CHAPTER structure. First it is important to determine

CHAPTER 1:
INTRODUCTION

1.0             
BACKGROUND
OF STUDY

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For a company to
be set up and do business it needs capital to finance its operations and buy
assets to use in the production and service provision process. The accounting
equation equates assets to equity plus liabilities. Capital exists in various
form such as ordinary shares, preference shares, debentures, e.t.c. All the
above mentioned sources of finance can be used and they have different
advantages and disadvantages which affects how the management intends to
finance the operations. The mixture of debt capital and equity is what is
referred to as capital structure.

 

First it is
important to determine what is equity and how is it different from debt capital
Equity refers to the ordinary shares of the company and the reserves that
belong to the company. In other words equity represents the capital that
belongs to the owners. Equity does not has to be paid back to the shareholders
rather they are given a return on their investment. Equity represents the
ownership of the company. In times of losses the shareholders do not get a
return.

 

Another
component of capital structure is debt capital which is in the form of loans,
redeemable preference shares, mortgages, debentures e.t.c. This form of
financing is very different from equity. It requires that the initial amount
given be repaid in the future. And there is a fixed amount that has to be given
as the cost of capital. This has to be paid whether there is a profit or not.

 

This brings us
to the next important thing, the cost of capital. The return that is given to
the providers of capital is the cost of capital. A high cost of capital means
that the company has to look for other alternative sources of finance. But does
it really mean that it all boils down to cost of capital or there are other
factors that management considers in deciding the best capital structure for
their business.

 

This research
aims to understand the factors that influence the capital structure. We are
going to be looking at companies with high gearing ratios and comparing with
those with low gearing and try to establish which factors played an important
role in the financing.

 

There are a
number of factors that influence the capital structure however some are beyond
the financial field thus the study will mainly concentrate on factors relating
to financial world. The study is important as it enables us to see the driving
forces behind financing decisions by managers in the current economic and socio-political
environment and understand the rationale behind those decisions.

 

This chapter is divided into six sub
topics which are (1) problem statement, (2) objectives, (3) scope of study /
limitations, (4) significance, (5) literature review and (6) research
methodology.

 

1.1 
PROBLEM
STATEMENT

Capital
structure is importance for all firms either Shariah compliant firms or Non-Shariah
compliant firms. However finding the perfect composition of the capital
structure is the hard part. How do you arrive at the optimum level of debt and
equity? What is the perfect gearing ratio?

In the study,
the researcher wants to concentrate on the determinants of capital structure of
companies operating in Malaysia. Research has been done on many companies
outside Malaysia however here the research is still in primitive stages and the
study aims to assist those who conduct further research on the topic and also
act as a source of information to various people concerned with the topic.

 

 

 

 

1.2 
RESEARCH
QUESTION

In
order to achieve the above research objective, this study will try to answer
the following research question:

1.
How do firms in Malaysia manage and determine their company’s capital
structure?

2.
What are the main factors behind the capital structure?

1.3 
RESEARCH
OBJECTIVES

1.     
To
examine the factors that affecting capital structure of  firms in Malaysia.

2.     
To
analyse how firms manage their capital..

1.4 
SIGNIFINANCE
OF STUDY

This research
will give benefits to many people such as the researcher, students and society.
Capital structure is very important in a company as it affects the cost of
capital which reduces the profit. It is a very important decision that can be
the determining factor between winding up of a company or it’s survival. Thus
this research will assist those who want to indulge in financing their company
or start up in decision making.

It will also
assist those who will do further study on the topic. Student and researchers
will have a reference that applies to the Malaysian context. It will boost
their knowledge and it gives them an opportunity of confirming and criticising
the knowledge established from this research.

CHAPTER 2:
LITERATURE REVIEW

2.0 
 INTRODUCTION

The economy
nowadays days is more volatile because of the efficiency of the markets, thus
it is more complicated to determine the capital structure to adopt. However
there are six main factors that have been considered to influence the capital
structure which are cost of capital, growth opportunities, firm size, profitability
of the company and ownership.

 

Capital
structure is reflected in the statement of financial position. It is
represented by the accounting equation Assets= Liabilities pus Equity. There are
two main ratios which are used to analyse the capital structure of a company
which are debt to equity ratio and the gearing ratio.

 

Debt ratio
compare total liability to total equity. The higher the ratio the higher the
debt a company has in comparison to its equity. The main problem with this
ratio however is it includes operating debts which do not necessarily fall
under capital. Trying to establish the benchmark is also complicated as
companies and industries differ.

The second ratio
is the gearing ratio which is arrived at by comparing long term debt and
preference shares to equity and liabilities. This ratio indicates the
contribution of debt to the total capital provided. A higher gearing ratio
indicates that the company is highly leveraged.

 

Financial
leverage is the degree to which a company uses fixed-income securities such as
debt and preferred shares. The more debt financing a company uses, the higher
its financial leverage. A high leveraged company is at a higher risk since if
there is a loss it is required by the law to pay its debts which in turn may
lead to the company being insolvent and in extreme cases liquidation. A highly
leveraged company incurs a lot of expenses relating to financing costs which ultimately
reduces the profitability of the company. A highly leveraged company may find
it very difficult to obtain loans because of the huge debts that it already has.

