THỰC TRẠNG và GIẢI PHÁP sử DỤNG đòn bẩy tài CHÍNH để NÂNG CAO GIÁ TRỊ DOANH NGHIỆP

Bachelor of Finance & Banking Thesis

Situation and solution for using financial leverage to
improve enterprise value of Da Nang Housing
Investment Development Joint Stock Company

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ABSTRACT
The study aimed to investigate the effect of financial leverage on real estate enterprise’s
value as an annual strategic analysis that helps the analyst in predicting future company’s
value on the factors of the mentioned. Da Nang Housing Investment Development JointStock Company is a sample selected from Vietnamese real estate companies listed in
Vietnamese Stock Market. The study used the brochures issued by NDN for five years
during the period of 2010 – 2014. The study used a set of statistical methods to determine
the effect of study variables that reflect the operational, financing and investment aspects
on company’s value of the as an ultimate goal of increasing shareholder wealth The study
concluded that there is statistically significant direct relationship between two variables:
debt / total assets ratio and weight average cost of capital. The correlation was changed
follow the increase of debt ratios. The optimal capital structure was found when debt / total
assets ratio equal 62.5 percent.
The research begins with providing rationale of research which depicts the importance of
financial leverage in capital structure; especially, with respect to real estate companies.
Besides that, the research question and research objectives are proposed. After that, the
situations, features and optimal capital structure of NDN capital structure are figured out
by using financial statement analysis methodology. At last, the authors clarify issues NDN
facing with its capital structure and draw experience lesson for other firms. After
processing the data, the result reveals that it can be concluded that the structure of NDN

which is funded mainly by liabilities. In particular, short-term liabilities consist of shortterm payables and short-term loans accounted for a large proportion.

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ACKNOWLEDGEMENT
During the period of doing this research, the researchers received so much enthusiastic
help as well as the support which are the motivation to overcome the difficulties. Thanks to
the encouragement and enthusiastic guidance that the researchers have completed this
study.
Firstly, the researchers would like to thank to the lectures that are teaching as well as used
to teach at FPT of Business University in Ho Chi Minh Campus, gave us necessary base of
knowledge about principles of economic and Finance and Banking.
Secondly, the researchers would like to deepest thank to Ms. Nguyen Thi Thanh Van who
is our supervisor during time we do research in Da Nang. Due to her carefully and
enthusiasm instruction, the researchers had official raw materials, theories and econometric
knowledge at the beginning. In addition, she has supported the researchers with her
professional experiences and leading in the best way for fulfilling this study.
Finally, the researchers would like to thank FPT University in Da Nang Campus; they have
helped the researchers by making the best condition during time the researchers stay in Da
Nang from arrived to now. Including the cleaning staff and security, for doing what they
do. It’s been a pleasure and a privilege due to their efforts.

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Contents
ABSTRACT.........................................................................................................................iii
ACKNOWLEDGEMENT..................................................................................................iv
Contents.................................................................................................................................v

LIST OF FIGURE............................................................................................................viii
LIST OF TABLE..............................................................................................................viii
LIST OF ABBREVIATION...............................................................................................ix
CHAPTER 1: INTRODUCTION.......................................................................................1
1.1 Research background..............................................................................................................1
1.2 Overview about Vietnamese real estate.................................................................................1
1.3 Research questions..................................................................................................................2
1.4 Research object.......................................................................................................................2
1.5 Research objectives.................................................................................................................3
1.6 Research scope........................................................................................................................3
1.7 Methodology...........................................................................................................................3
1.8 Data overview..........................................................................................................................4
1.9 Research limitation..................................................................................................................4
1.10 Thesis structure.....................................................................................................................4
1.11 Conclusion.............................................................................................................................5

CHAPTER 2: LITERATURE REVIEW...........................................................................6
2.1 Capital structure......................................................................................................................6
2.1.1 Definition of capital structure...........................................................................................6
2.1.2 Ratio to define capital structure.......................................................................................7
2.1.3 Theories of capital structure.............................................................................................9
2.1.4 Optimal capital structure with financial leverage...........................................................12
2.2 Profitability............................................................................................................................12
2.2.1 Definition of profitability................................................................................................12
2.2.2 Ratio to define profitability............................................................................................13
2.3 Financial Leverage.................................................................................................................15
2.4 Firm value..............................................................................................................................19
2.4.1 Definition........................................................................................................................19
2.4.2 The role of firm valuation:..............................................................................................19
2.4.3 Valuation model.............................................................................................................20

