corporate structure

7/30/2019 Corporate Structure

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Impacts of Capital Structure on Firms Profitability

By [Your Name]

[Instructors Name]

[Institutions Name]

[Date]


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Declaration

While conducting the proposed research work, I, being a hard-working, innovative and

conscientious researcher, come up with the factual severity of consequences allied with an act of

plagiarising content from others work. Moreover, I do comprehend the rules and regulations my

university encompasses against submitting a plagiarised document. Adhering to all these strict

and restricted rules and regulations against plagiarism, I have made all possible endeavours to

keep my research report under the level of allowed percentage of plagiarism. Before presenting

my research report to my esteemed research guiders and professors, I, hereby declare the

authenticity and uniqueness of the presented dissertation, which is, by all means, an innovative

piece of writing and is an outcome of hypothetically and logically researched facts and figures

allied with the project subject matter which I meticulously researched during my investigative

course project. Although, this dissertation is an original piece of research but still, there are some

ideas, concepts and theories that are being taken and inspired from previously presented works in

this particular domain for endowing my researched topic with a literal and theoretical support as

well as for influencing the analyzed outcomes of the proposed research-based exposition.


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Signature: _____________ Date: _____________

Acknowledgements

The successful completion of this research work was a knowledgeable experience that

comes up as an outcome of my continual endeavors for several months. The accomplishment of

this research work is not due to a stand-alone performance; in fact it is the combine effort of

some dedicated and inspirational individuals who work with me and guide me through and

through with their all-inclusive knowledge an d expertise in the projected context. There are

several influential personages who have impacted my research work in a very constructive way

but, there are some worth mentioning names, without whom, this dissertation would never reach

to its end. These magnificently meritorious personalities are:

[Person 1] [Person 2] [Person 3]


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Sincere thanks and gratitude to all who lend their helpful hands for the completion of my

research as you all really make it commendable by all means.

In addition to that, I would also like to acknowledge those interviewees who

cooperatively collaborated with me and assist me in drawing some valuable outcomes for my

research.

Finally, I would like to thank my family and close friends who supported me in my work

and give me I can do attitude. Thank you all for being there with me and backing me for my

research-based achievements.


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Table of Content

Declaration.................................................................................................................................................... 1

Acknowledgements....................................................................................................................................... 3

Chapter I ....................................................................................................................................................... 6

INTRODUCTION ........................................................................................................................................ 6

Research Hypothesis ............................................................................................................................... 10

Research Question .................................................................................................................................. 11

Research Aims and Objectives ............................................................................................................... 11

General Research Methods ..................................................................................................................... 11

Research Approaches.......................................................................................................................... 11

Research Strategies ............................................................................................................................. 11

Research analysis ................................................................................................................................ 11

Validity and Reliability of Results ...................................................................................................... 12

Research Outline..................................................................................................................................... 12

Chapter Summary ................................................................................................................................... 13

Chapter II .................................................................................................................................................... 13

REVIEW OF LITERATURE ..................................................................................................................... 13

Introduction............................................................................................................................................. 13

What are Capital Structure and Cost of Capital? .................................................................................... 13

Literal Revelations about the Relationship between Capital Structure and Firms Profitability ............ 15

Chapter Summary ................................................................................................................................... 19

Chapter III ................................................................................................................................................... 20

RESEARCH METHODS ........................................................................................................................... 20

Data and Sampling.................................................................................................................................. 20


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Source of Data..................................................................................................................................... 20

The Sample ......................................................................................................................................... 20

Variable Description ............................................................................................................................... 21

Dependent and Independent Variables ............................................................................................... 21

Capital Structure ................................................................................................................................. 21

Profitability ......................................................................................................................................... 21

Degree of Financial Leverage ............................................................................................................. 22

Chapter I

INTRODUCTION

Organizations use different types financing techniques to fund its assets. This type of

financing refers to as Capital Structure of any corporation. The financing techniques that build a

firms capital structure may take account for different levels of debts, equity, and further

arrangements of financial funding. Organizations, which ultimately aim to magnify the overall

market value of their business, use collective approaches of financing that largely include bonds,

