Applied Financial Economics

ISSN: 0960-3107 (Print) 1466-4305 (Online) Journal homepage: https://www.tandfonline.com/loi/rafe20

Does pecking order theory explain leverage

behaviour in Pakistan?

Muhammad Azeem Qureshi

To cite this article: Muhammad Azeem Qureshi (2009) Does pecking order theory explain
leverage behaviour in Pakistan?, Applied Financial Economics, 19:17, 1365-1370, DOI:
10.1080/09603100902817592

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Published online: 03 Aug 2009.

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Applied Financial Economics, 2009, 19, 1365–1370

Does pecking order theory explain

leverage behaviour in Pakistan?
Muhammad Azeem Qureshi
Bahauddin Zakariya University, Institute of Management Sciences,
Bosan Road, Multan, Pakistan
E-mail: mazeemqureshi@bzu.edu.pk; mazeemqureshi@yahoo.com

This study uses a 34 years’ standardized balance sheet data of the

manufacturing firms in Pakistan to know the leverage behaviour of these
firms over time. The results indicate that leverage has two pervasive
and significant relationships: one, negative relationship with current
and past profitability; and two, positive relationship with past dividends.
This provides empirical evidence to put forward strong support to Pecking
Order Theory (POT) in context of profitability and dividends. Moreover,
it provides empirical evidence to present a reasonable support to POT
regarding growth. However, apropos size POT gets nominal empirical
support from Pakistan.

I. Introduction financing is a must the firms prefer debt over equity

Capital structure is one of the most complex areas
of strategic financial decision making due to its long
term impact and interrelationship with other financial
decision variables. Due to its complexity and strategic
importance, corporate finance literature is full of
debate on what determines capital structure behav-
iour of firms. Pecking Order Theory (POT) and
Trade-Off Theory (TOT) are two such competing and
influential explanations. POT, while explaining lever-
age behaviour of the firms, suggests that there is no
well-defined target capital structure rather asym-
metric information between the firm and the market
creates a hierarchy of costs in the use of external
financing which is broadly common to all firms and
the choice of debt or external equity is, at least,
a partial function of management’s view of the firm’s
future prospects. The firms prefer internal to external
financing not only to avoid cost but also to avoid
attention by not going to financial markets in view
of asymmetric information. However, if external
because of lower information costs associated with
debt (Myers, 1984).
The observations of Myers (1984) are contrary
to the TOT which suggests a unique optimal capital
structure in an industry class to which the firms
gravitate. The proponents of TOT suggest that the
firms pursue an optimal capital structure by evaluat-
ing the costs and benefits of the additional financing.
They found empirical evidences in different settings
that a variety of financial ratios converged to industry
averages which support TOT; see Harris and Raviv
(1991) for a comprehensive literature review of both
the theories.
Empirical evidence regarding POT is mixed and
inconclusive (Prasad et al., 2001; Fama and French,
2002). Some studies support POT (Baskin, 1989;
Allen, 1993; Adedeji, 1998; Shyam-Sunder and
Myers, 1999; Tong and Green, 2005) while others
do not (Brennan and Kraus, 1987; Vilasuso and
Minkler, 2001). This study attempts to see if POT can
explain leverage behaviour of Pakistani firms.