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2.4.4 Role of using financial leverage to maximize firm value.................................................23
2.5 Gaps in the literature review.................................................................................................24
2.6 Theoretical Model.................................................................................................................27
2.6.1 Stable Growth Firm:........................................................................................................27
2.6.2 The General Version of the FCFF Model:........................................................................27

CHAPTER 3: METHODOLOGY ...................................................................................30
3.1 Introduction...........................................................................................................................30
3.1.1 Philosophy .....................................................................................................................30
3.1.2 Approaches.....................................................................................................................31
3.1.3 Methods.........................................................................................................................31
3.2 Data collection method.........................................................................................................32
3.2.1 Sampling techniques.......................................................................................................32
3.2.2 Secondary data collection method.................................................................................32
3.3 Data analysis methods...........................................................................................................33
3.3.1. Financial analysis ..........................................................................................................33
3.3.2 Using Free Cash flow to Firm model to figure out firm value maximization...................34
3.3.3 Sensitivity data...............................................................................................................34
3.4 Ethical considerations............................................................................................................35
3.5 Limitations of research project..............................................................................................36
3.6 Summary ..............................................................................................................................36

CHAPTER 4: ANALYSES AND FINDING....................................................................37
4.1. Overview about construction in Viet Nam and NDN Company............................................37
4.1.1 Real Estate industry........................................................................................................37
4.1.2 The economic potential of the real estate industry........................................................39

4.1.3 Achievement...................................................................................................................40
4.1.4 Organizational Structure.................................................................................................41
4.2 The situation of Da Nang Housing Investment Development Joint Stock Company..............41
4.2.1 Capital Structure ratio....................................................................................................41
4.2.2 Profitability ratio.............................................................................................................45
4.2.3 Financial leverage ratio...................................................................................................51
4.3 Impact of financial leverage on Enterprise Value..................................................................52
4.3.1 Weight Average Cost of Capital (WACC).........................................................................52
4.3.2 Free Cash Flow ...............................................................................................................62
4.3.3 Impact of financial leverage on enterprise value............................................................65

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4.4 Summary...............................................................................................................................68

CHAPTER 5 – CONCLUSION AND RECOMMENDATION.....................................69
5.1 Key finding.............................................................................................................................69
5.2 Conclusion.............................................................................................................................72
5.3 Recommendation..................................................................................................................73
5.3.1 Recommends for using the optimal capital structure:....................................................73
5.3.2 Constructing a reasonable debt structure......................................................................74
5.3.3 Recommends for improving firm value..........................................................................75
5.4 Limitation..............................................................................................................................76

REFENCES.........................................................................................................................77
APPENDIX ..........................................................................................................................a
APPENDIX 1: FINANCIAL STATEMENTS OF DA NANG HOUSING INVESTMENT DEVELOPMENT
JOINT STOCK COMPANY (NDN) FROM 2010 TO 2014 (Unit: thousand VND) ...............................a
APENDIX 2: INCOME STATEMENT OF DA NANG HOUSING INVESTMENT DEVELOPMENT JOINT

STOCK COMPANY (NDN) FROM 2010 TO 2014 (Unit: thousand VND) ..........................................e

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LIST OF FIGURE
Figure 1: Theoretical model (Tharshiga Murugesu, 2013)
Figure 2: Theoretical model (Mapayo, C, 2011)
Figure 3: Theoretical model (Prof. (Dr). T. Velnampy & J. AloyNiresh, 2012
Figure 4: Research process
Figure 5: Real Estate industry level
Figure 6: Urbanization rate
Figure 7: GDP growth and real estate sector
Figure 8: Organizational Structure
Figure 9: Total debt ratio
Figure 10: Total Equity ratio
Figure 11: Equity multiplier
Figure 12: Gross profit margin
Figure 13: Operating profit margin
Figure 14: Net profit margin
Figure 15: Return of Asset (ROA)
Figure 16: Return on Equity (ROE)
Figure 17: Degree of Financial leverage (DFL)
Figure 18: Impact of financial leverage on WACC
Figure 19: Impact of financial leverage on enterprise value