TFCs, lease financing, bank loans and various other options allied with equity. As a matter of

fact, capital structure of one organization varies from that of the other depending upon the

strategy employed by these organizations for maximizing their overall financial standing and

reputation in open, international markets. These differentiating techniques of capital structure, as

proposed by different organizations operating in different industrial sectors of various

international markets that are segregated from one another on the basis of various economical,

social and environmental factors, have come up with a number of theoretical and practical

contemplations regarding capital structure so as to give appropriate explanation regarding

deviations that take place in organizational capital structures with the passage of time or due to


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regional distributions. Apart from that, literature in this context depicted some clear empirical

evidences that substantiating one particular theory of capital structure does not always fit best for

every type of businesses. In this research aim is to explore upon the relationship between capital

structure and profitability of the organizations. In due course, this research has investigated and

inquired about how profitability is impacted by capital structure of the organization and how this

amalgamation is constructively influencing the firms operating in the chemical sectors of

Pakistan. The author has made exhaustive research in this domain and after analyzing the bits

and bytes of Pakistani chemical sectors, it has been concluded that the projected research work is

among the very few researches of empirical nature that have been conducted so far specifically

in Pakistan, while undertaking the countrys chemical industries . Although a number of

researchers investigated the impacts of capital structure on profitability but chemical sector of

Pakistan is still enacted so far and so forth.

Miller and Modigliani published a meticulously researched paper in 1958, which serve as the

cornerstone for strengthening the overall research domain of capital structure and its certain

impacts on firms profitability. Various researchers got motivated and inspired with Miller and

Modiglianis work and since then the debate on firms capital structure is ongoing in developed s

well as developing international trade markets. Nonetheless, developed trade markets are

investing much in exploration and elaboration of this particular field as compared to the

developing economies and this is due to lack of knowledge and certain expertise in this particular

field. Pakistan is one of those under-developed economies where capital structure and its

relationship with profitability of Pakistani firms. These factual revelations from Pakistani

industrial sectors limit and hinder the progression of the proposed research work to a

considerably high extent. These certain gaps make the overall research perplexed enough to


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decide whether the theoretical and empirical researches carried out in developed economies and

their relevant conclusions are also applicable in industrial sectors of underdeveloped countries.

Before setting up the basis of this research work, it was also taken into account that whether the

set of various different factors, which are influencing the decisions on capital structuring of

developed countries, are also effectual and influential for the developing economies. In general,

it cannot be distinctively established that the factors influencing capital structure and thus, the

profitability of the companies operating internationally are portable across countries as well. In

2005, Rajan and Zingales carried out exhaustive study on the G-7 countries, which was later

elaborated and explained by Booth et al in 2001, who incorporated data from developing

economic markets of the world to come up with comprehensively studied subject matter. These

studies concluded that some common features do exist in different organizational capital

structures operating in different countries; however, these features are required to be researched

further so that the determinants of capital structure could be identified in particular industrial

settings of developing countries.

In researched industrial domain of Pakistan is considered to be emerging these days. Pakistan,

itself, is a developing country and encompasses three stock exchanges, out of which the Karachi

Stock Exchange (KSE) is the largest among the rest. In KSE, the quantity of listed companies is

over 700, as per recent research. Unlike other developed countries, Pakistan is also following the

ritual of developing economies, where the area of capital structure is unexplored and unsearched

to a great extent. Previously, researchers never integrate capital structure as a dependent variable

in their researches and explorations regarding Pakistani industrial sectors. But, this paper is

aimed to set new standards and to raise the bar of research and development ahead of typically


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squared Pakistani industrial sector. New discussions and new conclusions are the underlining

aspects of the proposed research work.

1.1. The Background of Pakistans Chemical Industry

The economic conditions of any country are greatly and evidently influenced by its chemical

sector. It is usually contemplated that the modern structure of the world is plinth upon the

effectiveness of chemical industries being operated within it. The reason behind so much

emphasis on chemical sectors globally is the valuable operation it performs in which all the

essential raw materials are converted into thousands of different products that are further used in

several industries to manufacture millions of other consumer goods upon which our everyday life

is greatly dependent. Nowadays, chemical industry around the world is categorized into four

basic operations which may include production of usual chemicals, special chemicals, study of

chemicals involve in daily life, and chemicals used for consumer products. The rapidly evolving

scientific and technological advancements and breakthroughs are the main reason for the

outstanding success of chemical industries in most developing countries including Pakistan, as

these technologies are frequently raising the bar of newly devised procedural tools for

manufacturing products of significant value for the consumers.

