The all the earlier tests carried out about

The
financial managers are always confronted
with the problem of having the most appropriate financial
structure for their firms. According to Myers (2001), neither there is any
universal theory related to the managers’ choice to adopt the standard
“Debt/Equity” ratio nor they should
expect it. The researchers try to their level best for having a standardized
formula for applying in the organizations to have optimal determinants of the
financial structure keeping in view the framework of different theories, e.g., the trade-off theory (TOT), market
timing theory and pecking order theory (POT). Unfortunately, these theories have not proved worth, and all the
earlier tests carried out about these theories
have produced inexplicable and ambiguous
results.

The
TOT argues that the profitability and
leverage are positively correlated, i.e.
the profit will always result in higher leverage ratio.

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According
to Rajan and Zingales (1995), the leverage of larger firms is considerably more
negatively correlated with profitability for small firms in Japan, Italy, and Canada, while in the United Kingdom it
is more positively correlated. This means
that the higher profitability will result in lower leverage ratio. This shows a straightforward
contradiction to the TOT.

It
is clear from these contradictory results that some
hidden players in the background affects these variables strongly. These
studies show that the financial structure of the firm may become inconsistent
as and when financial and economic conditions are
changed. As we know that firms usually
raise financing through the three fundamental sources, i.e., through internally
generated funds, or from external debt and new equity. According to the POT,
the “Companies prioritize their sources of financing, first preferring internal
funding, then
go for the debt, and  raising equity as a last resort. Hence the firms prefer
to finance their assets through the internal
sources over the debt financing. Similarly,
the debt financing has preference over the new issue of equity financing.

The
prevailing economic conditions are an equally
important consideration for both financial as well as non-financial
managers. The economy plays a vital role in the selection of the desired financial structure. One can opt for a different and unique financial structure entirely
in the era of prosperity as compared to
the era of recession and slumps.
Therefore, it is necessary to research
leverages’ role in shaping the profitability in the presence of both types of
economic conditions

1.2
Problem Identification

The
borrowed money has played a vital role in the business’s life cycle. There
remains a big mystery for owners of the business that whether this borrowed
money would have positive or negative impacts on the health of their business.
Typically, the money rose through bonds and loans results in financial
leverage. The money rose through these instruments results ultimately in
shareholder’s wealth maximization. As the FL
plays a vital role in the Return on Equity (ROE). Therefore, to choose a
right combination of the equity and debt to finance the assets of the firm is
of paramount importance. It depends on the preference of the firm’s management
whether to finance their assets by borrowed money or equity. The funds acquired
through the debt provide some tax benefits. But on the other hand, this
increases a fixed charge in the form of interest. Previous studies conducted by
Chen, Harford and Kamara (2016) state that this tax and fixed costs benefit
works well in the boom periods. While in the recessions/ slumps this tax and fixed costs benefit does not work due
to the low profitability (or loss). In fact, during the recessions, the firms pay
the fixed cost in the form of interest consistently, whereas the firms keep functioning far behind their
capacity. 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 periods
it increases losses. The financial crisis 2008 had a devastating and shocking
effect on US Economy. The Insurance and mortgage sector faced huge losses. It
also affected the UK and some other European economies. The East Asian
economies experienced moderate to low effects.

According
to the best of my knowledge, the topic “Role of FL and OL in firm’s
profitability during pre &post-2008
financial crisis particularly in the chemical sector of Pakistan” has never
been explored earlier. The OL has also reported being
positively associated with the profitability. Since in the sales growth
period, fixed costs do not increase precisely
in the same ratio as the sales growth does increase. Therefore, to increase the
fixed costs in the business is analogous to the issuance of internal debt. This
phenomenon, in contrast, decreases the dependence on the external financing, i.e. reducing the FL. The OL is the portion of
fixed costs scaled by total assets. The individual relationship between OL and
profitability is also positive.

1.3
Problem Statement

Leverage related decisions always
remain disputed among the organizations. Especially,
during the financial crisis, the role of leverage remains quite controversial. Some
researchers like Ahmad, Salman and Shamsi (2015) and Javed, Rao, Akram and
Nazir (2015), etc.  believe that the leverage is negatively
related to the profitability whereas the
Otaibi (2015) believes that there is a positive
relationship between leverage  and profitability. Similarly, Gatsi, Gadzo and Akoto (2013), state that the FL
negatively impacts the profitability and OL positively impacts the
profitability of the organization. This discussion is essential in the field of corporate finance to design corporate
financial strategy because it is evident from the prior literature that
economic conditions and industry type can significantly alter the results of
the research studies conducted on the relationship between leverages and
profitability. Therefore, the current research
is conducted to investigate the effect of FL and OL on the firms’ profitability
in the chemical industry during pre -financial
crisis periods. The data comprises all 43 (29 listed under the chemical head
while 14 other firms whose products are related to chemical &
Pharmaceutical industry) chemical firms listed at PSX (KSE) for two different
periods, i.e., from
2004 to 2008 and from 2009 to 2015. The study explores the proposed relationship
between the dependent variable
(Profitability) and two independent variables (FL and OL) with focus on
chemical firms listed on PSX.

