Capital structure and company performance: The case of free zone companies in Ghana

The study investigates the effect of tax savings on the capital structure of free zone companies in Ghana. Using a panel regression model, the study specifically examines the determinants as well as the effect of capital structure on the financial performance of these companies. The study used data from annual reports of these companies from 2009–2012. The results of the study show that tax has a positive and significant relationship with the capital structure of the free zone companies, and even though the companies do not pay corporate tax for the first 10 years, they operate in Ghana and pay the lowest corporate tax after the first 10 years. The regression results also show that the age of the company, size, profitability and company risk are important in influencing the decisions on the capital structure of the free zone companies. Capital structure of the companies has an inverse relationship with return on asset, which measures the financial performance of these companies. The study provides useful recommendations for policy direction and to managers of these companies.


Introduction
Capital structure refers to a company's financial framework, which consists of the debt and equity that are used to finance the company.Capital structure is essential in determining how a company finances its overall operations and growth by using different sources of funds.The modern theory of capital structure originated from the groundbreaking contribution of Modigliani and Miller in 1958, under the perfect capital market assumption that if there is no bankruptcy cost and capital markets are frictionless and without taxes, the company's value is independent of the structure of the capital.In 1963, Miller and Modigliani modified the assumptions to include tax because the use of debt reduces the amount of tax a company has to pay and increases the value of the company.At the corporate level interest on debt is generally deductible from the taxable income, and this provides companies with an incentive to finance their operations with debt rather than equity, especially in countries that levy high tax (Graham 1996(Graham , 2000;;MacKie-Mason 1990).The relationship between company performance and capital structure has succeeded in attracting a good deal of public interest because it is a tool for socio-economic development.Also when there is good company performance and capital structure, there will be a proper and efficient practice in the administration of business entities.
The Ghana Free Zones programme was established by an Act of Parliament (Act 504) in 1995 to promote export-oriented investment in Ghana.It is an integrated programme, which promotes the processing and manufacturing of goods through the establishment of export processing zones and encourages the development of commercial and service activities in the seaport and airport areas.Companies in Ghana registered under the free zone programme enjoy 100% exemption from paying income tax on profits for the first 10 years, and this tax does not exceed 8% thereafter.The three main goals for which the government establishes free zones are: to provide a country with foreign exchange earnings by promoting non-traditional exports; to create jobs and generate income; and to attract foreign direct investment, technology transfer, knowledge spillover, demonstration effects and backward linkages (http://www.gfzb.gov.gh).

Problem statement
In Ghana a number of researches have been carried out on the determinants of capital structure (Abor 2008;Abor & Biekpe 2004;Amidu 2007;Boateng 2004), capital structure and firm performance (Abor 2005;Kyereboah-Coleman 2007), stock market and capital structure (Bokpin & Isshaq 2008), and the role of debt in balance sheet (Aboagye 1996), amongst others.None of these studies focused on capital structure and performance of free zone companies in Ghana which provided employment to 30 080 employees and contributed $10 104.63 million to Ghana's export in 2011.In addition, the tax-based theory suggests that in a world with corporate taxes, the tax deductibility of interest for corporations creates a clear preference for debt in the corporate capital structure.Therefore, companies that are highly levered are supposed to outperform their counterparts that are less levered.However, free zone companies do not pay corporate tax for 10 years of operation and also fall within a lower tax bracket (i.e.0%-8%) after the 10-year period.The non-free zone companies in Ghana pay a corporate tax of about 25%.The absence of corporate tax for 10 years and a very low tax rate after the first 10 years provide a unique environment in which the capital structure theory can be tested to unearth whether the use of debt actually contributes to the value of the company.

Research objectives
The main objective of this study was to investigate how tax savings influence the capital structure of free zone companies in Ghana.
The specific objectives of the study were the following: 1.To examine the determinants of capital structure of these companies 2. To examine the financial performance of the free zone companies.

Significance of the study
The study seeks to examine the effect of tax savings on the capital structure of free zone companies in Ghana.The results of this study will help researchers know whether Miller and Modigliani modified assumptions on capital structure to include tax shield holds in Ghana.If it does not hold, researchers can investigate further what influenced the capital structure of these companies.The study will also add to the existing literature on the capital structure and performance of companies in Ghana.It will also inform managers of these companies on their financial performance and the steps to be taken to be competitive on the international market, as approximately 70% of their products and services are exported.

