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Determinants
Determinants of capital structure of capital
An empirical study of firms in manufacturing structure
industry of Pakistan
Nadeem Ahmed Sheikh 117
School of Management, Huazhong University of Science and Technology,
Wuhan, People’s Republic of China and
Institute of Management Sciences, Bahauddin Zakariya University,
Multan, Pakistan, and
Zongjun Wang
School of Management, Huazhong University of Science and Technology,
Wuhan, People’s Republic of China
Abstract
Purpose – The aim of this empirical study is to explore the factors that affect the capital structure
of manufacturing firms and to investigate whether the capital structure models derived from
Western settings provide convincing explanations for capital structure decisions of the Pakistani
firms.
Design/methodology/approach – Different conditional theories of capital structure are reviewed
(the trade-off theory, pecking order theory, agency theory, and theory of free cash flow) in order to
formulate testable propositions concerning the determinants of capital structure of the manufacturing
firms. The investigation is performed using panel data procedures for a sample of 160 firms listed on
the Karachi Stock Exchange during 2003-2007.
Findings – The results suggest that profitability, liquidity, earnings volatility, and tangibility
(asset structure) are related negatively to the debt ratio, whereas firm size is positively linked to the
debt ratio. Non-debt tax shields and growth opportunities do not appear to be significantly related to
the debt ratio. The findings of this study are consistent with the predictions of the trade-off theory,
pecking order theory, and agency theory which shows that capital structure models derived from
Western settings does provide some help in understanding the financing behavior of firms in
Pakistan.
Practical implications – This study has laid some groundwork to explore the determinants of
capital structure of Pakistani firms upon which a more detailed evaluation could be based.
Furthermore, empirical findings should help corporate managers to make optimal capital structure
decisions.
Originality/value – To the authors’ knowledge, this is the first study that explores the determinants
of capital structure of manufacturing firms in Pakistan by employing the most recent data. Moreover,
this study somehow goes to confirm that same factors affect the capital structure decisions of firms in
developing countries as identified for firms in developed economies.
Keywords Capital structure, Stock exchanges, Manufacturing industries, Pakistan
Paper type Research paper
Managerial Finance
The authors are thankful to Dr Don Johnson, Dr Muhammad Azeem Qureshi, and two Vol. 37 No. 2, 2011
anonymous reviewers for their detailed comments and suggestions that substantially improved pp. 117-133
q Emerald Group Publishing Limited
the paper. They are also thankful to Ms Lisa Averill and Mr Javed Choudary for their 0307-4358
comprehensive editing of the manuscript. DOI 10.1108/03074351111103668
MF 1. Introduction
37,2 Decisions concerning capital structure are imperative for every business organization.
In the corporate form of business, generally it is the job of the management to make
capital structure decisions in a way that the firm value is maximized. However,
maximization of firm value is not an easy job because it involves the selection of debt and
equity securities in a balanced proportion keeping in view of different costs and benefits
118 coupled with these securities. A wrong decision in the selection process of securities may
lead the firm to financial distress and eventually to bankruptcy. The relationship
between capital structure decisions and firm value has been extensively investigated
in the past few decades. Over the years, alternative capital structure theories have been
developed in order to determine the optimal capital structure. Despite the theoretical
appeal of capital structure, a specific methodology has not been realized yet, which
managers can use in order to determine an optimal debt level. This may be due to the fact
that theories concerning capital structure differ in their relative emphasis; for instance,
the trade-off theory emphasizes taxes, the pecking order theory emphasizes differences
in information, and the free cash flow theory emphasizes agency costs. However, these
theories provide some help in understanding the financing behavior of firms as well as
in identifying the potential factors that affect the capital structure.
The empirical literature on capital structure choice is vast, mainly referring to
industrialized countries (Myers, 1977; Titman and Wessels, 1988; Rajan and Zingales,
1995; Wald, 1999) and a few developing countries (Booth et al., 2001). However, findings
of these empirical studies do not lead to a consensus with regard to the significant
determinants of capital structure. This may be because of variations in the use of
long-term versus short-term debt or because of institutional differences that exist
between developed and developing countries.
The lack of consensus among researchers regarding the factors that influence the
capital structure decisions and diminutive research to describe the financing behavior of
Pakistani firms are few reasons that have evoked the need for this research. We hope that
findings of this empirical study will not only fill this gap but also provide some
groundwork upon which a more detailed evaluation could be based.