Dated back to year 1947, there were no marks of existence of chemical industry in Pakistan. As

years passed, various industrial sectors emerged and progressed in Pakistan but, its Chemical

Industry has a lot of scope for further development and exploration.

Up till now, a lot of developments have been experienced by the chemical industry of Pakistan

but still it is somewhere between organized and unorganized industrial domain with certain

needs of improvements and enhancements proposed by governmental as well as private agencies


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in Pakistan. Recently, the approximated investments in chemical sectors of Pakistan ranged

between Rs.550 to 600 billion; and currently, the products related chemical sectors make up 17%

of the total import bill.

Surveys and researchers explored Pakistans capabilities for strengthening its chemical industries

and concluded that there is much potential of producing technologically-high chemical products

in Pakistan; but, little efforts for improvising the administrative aptitudes and encoring more

investments from governments and privately-owned companies are required to perk up the

overall level of chemical production in Pakistan.

Research Hypothesis

In this research work, following research hypotheses are to be tested:

Research Hypothesis 1:

HO1: Capital Structure does not have any impact on the overall profitability of thechemical industry in Pakistan

HA1: Capital Structure does have impact on the overall profitability of the chemicalindustry in Pakistan

Research Hypothesis 2:

HO2: Capital Structure does not have an effect on financial leverage HA2: Capital Structure does have an effect on financial leverage


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Research Question

This research work is commissioned to answer what are impacts of capital structuring

techniques employed by a company on its overall profitability and business strength while

highlighting the Chemical sectors of Pakistan.

Research Aims and Objectives

In this research, work aim is to explore upon the chemical industry of Pakistan; however,

the core objective of proposed research work is to evaluate the significance of capital structure of

the company on its profitability and productivity.

General Research Methods

The general research methods employed in this research work are highlighted below.

Research Approaches

The approaches to carry out this research work are Inductive as well as deductive research

approaches that have been destined so that meticulous research conclusions could be achieved.

Research Strategies

Owing to the extensively vast domain of the undertaken topic, considerably and

thoughtfully formulated strategies have been adopted for the creditable conduction of this

research work. The core research strategies that have been implemented for this research consist

of pragmatic experiments, statistical evaluations and empirical studies.

Research analysis

As analysis is the cornerstone for any realistic research work thus, in this research it has

been aimed to make the most of Descriptive as well as inferential statistics so as to analyze and

describe the resulted information in more explanatory manner.


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Validity and Reliability of Results

Research results should be extremely accurate to enable implementation and realization

of the research purposes. Therefore, the researcher will ensure that accuracy is maintained from

data collection and analysis to presentation. This is done to ensure that the results are reasonable

and reliable.

Research Outline

This dissertation is being stream-lined within an arrangement of the following chapters:

Chapter 2 Research Methodology: in this chapter, various convincing research models would

be considered which could be best suited for collecting data for this research, and along with that

other supporting research clauses will also be highlighted in this section. The chapter will be

dealing with data analysis procedures and instruments at its highest priority.

Chapter 3 Findings and Analysis: Conducted statistical, theoretical and logical results will be

illustrating in this chapter by using various graphical and pictorial illustrations and expressions

and will be analyzed on the basis of primary and secondary research.

Chapter 4 Discussion: This chapter will take account for the previously researched and

extracted results and findings of chapter 3. On the basis of these results, this chapter will propose

some realistically exacting dissections so as to relate the retrieved findings with the proposed

research topic.

Chapter 5 Conclusions and Recommendations: This chapter is based upon the factual and

figural information that have been conducted in previous chapters and on the basis of that factual

revelation, this chapter is destined to exhaustively conclude the analytical facts and figures of the


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research. This section would also present some thoroughly mulled over recommendations on the

basis of all the prior logical and behavioral revelations from chapter 4.