Review of literature
An appropriate capital structure is a critical decision for any business organisation.The decision is important not only because of the need to maximise returns to various stakeholders, but also because of the impact such a decision has on a company's ability to deal with its competitive environment.The prevailing argument originally developed by Modigliani and Miller (1958) was that an optimal capital structure existed that balanced the risk of bankruptcy with the tax benefits of debt.Once established, the capital structure should provide greater returns to stakeholders than they would have received from all equity companies.The successful selection and use of capital is one of the key elements of the firms' financial strategy (Kajananthan 2012;Velnampy & Niresh 2012).Brander and Lewis (1986) and Maksimovic (1988) provided the theoretical framework that links capital structure and market structure.Contrary to the profit maximisation objective postulated in the literature on industrial organisation, these theories are similar to corporate finance theory in which it is assumed that the company's objective is to maximise the wealth of its shareholders.Furthermore, market structure is shown to affect capital structure by influencing the competitive behaviour and strategies of companies.According to Kajananthan (2012), Achchuthan, Kajananthan and Sivathaasan (2013), and Kajananthan and Achchuthan (2013), capital structure is related to corporate governance practices regarding liquidity.Abor (2005) reviewed the impact of capital structure on profitability of the 22 companies listed in the Ghana Stock Exchange from 1998 to 2002.Results showed that there was a positive and significant relationship between capital structure (total debt to total assets (TDTA) ratio) and return on equity (ROE).Abor also indicated that profitable companies have more dependence on financing through liability, and a high percentage (85%) of the liabilities of these companies are of short-term.Abor (2008) compared the capital structures of publicly quoted firms, large unquoted firms, and small and medium enterprises (SMEs) in Ghana.The study also examined the determinants of capital structure decisions amongst the three sample groups.The regression results indicated that age of the firm, size of the firm, asset structure, profitability, risk and managerial ownership are important in influencing the capital structure decisions of Ghanaian firms.Jensen and Meckling (1976) drew attention to the impact of capital structure on the performance of enterprises, number of tests as an extension port to inspect the relationship between performance of firm and financial leverage.However, the results documented were contradictory and mixed.Some studies have reported that positive relationships (Ghosh et al. 2000) also support the argument.Several others have reported a negative relationship between debt and financial achievement like Fama and French (1998) and Simerly and Li (2000).Capital structure is said to be closely linked to the financial performance (Zeitun & Tian 2007).San and Heng (2011), in their research, studied the relationship between capital structure and corporate performance of Malaysian construction sector from 2005-2008.In this study, 49 companies were selected as samples.Results showed that there was a significant relationship between capital structure and corporate performance.
Aburub ( 2012) in his research investigated the impact of capital structure on the firm performance of companies listed in the Palestine Stock Exchange from 2006-2010, in which 28 companies were selected as samples.In this study, ROE, return on assets (ROAs), earnings per share (EPS), market value to book value of equity ratio (MVBR) and Tobin Q ratio as five measures of accounting and market of firm performance evaluation and also as dependent variables, and short-term debt to total assets (SDTA) ratio, long-term debt to total assets (LDTA) ratio, total debt to total assets (TDTA) ratio and total debt to total equity (TDTQ) ratio as four measures of capital structure and also as the independent variables were selected.Results indicated that the capital structure has a positive effect on firm performance evaluation measures.
Onaolapo and Kajola (2010) investigated the effect of capital structure on financial performance of companies listed in the Nigeria Stock Exchange.This study was performed on 30 non-financial companies in 15 industry sectors in a 7-year period from 2001-2007.The results showed that the capital structure (debt ratio, DR) has a significant negative effect on financial measures (ROA and ROE) of these companies.Fosberg and Ghosh (2006) in the research conducted on the 1022 companies in the New York Stock Exchange (NYSE) and 244 companies in the America Stock Exchange (AMEX) concluded that the relationship between capital structure and ROA was negative.Houang and Song (2006), in the research conducted on 1200 Chinese companies during 1994-2003, concluded that financial leverages had a negative relationship with ROA and growth opportunities.Andersen (2005) reviewed the relationship between capital structure and firms performance for 1323 companies from various industries and concluded that there was a significant relationship between capital structure and ROA.Elsayed Ebaid ( 2009) studied the effect of capital structure on the performance of 64 Egyptian companies from 1997 to 2005.The results suggested that there was a significant negative relationship between ROA and TDTA ratio, but there is a non-significant relationship between ROE and TDTA ratio.Mramor and Crnigoj (2009) concluded that there was a significant negative relationship between financial leverage (TDTA ratio) and ROA ratio.A number of empirical studies have identified company-level characteristics that affect the capital structure of companies.Amongst these characteristics are age of the company, size of the company, asset structure, profitability, growth, company risk, tax and ownership structure.

