BUSINESS RESEARCH METHODS FINAL

PROJECT REPORT

RESEARCH PROPOSAL

THE EXTENT TO WHICH CAPITAL

STRUCTURE DECISIONS ARE
AFFECTED BY THE THREE COMMON
THEORIES IN PAKISTANI FIRMS

Submitted To:

Miss Saira Raza Khan

Submitted By:

Ghulam Mustafa (070718)

Ghazanfar Ahmad (070716)

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INTRODUCTION
The literature on determinants of capital structure is well known of the existence of three
theories that are trade off, pecking order and free cash flow (managerial agency costs).
Each theory presents a different explanation of corporate financing.
The trade off theory is concerned with the trade off between debt tax shields or tax
saving, and bankruptcy costs, according to which an optimal capital structure is assumed
to exist.
The pecking order theory assumes hierarchal financing decisions where firms depend
first on internal sources of financing and, if these are less than the investment
requirements, the firm seeks external financing from debt as a second source, then equity
as the last resort.
The free cash flow theory assumes that debt presents fixed obligations such as debt
interests and principals to pay, that have to be met by the firm. These obligations are
assumed to take over the firm's free cash flow (if exists), therefore prevents managers
from over consuming the firm's financial resources.
It was recognized that the three theories are "conditional" in a sense that each works out
under its own assumptions and propositions (Myers, 2001). That is, none of the three
theories can give a complete picture of the practice of capital structure. This means that
firms can pursue capital structure strategies that are conditional as well. That means that
when the business conditions change, the financing decisions and strategies may change,
moving from one theory to another. This is the main reason that the literature does not
include one theory or one explanation on the determinants of capital structure. In fact, an
interrelationship can be observed between and among the three theories of capital
structure.
For example, the trade off theory assumes a higher use of debt as long as the debt is
associated with positive tax shields and less bankruptcy costs. This does not mean that
the firm can reach the maximum debt ratio if, under the assumptions of the pecking order
theory, the firm is profitable enough to replace debt with internal financing using the
accumulated retained earnings which is can be considered as a part of an equity
financing. According to the free cash flow theory, it is affected by the severity of the
agency costs associated with debt or equity financing. In fact, the agency theory presents
another explanation of debt financing. That is, as long as the agency problem arises from
the presence of information asymmetry, Ross (1977), Myers and Majluf (1984) and John
(1987) have shown that under asymmetric information, firms may prefer debt to equity
financing. Therefore, the interrelationships between and among the three theories of
capital structure call for further examination.
It was also found that studies on the determinants of capital structure include selected
determinants in a regression equation. This is what Fama and French (2002) referred to as
the two theories of capital structure that are trade off and pecking order have share many
common predictions about the determinants of leverage.
In this research, the study had used leverage (total debt to total asset) as dependent
variable and tangibility, size, profitability, growth, volatility and non debt tax shields as
independent variables. However, Myers (2001) had stated that each theory works out
under its own assumptions. Thus, for this study, the explanatory power and significance
of each theory that are represented by independent variables will show the extent of these
variables can explain the leverage.

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PROBLEM STATEMENT
To what extent the three theories can give impact to the capital structure decision on the
firm’s leverage. Besides that, it also to examine which factors is reliably important for
predicting capital structure of Pakistani firms.

OBJECTIVE OF THE STUDY

The objective of this paper is to examine the extent to which capital structure decisions
are affected by the three common theories that are trade off, pecking order and free cash
flow. Besides that, it also to explore whether the main theories of firm financing can
explain the capital structure of these firms. The leverage ratio is used as an alternative for
firm’s capital structure. The type of industry especially, the firm specific characteristics is
used as a control variable that may have effects on changes of capital structure.

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LITERATURE REVIEW
PROFITABILITY
One of the main theoretical controversies is the relationship between leverage and
profitability of the firm. Profitability is a measure of earning power of a firm. The earning
power of a firm is the basic concern of its shareholders. Based on the previous research in
the agency models of Jensen and Meckling (1976), Easterbrook (1984) and Jensen
(1986), higher leverage helps to control agency problem by forcing managers to pay out
more of the firm’s excess cash. So, the strong commitment to pay out a larger fraction of
their pre interest earnings to debt payments suggests a positive relationship between book
leverage and profitability. This result is also consistent with the signaling hypothesis by
Ross (1977), where higher levels of debt can be used by managers to signal a positive
future for the firm.