Applied Financial Economics ISSN 0960–3107 print/ISSN 1466–4305 online ß 2009 Taylor & Francis 1365
http://www.informaworld.com
DOI: 10.1080/09603100902817592
1366
Table 1. Predicted relationship of leverage and its four determinants under POT and TOT
Predicted relationship with leverage
Determinant of leverage POT
Profitability Negative (Myers, 1984; Myers and Majluf, 1984;
(Current/Past) Titman and Wessels, 1988; Baskin, 1989;
Fama and French, 2002)
Size Negative (Baskin, 1989; Allen, 1993;
Rajan and Zingales, 1995)
Growth rate Positive (Baskin, 1989; Allen, 1993)
Past dividend rate Positive (Baskin, 1989; Allen, 1993)
Apart from introduction, this study is organized
as follows: Section II describes the model and
its theoretical framework, Section III presents the
analysis and Section IV provides conclusions.
II. The Model and its Theoretical
Framework
The POT and TOT have different implications for
leverage behaviour of the firms, but it is difficult
to adequately distinguish between the two (Fama
and French, 2002). Corporate finance literature
presents three main methods to test POT. First
method suggests a negative impact of profitability on
firm’s leverage, ‘most pervasive empirical leverage
regularity’, for a given level of dividend which
indicates that firm prefers to use internal equity over
leverage and adheres to POT (Titman and Wessels,
1988; Myers, 1993). But this approach does not
specifically test POT in isolation as other leverage
determinants are also simultaneously investigated
(Prasad et al., 2001). Second method is to conduct
interview to assess the expected leverage behaviour of
the firms’ policy makers (Pinegar and Wilbricht, 1989;
Bancel and Mittoo, 2004; Brounen et al., 2006).
But in third method, the model based approach tests
POT in isolation (Tong and Green, 2005), which this
study adopts to test POT in Pakistan.
The POT and TOT give similar prediction about
the firms’ leverage behaviour in response to almost
all determinants of leverage except profitability,
size, growth and dividend. Table 1 summarizes
the predicted relationship of leverage and its three
determinants under POT and TOT from selected
literature.
Allen (1993) develops the following model
(i.e. Equation 1) using Australian firms’ data to
M. A. Qureshi
TOT
Positive (Ross, 1977; Blazenko, 1987;
Ravid and Sarig, 1991)
Positive (Warner, 1977; Diamond and
Verrecchia, 1991; Klein and Belt, 1993;
Rajan and Zingales, 1995; Jordan et al.,
1998; Anderson and K. Makhija, 1999)
Negative (Rajan and Zingales, 1995)
Negative or Insignificant (Tong and
Green, 2005)
estimate impact of current and past profitability and
firms’ growth on their leverage.
Lt ¼ a1 þ a2 ROAt þ a3 ROAt1 þ a4 ROAt2
þ a5 ROAt3 þ a6 Gt þ et ð1Þ
where Lt and ROAt are current period leverage
and profitability, ROA tn is past profitability and Gt
is growth rate in firms’ assets (Return On Assets
(ROA)).
Tong and Green (2005) add size as third determi-
nant to prescribe the first model (i.e. Equation 2)
to test POT for Chinese firms.
Lt ¼ a1 þ a2 ROAt þ a3 ROAt1 þ a4 Sizet1 þ a5 Gt þ et
ð2Þ
Further, they present argument of Baskin (1989)
that a significant positive relationship between the
past dividend rate and current leverage supports the
POT. While, they argue that TOT implies either
negative or insignificant relationship between lever-
age and dividend. Adding lagged dividend rate to
Equation 2 they present second model to test the two
competing theories.
Lt ¼ a1 þ a2 ROAt þ a3 ROAt1 þ a4 Sizet1 þ a5 Gt
þ a6 Divt1 þ et ð3Þ
This study adopts these two models to see if POT
or TOT better explains corporate leverage behaviour
in Pakistan.
III. The Data
The objective of this study is to see if POT or TOT
better explains the leverage behaviour in Pakistan.
For this purpose it employs the models described in
Equations 2 and 3 for a standardized balance sheet
Does POT explain leverage behaviour in Pakistan? 1367
aggregated data of 34 years (from 1972 to 2005 both Table 2. Composition of different financing sources in
