Capital Structure Choice And Effects Essay Example Pdf - Free Essay Example

Have you clearly indicated the discipline or sub-discipline in which your area of interest resides? One of the most important financial decisions a firm must contend with is the capital structure choice. Its effect on overall firm value was first tackled by Modigliani and Miller (1958 1963 cited in Arnold, 2005). Their findings which stated that due to the effects of the tax shield debt financing will add more value to the firm has formed the bases on many research on capital structure and has thus become a very important aspect of corporate fine. It is based on the fallout from these further studies that we propose the topic area below; Capital Structure Choice and Performance of Football Clubs: Evidence from the English Premier League 2. Proposed Working Title Yes No Have you clearly indicated the particular focus or areas of focus that you will address within your chosen topic area?   Are you sure this is not a strategic question? (check Fisher 2007, p. 34)   Empirical Investigation Into the Relationship Between Capital Structure Choice and Performance of Football Clubs in the English Premier League. 3. Proposed Research Aims Yes No Have you been explicit about what is it that you are trying to find out or resolve?   This research aims to empirically investigate the capital structure of football clubs and the effect of this debt policy on the financial performance of these clubs. Most literature available has focused on the determinants of capital structure, and has also tried to develop the ideal mix of debt and equity for firms. Whereas some considerable work has been done on the relationship between a firms capital structure and financial performance, these have focused on standard industries and businesses. Largely missing from the body of literature is the focus on businesses with the dynamics of professional football or professional sports industry. This clearly indicates a gap in the literature that this research aims to address. With the significant level of investment required to be successful in the industry, such research will be invaluable to future businessmen who would want to invest in the industry, academics and not least the supporters of these football clubs. Thus, the aim of this paper is to examine the effect of the financing decision (capital structure choice) on the overall financial performance of football clubs. It also aims to analyse the financial leverage of these clubs and investigate its relationship with time. 4. Research Context Yes No Have you provided a clear indication of why this is a business and management related topic of interest?   Have you been explicit about the organisation/ the organisational section/ region/nation, and feasibility of data collection?   The football industry has changed significantly over the last decade. Clubs have made significant structural changes, have implemented development strategies and made significant investments to maximise their earnings. Delloites money league 2009 reports combined revenue of the top twenty European clubs to be over ÃÆ' ¢Ãƒ ¢Ã¢â€š ¬Ã… ¡Ãƒâ€šÃ‚ ¬3.9 billion. Seven of the clubs from the top twenty were from the English Premier League with combined revenue of about 35% of the total. These figures point to the resistance of football clubs to the recession. Despite this success, there have been concerns about the levels of debt in the Premier league, a total of  £3.1 billion pounds as at June 2009 (Conn, 2009). Conn (2009) further stated that the total debt was despite a four year  £2.7 billion pound TV sponsorship deal to the league. There have also been concerns over the ownership structure, which have been cited as reasons for the enormous debt of the clubs (Press Association , 2010). Delloite in its annual review of football finance in 2009 classified the debt in two as bank loans and interest free loan from owners. The report also indicated that the top ten by net debt in the premiership were either amongst the highest revenue generating and strongest performing, those clubs that benefit from interest free loans from owners, and or newly acquired clubs (Norrish, 2009). ESPN (2010) also report that latest annual reports indicate that only seven out of the twenty clubs made a profit. Premier league clubs are either incorporated as private or public listed companies with dual objectives of promoting football as a sporting activity and running a business. This dual mission distinguishes football clubs from standard businesses. Hamil et al (2004) identify a complex relationship between this dual mission which therefore have implications for corporate governance and performance. In general, the more clubs spend on players, the more they are likely to win, and there is also a direct relationship between winning and revenue (Hamil et al, 2004; Delloite Money league, 2010). Another argument by Hamil et al (2004) is the fact that despite increase in TV revenue and other streams of revenue, football clubs rely on fundamentally on its supporters for revenues. This research aims to contribute to existing literature on the relationship between capital structure or financial leverage or debt policy and performance. Focus will thus be placed on the football industry in the United Kingdom specifically English Premier League clubs. Data collection will be feasible as performance measures from financial statements will be employed. These are available in annual reports, and also on financial databases, for example FAME. 5. Outline Literature Review Yes No Have you provided an overview of work in the field?   Have you ensured you include authors arguments themes?   Have you critiqued in depth, the work of at least two authors in relation to: their choice of research methods, their findings and their conclusions?   Have you ensured that this section links directly to your Research Questions?   