The rest of the paper is structured as follows. In Section 2, the most prominent
theoretical and empirical findings are surveyed. In Section 3, the potential determinants
of capital structure are summarized, and theoretical and empirical evidence concerning
these determinants are provided. Section 4 is the empirical part of the paper which
describes the data and methodology employed in this study. Section 5 is devoted to
results and discussion, and finally Section 6 presents the conclusions of this study.
Profitability
The trade-off theory suggests a positive relationship between profitability and leverage
because high profitability promotes the use of debt and provides an incentive to firms to
avail the benefit of tax shields on interest payments. The pecking order theory postulates
that firms prefer to use internally generated funds when available and choose debt over
equity when external financing is required. Thus, this theory suggests a negative
relationship between profitability (a source of internal funds) and leverage. Several
empirical studies have also reported a negative relationship between profitability and
leverage (Toy et al., 1974; Titman and Wessels, 1988; Rajan and Zingales, 1995; Wald,
1999; Booth et al., 2001; Chen, 2004; Bauer, 2004; Tong and Green, 2005; Huang and Song,
2006; Zou and Xiao, 2006; Viviani, 2008; Jong et al., 2008; Serrasqueiro and Rogão, 2009).
Size
Several reasons are given in the literature concerning the firm size as an important
determinant of capital structure. For instance, Rajan and Zingales (1995) in their study
MF of firms in G-7 countries observed that large firms tend to be more diversified and,
37,2 therefore, have lower probability of default. Rajan and Zingales’ argument is consistent
with the predictions of the trade-off theory which suggests that large firms should
borrow more because these firms are more diversified, less prone to bankruptcy, and
have relatively lower bankruptcy costs. Furthermore, large firms also have lower agency
costs of debt, for example, relatively lower monitoring costs because of less volatile cash
122 flow and easy access to capital markets. These findings suggest a positive relationship
between the firm size and leverage. On the other hand, the pecking order theory suggests
a negative relationship between firm size and the debt ratio, because the issue of
information asymmetry is less severe for large firms. Owing to this, large firms should
borrow less due to their ability to issue informationally sensitive securities like equity.
Empirical findings on this issue are still mixed. Wald (1999) has shown a significant
positive relationship between size and leverage for firms in the USA, the UK, and Japan
and an insignificant negative relationship for firms in Germany and a positive
relationship for firms in France. Chen (2004) has shown a significant negative
relationship between size and long-term leverage for firms in China. Several empirical
studies have reported a significant positive relationship between leverage and firm size
(Marsh, 1982; Bauer, 2004; Deesomsak et al., 2004; Zou and Xiao, 2006; Eriotis et al., 2007;
Jong et al., 2008; Serrasqueiro and Rogão, 2009).
Tangibility
Myers and Majluf (1984) argued that firms may find it advantageous to sell secured debt
because there are some costs associated with issuing securities about which the firm’s
managers have better information than outside shareholders. Thus, issuing debt
secured by the property with known values avoids these costs. This finding suggests a
positive relationship between tangibility and leverage because firms holding assets can
tender these assets to lenders as collateral and issue more debt to take the advantage of
this opportunity. Furthermore, the findings of Jensen and Meckling (1976) and Myers
(1977) suggest that the shareholders of highly leveraged firms have an incentive to
invest suboptimally to expropriate wealth from the firm’s debt holders. However, debt
holders can confine this opportunistic behavior by forcing them to present tangible
assets as collateral before issuing loans, but no such confinement is possible for those
projects that cannot be collateralized. This incentive may also induce a positive Determinants
relationship between leverage and the capacity of a firm to collateralize its debt. Several of capital
empirical studies have reported a positive relationship between tangibility and leverage
(Wald, 1999; Chen, 2004; Huang and Song, 2006; Zou and Xiao, 2006; Viviani, 2008; structure
Jong et al., 2008; Serrasqueiro and Rogão, 2009).
However, the tendency of managers to consume more than the optimal level of
perquisites may produce a negative correlation between collateralizable assets and 123
leverage (Titman and Wessels, 1988). The firms with less collateralizable assets
(tangibility) may choose higher debt levels to stop managers from using more than the
optimal level of perquisites. This agency explanation suggests a negative association
between tangibility and leverage. Booth et al. (2001) have reported a negative relationship
between tangibility and leverage for firms in Brazil, India, Pakistan, and Turkey. Some
other empirical studies have also reported a negative relationship between tangibility
and leverage (Ferri and Jones, 1979; Bauer, 2004; Mazur, 2007; Karadeniz et al., 2009).