years inclusive) of manufacturing firms grouped in Pakistan
10 economic groups listed on The Karachi Stock
Economic External Internal LT ST
Exchange (Guarantee) Limited (KSE).1 This analysis
group equity equity liabilities liabilities
is limited to the manufacturing firms for the following
reasons: Textile 16.15 7.77 22.59 53.49
Textile (O) 22.56 10.05 20.69 46.70
Cement 23.03 15.94 25.28 35.74
(i) The published data is restricted to nonfinan- Chemical 22.09 13.40 18.85 45.67
cial firms only. Engineering 12.90 12.31 10.78 64.01
(ii) The financial services/services providing firms Jute 18.81 14.97 07.00 55.85
are subject to a different set of regulations and Paper and board 18.05 12.54 27.91 41.50
Sugar 18.51 16.83 19.69 44.97
control of government/SBP that may affect Tobacco 22.66 14.49 07.00 55.85
their capital structures. However, the manu- Vanaspati 14.69 34.06 16.54 102.83
facturing firms’ capital structures are outcome
of their endogenous management decisions.
(iii) The financial firms are subject to different set
of taxation and accounting considerations Table 3. Definitions of variables
and their financing decisions are likely to be
Variable name Label Description
affected accordingly.
Leverage L1 Long-term Liabilities/Total Assets
All data are at book values. The nonavailability Leverage L2 Total Liabilities/Total Assets
Profitability R Net Profit Before Tax/Total Assets
of market values may not affect robustness of the Size S ln(Total Assets)
results as there is no widespread agreement on Growth rate G Total Assets in yeart/Total Assets
whether book or market values are more appropriate in yeart1
to test capital structure theory (Baskin, 1989; Prasad Dividend rate Div Total Dividend Paid/Total Equity
et al., 2001; Tong and Green, 2005). Table 2 presents
average composition of the financing sources of
Pakistani firms for the period under review.
Table 2 depicts a dominant role of external IV. Analysis
liabilities over equity with short term liabilities
as major financing component. Low proportion Table 5 indicates that model 1 explains more than
of internal equity may be an indicator of poor 40% of variation in leverage, using proxy L1, in five
profitability of listed firms in Pakistan. of 10 sectors. Of these five sectors, current and past
This study will take two measures of leverage. The profitability have inverse relationship with leverage
first measure, long-term liabilities to total assets (L1), in four and all five sectors, respectively. Size has
is commonly found in relevant literature. While the negative relationship with leverage in only one of five
second, total liabilities to total assets (L2), is taken sectors. Moreover, growth has positive relationship
keeping in view the strong presence of short-term with leverage in four of five sectors.
liabilities. Table 3 shows definitions of the two The explanatory power of model 1 increases to
proxies for leverage and its four determinants. over 45% and number of sectors to six if we use Total
Table 4 presents the descriptive statistics. The mean Liabilities/Total Assets (TL/TA) as leverage proxy.
L1 ranges between 27 and 7%, and mean L2 ranges The current and past profitability depict inverse
between 116% (indicating a negative equity due relationship with leverage respectively in four and
to accumulated losses) and 61%. This indicates that five of these six sectors. The size has a negative
current liabilities are a major financing source in relationship with leverage in four of six sectors and
Pakistan. The average profitability, ranging from growth has positive relationship in three sectors.
1% in Vanaspati sector to 11% in Chemical These findings suggest that TL/TA is a better proxy
sector, indicates poor return on assets in Pakistan for leverage in Pakistan.
and consequently a poor dividend payout ratio is The above analysis indicates that current and past
observed during the period under review. profitability has inverse relationship with leverage

