final thesis for submission

‘IMPACT OF CAPITAL STRUCTURE ON PROFITABILITY OF BANKING SECTOR’

Submitted By:

MAHNOOR MALIK ( 2010-NUST-BBA-112)

SYEDA RAIHA RAZA GARDEZI (200-NUST-BBA-99)

Submitted to:

Fazli Azim

NUST Business School

National University of Sciences & Technology

Islamabad,2014

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Acknowledgements

First of all we thank Allah Almighty for providing us with the opportunity to gain knowledge and learn. Who gave us the strength to complete this project with the right most capabilities. Next we are extremely grateful to our instructor Mr.Fazli Azim who guided us on the right path throughout the course of the project. If we did not receive his guidance we would not have been able to complete this report

on time. In the end we would like to thank all our friends and family who constantly gave us moral support.

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EXECUTIVE SUMMARY

The modern theory of capital structure was started by Modigliani & Miller (1958). This forms the basis of capital structure. They proved that debt and equity financing do not affect the value of the firm. The relationship between capital structure and profitability concludes that there is a round shape relationship between them; both are interlinked with each other because of costs of external financing, tax shield and the interest rate.Emery (1971) measured the effect of competition on banks’ profitability. His findings were that competition had no impact on firm’s profitability. If competition poses no direct impact than that surly means that other internal factors play a stronger role. If that is the case than we aim to investigate which factor poses a direct relation and whether this holds true for the entire banking industry? For this reason we have taken into consideration the effect of Islamic banking and conventional banking separately.Bourke (1989) found an important positive relation between the capital and profitability. He concluded that higher the capital ratio, higher the profitability of the bank. Thornton (1992) also found similar results between capital and profitability of banks. Nienhaus (1983) compared the profitability of Islamic banks with Conventional banks. According to his research, Islamic banks profit sharing ratio was positively related to the lending rate of the conventional banks profitability. Islamic banks are less risky because there is no interest.

For the purpose of this study we analyzed eight banks, four Islamic and four conventional.After collecting data we conducted regression analyses in order to find the correlation between the different variables and the two banking sectors.

The results were very interesting to observe as it showed that shows that the effect of capital structure (from debt to total asset and debt to total equity) of conventional bank on profitability (ROA) is positively affected which means positive relationship between profitability and capital structure .But in the case of Islamic banks the profitability of Islamic bank negatively affected by the capital structure which means negative relationship between profitability and capital structure.

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ContentChapter 1: INTRODUCTION..........................................................................................................................6

BACKGROUND OF STUDY.........................................................................................................................6

AIMS AND OBJECTIVES............................................................................................................................7

Chapter 2 :LITERATURE REVIEW..................................................................................................................8

PROBLEM STATEMENT..........................................................................................................................12

Chapter 3 :METHODOLOGY.......................................................................................................................12

Research design.....................................................................................................................................13

1. Data collection...........................................................................................................................13

2. Variable categorization..............................................................................................................13

3. Variable defined.........................................................................................................................13

4. Assumptions and limitations......................................................................................................13

5. Data analysis..............................................................................................................................14

Hypothesis testing.................................................................................................................................14

Chapter 4 : Research analysis Discussion...................................................................................................15

Conventional banking:...........................................................................................................................15

Data analysis and discussion..............................................................................................................15

Islamic Banking......................................................................................................................................19

Data analysis and discussion..............................................................................................................19

Comparison...........................................................................................................................................23

Chapter 5: Conclusion...............................................................................................................................24

Further recommendations.....................................................................................................................24

Appendix...................................................................................................................................................26

References.................................................................................................................................................32

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Abstract

Capital structure mainly comprises of debt financing and equity financing. Capital structure affects the liquidity and profitability of the firm. Capital structure has many dimensions such as leverage, size, growth, etc. It is very difficult to state which portion is the best choice to adopt in order to minimize a firm’s value to its shareholders as well as maximize its corporate profitability. Profitability is defined as generating financing through retained earnings so that firm can maximize the value of the existing shareholders. In order to understand how the capital structure affects profitability four conventional and four Islamic banks were taken into consideration. The trend of increasing profit with the trend of changing different ratios was analyzed. Data was collected for the past 19 years to ensure that adequate information is analyzed and that the trends are not influences by any short term changes. The results were very interesting to observe as it showed that shows that the effect of capital structure (from debt to total asset and debt to total equity) of conventional bank on profitability (ROA) is positively affected which means positive relationship between profitability and capital structure .But in the case of Islamic banks the profitability of Islamic bank negatively affected by the capital structure which means negative relationship between profitability and capital structure.