Chapter Summary

This introductory chapter gives the brief but insightful knowledge about the whole

dissertation. It spotted light on backgrounds of the study, the introduction of the concept which is

being researched, the aims and objectives associated with the research work, backgrounds along

with the key rationales of the study, the adopted research methodology for the research,

definitions for various important terms that have been used throughout the paper and the outline

of subsequent chapters.

Chapter II

REVIEW OF LITERATURE

Introduction

In this chapter, the author has given an essence of wisdom in which he looks to establish

an academic contemplation regarding the capital structure and firms profitability, on the basis of

which both, literal and statistical analysis has been constructed evidently. The purpose of this

chapter is to augment the readers perspective on the numerous concepts that the firms capital

structure involves, as well as its conjectural impacts on the profitability and productivity of the

company.

What are Capital Structure and Cost of Capital?

In business domain, utilization of different funding types is a common practice in various

organizations which is usually being employed so that business could run more smoothly.


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Funding for this purpose falls under the category of Capital Structure which is the composition

of various different types of financing that a business entity or firm employs for acquiring

resources that are necessary to affirm its operational growth and business expansion. Capital

Structure primarily comprises of long-term debt, preferred stock, and net worth. Financial

accounting allows company to quantify its Capital Structure by analyzing different types of

financing the company comes up with as a percentage of all its financing activities. Here it

should be noted that Capital Structure differs from the financial structure of the company as,

capital structure takes account for the short-term debt and liabilities of the company (Capital

Structure Decision, 2010).

Mostly companies raise their funds by means of their equity or via market debts. As far

as Debts are concerned, these debts come in the form of an agreement, bond or long-term notes

payable; on the other hand, equity can be attributed as the preferred stock, common stock or

retained earnings. Both types of business financing depict some advantages along with some

disadvantages in comparison to each other. In case of funds are raised by debt, the founders or

owners of the company hold the rights of ownership of the company and have complete control

over it. But these companies are required to pay the amount in principal as well as interest to the

concerned debt holders. However, in equity, this privilege is not being given because in this type

of capital structure, the shareholders turn out to be a central part of the company. Most of the

business expert finds debt financing to be easier and less expensive specifically for the firms

operating at small scale. This is because these business experts contemplate regular payment of

interest as a burden for the financial status of the company and can negatively impacts its overall

earnings. Nonetheless, equity financing comes up with no obligations for repaying the money to

the outsiders. In fact, in equity financing, shareholders are allowed to take a chance on


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realistically logical ideas for endowing the company with better learning options and growth

opportunities.

As far as Cost of Capital is concerned, business experts defines it as (Modigliani &

Miller, 1998):

the required return necessary to make a capital budgeting project, such as building a

new factory, worthwhile.

This signifies that the cost of capital takes account for the cost of debt and cost of

equity. The cost of capital helps companies to determine how it can raise funds in terms of

money, by means of stock issuance, borrowing, or combination of both. It is the rate of return

which a firm would be given if it invested in different business operations with similar risks.

Literal Revelations about the Relationship between Capital Structure and Firms

Profitability

Modigliani and Miller (1958) made efforts to understand the association among the capital

structure and income/market worth. Their observation stated that in a financial system having no

corporate and special taxation issues, capital structure is of no value on the value of the firm. To

put in plain words one can say, under the influence of several prescribed preventive speculations,

a un-influence company had the similar market value as a company under any type of pressure.

They consequently added corporate taxes in the theory they presented and illustrated that income

and market worth of the company will be at the optimum value if 100% debit is utilized by a

company for providing finance for its assets. Their most important speculation was that

commercial risk can be reasonably evaluated by the standard variation of operating revenue


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(EBIT) and that all current and potential shareholders in future have some related expectations as

regards to the commercial income and the likelihood of deviation in the assumed income. One

more major statement was they considered the corporations stocks and bonds were dealt with in

an ideal marketplace. However another vital supposition was that rate of interest on debit was in

a state of no risk rate for the company as well as individuals. Their theory with commercial

taxation illustrated that debit brings about advantages because of the accessibility of tax shield

due to interest being considered as a tax expense that can be deducted.