Capital Structure and the value of a firm has been one important area of discussion in recent years. Financial leverage is one of the essential financial decisions confronting firms (Glen and Pinto, 1994). The interest in the capital structure of firms increased greatly as a result of the debate started by Modigliani and Millers (1958) seminal work on the effect of capital structure on the value of the firm. They assumed that firms operate perfect markets and perfect competition with no taxes, no transaction costs, investors and managers have symmetric information, investors and corporations borrow at the same interest rate and efficient markets. Under these assumptions, they showed that a firms capital structure does not affect the overall value of the firm (Brigham and Houston, 2009). These assumptions, however, do not hold in the real world or in practice due to the importance of factors such as taxes, agency costs, imperfect markets and competition, risks, cost of financial distress and information asymmetry in explaining the capital structure of firms (Aggarwal and Baliga, 1987). By recognising corporate income taxes, Modigliani and Miller (1963) revised their former stance. They argued that under perfect markets and conditions of certainty firms maximize their value by increasing debt financing due to the tax-shield benefits (interest on debt is tax-deducible) associated with debt. Thus, implying that under such conditions, at the limit the optimal capital structure for a firm is 100% debt. Critics such as Grabowksi and Mueller (1972) disputed the theory on the grounds of the assumption of rational economic behaviour and perfect market conditions, and that owner goals are targeted only at maximizing profits. (Chaganti et al., 1995 cited in Abor, 2007) also criticised the theory for having limited applicability to small firms. Subsequent works carried out by various researchers have suggested alternatives to the Modigliani and Miller theory o f capital structure. For example, the inclusion of the agency theory (Jensen and Meckling, 1976), the pecking order theory (Myers, 1984), and the bankruptcy cost theory (Titman, 1984). The pecking order theory is of the view that markets may undervalue a firms new issues of shares due to the asymmetric information between managers and investors about a firms investment opportunities. This implies that existing shareholders of a firm may be negatively affected by issuing new shares through value transfer from the old to the new shareholders. The pecking order theory therefore implies that profitable firms with a high level of retained earnings are expected to lower their financial leverage relative to less profitable firms leading to a negative relationship between the level of debt and firms performance. The agency theory is of the proposition that higher leverage can be used as a method to mitigate the conflicts between shareholders and managers in the type of investment, amo unt of risk and conditions under which a firm is liquidated.(Jensen and Meckling, 1976). Several arguments have arisen including that of the possible reduction in agency costs by greater financial leverage. Berger and Bonaccorsi di Patti (2005), on the other hand argue that increased leverage has two sides, that is, increased leverage may reduce the agency costs of outside equity, but may in turn increase the agency costs of outside debt due to conflict between lenders and shareholders, and that further increases in a relatively high financial leverage may generate significant agency costs of external debt from a reduced effort to control risk or risk shifting that result in higher expected costs of financial distress, bankruptcy, or liquidation. These leads to debt holders demanding higher returns as compensation for their expected losses or higher risk therefore resulting in higher interest expenses for firms. Thus Bos and Fethersons (1993) argument that capital structure impacts on both the profitability and riskiness of a firm, and that that higher the gearing of a firm, the higher the possibility of failure when there is a reduction in cash flows required to meet debt obligations. These theories show that firms financing decisions may be influenced by many factors and therefore cannot be explained by one theory. It is also therefore worth noting that all these arguments lead to the conclusion that a firms capital structure has an impact on both its operations and performance and therefore on its value as a whole. Existing literature offers diverse views on the effect of the financing decision on firm value. Empirical studies have also been conducted to provide evidence supporting both positive and negative relationships between the level of debt and a firms performance. Examples of empirical studies supporting the positive relationship between the level of debt and a firms performance include (Hadlock and James, 2002; Berger and Bonaccorsi di Patti, 2006). According to Taub (1975 cited in Abor, 2007), there is a positive relationship between financial leverage of a firm and profitability. Petersen and Rajan (1994) also found a positive relationship between debt ratio and profitability but in this case for industries. Hutchinson (1995 cited in Abor, 2007) argued that gearing ratio has a positive effect on the firms return on equity provided that the ratio of earnings before interest and taxes to total assets exceeds the firms average cost of debt. He also argued that the extent to which a firms ratio of earnings before interest and taxes to total assets is likely to remain above the breakeven point and the flexibility with which it can adjust its financial leverage, if this ratio falls below average cost of debt, should be an indicator to the level of debt that the firm can commit to at a particular time. Champion (1999) also argued that the use of debt was one way to improve a firms performance. In another study, Rode n and Lewellen (1995) identified a positive relation between profitability and financial leverage as a percentage of the total buyout-financing package of leveraged buyouts. According to Hadlock and James (2002) the anticipation of higher returns by firms is the reason behind their preference for debt financing. There is also the suggestion of debt holders demanding performance-improving initiatives from managers. Evidence of this can be found in the high rate of management turnover in Japan due to poor performance in firms with principal banking relationships compared to firms that do not have this relationship (Kang and Shivdasani, 1995). Other studies also suggest