subsequently these propositions implied that the weighted average of these costs of capital to a firm would remain the same no matter what combination of financing sources the firm actually chose. (Miller, 1988)In 1962, Barges tested and evaluated the MM propositions predominantly on the validity of the hypothesis that the cost of capital to the firms is unaffected by capital s tructure. According to Barges (p. 143) With respect to the empirical methods employed by MM it was found that, under very frequently encountered conditions, their methods will result in tests which are biased in favour of their propositions and biased against the traditional views.?Barges had empirically proved the existence of some weaknesses in the research design and methodology of Modigliani and Millers study and concluded that (p. 147) Thus, on the basis of the evidence presented herein, the hypothesis of independence between average costs and capital structure appears untenable.?Subsequently many studies were conducted with focus on the determination of capital structure and many theories were presented.3.3 Profitability and Leverage theoriesSince MM propositions presented, many studies were conducted by releasing MM assumptions focusing on the extent to which each of the assumptions contributes to the determination of the firms capital structure. All these theories explains t he relationship between leverage and the value of the firm and hence profitability of the firm. There are various theories in order to further explain this relationship. Nevertheless, these theories are actually based on asymmetric information (Myers, 1984), tax deductibility (Modigliani and Miller, 1963 Miller 1977), Bankruptcy costs (Stiglitz, 1972 Titman, 1984) and agency costs (Jensen and Meckling, 1976 Myers, 1977). Two main theories are the pecking order theory and the trade off theory.Pecking Order TheoryThe Pecking Order Theory is based on information asymmetry between management and investors. So, the stock price of a firm may not reflect correct value of the firm. Myers and Majluf (1984) and Myers (1984) suggest that management issue the security which is overvalued and therefore, undervalued firms tend to avoid issuing equity. They argue that in imperfect capital markets, leverage increases with the extent of information asymmetry.They provided theoretical support to Dona ldsons (1961) findings that firms prefer to use internally generated funds as a financing source and resort to externals funds only if the need for funds was unavoidable. According to (Myers 1995), the dividend policy is sticky? and the firms prefer internal to external financing. Firms prefer using internal sources of financing first, then debt and finally external equity obtained by stock issues.Therefore, asymmetric information models seldom point towards a well-defined target debt ratio or optimal capital structure. All things being equal, the more profitable the firms are, the more internal financing they will have, and therefore we should expect a negative relationship between leverage and profitability.The various studies such as Ross (1977), and Myers and Majluf (1984), Harris and Raviv, 1991 Rajan and Zingales, 1995 Booth et al., 2001have supported this relationship that is one of the most systematic findings in the empirical literature.Agency Costs TheoryThe Agency Costs T heory (Organizational Theory of Capital Structure) emphasize that capital structure was influenced by conflicts between shareholders and managers, and between debt holders and equity holders. Major study into this area was done by Jensen and Meckling (1976) that showed managers natural tendency to extract too many perquisites and stresses on self-interested behaviour. Obviously, agency costs would increase as the managers personal ownership stake in the firm decreases. This supplied an argument for debt financing and against public equity which was contributed by non management investors who cannot monitor management effectively. Fama and Miller (1972), using agency cost theory, proved that leverage was positively associated with firm value. Firms with longer credit histories would have lower cost of debt.The Trade of theoryThe trade-off theory is based on the considerations of benefits and the costs of debt. This theory argues that firms optimise their capital structure by trading the tax deductibility of interests, bankruptcy costs, and agency costs. This theory is consistent with traditional approach of capital structure. This theory leads to an opposite conclusion. Accordingly if the firms are profitable, they should prefer debt to benefit from the tax shield. Further as the past profitability is a good proxy for future profitability, profitable firms can borrow more because the likelihood of paying back the loans is greater. However after a certain level of leverage, the profitability and the value of the firm will reduce due to interaction of bankruptcy costs and agency costs.3.4 Various Studies on Capital StructureAs the issue of capital structure gained prominence and interest, a number of studies had been done over the years to explore the relationship between capital structure and a firms various characteristics e.g. growth opportunities, non-debt tax shields, firms volatility, asset systematic risk, asset unique risk, internal funds availability, as set structure, profitability, industry classification, and firm size. This study is concerned particularly on the relationship between capital structure and profitability.Most of the studies had concluded that capital structure measured by debt/equity ratio had an inverse relationship with profitability measured by Return on Investment (ROI). Professor Myers of MIT had written in 1995 that the strong negative correlation between profitability and financial leverage? is one of the most striking facts about corporate financing? (p.303). It is worthy to mention here that the aforesaid studies were the most comprehensive ever carried out in the US.One significant research was conducted by Bradley, Jarrell and Rim (1984) using Ordinary Least Squares method to analyze the capital structure of 851 industrial firms over a period of 20 years (1962-81). They concluded that an optimal capital structure