Growth opportunities
According to trade-off theory, firms holding future growth opportunities, which are a
form of intangible assets, tend to borrow less than firms holding more tangible assets
because growth opportunities cannot be collateralized. This finding suggests a negative
relationship between leverage and growth opportunities. Agency theory also predicts a
negative relationship because firms with greater growth opportunities have more
flexibility to invest suboptimally, thus, expropriate wealth from debt holders to
shareholders. In order to restrain these agency conflicts, firms with high growth
opportunities should borrow less. Several empirical studies have confirmed this
relationship, i.e. Deesomsak et al. (2004), Zou and Xiao (2006) and Eriotis et al. (2007). Wald
(1999) has shown that the USA is the only country where high growth is associated with
lower debt/equity ratio. This finding confirms the predictions of Myers’s (1977) model
that ongoing growth opportunities imply a conflict between debt and equity interests.
This conflict also causes the firms to refrain from undertaking net positive value projects.
Earnings volatility
Several empirical studies have shown that a firm’s optimal debt level is a decreasing
function of the volatility of its earnings. The higher volatility of earnings may indicate
the greater probability of a firm being unable to meet its contractual claims as they come
due. A firm’s debt capacity may also decrease with an increase in its earnings volatility
which suggests a negative association between earnings volatility and leverage. Various
empirical studies have shown a significant negative relationship between leverage
and earnings volatility (Bradley et al., 1984; Booth et al., 2001; Fama and French, 2002;
Jong et al., 2008).
Liquidity
The trade-off theory suggests that companies with higher liquidity ratios should borrow
more due to their ability to meet contractual obligations on time. Thus, this theory
predicts a positive linkage between liquidity and leverage. On the other hand, the
pecking order theory predicts a negative relationship between liquidity and leverage,
because a firm with greater liquidities prefers to use internally generated funds while
MF financing new investments. A few empirical studies have shown their results consistent
37,2 with the pecking order hypothesis (Deesomsak et al., 2004; Mazur, 2007; Viviani, 2008).
Variables Definition
Dependent variable
Debt ratio (DRit) Ratio of total debt to total assets
Explanatory variables
Profitability (PROFit) Ratio of net profit before taxes to total assets
Size (SIZEit) Natural logarithm of sales
Non-debt tax shields (NDTSit) Ratio of depreciation expense to total assets
Tangibility (TANGit) Ratio of net-fixed assets to total assets
Growth opportunities (GROWit) Ratio of sales growth to total assets growth (due to the absence of
data related to advertising expense, research and development
expenditures, and market-to-book ratio)
Earnings volatility (EVOLit) Ratio of standard deviation of the first difference of profit before
Table I. depreciation, interest, and taxes to average total assets
Definition of variables Liquidity (LIQit) Ratio of current assets to current liabilities
Methodology Determinants
This study employed panel data procedures because sample contained data across firms
and overtime. The use of panel data increases the sample size considerably and is more
of capital
appropriate to study the dynamics of change. In order to estimate the effects of structure
explanatory variables on the debt ratio (a measure of leverage), we used three estimation
models, namely, pooled ordinary least squares (OLS), the random effects, and the fixed
effects. Under the hypothesis that there are no groups or individual effects among the 125
firms included in our sample, we estimated the pooled OLS model.
Since panel data contained observations on the same cross-sectional units over
several time periods there might be cross-sectional effects on each firm or on a set of
group of firms. Several techniques are available to deal with such type of problem but
two panel econometric techniques, the fixed and the random effects models, are very
important. The fixed effects model takes into account 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. The random effects
model estimates the coefficients under the assumption that the individual or group
effects are uncorrelated with other explanatory variables and can be formulated. This
study also employed the Hausman (1978) specification test to determine which
estimation model, either fixed or random effects, best explains our estimation.
The description of three estimation models – pooled OLS, the fixed effects, and the
random effects – is given below:
DRit ¼ b0 þ b1 PROF it þ b2 SIZE it þ b3 NDTS it þ b4 TANGit þ b5 GROW it
þ b6 EVOLit þ b 7 LIQit þ 1it
DRit ¼ b0i þ b1 PROF it þ b2 SIZE it þ b3 NDTS it þ b4 TANGit þ b5 GROW it
þ b6 EVOLit þ b7 LIQit þ m it
DRit ¼ b0 þ b1 PROF it þ b2 SIZE it þ b3 NDTS it þ b4 TANGit þ b5 GROW it
þ b6 EVOLit þ b7 LIQit þ 1it þ m it
where:
DRit ¼ debt ratio of firm i at time t.