 

 

 

 

 

 

 

 

1.4
Research Questions

The
following are the research questions of the study;

Question 1: What is the relation between
leverages (operating and financial) and profitability in the chemical sector
firms of Pakistan?

Question
2: Do leverages (operating and financial) increase/decrease the firms’
profitability in the chemical sector firms of Pakistan?

Question
3: What is the role of leverages (operating and financial) after the financial crisis?

1.5
Rationale of the Study

Similarly,
both internal and external sources of funding also have their own merits and
demerits. The internalsources are convenient
but involve the opportunity costs while external sources are more expensive and
not hassle-free. The
external financing sources have fixed interest costs associated with them
irrespective of the firm’s performance. They act like a dual-edged weapon. In the era of
prosperity, they prove themselves to be more productive while in the periods of
worries, they harm more than internal sources.

Both
types of leverages either financial or operating work like a magnifying glass.
In the boom periods, they give better justification of their existence. On the
other hand, they prove themselves to be more hostile during recessions. The
current study attempts to investigate whether the FL and OL have any positive
or negative impacts on the chemical sector of Pakistan with particular emphasis on pre -crisis
period. This study comprises the chemical industry
of Pakistan. The chemical sector has been
selected due to the following reasons;

·                 
Firstly, the
chemical sector is a large sector, and the beneficiaries of this industry are masses directly.

·                 
Secondly, the
better financial planning will bring down the input cost which will benefit the
masses.

 

 

 

 

·                 
Thirdly, the
financial managers of the concerned industry will become vigilant to keep eyes
on the economic changes occurring in their surrounding and will work proactively to control the profitability by
adjusting their leverages structure.

·                 
Fourthly, since
Pakistan is a developing country, therefore it needs a lot of research nearly
in all essential fields and sectors. Our
study will also contribute towards development and prosperity of our beloved country by having sound financial planning and managing scarce resources

·                 
It is evident
from the literature review that almost all other sectors have been explored by the researchers except the
chemical sector as per best of my knowledge. The distinctive feature of this research is its bifurcation between two
prominent economic conditions, i.e., pre and post-crisis periods. So it is of
utmost importance to conduct this study
in the most demanding and significant
industrial sector like chemicals.

1.6          
Objectives of
the study

·                 
It is a matter of great interest that the leverages
have shown different behavior in the various
industries. Therefore, it is high time to conduct the research study on the
chemical sector of Pakistan as well. This
will enable us to establish our opinion that whether leverages behave differently
in unrelated industries or the economic condition of the country causes the leverages to behave differently.

The
following are the objectives of this research;

·                 
To investigate
the impact of leverages  on the
profitability of the firms in chemical sector firms of Pakistan

·                 
 To examine
the relationship between leverages and
profitability of chemical sector firms of Pakistan before and after the 2008
crisis.

·                 
To suggest the
chemical industry, the most appropriate course of action by predicting the
future economic conditions of the country.

 

 

 1.7 Significance of the Study:

The
study will also have significant
implications for the respective industry in determining the most appropriate
structure of FL, OL or blend of both. This
will help to forecast the profitability of the firms related to the chemical
sector and other sector firms in general by choosing the ideal amount of debt
and fixed costs in a proactive manner. The firms
will be able to manage the funds to finance assets either from internal or
external sources depending upon the prevailing economic conditions. The
industry will be able to adjust its financial and operating leverage or total
leverage before any significant change in the economic conditions
of the country. The chemical sector is the focus of this study because the
respective industry is making development consistently. The masses of the country are direct
beneficiaries of the out-put of
this chemical industry. Since the country
is on the fast development track, therefore this sector is also making progress in leaps.  There is a general hypothesis that the risk
and returns are directly proportional to each other, i.e. the higher the risk, the higher the return or profitability. As leverage
increases the risk of the firm which in turn increases the returns. This
increase in return ultimately enhances
the shareholders’ wealth. If leverage causes profitability and maximization of
shareholders’ wealth, then the
long-term sustainable growth in the
chemical industry is quite possible. So, the proposed study is of paramount
importance for the masses, chemical sector, and
financial manager. The study will have following implications for various
stakeholders;

·                 
This will help the researchers and the professionals related to the field
of finance by improving their understanding regarding the theoretical aspects
of the leverages and state of economy particularly in the chemical sector and
generally in all other sectors those have either incorporated or intending to
incorporate the leverages in their capital structure for enhancing the firms’
profitability.

·                 
The financial
managers will have an opportunity to equip themselves with the strong
theoretical understanding of depicting the crisis well in advance and taking
appropriate measures to protect or enhance their firms’ profitability in a
proactive manner. It will enable the financial managers to understand the
nature and effects of leverages during the recession and boom periods of the economy which will ultimately result in better
financial planning and control to achieve
targeted profitability.