Mandelker and Rhee (1984) in their research determined an association between Degree of

Operating Leverage (DOL), Degree of Financial Leverage (DFL) and beta. They were

proficiently gave you the empirical idea that DOL and DFL elucidated round about 38 to 48

percent alterations in a cross-section of information and statistics. Productivity and functionality

are some fundamental point of disagreement among the two presumptions that were presented by

Myers (1984) which were the Pecking Order Theory (POT) and Static Tradeoff Theory (STT).

Myers categorized the modern-day view on capital structure into two speculative subdivisions.

The initial one is the Static Tradeoff Theory (STT), which has the capability to explain about a

firm and the path it goes after being the target debt-equity relation and then works on the defined

conduct accordingly. The advantages and expenditures which are incorporated with the debit

preferences places this objective relation. These take account of taxes, cost of economic distress

and costs of the agency.

Subsequent to this is the Pecking Order Theory (POT) presented by Myers (1984) and Myers and

Majluf (1984), stated that a corporation pursues a chain of command in executing the financial


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decisions when setting up their capital structure. Primarily, firms have a preference in financing

their developmental objectives with the help of internal financing i.e. retained earnings. In the

case where they may require external financing, they initially submit an application for a bank

loan after that for public debt. As a final alternative, the corporation will allow equity to support

projects financial aspects. Therefore according to POT the lucrative companies are less expected

to sustain debt for fresh projects for the reason that they have the support of internal financing

for the attainment and completion of the project.

For the STT, the high the productivity of the corporation, the more are the causes it will have to

apply debt, by this means also reducing the tax burden on its status. On the other hand, the POT

takes this assumption for granted that bigger income works as a guide towards the increase in the

most important resource that firms desire to cover up their economic shortfall: retained earnings.

For that reason, the STT look forward to an encouraging correlation among productivity and

leverage, while the POT looks forward to precisely the opposite of the whole scenario discussed

above. In addition, for the Static Tradeoff conduct, the bigger the firm, the better are the

opportunities it has of issuing debit that may result in a constructive association linking debt and

volume. One of the main explanations for this is that the bigger the firm less is the danger of an

economic failure. Great companies do not think about the direct economic failure costs as a

dynamic factor in settle on the intensity of leverage since larger firms, being more distinctive in

their mannerisms; have fewer openings of economic failure (see, for details Titman and Wessels

(1988)).

Signaling Theory initially put forward by Ross (1977), elucidates that debt is taken as a

technique to underline the confidence of the investors in the company, that is, if a company

issues debt it gives an indicator to the markets that the company is expecting helpful cash flows


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in the making, as the principal and interest payments on debit are a fixed contractual duty which

the firm has to pay out from the cash flows it may hold. Hence, higher point in debt depicts the

managers self-belief in potential cash flows. An additional influence of the signaling feature in

the Pecking Order Theory is the difficulty of the under-pricing of equity. If a corporation issues

equity as an alternative of debt for sponsoring its new projects, investors will comprehend the

signal negatively. As managers have advanced facts and figures in relation to the firm than

investors, they may issue equity when it is priced highly.

Larry et al. (1995) take into account that there is an existence of a negative relation linking

leverage and future expansion. This relation is negative for corporation whose developmental

prospects are either not acknowledged by the capital markets or are not adequately precious to

prevail over the consequences of their debt extended beyond. They also established that leverage

does not trim down the development for firms recognized to have excellent profit opportunities.

To look at the relation among leverage and expansion they made use of the data set over a period

of 20 years and they discovered a powerful negative association between them.

In Pakistan, inadequate research work exists on the region of capital structure, for instance Booth

et al (2001) considered 10 emerging countries that included Pakistan. Nevertheless, this research

was restricted only to the most established 100 index companies. Second study by Shah and

Hijazi (2004) was an enhancement of the initial one as it incorporated all non-financial

companies listed on KSE for the period between 1997 and 2001. On the other hand, the second

study as well was central in nature according to its exercise of mutual deterioration theory

avoiding the fact that the permanent consequences and random consequences models. Attaullah

Shah and Safiullah Khan (2007) have extensively worked on Shah and Hijazi (2004) together


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with more years, with the help of relevant models of grouped information as well as more

descriptive variables.

