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Do tax shields of debt and non debt impact on firms’ performance?


Evidence from Sri Lankan Land and property sector

Sritharan, Vinasithamby
School of Management, Huazhong University of Science and Technology, Hubei, People’s Republic
of China

Abstract
Purpose- The aim of this research study is to investigate whether the debt provide any tax benefits as
debt tax shield and non-debt tax shield through financing decisions and how much they add to the
firm’s value in case of Sri Lankan land and property sector firms.
Design/methodology/approach - Related capital structure theories which are from different scholars
are analyzed for the purposes of find out the trend of those two types of tax shields and create a proper
investigate able scheme regarding the impact of debt tax shield and non-debt tax shields on firm’s
performance of Sri Lankan land and property sector firms for the time period from 2008 to 2012.
Findings - The analysis results reveal that capital structure measure of total debt ratio is negatively
related to performance measure of return on assets in both fixed and random regression models
significantly. Further debt tax shield and non-debt tax shield have negative relation with performance
measure of return on assets under the both fixed and random regression models, however both models
reveal statistically insignificant, so both tax shields haven’t any significant impact on firm’s
performance measure of return on assets.
Practical implications – This research explores the impact of tax shields and leverage on the firm’s
performance of Sri Lankan land and property sector firms and laid some contribution to the existing
literature as Sri Lankan firms’ context. Moreover that observed findings could assist the corporate
sector management as well as policy makers to take appropriate decisions in their fields.
Originality/value - Based on the knowledge of authors, this is the first study that reveals the impact of
debt tax shield and non-debt tax shields and leverage on the firm’s performance of Sri Lankan land and
property sector firms. Moreover, impact of debt tax shield and non-debt tax shield on performance is
misty, hence this study continue that search by the help of Sri Lankan land and property sector firms
data.

Keywords: Debt tax shield, Non debt tax shields, Firm’s performance, Land and property, and Sri
Lanka
Paper type: Research paper

1. Introduction
There is no difference in the main objective of the financial management on making capital structure
decisions as the value maximization of the firm but the business environment is different for firm to
firm. Hence managing organization is not an easy task in order to achieve this main objective. To
accomplish this task management should decide appropriate levels of debt and equity with the
concentration of involving factors and their cost benefits. For making easiness in this task, there are
many studies carried out and broadly examined all over the world on determinant of capital structure,
it can be found in the literature. Moreover purpose of determining optimal capital structure, there are
a number of capital structure theories also have been developed by different scholars, however
unfortunately they failed to formulate standardized methodology for this issue yet.

Furthermore these theories of concerning capital structure differ in their relative emphasis, its may be
due to the perception differences on the facts. In this way the trade-off theory developed by Modigliani
and Miller’s (1963) explained that, “the relevance of debt with the existence of taxes and bankruptcy
costs a benefit for debt is observed that serves to shield earnings from taxes”. And prediction of

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agency cost theory developed by Jensen and Meckling (1976) also supports to have more debt but with
different reason that state as “ high level of leverage is expected to low level of agency costs, because
of management discipline, inefficiencies can be reduce and leads to higher firm’s performance”.

Whereas pecking order theory of Myers (1984) saying that “profitable firms might have lower leverage
than unprofitable firms because of overleveraging or financial distress cost for debt might decrease the
efficiency of operations”. Trade-off and agency cost theories encourage having more debt, particularly
trade-off theory motivates for getting tax shield benefits. Hence, higher use of debt produces
increasing in firm’s performance through tax savings on interest payments.

Non-debt tax shields like investment tax credits and depreciation also affects the capital structure.
According to Ngugi (2008) findings, that the demand for debt is influenced by non-debt tax shields. So
then it can be expected non-debt tax shields influence on performance through influencing debt.
DeAngelo and Masulis (1980) found that “non-debt tax shields are the substitute of the tax shields on
debt financing”. They argue that depreciation deductions and tax-loss carry forwards can be as
replacements for the tax benefits of debt financing.