 

However bring
financing a company through debts has its own advantages .it allows accompany to
expand whilst retaining control. If shares are issued there will be a dilution
of power. Debt providers also do not have voting rights. By financing through
debt it allows the company to reinvest its capital. a company that does not
have debt is not practicing sound  and
healthy financial practices as debt financing opens up opportunity and it is
important for growth.

                  Anyhow the main factors that
influence the capital structure which are firm size, growth rate,
profitability, risk level of the environment and the business, liquidity, the
assets which are available as collateral and the cost of capital are explained
in great detail below.

 

Fig 1.

Source:
Kinde (June, 2011)

2.1 
Tangibility
(asset structure)

According to
pecking order and trade-off theories, the availability of tangible assets has a
direct impact on the capital structure since firms with more tangible assets
have a higher probability to receive loans and other forms of debt financing. Here
the providers of debt finance also look at the claims of those assets. If there
is a high level of debt which are based on the collateral assets debt financing
may be difficult to obtain. The debt to assets ratio can indicate the level of
claims on the assets by the liabilities. This is very important since if a
company fails and there is liquidation the company assets are sold in order to
pay the debts.

 

Other studies
also specifically suggested a positive relationship between the assets
structure and long term debt and negative relationship between the asset structure
and short term debt (Kinde, 2011). In this study, tangibility (asset structure)
is measured as fixed assets divided by total assets. Tangibility is expected to
affect the long-term or debt ratio rather than total liabilities ratio.

 

2.2 
Growth
Opportunities

Applying pecking
order arguments, growing firms place a greater demand on their internally
generated funds. The company can use its reserves and pay lower dividends in
order to allow reinvestment of income generated. However if the growth
opportunity is substantial firms usual turn to external sources of finance.

 

 When growth and investment opportunities
increase, huge capital funds will be required for the firm to seize all these
possible growth opportunities. The two main options available are issuing
shares or obtaining debt capital. if the firm does not intend to increase its
leverage it issues shares whilst if it does not intend to dilute the control of
the firm it obtains loans. The cost of capital also plays a huge role on this
one since if the cost of capital is higher it means less profits.

 

However, the
positive relationship between growth and leverage proves that growing companies
depend more on debt to finance their growth (Tornyeva, 2013). Pandey (2001)
finds a positive relationship between growth and both long-term and short-term
debt ratios in Malaysia.

 

2.3 
Firm
Size

Size of the firm
has a positive association with leverage, implying that leverage is higher for
large firms and lower for small firms. This can also be attributed to the fact
that firms which are huge in size have more collateral assets. As firms size
increases, they become more diversified and have more stable cash flows. They
are more stable which means less risk in comparison to small firms which is
attractive to debt providers. And in that sense the companies can obtain huge
debts. There is a positive correlation between firm size and the size of debt
finance and equity.

                  However it also important to
note that for huge companies the size of equity is also      high which means that the gearing ratio
maybe low irrespective of the size of the debt finance as it correspondents
with the size of the firm and the amounts concerned.

 

.

2.4 
Profitability

According to pecking order theory, Myers
(2003) discusses that firms prefer to finance with internal funds in order to
avoid financing costs and other cost of capital and companies that are highly
profitable have such funds at their disposal which means less debt. A company
with high levels of profits will have retained earnings at its disposal that it
can use to finance its operations Therefore, profitability is expected to have
negative relation with leverage.

 

However it is important to note that when
referring to profitability of a firm it does not relate to the performance of
the company in a single year rather over a period of time. The past
profitability of a firm, and hence the amount of earnings available to be
retained, should be an important determinant of its current capital structure.

 

Liquidity

Liquidity refers to money and other current
assets which can be converted into cash in order to meet short term debts. Liquidity
is very important for operations. A company that has liquidity problems may
fail to pay financing costs and other short term debts which may be from
suppliers. A low liquidity ratio indicates poor management of funds. It is a
warning sign that a company may fail to pay its debt which may lead to the
company becoming insolvent. Banks asses these firms with low liquidity as high
risk firms and thus the finance charge will be high. A high finance charge will
lead to force the company to look for other sources of finance such as equity.

 

However for companies with a higher
liquidity ratio they can get access to loans and other forms of debt financing.
As a higher liquidity ratio indicates that the company has a good cash flow management.
Companies with higher ratios above the benchmark level can also use the money
at their disposal to fund their operations and invest in other projects thus
reducing the need for debt. The ratio used to measure liquidity is by current
asset divided by current liability.

 

Risk Level of the economy and the
business.

Banks and other sources of finance
assess the riskiness of firms and the economic environment they operate in. A
company operating in a high risk industry or country will probably have low
levels of debt as the interest rate associated with such debts will be high in
order to compensate for the risk faced. There are various models which are used
to evaluate the credit riskiness of a company such as the Moody’s and Fitch
ratings which use Letters such as AAA to indicate the credit riskiness of a
company.