Key words : capital structure, debt financing, equity financing, profitability

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Chapter 1: INTRODUCTION

The main purpose of this paper is to find out the impact of capital structure on profitability of banking sector in Pakistan. This is the first study of its kind being conducted in the banking sector of Pakistan. We’ll collect data from 4 conventional banks(Allied bank ,National bank ,Habib bank, Standard Chartered) and 4 Islamic banks (Meezan bank ,Bank al Islamic ,Dubai Islamic bank ,Al Baraka bank). Secondary data is being gathered from all banking sectors websites to do the work for research paper.

There are a number of definitions of capital structure and profitability defined by various authors. An optimal capital structure is an important and complex issue in corporate finance.Capital structure is mainly defined as, “the proportion of debt and equity used by the firm to finance its assets”. Capital structure mainly comprises of debt financing and equity financing. Capital structure affects the liquidity and profitability of the firm. Capital structure has many dimensions such as leverage, size, growth, etc. It is very difficult to state which portion is the best choice to adopt in order to minimize a firm’s value to its shareholders as well as maximize its corporate profitability.Profitability is defined as “generating financing through retained earnings so that firm can maximize the value of the existing shareholders”(Myers,1984).Profitability has a positive relation with debt or retained earnings. Liquidity ratio has greatest significance and positive impact on profitability.

The relationship between capital structure and profitability concludes that there is a round shape relationship between them; both are interlinked with each other because of costs of external financing, tax shield and the interest rate.

Summary : the next chapter explore why the study was conducted and from where its roots are taken.

BACKGROUND OF STUDY

The question of market capitalization is highly important for the investors, internal banking team, auditors and other stakeholders because at the end of the day everyone aims to make profits. Typical question that arises is that if market capitalization actually creates an impact on the profitability or not. If yes than which bankers have a better performance than others? Which factor plays the most crucial role in determining the impact caused by the capitalization? Do assets or debt change the profits of the bank? Or does the banking structure shape the industry? If yes than which type of banking is impacted by which type of variable?

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Future no similar study has been carried out in the market of Pakistan. This means that the findings would be beneficial to the market of Pakistani investors.

AIMS AND OBJECTIVES

The aim of this research is to find which banking sector, conventional or Islamic banking is impacted by which variable. For that reason we have sub divided the main hypothesis into future divisions so that an in depth analyzes can be carried out. The important objectives of the study are listed below

Analyze any impact of market capitalization on the profitability of banks Discover the variables that create direct impact of profitability of banks Discover the relation of conventional banks and private banks on the productivity of

banks.

The evaluation will be done by analyzing real time data of eight Pakistani banks, four conventional and four Islamic.

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Chapter 2 :LITERATURE REVIEW

The modern theory of capital structure was started by Modigliani & Miller (1958). This forms the basis of capital structure. They proved that debt and equity financing do not affect the value of the firm. Still, this theory has many important implications in corporat efinance so we cannot ignore this. Various studies have been directed to explore the optimal capital structure inorder to test Modigliani-Miller’s assumption.

Myers (1977) found that high debt in capital structure reduces conflict between shareholders and managers on investment decisions. Later, Myers (1984) recommended using a low risk debt instead of increasing equity.Berger (2002) supports Myer’s argument. Higher profitability of a firm may give them higher expected returns for a particular capital structure, but this condition would not protect firms against future crises. Profit efficiency gas a strong positive correlation with expected returns and higher expected return is substituted for equity capital for effective risk management.

Emery (1971) measured the effect of competition on banks’ profitability. His findings were that competition had no impact on firm’s profitability. Emery (1971) and Vernon (1971) were the first ones to link bank size with profitability. Their samples were classified on the basis of total assets of the bank (size). Emery concluded that the larger banks had higher profitablity, because large banks are subjected to economies of scale. Vernon found that there was no relationship between size and returns. Later on, further researches carried out by Heggested (1977), Kwast and Rose (1982) and Smirlock (1985) were also in line with Vernon’s results.

In addition to this, Grossman, Hart (1982) and Williams (1987) found that higher financial leverage reduces agency costs through the threat of liquidation, and it also affects salaries and reputation of managers.

Bourke (1989) found an important positive relation between the capital and profitability. He concluded that higher the capital ratio, higher the profitablity of the bank. Thornton (1992) also found similar results between capital and profitability of banks.

Nienhaus (1983) compared the profitability of Islamic banks with Conventional banks. According to his research, Islamic banks profit sharing ratio was positively related to the lending rate of the conventional banks profitability. Islamic banks are less risky because there is no interest.

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Smirlock (1985) believed that high market share had a great influence on profitability and market growthalso resulted in high profitability by creating more opportunities for a bank. His findings indicated that market growth and profitability are positively related.