The empirical literature on impact of the debt tax shield and non-debt tax shield are dissimilar. Myers
(1984) says, the firms substitute debt for equity or equity for debt up to the value of the firm is
maximized, Athula et al.(2011) found a positive relationship between tax ratio and performance ,
Kebewar and Shah (2012) explored tax affected positively on profitability, and Zeitun and Tian
(2007)also stated a positive effect of tax on profitability.

But Klapper and Tzioumis (2008) showed that “smaller and more profitable companies more likely to
reduce debt levels”, and Wald (1999) and Deesomsak et al. (2004) reported a significant negative
relationship between leverage and non-debt tax shields. Whereas Felicia (2013) and Kahle and Shastri
(2005) ignoring the effect of these tax benefits impact on firm profitability.

Based on these arguments impact of debt tax shield and non-debt tax shield on performance is misty
and continuing debate on this issues. So empirical study is necessary and also studies on theses tax
shield issues have not much more consideration in Sri Lanka. Hence the main motivation of this study
is arising from the questions of does the debt provide any tax benefits through financing decisions?
And if so, how much do they add to the firm’s value? in case of Sri Lankan land and property sector
firms, and this study hopes that to answers this questions as well as gives a further understanding to
this topic.

The following part of this paper is structured as review of literature and followed by explanatory
variables, data and methodology, empirical results and discussions, and finally Conclusions of
this study.

2. Review of literature
Thinking of owners’ wealth maximization has been given more attention on the term of capital
structure through the consideration of cost benefit analysis of debt and equity. From the beginning,
time to time several theories were introduced concerning of capital structure by different scholars.

In this way, the traditional view of capital structure was rejected and an irrelevancy proposition was
introduced by Modigliani and Miller in 1958 with the assumptions of perfect competitive capital
market. Dissimilarity of these restrictive assumptions with reality, irrelevancy proposition was
replaced by the trade-off theory in 1963 by the same scholars. According to this theorem, the
concentration of capital structure choice becomes as an important value-determining factor. They
proposed value of a levered firm can be exceeded than an unlevered firm by the tax savings through

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the usage of debt. So based on this theory firms should employ as much debt as possible for increase
their value by having more tax-deductible interest payments.

The next important theory named as agency cost theory and introduced by Jensen and Meckling in
their 1976. This theory also considered debt to be an essential factor for generate managerial discipline
rather than tax savings. It explains the debt benefits through the help of bankruptcy and providing a
managerial discipline. Followed by this agency cost theory, the pecking order theory was proposed by
Myers and Majluf in1984 but it has against opinion regarding the debt level to previous theories of
trade-off and agency cost, and further it says as “profitable firms might have lower leverage than
unprofitable firms because of overleveraging or financial distress cost for debt might decrease the
efficiency of operations”.

More over to these theories, time to time some other theories also proposed but they were failed to get
mach more attention such as signaling hypothesis by Ross (1977), DeAngelo and Masulis’ (1980) tax
models and the optimal capital structure model by Bradley et al. (1984). However, still there is lack
of good support on significance of this debt tax shield and non-debt tax shields and its relationship
with firm’s performance especially in the developing nations.

At the same time empirically there were several researches conducted by many authors. According to
Modigliani and Miller (1963), the debt cost of interest can be treated as an expense in the financial
statement to offset the taxation. This tax shield of interest provides inducement to firms to have debt
finance, and payment of debt interest expense leads to rise firm’s value when equity can be traded for
debt and decreasing the cost of debt capital. Likewise study of Myers (1977) found that the firms with
high short term debt to total asset have growth rate and performance as high. Further the results reveal
that high performance is related with a high tax rate and it points out that profitable firms pay a high
tax rate.

DeAngelo and Masulis (1980) proposed a trade-off model including the impact of debt tax shield and
non-debt tax shields for optimal capital structure. And they said that non-debt tax shields are the
substitute for the tax shields on debt financing. That non-debt tax shields may be as investment tax
credits, accounting depreciation and depletion allowances. Myers (1984) said as “the firm should be
considered on balancing the value of debt tax shields against various bankruptcy costs though the
argument about how valuable the tax shields are, and which, if any, of the costs of financial
embarrassment are material”. And the firm can substitute equity for debt or debt for equity up to that
the firm’s value is maximized. Another study was conducted by Bradley et al. (1984) show evidence
for positive relationship between non-debt tax shields and leverage through the optimal capital
structure model.