that increasing leverage, by debt financing should, have positive implications for firm value and performance (Kyereboah-Coleman, 2007). In summary, these theories suggest that only managers who forecast a better future performance will opt for debt since increasing debt would also increase bankruptcy and liquidation co sts, as well as agency costs in general. In a survey of Chief Finance Officers, Graham and Harvey (2001) reported managers concern with maintaining financial flexibility and their firms credit rating when considering debt issues. With firm performance being one of the major inputs into credit rating decisions, this provides indirect evidence that managers opt for debt bearing in mind expected future performance. Jensens (1986) agency model suggests that agency problems could be worsened due to the additional cash outside debt brings into the firm. Alternatively, this will not happen if firms use the cash generated by the debt to tackle the gap between investment and financing needs. The subsequent excess free cash flow will be used to pay the periodic interest payments on the debt. Thus, the reducion in agency costs, and therefore improving firm value. Miller and Rock (1985), and Smith (1986) argue to the contrary. They indicate that debt eventually result in decreases in future ope rating performance, and therefore have a negative impact on the firms value. On the contrary other studies providing empirical evidence have shown a negative effect of debt on a firm profitability; (Titman and Wessels, 1988; Booth et al., 2001; Fama and French, 1998). Fama and French (1998), argue that excessive debt in a firms capital structure may create agency problems among shareholders and creditors which could result in a negative relationship between leverage and profitability. Hammes in another study in (2003, cited in Abor, 2005) found a negative relation between capital structure and performance when he compared Polish and Hungarian firms with industrialized countries firms. Mesquita and Lara (2003 cited in Abor 2005) examined the relationship between rates of return and debt and found a negative relationship for long-term financing and a positive relationship for short-term financing and equity. In a similar study by Abor (2007) on the effect of capital structure on the corporate profitability of SMEs in Ghana, he found a negative relation between long-term debt ratio and profitability with a positive relation between the short-term debt ratio and profitability. The above studies imply that a negative relationship could exist between debt level and firms performance (i.e. profitability). Majumdar and Chhibber (1999 cited Emaid, 2009) in their study of Indian firms in relation to capital structure and performance found that leverage has a negative effect on performance. Chiang et al. (2002) also found a negative relationship between high gearing and performance using firms in property and construction sector in Hong Kong. Amongst the various research methods employed for this study include the use of financial ratios to measure performance (Kyereboah-Coleman, 2007; Abor, 2007). This method appears to be the popular method, which may be due to the accessibility and the fact these variables can be applied to all firms. One limitation though is the dependence of information provided by companies which may be compromised. Tobins q (Abor, 2007) and stock market retain and their volatility (Saunders et al, 1990 cited in Kyereboah-Coleman, 2007) have also been used but these methods can only be applied to listed companies thus when analysing unlisted firms, they may not be appropriate. Two sets of data analysis methods that have been used are cross-sectional data analysis (Ebaid, 2009), and panel data analysis (Abor, 2007; Kyereboah-Coleman, 2007). Cross-sectional data analysis is used to measure different subjects without taking into account the time frame. It is however useful when there is limited time to conduct the research (Saunders et al, 2007). Panel data analysis, however is multi-dimensional, in that it considers both the comparison of subjects while taking into account the time frame as well. According to Baltalgi (1995, cited in Abor, 2007), panel data is better than cross-section alone due to the fact that the se veral data points increases the degrees of freedom whiles co linearity reduce therefore improving the efficiency of economic estimates. He further states that panel data also controls individual heterogeneity resulting from hidden factors, which leads to biased results when neglected in cross-section analysis. From the literature, it is evident that numerous studies have been carried out to examine the relationship between capital structure and firm performance. However, these studies have focused entirely on industrialised firms, standard companies with none focusing of a business with the dynamics of the football industry. Most of these researches were also carried out a few years ago and not many from the recession. It also clear that evidence from literature is inconclusive on the effect of capital structure on firm performance. This research, while seeking to contribute to existing literature on the topic area tries to bridge the gap by investigating at an industry (football industry) with completely different dynamics and incorporates the context of an economic downturn. 6. Research Questions (s) Yes No Have you briefly outlined your research question(s) and articulated clearly what exactly you intend to find out.   Do these questions link directly to the work outlined in the Literature Review Section above?   Have you explained what key operationalisable concepts you are interested in using?   Have you expressed your question(s) which can be answered in the time available (feasibility), rather than as vague expressions of what you might do?   Do your questions pick up the key themes explored above in the outline literature and do they link directly to the research strategy that you describe below?   