24
25
26
30

37
39
40
41
42
43
44
45
46
47
49
51
52
64
65

LIST OF TABLE
Table 1: Valuation model

21

Table 2: Total debt ratio

41

Table 3: Total Equity ratio

43

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Table 4: Equity multiplier

44

Table 5: Gross profit margin

45

Table 6: Operating profit margin

46

Table 7: Net profit margin

47

Table 8: Return of Asset (ROA)

49

Table 9: Return on Equity (ROE)

50

Table 10: Degree of financial leverage

52

Table 11: Impact of financial leverage on enterprise value

64

Table 12: target revenue and net income

69

Table 13: Lending rates in VND month 6/2015

72

Table 14: Government's policy

73

LIST OF ABBREVIATION
ROA: Return on asset
ROE: Return on equity
WACC: Weight average cost of capital

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EPS: Earning per share
DFL: Degree of financial leverage
EBIT: Earnings before interest and tax
FCFF: Free cash flow to firm
NDN: Da Nang Housing Investment Development Joint Stock Company
VIC: Vingroup Joint Stock Company

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CHAPTER 1: INTRODUCTION
1.1 Research background
In the market economy these days, all firms expect to gain the highest profit from the
capital. Furthermore, is enhancing the enterprise value. On the other hand, the efficiency of
firms always comes with certain risks. Risk is a critical factor to using and allocating
resources in operating activities. However, it is said that high risk high return. The level of
risks can be evaluated through the impacts of leverage ratios. As a result, firms can use the
leverage analysis to modify factors to be suitable for returns and risk acceptance. Leverage
is a tool to amplify force. Turn a small force into a larger force, the term "leverage" in
financial alluded using fixed costs to increase the profitability of the business.
However, in finance, leverage is a double-edged sword. If the operation of the business
works well, leverage will amplify the good ones multiply. Vice versa, leverage would
double the risks.
Important issues to be concerned and identified in this study is to analyze leverage and
leverage research that affect enterprise value as well as to find ways which change their
impacts so that business, which are companies in Vietnamese construction companies in
this case, can control the overall risks or use them as a positive tool to achieve the expected
return on equity. And then firms can make appropriate decisions related to funding which
can enhance the growth.

1.2 Overview about Vietnamese real estate
Real estate market Vietnam began to have prospered from around the years 2006 - 2008,
after a period of strong growth the market began to appear many shortcomings caused
investors as well as business start run into difficulties, accompanied by many implications
for the economy.
From early 2011 until now is the moment most clearly reflects the inadequacies of the

market, a lot of information, false signals and unhealthy negatively impacted investor
sentiment made the market appear to state outbreak overly price and trading volume.

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During the peak period, the real estate markets actually absorb relatively large amounts of
capital from investors as well as from the people, but it’s not true with the actual demand
on real estate market. People did not find the outlet for Vietnamese market.
Real estate becomes the hottest market in this time when many investors found the safe of
the continuous increase in land price. In fact, there are real estate market times to absorb
50% of total investment capital of the country created an imbalance condition. Businesses
are abandoned business turned to his former property investment and take this as the main
business areas. From the condition that causes the players 'virtual' buyers and sellers do
not consume increasingly price bubbles blow to the future consequences when the bubble
burst, the market will freeze, redundant. Inflation in 2008 and 2011 mainly due to the real
estate bubble caused. From this cause, people created a “virtual demand” in real estate
market without consume as blowing a bubble bigger and bigger day by day. The
consequence is the inflation in 2008 and 2011 mainly due to the real estate bubble caused.
In recent years, the real estate industry in Vietnam is showing signs of warming up and
expects to grow with new goals. So in this article we would like to mention the real estate
business to provide a solution for the future projects of the real estate business.

1.3 Research questions
With the research objectives that are determined above, the thesis is constructed based on
answering the following research questions:
•

What is situation between equity and debt of Da Nang Housing Investment

•

Development Joint Stock Company? What is enterprise value of this company?
What is the correlation between financial leverage and enterprise value of the Da

•
•

Nang Housing Investment Development Joint Stock Company?
How to financial leverage has effect on enterprise value?
What are the best recommendations for the company to use financial leverage to
improve the enterprise value?