1
Published by the State Bank of Pakistan (SBP).
1368 M. A. Qureshi
Table 4. Descriptive statistics

Textile Textile (O) Chemical Engineering Sugar Paper and board Cement Tobacco Jute Vanaspati
Mean
L1 0.22 0.21 0.18 0.11 0.19 0.27 0.25 0.07 0.14 0.17
L2 0.76 0.67 0.64 0.75 0.65 0.69 0.61 0.63 0.66 1.16
Rt 0.02 0.04 0.11 0.06 0.05 0.06 0.05 0.09 0.05 0.01
Rt1 0.02 0.04 0.10 0.05 0.05 0.06 0.05 0.08 0.05 0.01
S 10.12 8.41 9.40 9.25 8.92 7.97 8.77 7.62 7.15 7.18
G 0.12 0.12 0.12 0.14 0.11 0.10 0.14 0.10 0.08 0.06
Div. 0.05 0.05 0.14 0.07 0.06 0.09 0.05 0.08 0.05 1.85
Median
L1 0.22 0.21 0.18 0.11 0.20 0.29 0.26 0.07 0.16 0.08
L2 0.77 0.69 0.64 0.76 0.65 0.64 0.60 0.65 0.67 0.82
Rt 0.01 0.04 0.11 0.05 0.05 0.06 0.06 0.08 0.03 0.04
Rt1 0.01 0.04 0.11 0.05 0.04 0.05 0.05 0.08 0.03 0.04
S 9.83 7.58 9.09 9.47 8.92 8.05 8.14 7.58 7.44 7.21
G 0.11 0.08 0.11 0.12 0.10 0.08 0.08 0.08 0.06 0.05
Div. 0.05 0.05 0.12 0.07 0.05 0.08 0.05 0.09 0.03 0.08
Max.
L1 0.31 0.39 0.35 0.18 0.34 0.48 0.37 0.11 0.22 0.67
L2 0.93 0.82 0.75 0.83 0.80 1.03 0.72 0.80 0.82 2.57
Rt 0.12 0.09 0.21 0.16 0.17 0.19 0.13 0.34 0.20 0.16
Rt1 0.12 0.09 0.19 0.16 0.17 0.19 0.13 0.25 0.20 0.16
S 12.32 10.94 11.87 11.39 10.64 9.59 11.35 9.39 8.11 9.46
G 0.32 0.72 0.49 0.33 0.32 0.54 0.42 0.31 0.29 0.79
Div. 0.13 0.12 0.29 0.12 0.11 0.61 0.11 0.16 0.13 0.69
Min.
L1 0.14 0.10 0.06 0.04 0.04 0.04 0.14 0.00 0.01 0.02
L2 0.65 0.49 0.50 0.65 0.49 0.36 0.43 0.40 0.54 0.57
Rt 0.05 0.00 0.02 0.02 0.03 0.06 0.04 0.06 0.07 0.36
Rt1 0.05 0.00 0.01 0.02 0.03 0.06 0.04 0.06 0.07 0.36
S 8.16 6.22 7.27 6.55 6.95 6.20 6.26 5.83 5.39 4.39
G 0.04 0.04 0.02 0.03 0.11 0.17 0.00 0.14 0.23 3.55
Div. 0.01 0.00 0.07 0.03 0.01 0.99 0.00 0.01 0.00 64.17

irrespective of its definition. Moreover, this relation-
ship is more pronounced with past profitability.
This provides support to POT in profitability
context. Considering size, the above analysis
provides a little support to POT if we use Long-
Term Liabilities/Total Assets (LTL/TA) as leverage
proxy, but provides a reasonable support using
TL/TA. A moderate support to POT is observed
in the context of growth. In general the empirical
evidence using model 1 provides a reasonable support
to POT.
Table 6 presents the results of model 2. Model 2
improves the level of significance as well as perva-
siveness of the results in favour of POT. Table 6
suggests that model 2 explains more than 40% of the
variation in leverage, using proxy LTL/TA, in six
of 10 sectors. Of these six sectors; the current as well
as past profitability has an inverse relationship
with leverage in five, size has negative relationship
with leverage in only two, growth has positive
relationship with leverage in five and past dividend
has positive relationship in four sectors. Using
TL/TA, model 2 explains over 45% of variation
in leverage in nine of 10 sectors. The current and past
profitability portray an inverse relationship with
leverage in seven and all nine sectors, respectively.
The size has a negative relationship with leverage
in four, growth has positive relationship in six and
past dividend has a positive relationship in eight
sectors.
The above analysis suggests pervasiveness of
inverse relationship of current and past profitability
with leverage irrespective of its definition which
is more pronounced with past profitability. This
provides a robust support to POT in profitability
context. The above analysis provides little support to
POT regarding size using LTL/TA as leverage proxy,
but a reasonable support is observed using TL/TA.
A good support to POT is observed in the context
of growth and dominant support is observed in
Does POT explain leverage behaviour in Pakistan? 1369
Table 5. Results of model 1: profitability, size and growth as determinants of leverage