Predominantly in Automobile manufacturing of Pakistan, the single most important work

discovered in this regard is done by Zubairi and Zubairi and Rashid. In both of these papers, yet

another time productivity of this region has been made sure by means of diverse variables.

Therefore this dissertation aspires at targeting this information crack by reading through the lines

as to how productivity in turns affects capital structure all along with economic leverage.

Chapter Summary

So far in this chapter, all the literal information on capital structure in conjunction with

organizational profitability and other allied factors has been discussed with the fullness of

creditable conceptual, theoretical and figural data. This chapter concluded the influential factors

that support firms to become financially stable by employing adequate capital structuring

strategies in competitive market settings of developing countries like Pakistan. In next chapter,

the research methodology for exploring the realism and pragmatism of discussed information

would be exhaustively at question.


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Chapter III

RESEARCH METHODS

Data and Sampling

Source of Data

In this research work, the core source of data collection was the publication proposed by

the State Bank of Pakistan, named Balance Sheet Analysis of Joint Stock Companies Listed on

The Karachi Stock Exchange 2004-2009. The reason behind undertaking this particular

publication is that it endows with all-inclusive and credible information regarding the key

financial statements of the KSE listed companies during the period of past six years.

The Sample

This research work has emphasized upon the Pakistani chemical sectors. Thus, the data

samples were taken from all the firms listed on the Karachi Stock Exchange (KSE). But due to

incoherent and incomplete data sets available against some of the listed companies, this research

has only taken account for those with complete financial data while ignoring the rest. This study

made the most of the six years financial data allied with these firms. In this way, this research

has plenty of data for being used in employed statistical model to affirm the hypothesis proposed

at the beginning of this research work. Even though, researcher aimed to integrate the most

recent data of year 2012 but this data has not yet been published by the State Bank of Pakistan.


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Variable Description

Dependent and Independent Variables

So far this research has come up with exhaustive review of theories and contemplations

allied with capital structure of the companies; here, in this section, aim is to explore upon the

potential dependent and independent variables that are significant to be used within the projected

research domain. The debt to equity ratio has been taken as an alternative for capital structure

and is served as the dependent variable of the study. When it came to opting for the independent

variables, there was a range of variables available. Out of such vast selection range, the two most

important and relatively core independent variables taken for the study are profitability

(EBT/TA) and financial leverage (EBT/EBIT) of the firm.

Capital Structure

Here, in this study, capital structure is the dependent variable. Capital structure actually

stands for the amalgamation between equity financing and debt financing and supports the assets

side in the balance sheet of the company. As a matter of fact, capital structure has never been

taken as a dependent variable. As an alternate of capital structure measurement, in this study, the

debt to equity ratio is being used. As stated earlier in introductory chapter, the aim here is to

investigate and evaluate whether changes in capital structure impacts the profitability or degree

of financial leverage or both.

Profitability

In this study, profitability is calculated as the ratio of net income before taxes divided by

total assets. Analysis of previous studies depicted the usage of earnings before interest and taxes

(EBIT) divided by total assets, to calculate firms profitability because they took it as


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independent of effects produce by financial leverages. However, the data we took for this study

is from the publication of the State Bank of Pakistan, it does not allow us to calculate (EBIT).

Degree of Financial Leverage

The fixed financial costs in the income stream of the firm are considered as the financial

leverage of the firm in this study. The extent of the presence of fixed financial costs in a firm's

income stream is measured by the degree of financial leverage (DFL). Financial leverage

increases expected return on equity, but it also increases the risk faced by the shareholders. The

business risk part of total risk is affected by operating leverage, whereas financial leverage

affects financial risk thus affecting the total risk of the firm. Though capital structure theories

consider long term debt as a proxy for financial leverage but we measure degree of financial

leverage (DFL) as the ratio of earnings before taxes (EBT) to earnings before interest and taxes

(EBIT).

corporate structure

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