1.4 Research object
This thesis aims to do research on the situation, solution and impacts of financial leverage
on Da Nang Housing Investment Development joint stock Company (NDN). For more
information, the research will analyze the effects of financial leverage on enterprise value
of NDN.

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1.5 Research objectives
In order to clarify the topic above, this thesis focuses on achieving the following
objectives:
•Give the current situation and solution in NDN Company about debt and capital
structure.
•Measure the impacts of financial leverage of NDN in Vietnamese real estate
industry.
•Recommend some effective solutions for NDN Company to improve financial

leverage, capital structure on enterprise value.
The result of this thesis is expected to be valuable for NDN company to evaluate the
importance of leverage on firms’ performance, after that, suggest operational plans and
strategies to use leverage most effectively in order to gain firm value.

1.6 Research scope
The scope of the study is to clarify all perspectives of financial leverage that has an
impact on the enterprise value of Da Nang Housing Investment Development Joint
Stock Company. Secondary data will be collected from a selection of all audited
financial reports that were made publicly by Da Nang Housing Investment
Development Joint Stock Company from 2010 to 2014.

1.7 Methodology
This section will include three parts: the research philosophy, research approach and
research method.
Firstly, about the research philosophy of this research, it will be illustrated via positivism.
Our group prefers collecting financial data of NDN to prove the impact of leverage on
profit of through that affect value of the firm.
Secondly, in the research approach, deductive approach will be applied for this research.
We think that deductive approach is the most reasonable choice for this study. Because of
the limited time for the research, it is difficult to apply inductive approach that develops a
new theory. Therefore, studying in deductive reasoning is more narrow in nature and
suitable in this study.
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Finally, the research method is the combination of both quantitative and qualitative
methods (mixed methods) with more concentration on quantitative method. We focus on
collecting quantitative data which mainly was numerical data collected from the financial
reports to use for statistical and numerical analysis. On the other hand, qualitative data is

also collected from research article of financial expert in the industry.

1.8 Data overview
The main materials used in this research are quantitative data which almost was secondary
data that is synthesized from the audited financial reports of NDN and further industrial
reports that are related to the issue of the thesis; the data was collected from 2010 to 2014.
Moreover, qualitative data is also used to reinforce the evidence that we have found
through analysis of quantitative data. Qualitative data are collected from research article of
financial expert in the industry.

1.9 Research limitation
Some of unanswered questions or require further research beyond the limits of the study.
Limitations of time and the data is not really accurate 100%, so maybe the question will
not be answered fully.

1.10 Thesis structure
• Chapter 1 - Introduction: Providing the background of the topic, overview of
Vietnamese economy and aquatic industry, problem statement, research questions
and research objectives, research scope, methodology, data overview, research
limitation, thesis structure.
• Chapter2 - Literature review: Having some the previous researches and theories
regarding to financial leverage.
• Chapter 3 - Methodology: Chapter 3 focuses on selecting research methods, the
approaches of collecting data and analyzing them.
• Chapter 4 – Data Analyses and Findings: This chapter attempts to analyze the
collected data. Based on the analyzed data, the research will give findings discussions.
• Chapter 5 - Conclusion and Recommendations: Answering the research questions
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and meeting the research objectives and making recommendation.

1.11 Conclusion
To recap, chapter 1 gives an overview about the topic. It states the importance of
capital structure and gives information about Vietnamese aquatic industry. There are
three general problems of the research to be answered are “What is current status of
debt and profitability situation of Da Nang Housing Investment Development Joint
Stock Company? What is the correlation between financial leverage and profits of the
Da Nang Housing Investment Development Joint Stock Company? What are the best
recommended solutions for the company to use financial leverage the most effective
way for their growth?” Based on the research question, information will be collected
to analyze and evaluate about Da Nang Housing Investment Development Joint Stock
Company case study. This chapter also gives a slight look about the r e s ea r c h
o b j ec t , r e s ea r c h o b j e c t i v e s , research scope, methodology, data overview,
research limitation and thesis structure.

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CHAPTER 2: LITERATURE REVIEW
This chapter presents the theoretical and empirical literature review over the capital
structure theories and researches. The theoretical literature review will be referred in the
first. The next section covers reviews of prior empirical studies including those conducted
in the company. The conclusion and knowledge gap will be mentioned in the last section.