Stulz (1990) argued that giving managers a huge share of the firm reduces the firm’s value. According to him the firm’s value increases as the manager share in the ownership increase. But when the ownership of the manager reaches to 50% or above, the majority of owner and additional transfer of ownership to manager have no impact on the firm value.

Raviv (1991) and Myers (2001) analyzed that higher financial leverage is positively correlated to firm value and high leverage increases the obligation to manager. This relationship is also proved by the studies of Titman and Wessel (1988), Mester (1993), Pi and Timme (1993), Gorton and Rosen (1995), Mehran(1995), McConnell and Servaes (1995) DeYoung, Spong and Sullivan (2001).

Steinherr and Huveneers (1994) examined the impact of foreign banks on the profitability of local banks. Their study proved that the existence of foreign banks produced an unbelievable impact on the profitability of various types of banks.

Stienherr and Huveneers (1994) also included that the size of banks are independent variables in their profitability study and found that it had mixed effect on the performance of various groups of banks.

Berger (1995) investigated that there was a positive relationship between capital asset ratio and earnings of the bank. Berger investigated the results on the data of US Banks from 1983 to 1989. The results of Berger (1995) were conventional understanding of the relationship between earning and capital. The conventional point explains the negative relationship between capital and earnings, as higher capital reduces the risk and decreases the return on equity.

De Young (1997) compared the two banks cost ratios and concluded that banks was improper because there are some difference in product mix, market conditions and other characteristics that could influence bank’s cost. Berger and De Young (1997) discovered the relationship between loan quality, efficiency and bank capital. They used the data of U.S. conventional banks from the year 1985 to 1994. They were also of the view that cost in efficient bank may tend to have high loan problems and bad quality loan.

John C. Groth and Ronald C. Anderson (1997) defined capital structure and influence on the cost of capital and the value of a company. There is no formula to determine the optimal capital structure of the firm. Proper use of debt and equity in capital structure shows the lower the cost of capital and that low cost of capital helps in increasing the value of the firm.

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Michealas.N (1998) said that non-financial and behavioural factors influence the capital structure. Atlmad (1998) said, nowadays Islamic banks have managed to position themselves especially in Muslim countries as an financial institution and they offers banks facilities similar to conventional banks.

Nicos Michealas, Francis Chittenden and Panikkos Poutziouris (1998) considered non-financial and behavioural factors which influenced capital structure decisions. They used the method of interviews for their study. They found that debt proportion in capital structure depends on certain factors like social norms and values, need for control, perceptions and previous experience.

Demirguc- Knut and Huizinga (1999) conducted a study which examined the determinants of banking performance for 80 different countries, during the period 1988-1995.They concluded that foreign banks have higher profitability than domestic banks in developing countries, while they have less profitability than domestic banks in developed countries. Their overall results show support for the positive relationship between the capital ratio and financial performance.

Chiang Yat Hung, Chan Ping Chuen Albert, Hui Chi Man Eddie (2002) showed the relationship between profitability, capital structure and cost of capital among property developers and contractors in Hong Kong. They collected data from Data stream, an electronic financial database. The analysis of this paper showed that amount is generally higher among contractors than developers and capital is positively related with asset but negatively with profit margins.

According to Yudistira (2003), most of the Islamic banks are within Middle Eastern or Emerging countries. Many universal banks have also started to do huge demand of Islamic financial products because it’s less risky. This also confirms that Islamic banking is as efficient as the conventional banking. Islamic bank acts as an intermediary between borrower and lender creating a relationship of financial trust and partnership.

Rose & Hudgins (2008) argued that both Islamic and conventional banks run the same financial functions, means both are doing business with two types of individual and institutions. (1) Saving deficit whose expenditures are more than its income so they raise funds through borrowing (2) Saving surplus whose income is more than its expenditures so they have surplus funds for saving and investing. but on this argument, Moody (2008) said, although both Islamic and conventional banks runs same financial functions but Islamic banks are based on PLS, so they differ from conventional banks because conventional banks are based on market interest.

Naceur (2003) notices that high net interest margin and profitability are likely to be associated with banks with high amount of capital and large overheads. He also noticed that other determinants such as loans has positive and bank size has negative impact on profitability. Bashir and Hassan (2003) and Staikouras and Wood (2003) show that a higher loan ratio actually impacts profits negatively.

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Christos K. Staikouras, Geoffrey E. Wood (2004) examined the determinants that are responsible for the profitability in European banks. As a sample whole of the European banking sector is taken during the period of 1994 to 1998. They use OLS and fixed effect models as methodology. They conclude their paper as the Banks that have greater level of equity are more profitable. Bank returns and loan to asset ratio are negatively related to each other.

