Optimal Capital Structure Threshold and its Impact on the Financial Performance of Pharmaceutical and Chemical Companies: A Trade-off and Agency Cost Theory Perspective

Purpose: The viability and growth of any business depend on securing the required capital and financial resources. Decisions regarding the optimal capital structure are crucial, not only for survival, growth, and efficiency but also for navigating the competitive environment. Managers, in the realm of company financing, aim to identify the optimal blend of financial resources, known as the capital structure, involving a combination of debt and equity. So, this research aims to determine the threshold level of optimal capital structure in two scenarios, namely debt and equity, and assess their impacts on the financial performance of pharmaceutical and chemical companies listed on the Iranian stock exchange. Previous research on financial management decisions regarding the determination of the optimal capital structure and its impact on company financial performance has presented diverse perspectives and theories, categorizable into distinct groups. Among them, both agency theory and trade-off theory can substantiate the existence of positive or negative associations between capital structure and the financial performance of companies and industries. Within the first category, studies rooted in agency theory elucidate a direct positive relationship between capital structure and company financial performance. They posit that managers lack the motivation to maximize efforts in securing shareholder interests; instead, they pursue personal interests or the policies aligned with their own benefits. Consequently, managerial decisions to finance the capital structure through debt serve as a control mechanism to curb opportunistic behavior and safeguard shareholder interests, leading to a reduction in the company's free cash flows and the compultion of managers to avoid negative investments for the benefit of shareholders. Conversely, studies in the second category focus on interpreting the negative and indirect relationship between capital structure and company performance and contend that, based on the trade-off theory, the potential for incurring bankruptcy costs does exist. As financing with debt entails tax advantages and costs associated with debt financing (bankruptcy costs and financial distress costs), an increase in debt leads to a decrease in net income and an increase in total costs. Excessive debt may also push the company into a financial crisis or bankruptcy, resulting in a decline in the company's value and performance. In the light of previous studies and theories, it is evident that determining the threshold level of capital structure and its impact on financial performance is a challenging issue that has garnered the attention of numerous researchers. Using the data for 31 companies in the pharmaceutical and chemical sector from 2011 to 2022, a non-linear threshold regression approach was applied to address the core questions ‘What is the relationship between optimal capital structure and the financial performance of these companies, considering the trade-off theory and the agency cost theory?’ and ‘Is this relationship linear or non-linear?’
Methodology: This research sought to determine the optimal threshold level of capital structure in two scenarios, modeling its relationship with the company's financial performance. We identify this threshold in scenarios of financial leverage and equity. Building upon prior theories and foundations, we elucidate the threshold levels of financial leverage and asset return in the first scenario and equity and asset return in the second scenario using the Panel Smooth Transition Regression (PSTR) model. The PSTR model, a non-linear threshold regression model in econometrics, accommodates varying coefficients over time and regimes, addressing the challenge of heterogeneous estimated parameters. Following the recommendations of Gonzalez et al. (2017) and Collitaz & Hurlin (2006), we model the potential non-linear relationship between variables using a transition function and a threshold variable. The functional form of the PSTR model, incorporating two extreme regimes and a continuous transition function, is employed.
Findings and discussion: The research findings demonstrate a non-linear threshold relationship between optimal capital structure and asset return in both scenarios. In the first scenario, an increase in financial leverage results in a decrease in asset return within the optimal capital structure. Conversely, in the second scenario, an elevated equity-to-asset ratio significantly enhances asset return. The impact of asset return through debt is more pronounced than through equity, suggesting a preference for debt financing over equity in financial investment decisions within pharmaceutical and chemical companies.
The results regarding large shareholders' share indicate that these companies have successfully limited market dominance, fostered non-competitive behaviors and increased asset returns beyond the threshold level of optimal capital structure. Before reaching the threshold level in the first scenario, variables such as large shareholders' stakes, company size, and intensity of entry barriers enhance the asset return. Despite debt funding during this stage, increased structural variables, representing market dominance and favorable conditions, contribute to the increase of the asset return. Even after reaching the threshold, these variables continue to positively influence financial performance. The impact of financial leverage exhibits a non-linear relationship and suggests a decrease in the asset return beyond the threshold (0.44). Regarding the equity-to-asset ratio, both before and after the threshold level of 0.17, its increase strengthens the asset return.
Conclusion and policy implication: According to the results of the research, certain suggestions can be made for future research. Financial planners and stakeholders are advised to resolve their conflict of interests by determining an appropriate concentration level for shareholders to enhance the company's asset return. Managers, in financial decision-making for investment, are also recommended to have a higher percentage of financing from debt channels compared to equity.