2.1 Capital structure
Capital structure mentions the alternatives which can be applied to obtain the necessary
capitals for firms’ business activities with suitable priorities. Two main factors of financing
be available to firms are debt and equity. The process of financial decision making is the
effort on the specification of the optimal capital structure, where the businesses’ value is

maximized and cost of capital is minimized. The measurement of one firm’s cost of capital
in financed is the Weighted Average Cost of Capital (WACC).
2.1.1 Definition of capital structure
There were many difference definition of capital structure have been mentioned in
literature review. The capital structure is typically defined by the financial leverage, which
is the aim of using the relatively debt to increase expected return on equity ROE, maximize
the firm value and minimize the cost of capital.
One of the theories related to capital structure states that, in the absence of taxes and
bankruptcy costs, the composition of the right-hand side of the balance sheet (debt and
equity financing elements, including the relative amount of leverage) would not matter - no
optimal capital structure would exist. (See Modigliani and Miller 1958; Jensen and
Meckling 1976; Myers 1977)
According to Brealey and Marcus (2009), capital structure is the combination of long term
debt to equity ratio.

Nevertheless, because capital structure related to the measures

companies control their debt-to-equity proportion, it seems not good enough to include
equity and long term debt in the definition of capital structure; the firms are also
considered issuing short term debt or convertible debt to rising capital. The final decision
will relate to the essence of financed asset.
In the other hand, in the research of Welch (2011), instead of evaluating capital structure
by ratio of total debt on total asset, he used only the financial liabilities and equity to
evaluate the capital structure. With the aim of reviewing the literature adequately to
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use a definition of capital, the mixed financial debt consisting long-term, short-term debt
and equity are defined as capital structure.
The definition is able to be applied for examining the capital structure theories in the

following parts. In this study, we did not go deeper into the capital structure, as well as
factors related to it. The study will indicate the relationship between financial leverage and
capital structure. The impact factor, and added on optimizing capital structure, financial
leverage to boost corporate profits.
2.1.1.1. Equity capital
Equity capital is the capital owned by the business owner and the members of the joint
stock company.
There are three sources to make up equity: the amount of the capital contribution of the
investors, the total amount generated from the results of production and business activities
(undistributed profits) and the difference in revaluation of assets.
According to Myers (1984) the larger equity capital is lead to the lower financial leverage.
It will not take advantage of the benefits of the use of leverage in the firm.
2.1.1.2 . Debt capital
Debt capital is the capital that a business raises by taking out a loan. It is a loan made to a
company that is normally repaid at some future date. Debt capital differs from equity or
share capital because subscribers to debt capital do not become part owners of the
business, but are merely creditors, and the suppliers of debt capital usually receive a
contractually fixed annual percentage return on their loan, and this is known as the coupon
rate.
High debt capital index means that the financial leverage is being used intensively.
However, when debt capital is too high also means financial leverage increased very high,
it will bring more risks for the enterprise.
2.1.2 Ratio to define capital structure
Total Debt Ratio:
The ratio focus on the impact of debt, equity and firm employs in capital structure. Total
debt ratio indicate the extent of enterprise’s leverage. It can be defined as the proportion of
an enterprise’s asset that are financed by debt. The higher total debt ratios of corporation
show that they use more debt in their capital structure. (Parrino et al., 2011)
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If this ratio is 0.50, it means that 50 percent of the company’s assets are financed with
debt. This ratio can be high or low; however, to analyze whether this ratio is good or bad, it
depends on how the company’s capital structure affects the value of the firm. In addition,
there are many factors affecting the total debt ratio, so we should consider that to evaluate
the firm effectively.
For instance, in the study of Quang Do Xuan and Wo Zhong Xin (2013) that companies in
Vietnam mainly used short-term debt to finance their assets. The reasons for this issue can
be explained that first, commercial banks tighten lending conditions for long-term loans;
second, corporate bond market is in the early stage of development, so firms’ need of longterm debt is not high; and finally, companies in Vietnam do not have enough good brand
and reputation for long-term credits. Basing on issues above, analyzing short-term debt to
total asset ratio will assess the use of current liabilities in firm and factors affecting on debt
decisions of firm managers.
Debt To Equity Ratio:
It tell us the extent which a firm uses debt funding or financing leverage has implications
for capital structure of the firm. By raising funds through debt, shareholders are able to
maintain control without having to increase investment. If a firm earns more money with
debt than the interest they have to pay due to debt, shareholders returns are leveraged
(Erhardt and Brigham, 2006). But Investopedia stated that “Aggressive leveraging
practices are often associated with high levels of risk. This may result in volatile earnings
as a result of the additional interest expense.”