Givoly et al (1992) explored a positive relation between leverage changes and changes in corporate tax
rates in US and summarized that there was a substitution effect also between debt tax shield and non-
debt tax shields like DeAngelo and Masulis (1980) finding. Shukla and Trzcinka (1992) also
contributed with a positive effect of non-debt tax shields with leverage. Engel, Erickson, and Maydew
(1999) proposed companies can get considerable tax benefits from substituting tax-nondeductible
regular preferred stock by tax-deductible trust preferred stock. Hovakiman et al. (2002) recommended
that profitable firms to be prefer to issue debt rather than equity and should more like to repurchase
equity instead of debt, to receive tax benefits. In 2004 Huang and Song studied more than 1,000 listed
Chinese companies and summarized their result as that non-debt tax shields positively related with
leverage. Tian and Zeitun (2007) also reported a positive effect of tax on profitability.

One of the Sri Lankan studies of Athula et al. (2011) also reported a positive relationship of tax with
firm’s performance for the data 2002–2008. Some other recent studies also provides positive relation
evidences such as Kebewar and Shah (2012) show that tax and growth opportunities have positive

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effect on the profitability, and Pfaffermayr et al. (2013) established evidence that debt ratio is
positively associated with the tax rate and negatively with age of firm and further that, debt tax shield
is more important for older firms than younger firms.

In contrast, Miller (1977) found due to the personal tax disadvantage of debt, firms provide high
interest rates to compensate debt holders; hence the tax benefits of debt pass out to debt holders instead
of equity holders. On the other hand, if the country preferentially taxed on dividends, the result being
weaker in those countries. And this situation can leads to support with personal taxes influence payout
policies and capital structure. Wald (1999) and Deesomsak et al. (2004) found a negative relationship
between leverage and non-debt tax shields as significant. Bauer (2004) has reported a negative but less
significant effect between non-debt tax shields and the leverage. Later on Viviani (2008) show a
negative relationship between short-term debt ratio and non-debt tax shields as significant result.

Whereas some of other authors supported as tax have no effect on leverage, such as Titman and
Wessels (1988) show that non-debt tax shield has not any significant effect on leverage or capital
structure. Kahle and Shastri (2005) disregarded the effect of tax benefits can impact on firm
profitability and capital structure as potentially.

Consequently when we considering these above contradictory findings, still debt tax shield effect on
firm’s performance is ambiguity and empirical investigation is needed.

3. Explanatory Variables
According to the research objectives of this study, dependent and independent variables are included
from the existing literature. There were several different proxies also used to measure theses variable
in the literature, among them this study selected largely adopted measurements as this study variables’
measures. The dependent variable is firm’s performance; the explanatory variables include total debt
ratio, debt tax shields and non-debt tax shields.

Total debt
Jensen (1986) said mainly companies can get two types of benefits from its debt such as tax shield and
disciplines of managers. Debt increases the value of the firms because in interest payments are not
taxable. So this is the first benefit of debt called as tax shield. And other one, naturally managers have
interest to invest free cash flows in profitable projects to earn profit for expenses, dividend payment
and to have more cash balance like that. If the firm have commitment to pay some fixed payments like
interest payment, that commitment will motivate management to earn more profit for such compulsory
payments. Interest is fixed and compulsory payment compare to dividend. So management do not like
to waste excess free cash flows. Hence shareholders attract by debt to discipline the management. So
based on these importance, this study is decided to include total debt ratio as one of the variable in this
study.

According to the literature, several studies used many different methods to measure debt ratio. Among
those differences, whether use short-term debt or long-term debt or total debt or all these three is the
main argument, which is raised from the usage of debt in terms of debt maturity periods. On the other
side another argument of whether use book value or market value, because debt can be divided by total
assets or the sum of book value of debt plus the market value of equity.

