Thefinancial managers are always confrontedwith the problem of having the most appropriate financialstructure for their firms. According to Myers (2001), neither there is anyuniversal theory related to the managers’ choice to adopt the standard”Debt/Equity” ratio nor they shouldexpect it. The researchers try to their level best for having a standardizedformula for applying in the organizations to have optimal determinants of thefinancial structure keeping in view the framework of different theories, e.g., the trade-off theory (TOT), markettiming theory and pecking order theory (POT).
Unfortunately, these theories have not proved worth, and all theearlier tests carried out about these theorieshave produced inexplicable and ambiguousresults.TheTOT argues that the profitability andleverage are positively correlated, i.e.the profit will always result in higher leverage ratio. Accordingto Rajan and Zingales (1995), the leverage of larger firms is considerably morenegatively correlated with profitability for small firms in Japan, Italy, and Canada, while in the United Kingdom itis more positively correlated. This meansthat the higher profitability will result in lower leverage ratio. This shows a straightforwardcontradiction to the TOT. Itis clear from these contradictory results that somehidden players in the background affects these variables strongly.
Thesestudies show that the financial structure of the firm may become inconsistentas and when financial and economic conditions arechanged. As we know that firms usuallyraise financing through the three fundamental sources, i.e.
, through internallygenerated funds, or from external debt and new equity. According to the POT,the “Companies prioritize their sources of financing, first preferring internalfunding, thengo for the debt, and raising equity as a last resort. Hence the firms preferto finance their assets through the internalsources over the debt financing. Similarly,the debt financing has preference over the new issue of equity financing.
Theprevailing economic conditions are an equallyimportant consideration for both financial as well as non-financialmanagers. The economy plays a vital role in the selection of the desired financial structure. One can opt for a different and unique financial structure entirelyin the era of prosperity as compared tothe era of recession and slumps.
Therefore, it is necessary to researchleverages’ role in shaping the profitability in the presence of both types ofeconomic conditions1.2Problem Identification Theborrowed money has played a vital role in the business’s life cycle. Thereremains a big mystery for owners of the business that whether this borrowedmoney would have positive or negative impacts on the health of their business.Typically, the money rose through bonds and loans results in financialleverage. The money rose through these instruments results ultimately inshareholder’s wealth maximization. As the FLplays a vital role in the Return on Equity (ROE). Therefore, to choose aright combination of the equity and debt to finance the assets of the firm isof paramount importance. It depends on the preference of the firm’s managementwhether to finance their assets by borrowed money or equity.
The funds acquiredthrough the debt provide some tax benefits. But on the other hand, thisincreases a fixed charge in the form of interest. Previous studies conducted byChen, Harford and Kamara (2016) state that this tax and fixed costs benefitworks well in the boom periods. While in the recessions/ slumps this tax and fixed costs benefit does not work dueto the low profitability (or loss).
In fact, during the recessions, the firms paythe fixed cost in the form of interest consistently, whereas the firms keep functioning far behind theircapacity. We can conclude now that the FL can work like a dual-edged sword, i.e. in the boom periods it benefits whereas in the recession periodsit increases losses.
The financial crisis 2008 had a devastating and shockingeffect on US Economy. The Insurance and mortgage sector faced huge losses. Italso affected the UK and some other European economies. The East Asianeconomies experienced moderate to low effects. Accordingto the best of my knowledge, the topic “Role of FL and OL in firm’sprofitability during pre &post-2008financial crisis particularly in the chemical sector of Pakistan” has neverbeen explored earlier. The OL has also reported beingpositively associated with the profitability. Since in the sales growthperiod, fixed costs do not increase preciselyin the same ratio as the sales growth does increase. Therefore, to increase thefixed costs in the business is analogous to the issuance of internal debt.
Thisphenomenon, in contrast, decreases the dependence on the external financing, i.e. reducing the FL.
The OL is the portion offixed costs scaled by total assets. The individual relationship between OL andprofitability is also positive. 1.3Problem Statement Leverage related decisions alwaysremain disputed among the organizations. Especially,during the financial crisis, the role of leverage remains quite controversial. Someresearchers like Ahmad, Salman and Shamsi (2015) and Javed, Rao, Akram andNazir (2015), etc. believe that the leverage is negativelyrelated to the profitability whereas theOtaibi (2015) believes that there is a positiverelationship between leverage and profitability. Similarly, Gatsi, Gadzo and Akoto (2013), state that the FLnegatively impacts the profitability and OL positively impacts theprofitability of the organization.