According to John and Scott (2011), it is also a measurement of company’s ability to
handle it’s obligations. The company with a high ratio will be in danger if the cost of
borrowed capital surpasses the return from business activities and becomes to much for the
company to handle. As a result, the company may go bankrupt. Moreover, investing in a
highly leveraged firm is unfavorable by its creditor because of its financial riskiness

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Equity Multiplier:
The equity multiplier tells us the amount of assets that the firm has for every dollar of
equity. (Parrino et al., 2011).

The equity multiplier gives investors an insight into what financing methods a company
may be able to use to finance the purchase of new assets. It's also an indicator of potential
threats a company may face from economic conditions that affect the debt-equity mix.
When a firm's assets are primarily funded by debt, the firm is considered to be highly
leveraged and more risky for investors and creditors. This also means that current investors
actually own less of the company assets than current creditors.
Lower multiplier ratios are always considered more conservative and more favorable than
higher ratios because companies with lower ratios are less dependent on debt financing and
don't have high debt servicing costs.
The multiplier ratio is also used in the DuPont analysis to illustrate how leverage affects a
firm's return on equity. Higher multiplier ratios tend to deliver higher returns on equity
according to the DuPont analysis. Thusly we can rewrite it as the formula follows:

2.1.3 Theories of capital structure
Most researchers on capital structure take as their point of departure the seminal work of
Modigliani and Miller (1958), who derived the Leverage Irrelevance Theorem, concluding
that capital structure does not impact firm value in an ideal environment. Their assumption
of an ideal financial environment excludes the impact of tax, inflation and transaction
costs. This theory, known as MMI, received criticism from peers who question the validity
of their theory given the fact that the no firm actually operates in an environment without
the impact of tax, inflation and transactional costs.
This prompted Modigliani and Miller (1963) to issue a correction, which is referred to as
MMII. They still argue that a change in the debt/equity ratio does not impact on firm value,

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however when taxes and other transaction costs are considered two factors need to be
acknowledged:
First, a firm’s weighted average cost of capital (WACC) decreases as it increases its debt.
Second, a firm’s cost of equity increases as it increases its debt since shareholders bear
higher business risk due to the increased possibility of bankruptcy
Given the great debate on capital structure, and adding to the aforementioned Modigliani
and Miller models (1958 & 1963), a number of theories have provided further
contributions.
Jou and Lee (2004) highlight some of the theories that will be further investigated. They
state that while MM1 claims that a firm’s financing decision is separate from its
investment decision under perfect market conditions, these two decisions are linked
through four sources of market imperfections:
1.
2.
3.

Capital has some resale value and is more costly to purchase later.
Debt obligations are tax deductible with full loss offsets.
Conflicts of interest between equity and debt holders over the initial

capacity may arise because equity has limited liability.
4.
There are certain costs incurred in the event of bankruptcy.
Consideration will now be given to various capital structure theories that have been
developed over a number of decades. The abovementioned points will also be
discussed in greater detail

2.1.3.1 The pecking order theory

Myers and Majluf (1984) propose that the “pecking order” framework is based on
asymmetric information since managers have inside information on the future prospect of
the firm and act in the favor of existing shareholders. According to pecking order theory
firms prefer internal finance (from retained earnings) to external finance, and when
external finance is required, firms prefer debt before equity. Myers (1984) modifies the
strict pecking order hypothesis and suggests that firms with many investment opportunities
may decide to issue equity before it is absolutely necessary.
The outcomes of empirical tests on pecking order theory are mixed. ShyamSunder, and
Myers (1999) find support for the pecking order hypothesis utilizing data from the New
York Stock Exchange for various sectors, over the period 1971- 1989. Frank and Goyal