Among the past studies, total debt to total assets as book value to measure capital structure was used
by Bos and Fetherston (1993) and Bunkanwanicha et al. (2006). Study of Frank and Goyal (2005) also
quoted as most of the studies focused on a single measure of leverage for total debt measurement such
as total debt to equity or total debt to total assets. The study of Rajan and Zingales (1995) used total
liabilities divided by total assets, total debt divided by total assets, total debt divided by net assets and

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total debt divided by capital as their capital structure measures. Hence this study decided to use total
debt to total assets as a single measure for leverage in this study.

In the other side, the book value vs. market value measures, still that is also controversy. Fama and
French (2002) study says most of the previous studies used the book value of debt because of the
goodness in measuring the capital structure. Earlier Stonehill et al. (1975) study also supported to book
value usage rather than market value. Later on Myers (1977) study also put some argument to support
the book value. Study of Shah and Khan (2007) provides support to usage of book value measurement
of capital structure, from the developed country study of Citron (1992) also stated some evidence for
usage of book value. Hence, based on this evidences this study decides to use book value to measure
capital structure, and ignoring the market value.

Debt Tax shields


Initially the trade-off theory of Modigliani and Miller (1963), proposed that the firms preferred debt
financing for the advantage of tax deductibility of interest payment. Hence, a positive relationship was
expected between leverage and effective tax rate. According to the literature over the influence of tax
rate on leverage recorded as controversy results. Jahera and Lyold (1996) stated a positive relationship
Krishnan and Moyer (1996) found that effective tax rate significantly influence on capital structure,
DeAngelo and Masulis (1980) explored a trade-off model for the optimal capital structure that
included the impact of debt tax shields. This tax shield of interest provides inducement to firms to have
debt finance, and payment of debt interest expense leads to rise firm’s value. Likewise study of Engel,
Erickson, and Maydew (1999) proposed evidence that companies can get considerable tax benefits
from substituting tax-nondeductible regular preferred stock by tax-deductible trust preferred stock.
Some of the later studies also concern on incremental financing decisions and found evidence as the
use of debt is promoted by high marginal tax rates (Mackie-Masson, 1990; Trezevant, 1992). Based
on these evidences, this study includes debt tax shield as one of the explanatory variable and
furthermore, in the past study of Tian and Zeitun (2007) used a proxy of total tax (annul tax expenses)
to earnings before interest and tax (EBIT). Hence the same proxy is followed for the measurement of
the debt tax shield.

Non-debt tax shields


Non-debt tax shields can be including that the tax deduction from investment tax credit and
depreciation. DeAngelo and Masulis (1980) study incorporated non-debt tax shields and extended the
Miller’s analysis, and further it proposes as non-debt tax shields are the substitute of the tax shields
from the debt financing. So firms have larger non-debt tax shields are expected to have their capital
structure with less debt level.

Non-debt tax shield is commonly used by many research scholars as one of the variables in finding its
effect on the capital structure choice. Non-debt tax shield may have different outcomes regarding to
level of short term and long term debt; further more if firm have higher non-debt tax shields with lower
taxable profit while non-debt tax shields are deductible. Empirical studies cater conflicting findings on
this issue also. In the literature, a number of proxies used to measure non-debt tax shield. Buferna et
al. (2000) and Wald (1999) employed with the ratio of depreciation over total assets taken a proxy for
non debt-tax shields. Based on these evidences, the same proxy followed for the measurement of the
non-debt tax shield in this study.

4. Data and methodology


Data
This study mainly uses its source of data as financial statements, which published in the annual report
of the listed companies at CSE, Sri Lanka. Mainly the data from balance sheets and income statements
were taken from annual reports of the companies over 5 years from 2008 till 2012. All this collected
financial data are in terms of Sri Lankan Rupees. The purpose of getting 5 years period of data as

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balanced panel data set, our study only considered the firms that are listed in CSE since 2007, hence
that a period of 5 years data set can be obtained. According to the CSE records 18 firms were listed
under the Land and property sector in the CSE, Sri Lanka since 2007 thus, 18 firms are taken as a
balanced panel data set for this study.