Panayiotis P. Athanasoglou, Sophocles N. Brissimis, Matthaios D. Delis (2005) found the determinants of profitability in banking sector. According to their study, profitability of the bank depends mainly on the size of the bank and its financial strength. Other determinants are operating expense, cost decisions made by bank's management and ownership status of the bank.

Joshua Abor(2005) examined the relationship between the capital structure and profitability for the listed firms in Ghana during the period of five years. He applied regression analysis for this research and used ROE as a determinant of capital structure. On the basis of this study he found that a positive relationship exists between the short term debt to total asset ratio and ROE whereas a negative relationship exist between long term debt to total equity ratio and ROE. Debt financing is the main option for the profitable firms in Ghana.

Akoto, Richard Kofi(2008) examined the relationship between capital structure and profitability of banking sector in Ghana. They collected the data from 14 banks of Ghana for the time period of 10 years. They concluded their research as the profitability is inversely proportional to the debt financing.

Mohamed Goaied (2008) examined the effect of macroeconomic variables, bank characteristic, financial structure on banks’ net interest margins and profitability. He collected the data from the banking sector of Tunisia over the period of 1980 to 2000. They found that macroeconomic variables are negatively related whereas development in stock market is positively related with the profitability of the banking sector of Tunisia.

Ade Salman Al-Farisi, Riko Hendrawan(2011) examined the effect of capital structure on the profitability of Islamic and conventional banking sector in Indonesia. They collected the data from 105 banks of Indonesia during the period of 2002 to 2008. They ran DFA test. They concluded from their research that channeled loans positively influence the profit efficiency whereas labor cost and marketable securities negatively influence the profit efficiency. Total equity and total asset negatively influence the profit efficiency.

Ramachandran et al (2011) described the effect of capital structure on profitability. They used the data of 102 IT firms during the period of 1999-2007 and applied Pearson’s coefficient and regression analysis on gathered data. Dependant variables in their paper were ROE and ROCE whereas independent variables were debt to total asset and debt to equity ratio. They concluded in their research paper that capital structure significantly affects profitability and a positive relationship exists between profitability and capital structure in the IT firms of India.

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J. Aloy Niresh(2012) examined the impact of capital structure on profitability. For that purpose he collected the data from 10 listed Srilankan banks during the period of 2002 to 2009. He concluded that capital structure directly affects the profitability of banking sector. According to him, the determining factor for the profitability of Srilankan banking sector is total debt.Summary: the next chapter identifies the problem that was aimed to resolve.

PROBLEM STATEMENTConventional banking and Islamic banking showed different results of their past performance of different capital ratios thereby creating discrepancies in the expected and actual movement in the companies output.Both the Islamic and conventional banks have the root of banking sector however they yield complete contradictive results. This matches with the findings of different other scholars as mentioned in the literature review.

Summary: the next chapter tells how the study was carried out and what methods were adopted.

Chapter 3 :METHODOLOGYThis study has been carried out by doing market analysis of Pakistan. The method designed to collect data plays a crucial part in framing where the study would be headingSalman al-farsi.A, Hindrawan.R (2011). Both qualitative and quantitative methods were adopted in order to gather information. However major portion of the data has been collected through secondary means rather than primary. The main reason because of the nature of the research we had to analyses the already existing data in order to make conclusions.

The qualitative method was adopted to formulate and analyze graphs that displayed relationships between different variables and the qualitative method analyzes the hypothesis and helped in discussing whether the hypothesis was true or false. Hypothesis testing depicts the solution of the entire research Kwast, Mayron L. and John T. Rose (1982). This is why we also sub divided the main hypothesis into future categories so that it can be analyzed with most precision about the findings. Different correlations and regression techniques have also been used to arrive at conclusion. Based on all the mentioned techniques hypothesis was either accepted or rejected.

Since the impact of existing industry variables had to be identified on the profitability of banks for this reason secondary data was selected. As primary data means collecting the information through survives or other first handed techniques. But through that we would have been able to only analyze the market on that given date. This is way data was collected from the annual reports of eight selected banks.We’ll collect data from 4 conventional banks(Allied bank ,National bank ,Habib bank, Standard Chartered) and 4 Islamic banks (Meezan bank ,Bank al Islamic ,Dubai Islamic bank ,Al Baraka bank). The data was collected for the past 19 years so

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that in-depth analyses would be arrived upon. However some of the banks were established after 1995 so for those banks the recent available data was gathered.

Research design

1. Data collectionThe data used for this study has been collected from the banks official website. If the annual report was not available than the official annual report was derived from other financial websites. Some of the variables that we selected for analysis were not given in the report so they were calculated by our self.