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(2003) observed little support for pecking order hypothesis also using American publicly
traded firms for the period 1971 to 1998, and argued instead that net equity issues are more
closely correlated with financing deficit than are net debt issues. The pecking order
hypothesis seems to be more applicable to data prior to 1990 then post 1990. Fama and
French (2005) examine the financing decisions of many individual firms and observe that
these decisions are in conflict with the pecking order hypothesis. They also find that while
equity is supposed to be the last financing alternative, most firms issue some sort of equity
every year. Seifert and Gonenc (2008) in their study titled, The international evidence on
pecking order hypotheses , find little overall support for pecking order behavior in the US,
UK and Germany for the period 1980 to 2004. They indicate that this is largely attributed
to the information asymmetry due to widespread ownership of stock where insiders know
more than outside investors. They find evidence to support pecking order behavior in
Japan during the 1980s and 1990s. Ni and Yu (2008), also find little support for pecking
order theory amongst Chinese listed firms in 2004. They conclude that in China, large
companies follow the pecking order hypothesis while small and medium companies do not.
2.1.3.2 The trade-off theory

Myers (2001) postulates that debt offers firms a tax shield, and firms therefore pursue
higher levels of debt in order to gain the maximum tax benefit and ultimately enhance
profitability. However, high levels of debt increase the possibility of bankruptcy.
The advantages of this approach include the possibility of deducting interest payments
from company tax (Modigliani and Miller, 1963). Kim (1978), states that the disadvantage
of debt is the potential cost of financial distress. Jensen and Meckling (1976) add that an
additional disadvantage is the agency costs for equity holders and debt holders. To further
substantiate this argument DeAngelo and Masulis (1980) predict an inverse relationship
between leverage and investment tax shield, while the association between the corporate
tax rate and the debt level is expected to be positive. However Nagesh (2002), in his
investigation into sixty four JSE listed firms, finds a negative relation between the tax rate
variable and the extent of leverage. He also concludes that the trade-off between
investment related tax shields and debt-related tax shields is unobserved.
Myers (1984) asserts that the trade-off approach implies that a firm’s leverage reverts to a
target or optimal level. Negesh (2002) states that Frank and Goyal (2005) break Myers’
notion of trade-off into two parts:

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1.

The static trade-off theory, where a firm’s leverage is determined by a

single period trade-off.
2.
Target adjustment behavior, where the firm’s leverage gradually reverts to
the target over time.
More recently authors have developed a dynamic trade-off model in an attempt not
only to verify the prediction that leverage reverts to an optimal level, but also to

understand how quickly this adjustment is made (Hennessy and Whitehead, 2005).
2.1.4 Optimal capital structure with financial leverage
An optimal debt/equity ratio is achieved when the value of a firm is maximized while the
cost of capital is minimized (Firer et al., 2004 and Erhardt and Brigham, 2003). In contrast,
Myers (1984) holds that the various capital structure theories do not explain actual
financing behavior and it is therefore presumptuous to advise firms on optimal capital
structure.
However various researchers have found evidence in support of a positive relationship
between optimal capital structure and a maximised firm value: Ward and Price (2006)
indicate that an increased debt/equity ratio in a profitable business increases shareholder
returns, but also increases risk. Sharma (2006) concludes that there is a direct correlation
between leverage and firm value. Fama and French (2002) conclude that there should be a
positive relation between debt ratio and firm profitability. Contrary to this, Beattie,
Goodacre and Thomson (2006) question the theoretical work on capital structure, arguing
that the practical applications of capital structure theory are limited. A further ongoing
debate poses the question of whether capital structure influences firm value or vice versa.
Margaritis and Psillaki (2007) find that an inverse causal relationship exists between
efficiency and leverage. They conclude that the effect of efficiency on leverage is positive
at low to mid-leverage levels and negative at high leverage ratios. Finally, Stewart Myers,
writing on optimal capital structure in 2001, concludes that, “there is no universal theory of
the debt-equity choice and no reason to expect one” (Myers, 2001, p.81).

2.2 Profitability
2.2.1 Definition of profitability
Corporate performance plays a major role in determining firm’s capital structure.
Profitability

ratios

are

the

most

popular

metrics

used

in financial

analysis.