Methodology
The estimation of the pooled OLS model performs under the hypothesis of “there are no groups or
individual effects among the included sample data”. While the pattern of panel data enclosed the
observations for the same cross-sectional units over time series (several time periods), so there might
be cross-sectional effects on each firm or might be on a set of group of firms. To deal with such
problem, there are several techniques are existing in practice, even though, the panel econometric
techniques of the fixed and the random effects models are widely used as important models for such
problems. The fixed effects model estimates as “the individuality of each firm or cross-sectional unit
included in the sample by letting the intercept vary for each firm but still assumes that the slope
coefficients are constant across firms”. While, the random effects model takes as “the coefficients
under the assumption that the individual or group effects are uncorrelated with other explanatory
variables and can be formulated”.

When it believes as some of the omitted variables might be fixed over the time however vary among
panels, at the same time some of others might be constant among panels but fluctuate over time. In
these situations random effects model regression can be applied.

Based on these arguments this study decided to perform fixed and random effect models only and
avoided the pooled model because of the nature of panel data as stated above. Furthermore this study
performed Hausman (1978) specification to select the suitable model from fixed and random effect
models for the best interpretation of our estimation. And the description of two econometric estimation
models (fixed effects and random effects) can be written as follows;

ROA it = β0i+ β1 TDR it + β2 DTS it + β3 NDTS it + µit

ROA it = β0+ β1 TDR it + β2 DTS it + β3 NDTS it + εi+ µit

Where;
ROA it – return on asset of firm i at time t.
β0 – intercept.
β1 to β3 – coefficients of concerned explanatory variable.
β0i- intercept of firm i.
TDR it - dept ratios of firm i at time t.
DTS it – debt tax shields of firm i at time t.
NDTS it – non-debt tax shields of firm i at time t.
µit- random error term of firm i at time t.
εi- error component of firm i.

Analysis will be carried out in two methods of Descriptive statistics method and inferential statistics
method.

Data Processing and Analysis


Mainly Data were collected from the annual reports by the primary survey, then sorted and analyzed
by using a computerized data analysis package known as Stata12. Tables were used for purposes of
presenting and analyzing the findings of the study. Pearson correlation and regressions were used to
measure the relationships and strength between the study variables.

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5. Empirical results and discussions
Empirical results
Table 1 explains the summary statistics of the dependent and explanatory variables used in this study.
This critical descriptive statistics examination of the dependent and explanatory variables discloses
several issues. This accounting measure (ROA) is used as performance measure, which varies from
negative 28.18% to positive 76.48% with average ratio of 4.56% to the whole sample, and explains
that Sri Lankan land and property sector firms have lower accounting performance. The difference in
return on assets ranged from profitability of 76.48% (maximum value) to a loss of 28.18% (minimum
value) for the firms. This explores a great disparity among the firms in their profitability.

When considering the measures of leverage, which states a highest average ratio of 34.7% among the
measures. This means that amount of about 35 percent of total assets values financed by total liabilities
at the land and property sector firms of Sri Lanka. The average value of the debt tax shield of 4.9% is
higher than non-debt tax shield value of 0.76% for the firms tested.

Furthermore this result explores that the most volatile variable among the examined variables is debt
tax shield with a S.D of 1.994456 followed by total debt ratio with .3547412. Whereas the least
volatile (most stable) variable is non-debt tax shield ratio with a S.D of .0121721, followed by return
on assets with .1151675.
Table 1: Descriptive Statistics of the Dependent and Explanatory Variables
Variable Observations Mean Std. Dev. Minimum Maximum
ROA 90 .0456909 .1151675 -.2818567 .7648928
TDR 90 .3470892 .3547412 .0077866 1.772679
DTS 90 .0490727 1.994456 -8.350645 15.10241
NDTS 90 .007692 .0121721 0 .0626573
Note: ROA = the return on assets (net profit/ total assets); TDR = total debt divided by total assets;
DTS = total tax to earnings before interest and tax (EBIT). NDTS = Ratio of depreciation expense to
total assets
Source: Results obtained from the data analysis using the statistical software package of Stata12.