2. Variable categorizationThe dependent and the independent variables are as following

Dependent variable: Return on Assets, Debt to Total Assets, Debt to Total Equity, Total assets, Total equity , Total debt, total capital ratio, capital to asset ratio, loan/deposit ratio, equity multiplier, EPS

Independent variable: profitability

3. Variable definedReturn on assets is the money that is made through the use of assets. Debt to total assets shows the ratio of how much borrowing has been made to the assets that are owned by the company. Debt to total equity shows how much borrowings are with respect to the equity.total capital ratio, capital to asset ratio, loan/deposit ratio, equity multiplier and EPS.

4. Assumptions and limitationsSome of the assumptions that we made are as following

The data collected was for 19 years from 1995-2013, this assumes that the performance of the banks can be standardized through this period.

We did not consider all the banks in Pakistan to derive a conclusive analysis We selected generally the higher performing banks in order to make conclusions about

the whole banking industry

Some limitations of the study are as following

Some of the banks were not even established in 1995 so the data collected for them is for the number of the years after its embellishment. This automatically makes there outputs lesser reliable than the other banks.

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We have only focused on eight banks and have not considered all the banks in Pakistan to derive at the conclusion for the whole banking industry of Pakistan.

5. Data analysisThe hypothesis testing has been carried out considering the following factors

Correlation: this gave a precious measure of how much the relation exists between different variables. This measure gave the accurate significance if any variable had of profitability.

Graphical: this gave a visual idea of how the different variables were moving with the years. Total assets, total debt, total equity and total capital are balance sheet items.

Summary: the next chapter tells what hypothesis were drawn to base the study on.

Hypothesis testingThe following hypothesis were tested

H1: Profitability has a direct relation with the debt to equity ratio

H0:Profitability does not have a direct relation with the debt to equity ratio

H2: Return on assets has a direct relation with the debt to equity ratio

H0: Return on assets does not has a direct relation with the debt to equity ratio

H3:Debt to Total Equity and Debt to Total Assets have a direct relation with the profitability

H3:Debt to Total Equity and Debt to Total Assets does not have a direct relation with the profitability

H4: total capital ratio, capital to asset ratio, loan/deposit ratio and equity multiplier have a direct impact on profitability

H0:H4: total capital ratio, capital to asset ratio, loan/deposit ratio and equity multiplier does not have a direct impact on profitability

H5:loan/deposit has a direct impact on profitability

H0:loan/deposit do not has a direct impact on profitability

H6: EPS has a direct impact on profitability

H0: EPS has a direct impact on profitability

H7: conventional bank and Islamic bank has the same relation with profitability

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H0: conventional bank and Islamic bank do not has the same relation with profitability

Summary: the next chapter explores the application of regression model on the data that was collected and its analysis.

Chapter 4 : Research analysis Discussion

Conventional banking:

Data analysis and discussionData analysis involves the use of statistical model to investigate the relationship between the variables. The simple regression analysis fit best for our analysis which involves steps to validate the accuracy of expected relationship among the variables under study.

Table 4.1 Descriptive Statistics

N Minimum Maximum MeanStd.

Deviation

Return on Assets 18 .15 .37 .2250 .06083

Debt to Total Assets

18 .84 .93 .9025 .02425

Debt to Total Equity

18 8.69 16.55 12.1425 2.46088

Total assets 18 -18.3419 43.18439 13.59902 .024656

Total equity 18 -418.195 179.0433 132.0064 2.6545

Total debt 18 -0.00461 0.001749 0.001406 .0626

total capital ratio 18 -0.0149 0.059113 0.01636 .0242

capital to asset ratio

18 -0.01384 0.014232 0.006205 6.432

loan/deposit ratio 18 -0.52016 0.059067 0.128025 .0323

equity multiplier 18 -792.942 4124.363 1086.862 .3244

EPS18 -0.17954 0.091503 0.059909 .0987

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Valid N (listwise) 18Regression equation:

Simple linear regression is

Y=B0+B1x+B2xi

The regression equation of this analysis is

ROA=1.920+ (-2.234)+ 0.027 or

ROA=1.920-2.234+ 0.027

This result shows that for each unit increase in x(DTA), y(ROA) is predicted to decrease by 2.234 rate due to debt to asset (capital structure) and for each unit increase in DTE, y(ROA) is predicted to increase by 0.027. b0 is 1.920 which shows the average value of the dependent variable profitability (ROA), This shows there is negative associate decrease in profitability of 2.234 because of decrease in debt to total asset ratio whereas there is positive associate increase in profitability of 0.024 because of increase in debt to equity ratio.

