Term Paper Seni2

The purpose of this paper is to investigate the relationship that exists between the
capitals Structure and financial performance in case of selected commercial banks in

Ethiopia between the years of 2011-2015.
Introduction
The main objective of this study will be to investigate the impact of capital structure
on the financial performance of selected commercial banks in Ethiopia
The main sources that firms could use to provide the necessary finance are the internal
finance which is equity, and the external finance which is debt. Most of companies
use a mix between equity and debt which form the capital structure. Capital structure
was defined firstly by Modigliani and Miller as the mix between debt and equity that
the company uses in its operation. The paper that published by Modigliani and Miller
refers to the impact of capital structure on firm value under many restrictive
assumptions that have been modified by them five years later in (1963) [1]. After
Modigliani and Miller, Jensen and Meckling discussed the agency cost theory which
refers to the potential conflict between managers and shareholders in one side, and
between shareholders and debtors in another side. Since Jensen and Meckling’s
argument the relationship between capital structure and firm performance, many
researchers have begun to study the relationship between capital structure and firm
performance. The main objective of this paper is to examine the impact of capital
structure measured by debt ratio (DR) on financial performance measured by earning
per share (EPS), return on equity (ROE), and return on assets (ROA). Data of 136
firms listed as industrial sector companies on Istanbul stock exchange (ISE) during the
period 2005- 2012 will be used.
Introduction 2
Capital structure has been a subject of discussion for quite some sometime as far as
many financial institutions are concerned. Many firms are often found in difficult
situations when it comes to making appropriate financial decisions and more
especially in deciding on the capital structure a firm wants to adopt. The capital
structure takes two broad dimensions, which are equity financing and debt financing.
The nature and extent of association between capital structure and financial
performance of firms have involved attention in the writings of finance. The capital
structure encompasses the pronouncement about the amalgamation of the various
foundations of funds a firm uses to finance its tasks and capital investments. These
sources include the use of long-term debt finance called debt financing, as well as
preferred stock and common stock, also called equity financing. One of the most
important goals of financial managers is to maximize shareholders' wealth through the
determination of the best combination of financial resources for a company and
maximization of the company’s value by determining where to invest their resources
(Dahiru, 2016). The cost of capital considerably varies from one firm to another. For
instance, some firms are largely financed by debt through borrowing, while others
make greater use of shareholder’s funds. An important aspect in this respect is
whether there exist some capital structures which are better than others. A good
capital structure would be considered to be one that results in a low cost of capital
overall for the firm. This, therefore, means that a low rate of return needs to be paid on
provided funds and thus the discounted future cash flow values generated by the firm
are high, resulting in a higher value of the firm on overall. It is in this respect that i
critically review the capital structure theories as outlined below.  Franco Modigliani
and Merton Miller theorem  Trade-off theory of capital structure and taxes 
Pecking order theory  The market timing theory  Agency cost theor
I ntroduction 3
An
appropriate capital structure is important not only because of the need to survival and
growth or maximizing returns of business organizations, but also because of the
impact of such decision on firm’s abilityto deal with its competitive environment.
Financing and investment are two majordecision areas in a firm. In the financing
decision themanager is concerned with determining the best
financing mix or capital structure for his/her firm. Capital structure decision is the mix
of debt and equity that a company uses to finance its business (Damodaran,
2001). Capital structure has been a major issue in financial economics ever since
Modigliani and Miller showed in 1958 that given frictionless markets,homogeneous
expectations; capital structure decision of the firm is irrelevant. Modigliani and Miller
(M & M) (1958) wrote a paper on the irrelevance of capital structure that inspired
researchers to debate on this subject. This debate is still continuing. However, with the
passage of time, new dimensions have been added tothe question of relevance or
irrelevance of capital structure. MM declared that in a world of frictionless capital
markets, there would be no optimal financial structure (Schwartz & Aronson, 1967).
This theory later became known as the “Theory of Irrelevance”. In MM’sover-
simplified world, no capital structure mix is betterthan another. MM’s Proposition-II
attempted to answer the question of why there was an increased rate ofreturn when the
debt ratio was increased. It stated that the increased expected rate of return generated
by debt financing is exactly offset by the risk incurred, regardless of the financing mix
chosen. The relationship of the capital structure decisions with the firm performance
Was highlighted by a number of theories mainly, the agency theory, information
asymmetry theory, signaling theory and the tradeoff theory. The most important
among them is the agency problem that exists because ownership (shareholders)
And control (management) of firms lies with different people for most of the firms.
And for that reason, managers are not motivated to apply maximum efforts and are
more interested in personal gains or policies that suit their own interests and thus
results in the loss of value for the firm and harm shareholder’s interests.
Therefore, debt finance act as a controlling tool to restrict the opportunistic behavior
for personal gain by managers. It reduces the free cash flows with the firm by
Paying fixed interest payments and forces managers to avoid negative investments and
work in the interest of shareholders (Jensen and Meckling (1976)).
II. Objectives
The general objective of this study will be to investigate the impact of capital structure
on the financial performance of selected commercial banks in
Ethiopia.
The Specific Objectives of the study are:
1. To investigate the relationship between capital structure and financial performance
of selected commercial banks in Ethiopia.
2. To evaluate the effect of debt ratio, total debt to equity and loan to deposit in the
capital structure on financial performance of selected commercial banks.
3. To examine the effect of bank’s size and tangibility on financial performance.
Litrature Review Main body
b) Review of related empirical studies
Since the pioneering work of Modigliani and
Miller (1958), the financing decision of capital structure
and their impact on financial performance has been a
major field in the corporate finance literature. Since then,
numerous studies have attempted to investigate the
relationship between capital structure and financial
performance of the firms. Even though, the area of
capital structure and its impacts on financial perfor-