Methodology Data collection and source
Data on capital structure and company performance were collected from secondary sources, annual reports of 50 free zone companies for the period of 2009-2012.

Research hypothesis
To examine the determinants of capital structure of the free zone companies the following hypotheses were tested: The capital structure of the company was measured by the DR.
To examine the effect of the capital structure on the financial performance of the free zone companies, the following hypotheses were tested: H 1 : there is a negative and significant relationship between debt ratio and company performance.
H 2 : there is a positive and significant relationship between asset turnover ratio and company performance.H 3 : there is a positive and significant relationship between company size and performance.H 4 : there is a positive and significant relationship between company age and performance.
H 5 : there is a positive and significant relationship between growth opportunities and company performance.
H 6 : there is a negative relationship between quick ratio and company performance.Measure of company financial performance is ROA.
To test the hypotheses on the determinants of capital structure, the study used Abor's (2008) research model, in which he used the dependent variable, long-term DR as the capital structure and size, profitability, age, tax, asset structure and operation risk as explanatory variables.

Model specification
A panel regression model was used for the estimation in this study.Panel data involve the pooling of observations on a cross section of units over several time periods.A panel data approach is more useful than either cross-section or time series data alone.One advantage of using the panel data-set is that because of the several data points, the degrees of freedom are increased and collinearity amongst the explanatory variables is reduced; thus, the efficiency of economic estimates is improved.Panel data can also control for individual heterogeneity due to hidden factors, which, if neglected, in time series or cross-sectional estimations, leads to biased results (Baltagi 1995).The panel regression equation differs from a regular time series or cross-sectional regression by the double subscript attached to each variable.The general form of the model can be specified as: Where the subscript i denotes the cross-sectional dimension and t represents the time series dimension.The left-hand variable, Y it , represents the dependent variable in the model, which is the company's DR.X it contains the set of explanatory variables in the estimation model, α is the constant and β represents the coefficients.The model for the empirical investigation of the capital structure is as follows: Where: LDR it = DR (long-term debt/equity + debt) for company i at time t; SZ it = The size of the company (log of sales) for company i at time t; PR it = Earnings before interest and tax divided by total asset for company i at time t; CO it = Tangible fixed asset + inventories divided by total assets of company i at time t; TX it = Ratio of tax paid to operating income for company i at time t; OR it = Squared difference between the company's profitability and the cross-sectional mean of profitability for company i at time t; AG = Number of years since inception of the company to observation date.
To test the hypotheses for the effect of the capital structure on the companies' financial performance, Onaolapo and Kajola's (2010) research model was used, where the dependent variables, ROA, as accounting measures for evaluating the company's performance, and independent variable, the DR, as capital structure, were used.They also used variables of asset turnover (TURN), company size (SIZE), company age (AGE), assets tangibility (TANG) and growth opportunities (GROW) as control variables.The research model is as specified below: Where ROA = profit after tax divided by total asset; DR it = total debt divided by total asset; TURN it = sales divided by total asset; SIZE it = natural logarithm of sales; AGE it = number of years since inception of the company to observation date; QUICK it = current asset minus inventories divided by current liabilities; and GROW it = change in the natural logarithm of sales.