Table 4.2

Coefficientsa

Model

Unstandardized Coefficients

Standardized Coefficients

T Sig.B Std. Error Beta

1 (Constant) 1.920 .785 2.445 .026

Debt to Total assets

-2.234 .978 -.891 -2.284 .035

Debt to Total Equity .027 .010 1.072 2.749 .014

Total assets 12.42126 13.59902 0.384851 0.384851 0.384851

Total equity -119.576 132.0064 0.388631 0.388631 0.388631

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Total debt -0.00143 0.001406 0.335347 0.335347 0.335347

total capital ratio 12.42126 0.01636 0.209639 0.209639 0.209639


-119.576 0.006205 0.975715 0.975715 0.975715

loan/deposit ratio -0.00143 0.128025 0.10526 0.10526 0.10526

equity multiplier 0.022104 1086.862 0.159742 0.159742 0.159742

EPS0.000194 0.059909 0.481176 0.481176 0.481176

a. Dependent Variable: Return on AssetsThe table 4.2 shows that the fitted line has coefficient of constant b0 is (1.920) and coefficient of DTA is equal to (-2.234) which is b1 and the coefficient of DTE 0.027 which is b2 .The standard error of DTA is 0.978 and standard error of DTE is 0.010 which is the dispersion of dependent variable profitability (ROA), estimate around its mean. While the significant variable is DTE.

Measure of variation:

While developing a regression model to predict the dependent variable with the help of independent variable focus will be on a few measures of variation. Total variation can be partitioned into two parts: variation which can be attributed to the relationship between x and y is refer to as explained variation or regression sum of square (ssr). The second part which is unexplained can be attributed to factors other than the relationship between x and y, and is referred to as error sum of squares (sse).

Total sum of square (sst) =regression sum of square (ssr)

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Table 4.3ANOVAb

ModelSum of Squares Df Mean Square F Sig.

1 Regression .022 2 .011 3.788 .044a

Residual .049 16 .003

Total .070 18

a. Predictors: (Constant), Debt to Total Equity, Debt to Total Assetsb. Dependent Variable: Return on Assets

The table 4.3 shows the values of total sum of squares, regression sum of square and error of sum of squares according to the data. The tss is the total deviation in the dependent variable, profitability (ROA). The ess describe the variation within the fitted values of y, and is the sum of the squared difference between each fitted values of y and the mean of y. the square are taken to ‘remove’ the sig(+or-) from the residual values. The RSS describe the variation within the values of y, and is the sum of the squared difference between each values of y and the mean of y.

F statistics is the statistical ratio of regression mean square (MSR) and error mean square (mse), it is used to determined the significance of overall regression model in regression analysis. The value of f statistics in above model is 3.788.

Coefficient of determination:

Coefficient of determination is very commonly used of fit for regression models and is denoted by R square, it is the ratio of regression sum of squares (ssr) to total sum of square (sst), its values ranges 0_1.

Table 4.4

Model Summary

Model R R SquareAdjusted R

SquareStd. Error of the Estimate

1 .555a .308 .227 .05348

a. Predictors: (Constant), Debt to Total Equity, Debt to Total Assets

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This table shows the values of regression statistic for profitability (ROA) and capital structure (DTA, DTE, total assets, total equity, total debt, total capital ratio, equity multiplier). The value of R is 0.555 which indicates the percentage variation in profitability (ROA) due to capital structure (DTA, DTE, total assets, total equity, total debt, total capital ratio, equity multiplier). Adjusted R square shows the proportion variance in the dependent variable that was explained by the variation in dependent variable. The only difference between R square and adjusted square is that its value based on the degree of freedom.

In general there is a negative relationship between profitability and capital structure (DTA, total capital ratio, total assets) while there is a positive relationship between profitability and capital structure (DTE, total equity),(Bourke, 1989 and Thornton,1992) so this study is in line with above results.

Justification:

As there exist a negative relationship between asset finances and profitability in case of Conventional banking. It is obvious that the asset financing is riskier as compared to equity financing that’s why conventional banks are more involve in equity financing and the profitability of banks increase due to equity financing.

Islamic BankingSimple linear regression is based on the slope _intercept equation of a line;

Y=B0+B1x+B2xi

Data analysis and discussionData analysis involves the use of statistical model to investigate the relationship between the variables. The simple regression analysis fit best for our analysis which involves steps to validate the accuracy of expected relationship among the variables under study.

Table 4.1Descriptive Statistics

N Minimum Maximum MeanStd.