actually existed as proposed by finance theorists.Bradley, Jarrell and Kims findings were su pported by El-Khouri in 1989 who studied a sample of 1,040 Companies in US from 27 different industries covering a period of 19 years (1968-86). El-Khouris major findings were that there exists an optimal capital structure, and profitability was significantly but negatively related to capital structure.3.5 Rajan and Zingales StudyRajan and Zingales (1995), in their study of determinant of capital structure find that profitability is negatively or inversely related to gearing consistent with Toy et al. (1974), Kester (1986) and Titman and Wessles (1988). Given, however, that the analysis is effectively performed as an estimation of a reduced form, such a result masks the underlying demand and supply interaction which is likely to be taking place. More profitable firm will obviously need less borrowings, although on the supply-side such profitable firms would have better access to debt, and hence the demand for debt may be negatively related to profits.Most of such studies were conduc ted in US using local companies and hence represents financing and profitability relationship in US economy and might not be applicable in other countries around the globe. Some of the studies conducted in UK as well though changing business and economic environment and time period may have their impact on such capital structure and profitability relationship. Further as discussed earlier much attention was not given to one major aspect of the capital structure, which is the impact on the profitability and hence the value of the firm. So understanding the effect of capital structure on the profitability and hence the value of the firm in the current economic and business environment is the main motivation for this study.CHAPTER 3RESERCH FRAMEWORKI intend to use two major sets of variables (Ratios) i.e. Debt and Profitability to ascertain the relationship between the capital structure and profitability. The first set includes Gearing ratios Debt/Equity Ratio and Debt Ratio. The other set includes profitability ratios Return on Equity, and Return on Assets. The variables will be analyzed using the descriptive/time-series Correlation and regression technique.2.1 Data SampleThe data used for the empirical analysis will be derived from Hemscott database contains balance sheet, profit and loss and certain Key Ratio information for FTSE 100 companies in UK. For the purposes of this dissertation, I expect to utilise this data to obtain the required variables for all non-financial companies.2.2 The Model and Research MethodologyThe following model outlines the framework for research. It consist two major components i.e. the profitability of a firm as the dependent variables and the capital structure of a firm as the independent variables. The arrow pointing to the right indicated the expected direction of causality. However profitability and capital structure relationship is a two way relationship.DEBT RATIO ROEDEBT/EQUITYRATIO ROAThe model gave the foundation for anal ysis which was to explain the relationship among the two main groups of variables. In as much as possible, variables will be selected on the basis of the literature being reviewed. Thus, while this study is expected to give exciting results, there will be direct ties to earlier studies although may reflect the changing requirements of the time.One prominent issue here is the direction of the causality in the model. This research is based on the notion that the capital structure being practised by a firm would affect its profitability. This particular cause-and-effect relationship had been proved in various studies as found in the literature being reviewed. Though it should be kept in mind that there were a number of researchers who had argued that it was profitability which would influence the capital structure (Chudson 1945, Lamothe 1982, Bowen, Daley and Huber 1982). However, it is not within the scope of this study to determine the direction of causality in this particular relati onship but rather to focus on the significance of such a relationship.2.3 VariablesIn the first instance, great care was taken to define the dependent and independent variables to be used in the descriptive, co variance and regression analysis. As there are several alternative measures of profitability and gearing, only relevant measures are chosen for this cross-sectional analysis.Dependent VariableProfitability is dependent variable in this analysis and two measures of profitability employed in this analysis are Return on Equity (ROE) and Return on Assets (ROA).ROE is the return on equity and is measured as earnings before tax (EBT) divided by owners capital or equity.ROE = EBT/EQUITYROA is return on assets and is measured as earnings before interest and tax divided by total assets (Titman and Wessels, 1998 Fama and French, 2002 and Flannery and Rangan, 2006). The ratio of earnings before interest and tax (EBIT), to the book value of total assets (TA)ROA = EBITDA/TAIndependent Var iablesGearing Ratio represents capital structure. Therefore, in order to examine the sensitivity or otherwise of their cross-sectional results to the profitability following two ratios are used in this analysis and defined asDebt to Total Assets This is a simple ratio of total debt to total assetsDEBT RATIO= TD/ TADebt to Equity Capital This is the ratio of total debt to capital, with the capital calculated as total debt plus equity, including preference shares.DEBT/EQUITY RATIO = TD / (TD + ECR + PS)PS the book value of preference shares.Research Plan and Implementation ScheduleResearch work starts from week beginning from October 4, 2010 and is expected to complete in 10 weeks time. The work is scheduled as follows.Research PlanWeek Star Date 04-10-2010Week12345678910Background reading and literature reviewXXResearch design and planXChoice of methodologyXGathering dataXXXData analysis and refineXXXWriting up draftXXXEditing final documentXXProduce final documentXDocument passed to supervisor to readXResourcesI intend to use following resourcesHemscott database for data collection.MS Excel for analysing data.University of Wales online library, internet, and some books on finance.