The Australasian Accounting Business & Finance Journal, December, 2007. Tian & Zeitun: Capital
Structure and Corporate Performance: Evidence from Jordan. Vol. 1, No. 4. Page 40
Capital Structure and Corporate Performance:
Evidence from Jordan
Rami Zeitun
a
and Gary Gang Tian
b*
ABSTRACT
This study is to investigate the effect which capital structure has had on corporate performance
using a panel data sample representing of 167 Jordanian companies during 1989-2003. Our
results showed that a firm’s capital structure had a significantly negative impact on the firm’s
performance measures, in both the accounting and market’s measures. We also found that the
short-term debt to total assets (STDTA) level has a significantly positive effect on the market
performance measure (Tobin’s Q). The Gulf Crisis 1990-1991 was found to have a positive
impact on Jordanian corporate performance while the outbreak of Intifadah in the West Bank and
Gaza in September 2000 had a negative impact on corporate performance.
JEL Classification: G32 G33
Keywords: corporate performance and failure, capital structure, Jordan
a
Department of Finance and Economics, University of Qatar, Qatar.
Email: rami.zeitun@qu.edu.qa
b
School of Accounting and Finance, University of Wollongong, NSW 2522, Australia. Telephone: +61 2 4221 4301
Email: gtian@uws.edu.au
*
Corresponding author. Finance Discipline, School of Accounting and Finance, University of Wollongong,
Northfields Ave, 2522 Australia. Tel: +61 2 4221 4301. Email: gtian@uow.edu.au. We would like to thank Don
Ross, Yanrui Wu and Subba Reddy Yarram for their very helpful comments on the earlier draft of this paper. The
authors remain responsible for all errors.
1. INTRODUCTION
The topic of optimal capital structure has been the subject of many studies. It has been
argued that profitable firms were less likely to depend on debt in their capital structure than less
profitable ones. It has also been argued that firms with a high growth rate have a high debt to
equity ratio. Bankruptcy costs (proxied by firm size) were also found to be an important effect on
capital structure (Kraus and Litzenberger, 1973; Harris and Raviv, 1991). If these three factors
are considered as determinants of capital structure, then these factors could be used to determine
the firm’s performance.
In practice, firm managers who are able to identify the optimal capital structure are
rewarded by minimising a firm’s cost of finance thereby maximising the firm’s revenue. If a
firm’s capital structure influences a firm’s performance, then it is reasonable to expect that the
firm’s capital structure would affect the firm’s health and its likelihood of default. From a
creditor’s point view, it is possible that the debt to equity ratio aids in understanding banks’ risk
management strategies and how banks determine the likelihood of default associated with
financially distressed firms. In short, the issue regarding the capital structure and firm
performance are important for both academics and practitioners.
The Australasian Accounting Business & Finance Journal, December, 2007. Tian & Zeitun: Capital
Structure and Corporate Performance: Evidence from Jordan. Vol. 1, No. 4. Page 41
The objective of the current paper is to examine the effect which capital structure has on
corporate performance in Jordan. There is a lack of empirical evidence about the effect of capital
structure on the performance of firms in both developed and developing countries. Most of the
previous evidence on capital structure comes from the determinants of corporate debt ratio. To
the best of the authors’ knowledge, this research provides the first attempt to investigate the
effect of capital structure on corporate performance in Jordan. Our reason for choosing Jordan as
a case for this topic is its uniqueness, which we discuss below.
First, the Jordanian economy has been subject to a large number of external shocks in
the Middle East region during the period of our study. The first Gulf War was broken out in
1990-1991. Both the return of migrant workers and refugees due to this war increased the poverty
level and unemployment level in Jordan. For example, more than 300,000 people returned to
Jordan from Gulf countries during that period of time (World Bank, 2003). In addition, the
continuing strife in the West Bank and Gaza, and the second Gulf War in 2003 has had a negative
impact on tourism and investment in Jordan. Furthermore, Jordan was badly affected by the
Palestinian Intifadah
1
which began in September 2000. The Palestinian Intifadah affected firm
performance negatively as most of Jordanian companies' export production goes to these
neighbour countries. These macroeconomic factors (shocks), which have had an important effect
on firm performance and default, are unique Jordanian case and are hardly found in any other
existing study.
Secondly, the banking system in Jordan also makes this study unique. The banking
system
2
in Jordan is different from western countries as it contains both conventional commercial
banks and Islamic banks
3
. The credit policy in Islamic banks is different from the commercial
banks, which could affect corporate performance and default risk. Since bond markets and
Mutual Funds markets are undeveloped and inactive, both commercial and Islamic banking
systems play an important role in providing lending to Jordanian firms. These bank lending are
the main source of funds for these firms Therefore, this unique dual banking systems offers us a
new insight into the study on the effect of capital structure on firm performance.
Thirdly, it is worth noting that both Islamic and non-Islamic banks have a credit policy
which requires banks to provide more short-term loans rather than long-term loans (Creane et al.