Deviation

Return on Assets 18 -.91 .17 -.0475 .22475


18 .03 .92 .7595 .21182

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Debt to Total Equity

18 .74 13.37 5.9565 4.01906

Total assets 18 -2.88721 0.561321 -1.52573 0.161419

Total equity 18 2.769919 24.28419 2.844653 0.019256

Total debt 18 -0.00043 0.005983 1.95818 0.081884

total capital ratio 18 -0.03186 0.02415 -0.31147 0.762538


18 -0.02534 0.00196 -1.93732 0.084672

loan/deposit ratio 18 0.24574 1.150778 3.490619 0.006823

equity multiplier 18 -1134.5 -238.8 -3.46836 0.007067

Valid N (listwise) 18

Regression equation is:

ROA= (-0.743) +0.964+ (-0.006)This result shows that by increasing each unit of independent variable (DTA) than y increases 0.964 due to debt to total asset (capital structure) and for each unit increase in DTE, y decreases 0.0006 due to less equity financing. While -0.743 is the average value of dependent variable which is profitability (ROA). This shows there is positive associate increase in ROA of 0.964 because of decrease in debt to total asset ratio. Whereas there is negative associate decrease in ROA of (-0.006) because of increase in debt to equity ratio.

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Table 4.2

Coefficients

Model

Unstandardized Coefficients

Standardized Coefficients

T Sig.B Std. Error Beta

1 (Constant) -.743 .122 -6.078 .000


.964 .206 .908 4.681 .000

Debt to Total Equity -.006 .011 -.111 -.570 .576

Total assets -1.16295 0.762222 0.561321 -1.52573 0.161419

Total equity 13.52706 4.755257 24.28419 2.844653 0.019256

Total debt 0.002776 0.001418 0.005983 1.95818 0.081884

total capital ratio -0.00386 0.01238 0.02415 -0.31147 0.762538


-0.01169 0.006035 0.00196 -1.93732 0.084672

loan/deposit ratio 0.698259 0.200039 1.150778 3.490619 0.006823

equity multiplier -686.652 197.9759 -238.8 -3.46836 0.007067

EPS

-0.00082 0.001267 -0.64589 0.534473

The table 4.2 shows that the fitted line has coefficient of constant b 0 is (-0.743) and coefficient of DTA is equal to 0.964 which is b1 and the coefficient of DTE (-0.006) which is b2 .The standard error of DTA is 0.206 and standard error of DTE is 0.011 which is the dispersion of dependent variable profitability (ROA), estimate around its mean. DTA has significant value of 4.681.

21

Measure of variation:

While developing a regression model to predict the dependent variable with the help of independent variable focus will be on a few measures of variation. Total variation can be partitioned into two parts: variation which can be attributed to the relationship between x and y is refer to as explained variation or regression sum of square (ssr). The second part which is unexplained can be attributed to factors other than the relationship between x and y, and is referred to as error sum of squares (sse).

Total sum of square (sst) =regression sum of square (ssr)

Table 4.3ANOVAb

ModelSum of Squares df Mean Square F Sig.

1 Regression .665 2 .332 19.141 .000a

Residual .295 16 .017

Total .960 18

a. Predictors: (Constant), Debt to Total Equity, Debt to Total Assetsb. Dependent Variable: Return on Assets

The table 4.3 shows the values of total sum of squares, regression sum of square and error of sum of squares according to the data. The tss is the total deviation in the dependent variable, profitability (ROA). The ess describe the variation within the fitted values of y, and is the sum of the squared difference between each fitted values of y and the mean of y. the square are taken to ‘remove’ the sig(+or-) from the residual values. The RSS describe the variation within the values of y, and is the sum of the squared difference between each values of y and the mean of y.

F statistics is the statistical ratio of regression mean square (MSR) and error mean square (mse), it is used to determined the significance of overall regression model in regression analysis. The value of f statistics in above model is 19.141.

Coefficient of determination:

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Coefficient of determination is very commonly used of fit for regression models and is denoted by R square, it is the ratio of regression sum of squares (ssr) to total sum of square (sst), its values ranges 0_1.

Table 4.4

Model Summary

kModel R R Square Adjusted R SquareStd. Error of the

Estimate

1 .832a .692 .656 .13176

a. Predictors: (Constant), Debt to Total Equity, Debt to Total Assets

The table 4.4 shows the values of regression statistic for profitability (ROA) and capital structure (DTA, DTE). The value of R is 0.832 which indicates the percentage variation in profitability (ROA) due to capital structure (DTA, DTE). Adjusted R square shows the proportion variance in the dependent variable that was explained by the variation in dependent variable. The only difference between R square and adjusted square is that its value based on the degree of freedom.

In general there is a positive relationship between profitability and capital structure (DTA) while there is a negative relationship between profitability and capital structure (DTE), J. AloyNiresh(2012).