Correlation Matrix
The correlation matrix of the dependent and explanatory variables is presented in Table 2 below for the
purpose of examining the existing correlation among the variables. The results reveal that ROA has a
negative relationship with total debt ratio as 35.52% whereas positively correlated with debt and non
debt tax shield of the firms as 3.4% and tax at 4.51% respectively. The total debt ratio has a negative
correlation with debt tax shield as 6.72% but positive with non debt tax shield as 5.48%. The both
degree of associations are weak. But in case of debt tax shield, non-debt tax shield has weaker negative
relationship of 4.6%.

Hence these outputs reveal that accounting performance measure of ROA have a negative impact on
leverage and a positive impact on debt tax shield and non-debt tax shield of Sri Lankan land and
property sector firms.

This means that Sri Lankan firms enjoy tax benefits and they increase it though their operating
earnings. This is clearly reflected on the performance measure by this positive relationship. Further the
positive relationship of non-debt tax shields with leverage ratio expresses the strengthening of the
expected present value of tax savings derivable from non-debt tax shields. Anyhow it is important to
note that these descriptive statistics values and correlation analysis values are just point out the
associate link between related variables.

Table 2: Correlation Matrix of the Variables


ROA TDR DTS NDTS VIF

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ROA 1.0000
TDR -0.3552 1.0000 1.01
DTS 0.0340 -0.0672 1.0000 1.01
NDTS 0.0451 0.0548 -0.0460 1.0000 1.00
Note: ROA = the return on assets (net profit/ total assets); TDR = total debt divided by total assets;
DTS = total tax to earnings before interest and tax (EBIT); NDTS = Ratio of depreciation expense to
total assets
Source: Results obtained from the data analysis using the statistical software package of Stata12.
VIF - According to test of VIF (Variance Inflation Factor).

Normally when we are doing the regression analysis, the statistical problem of multicollinearity issue
should be considered among the independent variables. Hence prior to the regression analysis, the
previous defined explanatory variables were examined for appropriateness of the regression model. As
per the recommendation of Gujarati (2003) Variance inflation factor (VIF) was used to diagnostic of
multicollinearity issues among the explanatory variables. VIF measures express that none of the VIF
value indicates above 1.01 (cutoff value is 10); that shows multicollinearity problem does not exist
among the explanatory variables used in this study.

This result is strengthening by values of Table 2, that most cross-correlation coefficients of the
independent variables are quite small, therefore, giving little cause for worry about the
multicollinearity issues among the independent variables.

As per stated above in the methodology, the econometric techniques of fixed and the random effects
models were performed. The following Table 3 and Table 4 reveal output of those estimations
Furthermore both models total debt ratio, debt tax shield and non-debt tax shields given to be
significant at 5% level of confidence. Total debt ratio presented significant at both models whereas
debt tax shield and non-debt tax shields are insignificant under the both models.

As it is presented in Table 5, the Hausman chi-square statistic indicated as significant at 5% level. And
the null hypothesis that the coefficients estimated by the efficient random effects estimator are the
same as the ones estimated by the consistent fixed effects estimator is rejected, because that is
statistically significant. So difference in coefficients of the models are systematic, then it is safe to use
fixed effects model for the effect of total debt ratio on the ROA.

Table 3: Effect of explanatory variables on the ROA using the fixed effects model
Variables Coefficient SE t Prob.> | t |
TDR -.2391508 .0455425 -5.25 0.000
DTS -.0029338 .0047815 -0.61 0.542
NDTS -2.743622 1.778282 -1.54 0.127
Constant .1499455 .0237666 6.31 0.000
2 2
Note: R = 0.5624; Adjusted R = 0.4355; F (3, 69) = 9.54; Prob > F = 0.0000
ROA = the return on assets (net profit/ total assets); TDR = total debt divided by total assets; DTS =
total tax to earnings before interest and tax (EBIT); NDTS = Ratio of depreciation expense to total
assets
Source: Results obtained from the data analysis using the statistical software package of Stata12.