2003). Under this credit policy, banks concentrate their lending to the services sector rather than
the industrial sectors which normally requires long-term loans. This banking credit policy could
also have an impact on the capital structure of the borrowing companies, and could also force
these firms to choose a less than optimal capital structure, which could make them vulnerable in
the short term to an increase in the interest rate. This is especially true for smaller firms, which
are more exposed to insolvency than larger ones.
1
It refers to the Palestinian upheaval against Israel in Gaza and on the West Bank.
2
In Jordan, banks tend to play a measured role in collecting the deposits and issuing loans to companies that require
capital and finance, and it also provides risk assessments.
3
It is worth noting that there are other emerging countries that have the same characteristics such as the Middle
Eastern countries (Saudi Arabia, Lebanon, Syria, Yemen, Kuwait, UAE, Qatar, Libya, and Bahrain), Muslim
counties such as Malaysia, Indonesia, and Pakistan. Furthermore the MENA countries have the same characteristics
as been established by the World Bank. Therefore, the result of this paper is important.
The Australasian Accounting Business & Finance Journal, December, 2007. Tian & Zeitun: Capital
Structure and Corporate Performance: Evidence from Jordan. Vol. 1, No. 4. Page 42
The remainder of this paper is organised as follows. Section 2 discusses the literature
review. Section 3 discusses the methodology and the empirical models used to investigate the
effect of capital structure on corporate performance. Section 4 presents the analysis and
discussion of results. Section 5 summarises and concludes the paper.
2. LITERATURE REVIEW
One of the main factors that could influence the firm’s performance is capital structure.
Since bankruptcy costs exist, deteriorating returns occur with further use of debt in order to get
the benefits of tax deduction. Therefore, there is an appropriate capital structure beyond which
increases in bankruptcy costs are higher than the marginal tax-sheltering benefits associated with
the additional substitution of debt for equity. Firms are willing to maximise their performance,
and minimise their financing cost, by maintaining the appropriate capital structure or the optimal
capital structure. Harris and Raviv (1991) argued that capital structure is related to the trade-off
between costs of liquidation and the gain from liquidation to both shareholders and managers. So
firms may have more debt in their capital structure than is suitable as it gains benefits for both
shareholders and managers. However, as stated in the previous literature, underestimating the
bankruptcy costs of liquidation or reorganization, or the aligned interest of both managers and
shareholders, may lead firms to have more debt in their capital structure than they should (see, for
example, Harris and Raviv, 1991). Krishnan and Moyer, (1997) found a negative and significant
impact of total debt to total equity (TD/TE) on return on equity (ROE). Another study by
Gleason, Mathur and Mathur, (2000) found that firms capital structure has a negative and
significant impact on firms performance measures return on assets (ROA), growth in sales
(Gsales), and pre tax income (Ptax). Therefore, high levels of debt in the capital structure would
decrease the firm's performance.
However, not only does a firm’s level of leverage affect corporate performance and
failure but also its debt maturity structure (Barclay and Smith, 1995 and Ozkan, 2002).
Schiantarelli and Sembenelli (1999) investigated the effects of firms’ debt maturity structure on
profitability for Italy and the United Kingdom. They found a positive relationship between initial
debt maturity and medium term performance. A study by Barclay and Smith (1995) provides
evidence that large firms and firms with low growth rates prefer to issue long-term debt. Another
study by Stohs and Mauer (1996) suggested that larger and less risky firms usually make greater
use of long-term debt. They also found that debt maturity is negatively related to corporate tax,
the firm’s risk and earning surprises. In other words, the choice of debt structure could have an
impact on both corporate performance and failure risk. Furthermore, there are other factors,
besides capital structure, that may influence firm performance such as firm size, age, growth,
risk, tax rate, factors specific to the sector of economic activity, and factors specific to
macroeconomic environment of the country. These variables will be considered in this study. We
provide a definition of performance and the types of performance measures below.
The concept of performance is a controversial issue in finance largely due to its multi-
dimensional meanings. Research on firm performance emanates from organization theory and
strategic management (Murphy et al., 1996). Performance measures are either financial or
organisational. Financial performance such as profit maximisation, maximising profit on assets,
and maximising shareholders' benefits are at the core of the firm’s effectiveness (Chakravarthy,
1986). Operational performance measures, such as growth in sales and growth in market share,
The Australasian Accounting Business & Finance Journal, December, 2007. Tian & Zeitun: Capital
Structure and Corporate Performance: Evidence from Jordan. Vol. 1, No. 4. Page 43
provide a broad definition of performance as they focus on the factors that ultimately lead to
financial performance (Hoffer and Sandberg, 1987).
The usefulness of a measure of performance may be affected by the objective of a firm
that could affect its choice of performance measure and the development of the stock and capital
market. For example, if the stock market is not highly developed and active then the market
performance measures will not provide a good result. The most commonly used performance
measure proxies are return on assets (ROA) and return on equity (ROE) or return on investment
(ROI). These accounting measures representing the financial ratios from balance sheet and
income statements have been used by many researchers (e.g., Demsetz and Lehn, 1985, Gorton
and Rosen, 1995, Mehran, 1995, and Ang, Cole and Line, 2000).
