The present study aims to investigate to what extent capital structure has an impact on profitability and closely associated factors due to a series of bankruptcies and bail-outs within the last twelve months. The analysis refers to firms listed in the S&P 500 index on January 2004 and evaluates their performance from 2004 to 2008. The results show strong industry-specific characteristics for all factors observed, i.e. gearing, profitability, liquidity, investments and dividends. In addition, findings indicate a negative effect of higher gearing for almost all ten sectors in respect of the core variables analysed. Neither the trade-off nor the pecking order theory can be confirmed, however, more support for the former is found. Due to the complexity of capital structure choice, regulations have very limited effects that require the need for independent non-governmental monitoring agencies to improve transparency and have the authority to intervene if managers act at the expense of public interest.

Text Sample: Chapter 2.2.5, Capital Structure and Dividend Policy: Shareholders expect a return on their investments, either in the form of an increase in share prices or through dividends for placing equity at the disposal of a business. Since some organisations, such as pension funds and charities, periodically require revenues, dividends might be preferred that also reduces transaction costs. This reality might be overseen in the simplified MM argument of 1961, according to which, dividend policy does not matter in perfect markets. Dividend announcements, due to information that they contain, influence stock prices and thus the market value of a firm which has an impact on equity issues, according to the pecking order. This concept was approved by Asquith and Mullins on a sample of 168 publicly listed US companies from 1964 to 1980, who began to pay dividends. Also Baskin argues that ‘[d]ividends provide signals both to current and future earnings’ and found that higher dividend payments in 1965 resulted in considerably higher debt levels in 1972. He (ibid.:31) observed that the level of dividend payouts is rather stable, since ‘[s]erial correlation after twelve years is 0.714 and amounts to about 50% explained variance’. In contrast, Antoniou et al. find a negative correlation of gearing and dividend payments for US firms only, while Lintner argues that dividends depend on profits and successful investment strategies that allow a stable compensation for shareholders. Also Rozeff argues that more investment opportunities lead to lower dividend payout ratios that, however, do not reduce agency costs, which are offset by higher transaction costs for debt issuance. Thus, according to the pecking order theory, dividends contain information about the future that makes dividend policy a ‘sticky’ subject, ‘while capital spending varies over the business cycle’ that increases debt levels. According to Baskin, ‘the need to adhere to stable dividend policy appears to be much stronger than those motivating adherence to some statically defined optimal capital structure.” In a severe downturn, however, where profits and financial resources shrink, it is worth questioning whether a firm should stick with dividend policy or would be better selling undervalued assets to generate liquidity. An observation made by Graham is that ‘dividend-paying firms issue debt more conservatively than do non-dividend-paying firms, even though they presumably have less severe informational problems.’ This implies higher leverage for non-dividend-payers as is confirmed by Frank and Goyal. Thus, firms who pay dividends do not only have less interests to pay, but would also be able to reduce dividend payments in bad times and thus are able to avoid financial distress, while for them it is easier to continue investments. Another explanation is that non-dividend-payers have more growth opportunities, requiring new investments that are leveraged with external debt, while mature firms do not always have the possibility to invest in profitable projects. Baskin states that ‘an increase in equity issues necessarily results in greater dividends, and greater dividends in turn give rise to a larger burden of personal taxation.’ As a result, investors would prefer lower dividends in favour of faster growing share prices. While young firms with large growth potential do not have these problems with free cash flows, rational investors of mature firms expect dividends to avoid over-investment. Also large firms, who generally pay higher dividends, tend to expand more slowly than small ones, as observed by Baskin, which implies higher dividend payouts.

• Capital Structure

• Profitability

• Crisis

• Gearing

• S&P 500

• bankruptcy

Elmar Puntaier, born in Italy, holds a first degree in Industrial Engineering from the Politecnico di Torino and was awarded an MBA in Finance with distinction from the University of Leicester, following several years of managerial experience within the business-to-business sector. His interest in corporate finance and political economy encouraged him to analyse the causes and consequences of financial crises and the effects of globalisation, taking into account the heterogeneity of organisational structure and size within an increasingly interconnected economy. He now supports early stage businesses in their growth and strategic decision-making, in his role as a business development manager and mentor.