Constant R Rt1 S G R2 p-value

L1 ¼ LTL/TA
Textile 0.069 0.015 0.299 0.012 0.356 41.2 0.001
Textile (O) 0.132 0.218 0.053 0.005 0.223 17.5 0.051
Chemical 0.257 0.622 0.339 0.001 0.275 11.7 0.114
Engineering 0.044 0.374 0.373 0.010 0.050 46.7 0.000
Sugar 0.064 0.373 0.064 0.030 0.047 35.8 0.002
Paper and board 0.461 1.090 0.542 0.012 0.034 83.5 0.000
Cement 0.164 0.494 0.481 0.012 0.260 60.8 0.000
Tobacco 0.149 0.165 0.028 0.009 0.029 35.9 0.002
Jute 0.457 0.253 0.111 0.043 0.064 22.3 0.042
Vanaspati 0.125 0.071 0.482 0.039 0.093 48.0 0.000
L2 ¼ TL/TA
Textile 0.910 0.438 0.640 0.014 0.135 27.6 0.010
Textile (O) 1.060 0.098 0.965 0.041 0.051 69.7 0.000
Chemical 0.942 0.530 0.056 0.026 0.035 68.4 0.000
Engineering 1.010 0.481 0.097 0.026 0.040 57.0 0.000
Sugar 0.500 0.458 0.128 0.020 0.044 34.0 0.003
Paper and board 1.380 0.044 1.870 0.076 0.208 83.8 0.000
Cement 0.857 0.241 0.523 0.025 0.071 17.0 0.055
Tobacco 0.478 0.635 0.091 0.025 0.026 30.2 0.006
Jute 0.525 0.356 0.355 0.025 0.021 70.6 0.000
Vanaspati 0.782 0.810 0.740 0.267 0.162 46.6 0.000

Table 6. Results of model 2: profitability, size, growth and dividend as determinants of leverage

Constant R Rt1 S G Div R2 p-value

L1 ¼ LTL/TA
Textile 0.0187 0.036 0.458 0.0148 0.373 0.36 41.7 0.001
Textile (O) 0.206 0.496 0.385 0.00119 0.191 0.807 20.9 0.042
Chemical 0.102 0.632 0.463 0.00786 0.361 0.582 17.3 0.069
Engineering 0.0428 0.377 0.381 0.0104 0.0504 0.025 44.7 0.001
Sugar 0.032 0.37 0.377 0.0231 0.037 0.848 38.0 0.002
Paper and board 0.445 1.06 0.597 0.0104 0.0599 0.0334 83.5 0.000
Cement 0.0956 0.625 0.878 0.0166 0.226 1.11 66.9 0.000
Tobacco 0.156 0.153 0.0061 0.00861 0.0204 0.113 35.2 0.004
Jute 0.553 0.208 0.263 0.0508 0.0696 1.68 66.7 0.000
Vanaspati 0.022 0.088 0.489 0.0218 0.0923 0.216 50.3 0.000
L2 ¼ TL/TA
Textile 0.683 0.672 1.37 0.00021 0.215 1.64 59.7 0.000
Textile (O) 1.04 0.045 1.03 0.0402 0.0444 0.154 68.7 0.000
Chemical 0.89 0.533 0.097 0.0227 0.0641 0.195 69.4 0.000
Engineering 0.964 0.568 0.147 0.0259 0.0576 0.833 59.8 0.000
Sugar 0.318 0.464 0.728 0.033 0.062 1.62 49.2 0.000
Paper and board 1.35 0.094 1.98 0.0727 0.264 0.0714 84.2 0.000
Cement 0.762 0.424 1.07 0.0181 0.0245 1.54 29.9 0.011
Tobacco 0.421 0.737 0.375 0.0255 0.334 0.942 40.2 0.001
Jute 0.485 0.546 0.509 0.0276 0.0239 0.692 75.2 0.000
Vanaspati 0.766 0.84 0.76 0.253 0.159 0.172 45.1 0.001

favour of POT with reference to past dividend. V. Conclusion

In general the empirical evidence suggests that
model 2 performs better to provide support in The ongoing empirical debate between POT and
favour of POT in Pakistan. TOT has a little empirical evidence from
1370
developing countries. The objective of this study is to
fill this gap and provide empirical evidence from time
series data of manufacturing firms in Pakistan using
two models of Tong and Green (2005). This study
suggests that in Pakistan irrespective of its definition
leverage has two pervasive and significant relation-
ships: one, negative relationship with current and
past profitability; and two, positive relationship with
past dividends. This conclusion provides evidence
to support POT in context of profitability and
dividends. Moreover, it also provides evidence to
support POT regarding growth. However, apropos
size POT gets nominal empirical support from
Pakistan.
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