Shawn Grimsley stated that profitability ratio is a measure of profitability, which is a way

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to measure a company's performance. Profitability is simply the capacity to make a profit,
and a profit is what is left over from income earned after you have deducted all costs and
expenses related to earning the income. The formulas can be used to judge a company's
performance and to compare its performance against other similarly-situated companies.
However, Titman & Wessel (1988) agree that firms with high profit rates, all things being
equal, would maintain a relatively lower debt ratio because they are able to generate funds
from internal sources. Experimental results support the pecking order theory when
researchers also found out a negative relationship between profitability and debt financing
(saw Booth et at., 2001)
2.2.2 Ratio to define profitability

Gross profit margin
Parrino et al. stated that the gross profit margin referred to the percentage of net sales
which remains after factoring in cost of goods sold. Therefore, this ratio was calculated by
subtracting from net sale and dividing by net sales

In their perspective, the gross profit margin expresses control costs that directly relevant to
raw materials, labor and manufacturing expenses. The profitability ratio use to analyze an
enterprise’s performance.
Ebben (2014) also described the gross profit margin as an important financial tool to
maximize profitability, as well as evaluating the efficient business to compare with other
competitors. It is necessary to monitor changes of gross profit margin because of changes
that directly affect expense and revenue. If business owner do not understand its feature
and role, a higher risk of failure was inevitable.
Operating profit margin

According to Robert Parrino (2011), operating profit margin indicated how much profit a
company made after paying for cost of goods sold and all costs, exclude interest and taxes.
The information is use for calculation the operating profit margin that was obtained the
income statement. To calculate operating profit margin, the business owner would concern
to operating income and net sales
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The operating profit margin also expressed management’s ability through the profitability
from the firm’s operation..
Net profit margin
The ratio measures the percentage of net sales remaining after paying total costs, interest
and taxes. (Parrino et al. 2011)

From the formula, it is believed that the higher the firm’s net profit margin, the higher the

efficient business was in converting sales into profit. From evaluation this ratio, manager
could compare the company’s performance to the performance of competitor.
Return on assets

Return on assets (ROA) supports firm in evaluation of how much percentage of earning is
produced by each one unit of assets. Furthermore, this is also an extremely useful
measurement of how effectively firm managers employ assets to create profits.
According to Westerfield, Ross and Jaffe (2005), a high ROA is much preferred by the
company, because this shows that the firm gains more than what it has invested. High
values of ROA also provide an indication of firm’s good management and operation
efficiency to generate benefits. However, this does not mean an absolute correlation
between the high ratio and the effective performance in all companies. In general, for
capital-intensive industries such as steel or utilities, it is much difficult to achieve high
ROA since firms are forced to purchase highly expensive assets for production activities.
Therefore, ROA should be best applied in comparing with the previous ROA numbers or
with the ROA of similar companies.
Return on equity

Return on Equity (ROE) measures the amount of returns created by a single unit of equity
and states the firm’s ability in maximizing shareholder’s wealth as well as firm value. This

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also shows the investors how well managers are using their capital invested in the
company.
A higher ROE displays extent more efficient management in utilizing firm’s equity and a
better return for shareholders. This indicator, however, can be manipulated to high value
when shareholder’s equity goes down. This also means that the company is financing its
performance by liabilities rather than its own sources; hence, high ROE ratio can be a bad

signal when company gets trouble with its lending funds in the future. That is why
investors should interpret ROE coefficient in the context of company’s debt-equity
relationship to determine whether or not investing in company with a high ratio is a wise
decision.
DuPont equation
According to Kevin, Gary and Lynne (2011), this model was created by F. Donaldson
Brown, an electrical engineer who joined the giant chemical company’s treasury
department in 1914. It was first introduced by DuPont Company in 1970’s.
H. Kent and Gary (2009) reported that in DuPont Model, ROE was broken down into three
important parts and was expressed as the formula below:

DuPont system describes that ROE is affected by three things:
•
•
•

Operating efficiency ( Or profitability), measured by net profit margin;
Asset use efficiency, measured by total asset turnover;
Financial leverage, measured by equity multiplier

Michael and Eugene (2013) claimed that net profit margin was an indicator of firm’s
profitability. They also pointed out that this ratio told firm how much after-tax proceeds it
made for each unit of revenue. H. Kent and Gary also stated a company with a high net
profit can control its costs well and have an intelligent pricing strategy, thereby its
competitive position in the market seems to solid rather than one with lower ratio.

2.3 Financial Leverage
2.3.1 Definition of financial leverage
Robert, David & Thomas (2009) observe that the term financial leverage refers to the use
of debt in a firm’s capital structure. When a firm uses debt financing, rather than only

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