PROFit ¼ profitability of firm i at time t.
SIZEit ¼ size of firm i at time t.
NDTSit ¼ non-debt tax shields of firm i at time t.
TANGit ¼ tangibility of firm i at time t.
GROWit ¼ growth opportunities of firm i at time t.
EVOLit ¼ earnings volatility of firm i at time t.
LIQit ¼ current ratio of firm i at time t.
b0 ¼ common y-intercept.
b1 - b7 ¼ coefficients of the concerned explanatory variables.
1it ¼ stochastic error term of firm i at time t.
MF b0i ¼ y-intercept of firm I.
37,2 mit ¼ error term of firm i at time t.
1i ¼ cross-sectional error component.
DRit 1.0000
PROFit 20.3222 1.0000
SIZEit 0.1382 0.2054 1.0000
NDTSit 20.0739 2 0.0281 2 0.0391 1.0000
TANGit 0.0692 2 0.3182 2 0.2681 0.1841 1.0000
GROWit 20.0195 0.0082 2 0.0134 2 0.0310 0.0005 1.0000 Table IV.
EVOLit 20.2316 0.0722 2 0.6007 0.0917 2 0.0154 0.0078 1.0000 Pearson correlation
LIQit 20.6302 0.3929 0.1351 2 0.0703 2 0.5182 0.0276 0.1014 1.0000 coefficient matrix
6. Conclusions
This empirical study attempted to explore the determinants of capital structure of
160 manufacturing firms listed on the KSE Pakistan during 2003-2007. The investigation
is performed using panel econometric techniques, namely, pooled OLS, fixed effects, and
random effects. This study has employed the debt ratio (a measure of leverage) as an
explained variable. The debt ratio includes both long-term and short-term debt.
Although, the strict notion of capital structure refers exclusively to long-term debt, we
have included short-term debt as well because of its significant proportion in the make up
of total debt of the firms included in our sample.
According to the results of empirical analysis, profitability and liquidity are negatively
correlated with the debt ratio. This finding is consistent with the pecking order hypothesis
rather than with the predictions of the trade-off theory. The firm size is positively
correlated with the debt ratio. This finding supports the view of firm size as an inverse
proxy for the probability of bankruptcy. The debt ratio is negatively correlated with
earnings volatility, which is consistent with theoretical underpinnings of the trade-off
theory. The tangibility (asset structure) is negatively correlated with the debt ratio. This
finding is in contradiction with the predictions of the trade-off theory; however, it is in line
with the implications of the agency theory suggesting that firms with less collateralizable
assets may choose higher debt levels to limit the managers’ consumptions of perquisites.
Moreover, a significant negative impact of liquidity on the debt ratio indicates that firms
maintained excessive liquidity which may encourage managers to consume more than the
optimal level of perquisites. Consequently, firms with less collateralizable assets borrow
more to confine the opportunistic behavior of the managers. Contradictory results are
found concerning the variable non-debt tax shields. The total and random effects model
accepts this variable with a negative sign but the fixed effects model does not.
No significant relationship is found between the debt ratio and growth opportunities.
Finally, the difference in long-term versus short-term debt might limit the
explanatory power of the capital structure models derived from Western settings.
However, the results indicate that these models provide some help in understanding the
financing behavior of Pakistani firms.
Notes
1. The publication entitled “Balance Sheet Analysis of Joint Stock Companies listed on Karachi
Stock Exchange 2002 2 2007” is prepared by the SBP on the basis of information given in the
annual reports, made by the companies at the end of each accounting period. This is
mandatory for every public limited company to make financial statements in accordance with
the approved accounting standards as applicable in Pakistan. Approved accounting standards
comprise of such International Financial Reporting Standards issued by the International Determinants
Accounting Standard Board as are notified under the Companies Ordinance 1984.
of capital
2. The total debt is the sum of long-term and short-term debt. On average long-term debt
represents 24 percent while short-term debt represents 76 percent of the total debt employed structure
by the companies included in our sample. The reasons for heavy dependence of firms on
short-term debt include relatively high cost of long-term bank loans, and a limited and
undeveloped bond market in Pakistan. 131
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