Justification:

As the result indicates that the negative relationship exists between equity financing and profitability in case of Islamic banking. It is cleared that Islamic banks not operates fully according to Islamic laws i-e; Shariah. These Islamic banks use debt financing to earn more profit.

ComparisonConventional banks

Average=sum of total observation/no. of total observations

ROA DTA DTE0.225 0.9025 12.1425

Islamic banks

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Average=sum of total observation/no. of total observation

ROA DTA DTE-0.0475 0.7595 5.9565

By comparing the average of Conventional and Islamic banks, it is shown that the effect of capital structure (equity, debt financing which are calculated through the Debt to total asset ratio and debt to equity ratio) on the profitability (which is calculated through return on asset ratio) is positive or in simple words it is cleared from above tables that the profitability of conventional banking is positively affected by the mixture of debt and equity financing (capital structure). But in the case of Islamic banking the relationship between profitability and capital structure is negative which means that the profitability of Islamic banking is negatively affected by the capital structure of Islamic banks.

Summary: the next chapter explains the conclusions that were made.

Chapter 5: ConclusionThe main purpose of the study is to find out the impact of capital structure on profitability of banking sector .Secondary data has been taken from the duration of 1995 to2013.Regression test has been applied on the data .By the comparison of both conventional banks and Islamic banks the result shows that the effect of capital structure (from debt to total asset and debt to total equity) of conventional bank on profitability(ROA)is positively affected which means positive relationship between profitability and capital structure .But in the case of Islamic banks the profitability of Islamic bank negatively affected by the capital structure which means negative relationship between profitability and capital structure.

The contribution of this study is immense. The research was conducted to explore a number of variables in relation with profitability for conventional and Islamic banks. This means that the research contributed in exploring the different variables that can make an effect.

Further recommendationsA shift in trend is observed in 2002 and 2008 in financial ratios of all the banks. This was due to corporate governance that came in 2002 in Pakistan and financial crises in 2008. Further research can be done on this field to find out effect of corporate governance and financial crunch on financial ratios of banking sector in both Islamic and conventional banking.

24

Appendix

For albakara bank

0 20 40 60 80 100 12005

101520

Normal Probability Plot

Sample Percentile

19.4

60 65 70 75 80 85 90 95 10005

101520

65.4 Line Fit Plot

Series2Predicted 19.4

65.4

19.4

60 65 70 75 80 85 90 95 10005

101520

65.4 Line Fit Plot


65.4

19.4

26

For national bank

9.4 9.6 9.8 10 10.2 10.4 10.6 10.8 11 11.2 11.4-10

-505

10

11.2673611111111 Residual Plot

11.2673611111111

Resid

uals

0 0.001 0.002 0.003 0.004 0.005-0.5

0

0.5

1

0.0015819209039548 Residual Plot

0.0015819209039548

Resid

uals

0 20 40 60 80 100 1200

1

2

3


Sample Percentile

1.8

For alhabib bank

27

0.0005 0.001 0.0015 0.002 0.0025-0.02-0.01

00.010.02

0.00104127134724858 Residual Plot

0.00104127134724858

Resid

uals

0 20 40 60 80 100 1200

0.05

0.1

0.15


Sample Percentile

0.4

For standard chartered bank

0 20 40 60 80 100 1200

0.51

1.52

2.5


Sample Percentile

0.64

28

60 65 70 75 80 85 90 95 1000

0.51

1.52

2.5

61.1 Line Fit Plot


61.1

0.64

For askari bank

0 20 40 60 80 100 1200

0.51

1.52

2.5


Sample Percentile

1.4

60 65 70 75 80 850

0.51

1.52

2.5

61.2 Line Fit Plot


61.2

1.4

For mezan bank

29

0 20 40 60 80 100 1200

0.5

1

1.5


Sample Percentile

1.25

0 100 200 300 400 500 6000

0.5

1

1.5

298 Line Fit Plot


298

1.25

For burj bank

0 10 20 30 40 50 60 70 80 90 1000

0.51

1.52


Sample Percentile

1.1

30

0.1 0.15 0.2 0.25 0.3 0.35 0.4 0.45 0.50

1

2

0.100412139378044 Line Fit Plot


0.100412139378044

1.1

For bank islami

0 10 20 30 40 50 60 70 80 90 100

-0.15-0.1

-0.050

0.050.1


Sample Percentile

0.08

5

0.25 0.3 0.35 0.4 0.45 0.5 0.55

-15.00%-10.00%

-5.00%0.00%5.00%

10.00%

0.578999018645731 Line Fit Plot


0.578999018645731

0.08

5

31

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