However, there are other measures of performance called market performance
measures, such as price per share to the earnings per share (P/E) (Abdel Shahid, 2003), market
value of equity to book value of equity (MBVR), and Tobin’s Q. Tobin’s Q mixes market value
with accounting value and is used to measure the firm's value in many studies (e.g., Morck,
Shleifer, and Vishny, 1988, McConnel and Serveas, 1990, and Zhou, 2001). The performance
measure ROA is widely regarded as the most useful measure to test firm performance (Reese and
Cool, 1978 and Long and Ravenscraft, 1984, Abdel Shahid, 2003, among others)
4
. Two
accounting measures, ROA and ROE, are used as proxy measures for corporate performance, and
three market performance measures, P/E, MBVR, and Tobin’s Q. The stock market efficiency
and other economic and political factors could affect a firm’s performance and its reliability (See
Abdel Shahid, 2003).
In summary, a firm’s performance could be affected by the capital structure choice and
by the structure of debt maturity. Debt maturity affects a firm’s investment options. Also, the tax
rate is expected to have an impact on a firm’s performance. So, investigating the impact of capital
structure variables on a firm’s performance will provide evidence of the effect of capital structure
on firm performance.
3. ESTIMATION METHOD
3.1 Data
The data used in this section comes from the Amman Stock Exchange (ASE) and
includes the traded companies for the period 1989-2003
5
. All companies were required to deliver
their financial statements for every year between 1989 and 2003. The data set contains detailed
information about each firm. The items of interest were: balance sheets, income statements, tax
paid, interest paid, depreciation, and market valuation. By law, the full balance sheets and income
statements are available from firms. The data set is a moderately sized unbalanced panel,
consisting of 167 individual quoted firms, of which 47 were defaulted firms in the following year.
Our sample contains 16 sectors. No financial companies, such as banks, insurance firms, and
financial firms, are included in this analysis as their characteristics are different. The firms that
4
The performance measure ROA has received some occasional criticism. For more details see Fisher and McGowan,
1983.
5
It is worth noting that the data is unavailable after 2003 for all firms included in the study. Therefore, our sample
does not extend after 2003.
The Australasian Accounting Business & Finance Journal, December, 2007. Tian & Zeitun: Capital
Structure and Corporate Performance: Evidence from Jordan. Vol. 1, No. 4. Page 44
failed to deliver their statement for two years or more are considered failed, as they should
deliver their statement by law. Our sample includes 47 defaulted firms and 120 non-defaulted
firms.
3.2 Empirical Model and Proxies Variables
We used different measures of corporate performance: the return on assets (ROA),
return on equity (ROE), earnings before interest and tax plus depreciation to total assets (PROF),
market value of equity plus book value of debt to the book value of assets (Tobin’s Q)
6
, market
value of equity to the book value of equity (MBVR), price per share to the earnings per share
(P/E), and market value of equity and book value of liabilities divided by book value of equity
(MBVE). In this study, Tobin’s Q, MBVR, P/E, and MBVE are used to measure the market
performance of firms, while the ROE, ROA, and PROF are employed as measures representing
accounting performance measures.
More than one proxy for performance was used in this study in order to investigate
whether the independent variables explained the performance measures (accounting, market, and
stock market) at the same level or not. The researcher used the proxy (ROA) as an accounting
performance measure and the (Tobin’s Q) as a market performance measure. Tobin’s Q has been
used as a major indicator of firms’ performance. Even Tobin’s Q, as agreed by many researchers,
is a noisy signal. Because of the limitations of Tobin’s Q, other performance measures, ROE and
PROF, P/E, MBVR, MBVE, are employed as supplementary measures. Using accounting and
market measures of performance may shed light on the stock market activity and if there are
other factors that may affect corporate performance.
If capital structure does affect a firm’s performance and value, then a strong correlation
between the firm’s performance and capital structure would be found. So, we argue that a firm’s
debt ratio affects its performance negatively. Furthermore, it has been argued that short-term debt
influences a firm’s performance negatively, because short-term debt exposes firms to the risk of
refinancing. It is expected that the debt maturity ratios (short-term debt and long-term debt) will
have a significant impact on corporate performance because of the banking credit policy. Thus,
the hypotheses are:
1
H
: A firm's capital structure does influence its performance.
2
H
: Short-term debt decreases firm performance.
Growth opportunities are measured by growth of sales (Growth)
7
. It is expected that
firms with high growth opportunities have a high performance ratio, as growth firms are able to
generate profit from investment. So, growth opportunities are expected to positively affect a
firm’s performance. Thus, Hypothesis 3 can be stated as follows:
3
H
: Growth opportunities increase firm performance.
6
It is worth noting that firms in Jordan do not issue preference shares.
7
It is worth noting that growth of assets and book value of total assets minus book value of equity plus market value
of equity divided by the book value of total assets are used in this study.