Table 4: Effect of explanatory variables on the ROA using the random effects model
Variables Coefficient SE z Prob.> | z |
TDR -.1700361 .0375279 -4.53 0.000
DTS -.0012525 .0048798 -0.26 0.797
NDTS -.3421838 1.227551 -0.28 0.780

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Constant .1074021 .0242833 4.42 0.000
2
Note: R = 0.1220; Wald chi2 (3) = 20.59; Prob > chi2 = 0.0001
ROA = the return on assets (net profit/ total assets); TDR = total debt divided by total assets; DTS =
total tax to earnings before interest and tax (EBIT).; NDTS = Ratio of depreciation expense to total
assets
Source: Results obtained from the data analysis using the statistical software package of Stata12.

Table 5: Fixed and random effect test comparison


Variables Fixed effects Random effects Difference S.E.
TD -.2391508 -.1700361 -.0691148 .0258026
DTS -.0029338 -.0012525 -2.401438 1.286626
NDTS -2.743622 -.3421838 -.0016813 .
2 2
Note: chi (3)= 8.52; Prob>chi = 0.0364
TDR = total debt divided by total assets; DTS = total tax to earnings before interest and tax (EBIT).;
NDTS = Ratio of depreciation expense to total assets
Source: Results obtained from the data analysis using the statistical software package of Stata12.

Discussion
Based on the experimental results, total debt ratio has a significant negative impact on return on assets,
which expresses that firms have increasing profitability prefer to reduce their debt level in land and
property sector of Sri Lankan firms. This negative relationship of total debt on performance is
invariable with the findings of Fama and French (1998), Gleason et al. (2000), Singh and Faircloth
(2005), Abor (2007) and Ebaid (2009).

And this finding is very similar to many recent Asian developing and developed country studies also
such as Abdul (2012) explored that leverage has a significant negative relationship with firm’s
performance as measured by ROA, GM, and Tobin’s Q, Majumdar and Chhibber (1999) reveled that
leverage was negatively related with firm’s performance in India, another study with 10 developing
countries by Booth et al. (2001) found negative relationship of leverage with firm’s performance,
Nigerian study by Onaolapo and Kajola (2010) explored a negative significant impact of leverage on
firm’s performance and Pushner (1995) also inferred negative effect of leverage over firm’s
performance in Japan.

According to the Fama and French (1998) findings debt and firm’s value have a strong negative
relation between them, inferring the cause as “imperfect controls for profitability probably drive the
negative relations between debt and value” it is possible in case of Sri Lankan land and property sector
firms also because there are 18 firms with different ages different level of management qualities.

Pandey (2004) explored that, when seeing developed and developing countries category, the developed
nations commonly prefer to long-term debt whereas in developing countries’ companies most of them
prefer to have both short-term and long-term debt for their financial needs. Because of undeveloped
and small bond market or may be high-cost of long-term bank debt, Sri Lankan firms are more
preferred on the short-term debt than long-term debt for their financial needs, so heavily rely on short-
term debt (significant proportion in total debt) also might be the reason for negative relationship of
leverage with firm’s performance .

In addition to these arguments, this finding dissimilar with the “debt irrelevance theorem” of
Modigliani and Miller (1958) and agency cost theory but based on the pecking order theory profitable
firms might have lower leverage than unprofitable firms because of financial distress cost for debt
might decrease the efficiency of operations, or present debt may be signal information for expected
future operating profitability. This issue suggests that further analysis of a capable area for the future
study. However, based on the results of this study, the relationship is negative.

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The firm’s specific factors of debt tax shield and non-debt tax shield also have a negative relationship
with return on assets but that is statistically insignificant as given by the both models. This, empirical
outcomes indicate these two independent variables (other than capital structure) not impact on firm’s
performance. Thus, the Modigliani and Miller’s (1963) argument of trade-off theory for optimal
capital structure of “maximum use of debt generates tax savings on interest payments, which in turn
play an important role in improving firm’s performance” is questionable in case of land and property
sector firms in Sri Lanka.