·                 
 

 

 

·                 
The Pakistan
chemical industry as a whole will be benefited
in particular and other industrial sectors in general. The entire industry will
be able to restructure their leverage structure keeping in view current state
of the economic cycle.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

REVIEW OF LITERATURE

CHAPTER No. 02

The
POT was popularized by Myers (1984) in his paper. He argued that equity
financing is not striking mean of arranging capital because the managers are
assumed to know better about real internal
condition of the firm than investors. When the managers decide to raise the
additional money through “new equity
issue” then the investors believe that the managers think that the firmis overvalued and the managers are taking
advantage of this over-valuation. Consequently, the investors
will place a lower value on the new
equity issuance.

Campello
et al. (2010) proved that a survey of the real effects of financial constraints
during financial crises reveals that constrained firms tend to use internal
funding and put more effort on obtaining credit from banks by anticipating
restricted access to credit in the future.,

Chen,
Harford,and Kamara (2016) found that OL crowds-out the
FL while also increases the profitability. Thus the OL generates a negative
relationship between FL and profitability. The study was conducted in China with a sample from the pre-crisis period
of 2004 to 2007 and the post-crisis
period of 2008 to 2011 based on the sample median OL at the end of 2007. Only
firms with positive profitability were
selected.

Pandey
and Prabhavathi (2016) conducted a research
onautomobile industry in India. The sample consisted of 12 firms listed
on Indian stock exchange for the period from 2003 to 2013. The study concluded
that gross fixed assets have significant
impact on FL,i.e.
the debt cost is strongly associated with
the returns of the firms.

Ahmad, Salman,and Shamsi (2015) found that the financial
leverage has a statistically significant inverse impact on profitability in the
cement 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 Stock
Exchange and concluded that there is a positive
relationship between the FL and ROE. The study period was two years, i.e. 2011-2012. The sample size was 26 well
performing non-financial firms listed on
KSA stock exchange.

Khedkar
(2015) observed that degree of OL is
significantly negatively correlated with the ROI

Mule (2015) concluded that financial
leverage is a significant negative
predictor of financial performance
measured regarding Return on Assets (ROA)
and Tobin’s Q. The study was conducted on
all the firms listed in Kenya for the period from 2007 to 2011.

Obonyo
(2015) showed that there is a positive
relationship between financial leverage and earnings per share as a measure of financial performance of companies in the
construction and allied sector at the Nairobi Securities Exchange market in
Kenya. He studied the “Athi River Mining Cement Limited, Bamburi Cement
Limited” and East African Portland Cement Company Limited for a period of 2005
to 2012.

Javed,
Rao, Akram,and
Nazir (2015) revealed that financial leverage is
negatively associated with the return
on assets and equity in the textile sector of Pakistan. The study comprised 154
textile firms for the period from 2006 to 2011.

Patel (2014) conducted a study on Sabdar
Dairy in India. The period of study was from 1985 to 2014. It was found in this study that the coefficient of
DOL, DFL, and DTL is positive with EPS
but not significant. However, the overall model was statistically significant.

Inam and Mir (2014) studied that that
financial leverage positively affects the firm financial performance in fuel
and energy sector of Pakistan. The 12 firms were
included in the study from the fuel and energy sector of Pakistan.

Ali (2014) observed that there is a significant negative
relationship between leverage and return on assets. This study set out to
investigate the role of financial leverage
on firm performance of the non-financial blue chip companies listed under the
NSE 20 share index in Kenya for a period from 2008 to 2013.

Rajkumar
(2014) showed a negative relationship between the financial leverage and the
financial performance of the John Keells Holdings PLC. The study was conducted on John Keells Holdings plc in Sri
Lanka during the periods of 2006-2012

 

 

 

Gatsi,
Gadzo,and Akoto (2013) conducted a similar study in
the field of insurance firms in Ghana. The sample size was 18 firms listed in
Ghana from 2002 to 2011. The study showed
that financial leverage has a significant adverse
effect on the profitability of the insurance companies; OL has a positive and
statically substantial influence on
profitability

Rehman
(2013) showed the positive relationship of debt-equity
ratio with return on asset and sales growth, and the negative relationship of debt-equity ratio with earning per share, net
profit margin and return on equity in the sugar industry of Pakistan.

Mohapatra
(2012) revealed that ‘OL’ and ‘industry class’ have a significant bearing on
the capital structure of the Indian firms whereas the ‘profitability’ could not
be a clear determinant of corporate capital structure in India

Akhtar,
Javed, Maryam,and
Sadia (2012) showed that there is a definite
relationship between the financial leverage and the financial performance of the
fuel and energy sector of Pakistan. The data used for analysis consisted of 20
KSE listed firms for the period from 2000 to 2005.

Yoon
& Jang (2005) found that indicated that highly
leveraged firms were less risky in both market-based and accounting-based
measures