This discussion is essential in the field of corporate finance to design corporatefinancial strategy because it is evident from the prior literature thateconomic conditions and industry type can significantly alter the results ofthe research studies conducted on the relationship between leverages andprofitability. Therefore, the current researchis conducted to investigate the effect of FL and OL on the firms’ profitabilityin the chemical industry during pre -financialcrisis periods. The data comprises all 43 (29 listed under the chemical headwhile 14 other firms whose products are related to chemical industry) chemical firms listed at PSX (KSE) for two differentperiods, i.e., from2004 to 2008 and from 2009 to 2015. The study explores the proposed relationshipbetween the dependent variable(Profitability) and two independent variables (FL and OL) with focus onchemical firms listed on PSX. 1.4Research QuestionsThefollowing are the research questions of the study;Question 1: What is the relation betweenleverages (operating and financial) and profitability in the chemical sectorfirms of Pakistan?Question2: Do leverages (operating and financial) increase/decrease the firms’profitability in the chemical sector firms of Pakistan? Question3: What is the role of leverages (operating and financial) after the financial crisis?1.
5Rationale of the StudySimilarly,both internal and external sources of funding also have their own merits anddemerits. The internalsources are convenientbut involve the opportunity costs while external sources are more expensive andnot hassle-free. Theexternal financing sources have fixed interest costs associated with themirrespective of the firm’s performance.
They act like a dual-edged weapon. In the era ofprosperity, they prove themselves to be more productive while in the periods ofworries, they harm more than internal sources. Bothtypes of leverages either financial or operating work like a magnifying glass.In the boom periods, they give better justification of their existence. On theother hand, they prove themselves to be more hostile during recessions. Thecurrent study attempts to investigate whether the FL and OL have any positiveor negative impacts on the chemical sector of Pakistan with particular emphasis on pre -crisisperiod. This study comprises the chemical industryof Pakistan. The chemical sector has beenselected due to the following reasons;· Firstly, thechemical sector is a large sector, and the beneficiaries of this industry are masses directly.
· Secondly, thebetter financial planning will bring down the input cost which will benefit themasses. · Thirdly, thefinancial managers of the concerned industry will become vigilant to keep eyeson the economic changes occurring in their surrounding and will work proactively to control the profitability byadjusting their leverages structure.· Fourthly, sincePakistan is a developing country, therefore it needs a lot of research nearlyin all essential fields and sectors. Ourstudy will also contribute towards development and prosperity of our beloved country by having sound financial planning and managing scarce resources· It is evidentfrom the literature review that almost all other sectors have been explored by the researchers except thechemical sector as per best of my knowledge. The distinctive feature of this research is its bifurcation between twoprominent economic conditions, i.
e., pre and post-crisis periods. So it is ofutmost importance to conduct this studyin the most demanding and significantindustrial sector like chemicals. 1.6 Objectives ofthe study· It is a matter of great interest that the leverageshave shown different behavior in the variousindustries.
Therefore, it is high time to conduct the research study on thechemical sector of Pakistan as well. Thiswill enable us to establish our opinion that whether leverages behave differentlyin unrelated industries or the economic condition of the country causes the leverages to behave differently. Thefollowing are the objectives of this research;· To investigatethe impact of leverages on theprofitability of the firms in chemical sector firms of Pakistan· To examinethe relationship between leverages andprofitability of chemical sector firms of Pakistan before and after the 2008crisis.· To suggest thechemical industry, the most appropriate course of action by predicting thefuture economic conditions of the country. 1.7 Significance of the Study:Thestudy will also have significantimplications for the respective industry in determining the most appropriatestructure of FL, OL or blend of both. Thiswill help to forecast the profitability of the firms related to the chemicalsector and other sector firms in general by choosing the ideal amount of debtand fixed costs in a proactive manner. The firmswill be able to manage the funds to finance assets either from internal orexternal sources depending upon the prevailing economic conditions.
Theindustry will be able to adjust its financial and operating leverage or totalleverage before any significant change in the economic conditionsof the country. The chemical sector is the focus of this study because therespective industry is making development consistently. The masses of the country are directbeneficiaries of the out-put ofthis chemical industry. Since the countryis on the fast development track, therefore this sector is also making progress in leaps. There is a general hypothesis that the riskand returns are directly proportional to each other, i.e. the higher the risk, the higher the return or profitability. As leverageincreases the risk of the firm which in turn increases the returns.
Thisincrease in return ultimately enhancesthe shareholders’ wealth. If leverage causes profitability and maximization ofshareholders’ wealth, then thelong-term sustainable growth in thechemical industry is quite possible. So, the proposed study is of paramountimportance for the masses, chemical sector, andfinancial manager.
The study will have following implications for variousstakeholders;· This will help the researchers and the professionals related to the fieldof finance by improving their understanding regarding the theoretical aspectsof the leverages and state of economy particularly in the chemical sector andgenerally in all other sectors those have either incorporated or intending toincorporate the leverages in their capital structure for enhancing the firms’profitability.· The financialmanagers will have an opportunity to equip themselves with the strongtheoretical understanding of depicting the crisis well in advance and takingappropriate measures to protect or enhance their firms’ profitability in aproactive manner. It will enable the financial managers to understand thenature and effects of leverages during the recession and boom periods of the economy which will ultimately result in betterfinancial planning and control to achievetargeted profitability. · · The Pakistanchemical industry as a whole will be benefitedin particular and other industrial sectors in general. The entire industry willbe able to restructure their leverage structure keeping in view current stateof the economic cycle.