What is the effect of financial leverage (capital structure) on performance of football Clubs in the English Premier League? Previous studies available from literature indicate that there is a relationship between financial leverage (Abor 2005 2007; Kyereboah-Coleman, 2007; Emaid, 2009). However, researchers have established diverse opinions, both negative and positive relationship between capital structure and performance. The concept of performance here is solely financial and is measured by the profitability ratios; gross profit margin, return on assets and return on equity. 7. Research Strategy/Methods Yes No Have you provided a clear description of how you plan to carry out your research?   Have you explained why you have chosen particular research methods?   Have you clearly identified your population and sample(s)?   Have you identified what data you anticipate collecting?   Have you indicated what forms of analysis you propose to undertake?   Have you identified the major sources of risk (e.g. over reliance on a single individual/company, access requirements, time requirements)?   This research will take a realist stance such since we will look to identify the relationship between variables, in this case capital structure and financial performance measures. The realist approach is the most appropriate for this research as we are looking for possible patterns from the relationship between the variables which will allow us to make inferences and establish principles to come up with possible solutions to any problem that may arise (Fisher, 2007). Measurement and statistical methods will be used to establish the relationship between the variables. This approach coupled with the variables to be considered means that the use of quantitative analysis will be the best option. Thus, in relation to this research, a realist approach will allow for clear relationships to be established by the use of quantitative analysis. This will allow for law-like generalisations, which will be useful to investors and businesses (Fisher, 2007) However, as Fisher (2007) notices, there are some drawbacks with using purely statistical methods. While statistics can show the relationship between variables, it cannot prove cause and effect, as it does not identify how a variable influences the other. While this drawback may be important, the realist approach is the best available stance to conduct this kind of research as can be seen from its use in existing literature (Abor, 2005, 2007; Kyereboah-Coleman, 2007) Research Approach. There are two main approaches; deduction and induction. Induction deals with understanding the meanings to events whereas deduction is concerned with the explanation causal relationships between variables (Saunders et al, 2006). This study focuses on establishing the relationship between capital structure and financial performance of football clubs in the English Premier League therefore the deductive approach will be adopted to test the relationship between capital structure and firm performance. Another reason is the appropriateness of the deductive approach to the realist or positivist perspective and it is also to be less time and cost consuming (Saunders et al, 2006). The deduction approach has its drawbacks not least the criticism of it having a rigid methodology and does not allow for alternative explanations however, this enables studies to be conducted to replicate previous studies and allows quantifiable observations to be drawn which enable generalisations (Saunders et a l, 2006). From previous research, it has been established that there is indeed a relationship between capital structure and firm performance (Emaid, 2009; Abor, 2005 2007; Kyereboah Coleman, 2007). These factors justify the adaption of a deductive approach Research Strategy. As already stated, this research will employ quantitative analysis. We will employ the use of secondary data to conduct our primary analysis. This research will be based on case study approach as it may be impossible to assess financial information on certain clubs as they are relegated. The secondary data to be used will be documentary in nature as it will be information taken from annual reports and as well information stored in databases. The use of secondary data is justified in that they are principally used in descriptive and explanatory research and this research will have both features (Saunders et al, 2007). Secondary data can also be used to investigate patterns in data as well (Fisher, 2009). The use of secondary data will also enable us to select a larger research population as the data is readily available. This also allows greater control of the sample population. The focus of this research is on English Premier league clubs, meaning there would not be a constraint with sampling the entire population. However, we have decided to use purposive sampling to include only the football clubs that have never been relegated during the period under study. This decision was taken to eliminate some level of bias from the research. Relegation from the premier league and promotion usually come at a price, which is reduced and increase revenue respectively. Clubs that are relegated or promoted may be carrying a capital structure that will reflect the division they were in previously, therefore that might impact on the results. The limitation of this approach is that which according to Fisher (2007) is lack of randomness ensuring any calculation of margin of error unreliable, is however mitigated as the entire population that have been ever present in the premier league will be sampled. Data Collection and Analysis The research is to investigate the effect of capital structure on financial performance. As discussed in the literature review, we will use financial ratios as our performance measure. The period will be the 2004/2005 2008/2009. A five year period has been chosen to prevent bias while the period 2004/2005 -2008/2009 that is the most recent 5-year period. The independent variable is capital structure. This is the mix of debt and equity, therefore the data we will be looking for it the gearing ratio (ratio of debt to total capital employed) of the football clubs. The debt ratios which will be obtained from the financial statements include; short-tem ratio, long-term debt ratio and total debt ratio, and trade credit. The measures of performance (independent variables) include; gross profit margin (ratio of gross profit to sales [revenue]), return on assets (ratio