mance need extreme investigation and analyzed and
investigated in the other countries, it is not yet investing-

ated in Ethiopia but some of the attempt has been made
to investigate the determinants of capital structure:

The study made by Daniel Kebede (2011),
is to investigate the determinants of capital structure
in Ethiopia small scale manufacturing co operatives
the research method which employed in the study
is quantitative approach method specifically survey
method. The data is collected from the financial
statement of 13 small scale manufacturing co-
operatives for the period from 1998 to 2002 E.C. the
researcher also made unstructured interview method

to collect data from concerned bodies. In the study
the researcher used leverage as dependent variable
whereas size, tangibility, profitability, earning volatility,
growth and age are used as independent variables. The
finding of the study revile that size and tangibility
has positive relationship with leverage while profitability,
earning volatility, growth and age has an inverse
relationship with leverage. Finally the researcher
conclude that even though the three most dominant
capital structure theories are appear in Ethiopian
small scale manufacturing cooperatives, the best theory
that explain the capital structure theory of the sector is
trade off theory.
The main objective of the study made by
Woldemikael Shibru (2012) is to examine the
relationship between leverage and determinants of
capital structure decision and to explore which capital
structure theory is applicable in commercial banks in
Ethiopia.
He uses profitability, tangibility, growth, risk,
size and liquidity as a factor that determine the mix
of debt equity ratio. The researcher use mixed research
methods by combining qualitative and quantitative
approach together to achieve the stated objective. The
data source for the study is documentary analysis and
depth interviews. The study uses eight banks data for
twelve consecutive years (2000-2011). The results of the
analysis indicate that profitability, tangibility, liquidity and
growth have negative relationship with leverage. Size
and leverage has a positive relationship. There is no
The Impact of Capital Structure on Financial Performance of Commercial Banks in

Ethiopia
support to identify the level of leverage is affected by

risk. The conclusion of the study made by Shibru
(2012) is that profitability, liquidity, tangibility and
bank size are the major factor to determine capital
structure of commercial banks in Ethiopia and the
predominant capital structure theory applied in
Ethiopian banking industry is pecking order theory.

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The purpose of this paper is to investigate the relationship that exists between the

capitals Structure and financial performance in case of selected commercial banks in

capital structure and its impacts on financial perfor-

investigated in the other countries, it is not yet investing-

to investigate the determinants of capital structure:

researcher also made unstructured interview method

The Impact of Capital Structure on Financial Performance of Commercial Banks in

support to identify the level of leverage is affected by

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