REVIEW OF LITERATURECHAPTER No. 02ThePOT was popularized by Myers (1984) in his paper. He argued that equityfinancing is not striking mean of arranging capital because the managers areassumed to know better about real internalcondition of the firm than investors. When the managers decide to raise theadditional money through “new equityissue” then the investors believe that the managers think that the firmis overvalued and the managers are takingadvantage of this over-valuation. Consequently, the investorswill place a lower value on the newequity issuance.
Campelloet al. (2010) proved that a survey of the real effects of financial constraintsduring financial crises reveals that constrained firms tend to use internalfunding and put more effort on obtaining credit from banks by anticipatingrestricted access to credit in the future.,Chen,Harford,and Kamara (2016) found that OL crowds-out theFL while also increases the profitability. Thus the OL generates a negativerelationship between FL and profitability. The study was conducted in China with a sample from the pre-crisis periodof 2004 to 2007 and the post-crisisperiod of 2008 to 2011 based on the sample median OL at the end of 2007. Onlyfirms with positive profitability wereselected.Pandeyand Prabhavathi (2016) conducted a researchonautomobile industry in India.
The sample consisted of 12 firms listedon Indian stock exchange for the period from 2003 to 2013. The study concludedthat gross fixed assets have significantimpact on FL,i.e.the debt cost is strongly associated withthe returns of the firms.Ahmad, Salman,and Shamsi (2015) found that the financialleverage has a statistically significant inverse impact on profitability in thecement industry of Pakistan. The study period was from 2005 to 2010. Otaibi(2015) conducted a study on the data of the firms listed in Saudi Arabian StockExchange and concluded that there is a positiverelationship between the FL and ROE. The study period was two years, i.
e. 2011-2012. The sample size was 26 wellperforming non-financial firms listed onKSA stock exchange.Khedkar(2015) observed that degree of OL issignificantly negatively correlated with the ROIMule (2015) concluded that financialleverage is a significant negativepredictor of financial performancemeasured regarding Return on Assets (ROA)and Tobin’s Q.
The study was conducted onall the firms listed in Kenya for the period from 2007 to 2011.Obonyo(2015) showed that there is a positiverelationship between financial leverage and earnings per share as a measure of financial performance of companies in theconstruction and allied sector at the Nairobi Securities Exchange market inKenya. He studied the “Athi River Mining Cement Limited, Bamburi CementLimited” and East African Portland Cement Company Limited for a period of 2005to 2012.
Javed,Rao, Akram,andNazir (2015) revealed that financial leverage isnegatively associated with the returnon assets and equity in the textile sector of Pakistan. The study comprised 154textile firms for the period from 2006 to 2011.Patel (2014) conducted a study on SabdarDairy in India. The period of study was from 1985 to 2014. It was found in this study that the coefficient ofDOL, DFL, and DTL is positive with EPSbut not significant. However, the overall model was statistically significant.
Inam and Mir (2014) studied that thatfinancial leverage positively affects the firm financial performance in fueland energy sector of Pakistan. The 12 firms wereincluded in the study from the fuel and energy sector of Pakistan. Ali (2014) observed that there is a significant negativerelationship between leverage and return on assets.
This study set out toinvestigate the role of financial leverageon firm performance of the non-financial blue chip companies listed under theNSE 20 share index in Kenya for a period from 2008 to 2013.Rajkumar(2014) showed a negative relationship between the financial leverage and thefinancial performance of the John Keells Holdings PLC. The study was conducted on John Keells Holdings plc in SriLanka during the periods of 2006-2012 Gatsi,Gadzo,and Akoto (2013) conducted a similar study inthe field of insurance firms in Ghana. The sample size was 18 firms listed inGhana from 2002 to 2011. The study showedthat financial leverage has a significant adverseeffect on the profitability of the insurance companies; OL has a positive andstatically substantial influence onprofitabilityRehman(2013) showed the positive relationship of debt-equityratio with return on asset and sales growth, and the negative relationship of debt-equity ratio with earning per share, netprofit margin and return on equity in the sugar industry of Pakistan.
Mohapatra(2012) revealed that ‘OL’ and ‘industry class’ have a significant bearing onthe capital structure of the Indian firms whereas the ‘profitability’ could notbe a clear determinant of corporate capital structure in IndiaAkhtar,Javed, Maryam,andSadia (2012) showed that there is a definiterelationship between the financial leverage and the financial performance of thefuel and energy sector of Pakistan. The data used for analysis consisted of 20KSE listed firms for the period from 2000 to 2005.Yoon& Jang (2005) found that indicated that highlyleveraged firms were less risky in both market-based and accounting-basedmeasures