GROWTH
The empirical evidence regarding the relationship between leverage and growth
opportunities is rather mixed. Based on the previous research made by Titman and
Wessels (1988) had found a negative relationship but Kester (1986) had a contrast result
when does not find any support for the predicted negative relationship between growth
opportunities and gearing.
Moreover, from prior research made by Chingfu Chang et. al (2008), they found that
growth has a negative effect on leverage and this result is consistent with Booth et. al
(2001). This judgment is also consistent with Murray Z. Frank and Vidhan K. Goyal
(2004) in their research found that firms which have a high market to book ratio tend to
have low levels of leverage.

SIZE
The effect of size on leverage is unclear. According to Warner (1977) and Ang, Chua and
McConnel (1982) indicate that bankruptcy costs are relatively higher for smaller firms.
This judgment is also supported by Titman and Wessels (1988) when they argue that
larger firms tend to be more diversified and fail less often.

TANGIBILITY
Tangibility is defined as the ratio of tangible (fixed) assets to total assets. Harris and
Raviv (1990) predicts that firm with higher liquidation value will have more debt. Thus,
firms with more tangible assets usually have a higher liquidation value. This judgment is
also supported by Bouallegui (2004) which showed that leverage is also closely related to
tangibility of assets.

NON DEBT TAX SHIELD

Firms will use the tax deductability of interest to reduce their tax bill. Therefore, firms
with other tax shields, such as depreciation deductions, will have less need to exploit the
debt tax shield. According to Ross (1985) argues that if a firm in this position issues
excessive debt, it may become ‘tax exhausted’ in the sense that it is unable to use all its

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potential tax shields. Thus, the incentive to use debt financing diminishes as non debt tax
shields increase. Accordingly, in the framework of the trade off theory, one hypothesizes
a negative relationship between leverage and non debt tax shields.
Besides that, another study made by Wolfgang Drobetz and Roger Fix (2003) had
mentioned that the non debt tax shield are generally insignificant. Only in one regression
specification the estimated coefficient is significant but the sign is opposite to what the
trade off theory suggests means the result showed a positive relationship.

VOLATILITY
Leverage increases the volatility of the net profit. Higher volatility of earnings increases
the probability of financial distress, since firms may not be able to fulfill their debt
servicing commitments. Thus, firm’s debt capacity decreases with increases in earnings
volatility leading to an expected inverse relation with leverage (Rataporn Deesomsak,
2004).

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METHODOLOGY

Theoratical Framework

SAMPLE
Companies listed on the KSE 100 from year 2005 to 2009.
DATA COLLECTION
The data and information obtained regarding to this study are from secondary data. All
data will be gathered from the year 2005 until 2009. The information sources from
internet and Annual Report of various companies listed on the KSE 100 Index from year
2005 until 2009.

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HYPOTHESES
Hypothesis 1

H1.0: There is a negative relationship between profitability and leverage.

H1.1: There is a positive relationship between profitability and leverage.
Hypothesis 2

H2.0: There is a positive relationship between growth and leverage.

H2.1: There is a negative relationship between growth and leverage.
Hypothesis 3

H3.0: There is a negative relationship between size and leverage.

H3.1: There is a positive relationship between size and leverage.
Hypothesis 4

H4.0: There is a negative relationship between tangibility and leverage.

H4.1: There is a positive relationship between tangibility and leverage.
Hypothesis 5

H5.0: There is a positive relationship between non debt tax shields and leverage.
H5.1: There is a negative relationship between non debt tax shields and leverage
Hypothesis 6

H6.0: There is a positive relationship between volatility and leverage.

H6.1: There is a negative relationship between non volatility and leverage

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REFERENCES
Booth, A., V. Aivazian, A. Demirguc Kunt, and V. Maksimovic (2001). ‘Capital
Structure in Developing Countries. The Journal of Finance, Vol.56, pp. 87-130
Chingfu Chang, Alice C. Lee and Cheng F. Lee (2008). ‘Determinants of Capital
Structure Choice: A Structural Equation Modeling Approach.
Easterbrook, F. (1984). Two Agency Cost Explanations of Dividends, American
Economic Review Vol.74, pp. 650-659.
Harris M. and A. Raviv (1990). ‘Capital Structure and the Informational Role of Debt’,
Journal of Finance Vol. 45
Jensen, M. (1986). ‘Agency Cost of Free Cash Flows, Corporate Finance and Takeovers’,
American Economic Review Vol. 76, pp.323-339.
Ross, S. (1977). ‘The Determination of Financial Structure: The Incentive Signalling
Approach, Bell Journal of Economics Vol.8, pp. 23-40.