Results and discussion
Regression model of determinants of capital structure of free zone companies in Ghana is presented in Table 1.The results show that the size of the company has a positive and statistically significant relationship with the capital structure of the company.Larger companies are more likely to acquire long-term debt finance in their operations.
Especially with the free zone companies in Ghana most of the larger companies are multinational companies and are financed by their parent companies on long-term debt.This finding of positive relationship of long-term debt and size is consistent with previous findings (Abor 2008;Al-Sakran 2001;Barclay & Smith 1996;Barton et al. 1989;Friend & Lang 1988;Hovakimian et al. 2004;Kim et al. 1998;MacKie-Mason 1990).
Profitability and long-term debt show a negative and statistically significant relationship.The results of this study clearly support the pecking order hypothesis, in which profitable companies initially rely on less costly, internally generated funds and subsequently look for external resources if additional funds are needed.It is expected that more profitable companies will require less debt finance.This is because profitable companies would have a preference for inside financing over outside debt financing, as the cost of external financing is greater for the company.This is consistent with the findings by Esperança et al. (2003), Hall et al. (2004) and Abor (2008).
Tax was found to have a statistically significant positive relationship with long-term DR amongst free zone companies.This suggests that free zone companies with high tax rates rely more on long-term debt.This finding is very interesting because these free zone companies pay the lowest tax rate in Ghana.For the first 10 years of operation, these companies do not pay corporate tax at all and even after the first 10 years the tax ranges from 0%-8%, depending on the company's location and type of business.The results indicate that free zone companies do not take into consideration the tax savings enjoyed when applying for debt financing.The result is contrary to the findings of Abor (2008) who found a significant and negative association between tax and longterm DRs of quoted companies in Ghana.Thus, the tax-based theory does not hold in Ghana for free zone companies.
The results show a positive and statistically significant relationship of company risk with long-term DR at the 10% level, implying that companies with high risk exhibit high DR.This could be due to the fact that most of these  companies are funded on loan by their parent companies and not by the banks which will not give long-term debt to high-risk companies.Age and long-term debt have a positive and statistically significant relationship.These companies do not have access to public equity market because they are not listed in the stock exchange.As a result, long years of business could connote long business relationships with external debt providers and increase their chances of acquiring external long-term debt finance.
The effect of the regression model of capital structure on corporate financial performance of free zone companies in Ghana is presented in Table 2.The results show that statistically there is a significant negative relationship between the capital structure or DR and accounting measure of company performance evaluation (ROA) at 1% level.This relationship indicates that the companies that have high DR due to borrowing incur a lot of financial cost, which reduces the net income and hence ROA is reduced.The hypothesis that a company's capital structure should have a negative impact on its performance is confirmed.The results of this hypothesis are consistent with the research results of Onaolapo and Kajola's (2010), Fosberg and Ghosh's (2006), Houang and Song's (2006), Mramor and Crnigoj's (2009) and Zeitun and Tian's (2007) work.Company growth opportunities show a positive and statistically significant relationship with ROA at the 10% level.The results of this hypothesis are not consistent with the results obtained from the researches of Zeitun and Tian (2007) and Onaolapo and Kajola (2010).Size of the company, age, quick ratio and asset structure did not show any significant relationship with ROA.

Conclusion
The study investigated how tax savings influenced the capital structure decisions of free zone companies in Ghana.
The study specifically examined the determinants of the companies' capital structure and how the capital structure influenced the financial performance of the companies.
The results showed that company size was found to have a positive relationship with long-term debt.The results of the study seem to support the pecking order hypothesis, given that long-term debt has inverse associations with profitability of the companies.It was found that companies with a highrisk profile do not avoid taking more financial risk by using less long-term debt.The results indicate that older companies are more likely to rely on long-term debt finance.This is because they are often perceived to have better reputations with debt finance providers.Tax was found to have a positive relationship with long-term debt, which means that the free zone companies do not take into consideration the tax savings they enjoy when applying for debt in their capital structure.
With regard to the financial performance, the study showed that there is a strong negative and significant relationship between DR and performance measures of free zone companies (ROA).DR determines the financial health of companies.This ratio helps investors to identify risk rate for companies.The company that has a high DR will have a negative impact on company performance and value.Remarkably, free zone companies, by reducing the DR, can increase profitability and thus improve ROA measure.The results also show that there is a significant and positive relationship between company growth opportunities and ROA.Size of the company, age, quick ratio and asset structure did not show any significant relationship with ROA.Given this relationship, it could be noted that DR and company growth are the affecting factors on company financial performance.

Recommendations
The results of the study prove that an increase in leverage negatively affects the ROA.It also recommends that managers should not use excessive amounts of leverage in their capital structure, they must try to finance their projects with retained earnings and use leverage as a last option.Managers of these free zone companies are advised to consider the tax benefit when applying for debt in their capital structure because of the interest deductibility from taxable income at the corporate level.Policy makers should place greater emphasis on the facilitation of equity capital, as it provides a base for further borrowing, reduces businesses' sensitivity to economic cycles and provides companies with an access to syndicates of private and institutional venture capital suppliers because these companies are not listed in the Ghana Stock Exchange.
there is a positive relationship between size and capital structure of the company.
5 : there is a positive relationship between company age and capital structure of the company.H 6 : there is a negative relationship between company risk and capital structure.

TABLE 5 :
Correlation matrix with debt ratio as the dependent variable.

TABLE 6 :
Correlation matrix with ROA as the dependent variable.