of net profit to total assets), return on equity (ratio of net profit to shareholders equity). We will pick gross profit, net profit, sales, total assets, and shareholders equity figures from the financial statement. We will also use the control variables; firm size (log of total assets) and growth (log of sales growth) of the clubs. These variables have been chosen because of its wide usage by previous researchers on the same subject area (Ebaid, 2009; Abor, 2007;2005). Panel data analysis as employed by Abor, (2005 2007), since the two studies are similar. We will use the chi-squared test to test the variables. This is because it is most appropriate method to test for relationship between variables (Fisher, 2007). Limitations Like every research, this one is not devoid of limitations. One such limitation is that since the different football clubs under study are of diverse ownership structures, they may employ different accounting policies which will question slightly the reliability of the comparisons. Also, another limitation is the fact that all financial information needed would not be obtained from consolidated annual reports. However, this will not hamper the credibility of the research as the FAME database is a credible source to obtain financial information. The nature of football business means the possibility of the omission of certain parameter (for example transfer fees) from annual reports. These concerns may however balance each other as both the receipt and payment cancel each other therefore will have minimal effect on the research. Another risk is the sole dependence on secondary data. Even though this is a risk, we are confident of obtaining this data, and also previous studies have ut ilised similar data and it has not compromised their research. We are therefore confident that the credibility of this research will not be compromised as a result of this. 8. Ethical and legal concerns Yes No Have you provided a clear description of any potential ethical concerns within your project, including during the collection of data or presentation of findings?   Have you described how you will preserve confidentiality and anonymity of organisations and individual respondents?   Have you ensured you have discussed means for respondents to know about the research and their role within it, and that their participation is voluntary according to the principle of informed consent?   Have you considered whether any  good or harm may be caused by the research to individuals or organisations?   Have you discussed if there any ethical guidelines in the field (e.g. from professional bodies) that you will be following? Have you discussed how you will ensure that any data held on respondents is to be processed according to the Data Protection Act 1998, and stored according to safe practices (e.g. in a secured (electronic) container)?   If you are undertaking any primary research or primary analysis of secondary data, you must give further details below about how you will address any ethical issues within your research: Specific Ethical or Legal Concerns With Your Research Project The data that will be used may not be publicly available information in some cases. It is therefore imperative to abide by the terms and conditions of data usage from the databases. Preservation of Confidentiality and Anonymity The analysis shall be confidential and will be limited to the research in question only. No names of shall be mentioned in the research and all analysis shall be kept as general as possible. The data shall be held according to the Data Protection Act of 1998 Informed Consent Potential Good or Harm Caused by the Research Depending on the findings of the research, the outcome may reduce investor confidence; it may also create problems between fans and clubs depending on the outcome. For listed firms, the outcome of the research may increase or decrease value. There is also the likelihood findings may be commercially damaging. Ethical Guidelines in the Field What guidelines in the field are there that will guide your research ethics and how will these be applied? Processing and Storage of Data Data collected it shall be dealt with vigilantly and processed according to the Data Protection Act 1998 (OPSI, 1998). Upon completion and passing of this research, the information gathered from data shall be destroyed. Furthermore data shall be stored according to the safest of practices in a secured electronic container. 9. Schedule Yes No Have you identified the key stages and dates for activities that must be completed before others can start?   Have you identified what problems with access can you anticipate? Have you identified what activities are necessary in their own right and which are conditional on others being completed?   Submission of the proposal on the 9th of April 2010 is the first stage as without that you cannot progress to the dissertation therefore unable to graduate. The next stage is to wait for the results of the proposal and if it is passed, necessary changes will be made to the proposal to meet the desired standard. The next stage will be to start the link up with your assigned supervisor and plan to start the dissertation. The literature review from the proposal will then be developed and relevant data will be collected from then on with the blessing of the assigned supervisor. Since we do not envisage any difficulty with accessibility of data, data collection should not be a problem. Once data has been collected, the variables will be calculated and the analysis started. The research will be organised and planned by keeping a diary to aid this process. Since the time available is not much, it is imperative to stick to the plan schedule. This will ensure an accurate and successful c ompletion of the research. 10. General Guidelines Yes No   Have you avoided using lists or bullet points?   Have you just described an author or authors work instead of explaining or critically evaluating it?   Have you clearly linked the paragraphs within each section, and the sections themselves?   Have you proof read your work and ensured there are no spelling, grammatical, or copy errors?   Have you ensured that you have included a complete set of references in Harvard format?  Â