The theory (POT). Unfortunately, these theories have not proved

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.