This finding is consistent with many empirical study’s findings such as Kahle and Shastri (2005),
study reject the effect of these tax benefits, Fama and French (1998) stated that tax effect of debt
financing has insignificant affect over the firm’s value, Titman and Wessels (1988) argued that non-
debt tax shield was not significant in effecting leverage or capital structure choice of firms and
Bradley, Jarrell and Kim (1984) showed as there is no evidence to the theoretical predictions of
leverage levels are related to non-debt tax shields. In addition to these, Huang and Song (2004)
revealed decreases with non debt tax shields, profitability in Chinese listed firms as significant.

Whereas there were some of the studies that added value to the literature against to this findings of
insignificant debt and non-debt tax benefits such as Grossman and Hart (1986) showed the higher
performance level could be provided by tax shield of debt interest, Bauer (2004) stated that
performance positively correlated with tax in Czech Republic, Kemsley and Nissim (2002), found a
positive significant value for the debt tax shield and further more Carter and Manzon, (1995) and
Barclay and Smith (1995) also found positive relationship. One of the Sri Lankan studies of Athula et
al. (2011) found a positive relationship between tax ratio and performance at 10 per cent significant
level for the 2002 to 2008 time period data. However the influence of taxation is difficult to predict
and complex because of depends on the principles of tax deductibility of interest, income tax and non-
debt tax shields. So, we can expect a negative tax effect over the profitability, if companies do not take
advantage of this principle.

6. Conclusions
Through this empirical study, we are interested to explore the impact of debt tax shield and non-debt
tax shield on firm’s performance of Sri Lankan land and property sector firms. In other words, this
research paper tried to expand the empirical literature on the topic of the influence of debt tax shield
and non-debt tax shield on firm’s performance. Lack of Sri Lankan firms’ studies on this topic and the
studies on the tax benefits (debt tax shield and non-debt tax shield) of listed companies’ concentration
have motivated this research study. For this purpose, we investigated empirically the impact of debt
tax shield and non-debt tax shield on firm’s performance by using the well known panel econometric
techniques methods of fixed effects, and random effects on a balanced panel of 18 Sri Lankan
companies of land and property sector observed over the period 2008-2012.

There are several theoretical and empirical disagreements were observed between the researchers
recording this research study topic. Observed results indicate that capital structure measure of total
debt ratio is negatively related to performance measure of return on assets in both fixed and random
regression models. This result is reliable to the pecking order hypothesis. In addition, it is incongruent
with the irrelevance proposition developed by Modigliani and Miller (1958) whereas opposite to the
trade-off theory argument of Modigliani and Miller’s (1963). Based on the pecking order theory
profitable firms might have lower leverage than unprofitable firms because of overleveraging or
financial distress cost for debt might decrease the efficiency of operations, or present debt may be
signal information for expected future operating profitability, thus, negatively affect on the
performance.

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Further this study reveals that debt tax shield and non-debt tax shield have negative relation with
performance measure of return on assets under the both fixed and random regression models, however
both models reveal statistically insignificant. Main objective of this evaluation answered by this result
as the debt tax shield and non-debt tax shield haven’t any significant impact on firm’s performance
measure of return on assets. This result similar to very recent Nigerian study of Felicia (2013), found
that there is no significant any relationship between tax and market performance.

For potential research, this study has some key policy implications for investors, lenders as well as
financial managers. First, empirical findings indicate that financial decision makers should consider
the effects of leverage over the firm’s performance before changing the debt levels. Lenders should
carefully impose debt contracts considering its impact over the firm’s performance. Investors should
carefully verify the firm’s debt level when they making investment decisions on debt. Finally, at the
time of these key policy implementation of implication and other debt related decision making, do not
much more worry about the impact of debt tax shield and non-debt tax shield.

In gist, this study has placed some keystone by surveying the impact of debt tax shield and non-debt
tax shield on firm’s performance leading which a more thorough assessment of Sri Lankan land and
property sector firms’ debt tax shield and non-debt tax shield could be based. Furthermore, this study
proposed to estimate the relationship between debt tax shield and non-debt tax shield and firm’s
performance using the data from other sector firms or as whole listed firms in Colombo stock
exchange.

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