9 Emd

How do they adjust their capital structure
along their life cycle? An empirical study

about capital structure over life cycle of
Pakistani firms
Tanveer Ahsan, Man Wang and Muhammad Azeem Qureshi
Tanveer Ahsan is a PhD Abstract

Candidate at the School Purpose – The purpose of this study is to explain the adjustment rate made to target capital structures
of Accounting, Dongbei by listed non-financial firms in Pakistan during the courses of their life cycles and to determine what
University of Finance and factors influence their adjustment rates.
Economics, Dalian, Design/methodology/approach – The study used multivariate analysis to classify 39 years
People’s Republic of (1972-2010) of unbalanced panel data from listed non-financial Pakistani firms in terms of their growth,
maturity and decline stages. Further, it used a fixed-effects panel data model to determine the factors
China. Man Wang is
that influence capital structure and adjustment rates during the life-cycle stages of firms.
Professor at the School of
Findings – The study observed a low– high–low leverage pattern during the growth, maturity and
Accounting, Dongbei
decline stages of businesses in line with tradeoff theory. Furthermore, the study observed an adjustment
University of Finance and rate for growing firms of between 49.3-37.9 per cent, for mature firms of between 35.5-17.5 per cent and
Economics, Dalian, for declining firms of between 22.2-15.1 per cent toward their respective leverage targets. Furthermore,
People’s Republic of it was found that growing firms have higher leverage adjustment rates because, by having more
China. Muhammad investment opportunities, these firms can alter their capital structures easily by changing the
Azeem Qureshi is composition of their new issues.
Associate Professor at Practical implications – Erratic economic conditions in Pakistan have created an uncertain business
the School of Business, environment. Therefore, even mature Pakistani firms remain skeptical about the sustainability of positive
Oslo and Akershus trends among current economic indicators. Furthermore, to avoid uncertainty, Pakistani firms grab
University College of short-term opportunities by using quickly available short-term debt as a main financing source.
Government should introduce long-term policies that will stabilize the business environment and
Applied Sciences, Oslo,
strengthen the financial, as well as the judicial, institutions of the country so that these firms may benefit
Norway.
from long-term investment opportunities and access more options for raising external financing. The
results of this study will also help policymakers for other Asian economies where the capital markets are
underdeveloped and where firms have higher leverage ratios, such as Thailand, Indonesia and
Malaysia.
Originality/value – This is the first study in Pakistan that has used a multivariate approach to classify
firms into their different life-cycle stages and to discover the leverage adjustment rates of firms during
those life-cycle stages.
Keywords Pakistan, Panel data analysis, Adjustment rate, Firm life cycle, Target capital structure
JEL classification – C23, G32,
Paper type Research paper
P16
Received 20 June 2015
Revised 7 September 2015 1. Introduction
2 November 2015
Accepted 13 November 2015 This study examines the capital structure dynamics of non-financial firms listed in Pakistan
This paper is a part of a PhD
thesis submitted at the School
over the courses of their corporate life cycles by using large panel data, and it tries to
of Accounting, Dongbei improve understanding about the capital structure choices that firms in developing
University of Finance and
Economics, Dalian, People’s
countries make during their different life-cycle stages by taking Pakistan as a sample case.
Republic of China. The pioneering theory of capital structure irrelevance (Modigliani and Miller, 1958)
PAGE 276 JOURNAL OF ASIA BUSINESS STUDIES VOL. 10 NO. 3, 2016, pp. 276-302, © Emerald Group Publishing Limited, ISSN 1558-7894 DOI 10.1108/JABS-06-2015-0080
provided a solid foundation for the development of a number of different theories that
explained corporate capital structure behavior and, subsequently, a variety of empirical
research has emerged to prove or disprove these theories. However, corporate capital
structure is still puzzling. One of the reasons for that may be that firms evolve and progress
through different stages during their life cycles and the financial preferences of firms may
vary because of their changing conditions and according to their life-cycle stages (Fluck,
2000, Rocca et al., 2011). There is considerable evidence about the impact of life-cycle
stages on various aspects of firms’ behavior, such as the impact of life-cycle stages on the
demand for financial products (Berger and Udell, 1998), dividend policy (DeAngeloa et al.,
2006) and corporate governance (Connor and Byrne, 2015; Filatotchev et al., 2006).
Therefore, it is important to investigate the impact of corporate life cycles on capital
structures so that policymakers may develop financial policies accordingly. Previously,
empirical studies have been unsuccessful at combining organizational life-cycle stages
with corporate capital structure choices. Later, most empirical studies have used a
univariate approach, such as a firm’s age or its size, to investigate the impact of life-cycle
stages on capital structure behavior (Berger and Udell, 1998). Furthermore, many empirical
studies have demonstrated that a target (optimal) capital structure exists (Bradley et al.,
1984; Bontempi, 2002), and firms have tried to adjust their capital structures to meet the
target (optimal) capital structure (Drobetza and Wanzenried, 2006; Getzmann et al., 2014).
Empirical studies explaining the leverage adjustment rates of firms during their life cycles
are very rare. A recent study carried out in China explained significant variations in
leverage adjustment rates across life-cycle stages and found that this adjustment rate fell
from 68.52 per cent (birth) to 48.78 per cent (decline). Aside from this study, it is hard to find
any other significant work that covers both aspects (adjustment rate and life cycle) of
capital structuring.
Moreover, a recent study carried out in Pakistan found that non-financial firms in Pakistan
do have target leverage ratios (Ahsan et al., 2016). Accordingly, the aim of this study is to
explain the leverage adjustment rate of Pakistan’s listed non-financial firms during different
life-cycle stages. For this purpose, we applied multivariate analysis (Anthony and Ramesh,
1992) to an unbalanced panel data set of 13,375 firm-year observations (1972-2010) to
classify these firm-year observations into different life-cycle stages. Furthermore, we
applied a fixed-effects model (FEM) of panel data analysis to discover the impact of an
extended number of variables (at firm, industry and country levels) on leverage adjustment
rates for Pakistan’s listed non-financial firms during their various life-cycle stages. The
study contributes to the literature by discovering that firms operating in a bank-based
economy, using long-term debt as a minor source of financing, that have limited financing
options and face erratic economic conditions, follow a low– high–low leverage pattern
during their growth, maturity and decline stages as has been indicated by tradeoff theory
(TOT). Furthermore, the study reveals that the adjustment rate of growing firms is between
49.3 and 37.9 per cent of their respective leverage targets; for mature firms, it is between
35.5 and 17.5 per cent; and for declining firms, it is between 22.2 and 15.1 per cent.
Furthermore, we found that growing firms have higher leverage adjustment rates because,
having more investment opportunities, these firms can easily alter their capital structures by
changing the composition of their new issues. Moreover, good economic conditions also
help businesses to accomplish adjustment processes.
1.1 Why Pakistan?

Strong financial institutions provide easy access to reliable information that lowers
transaction costs. However, according to World Governance Indicators (WGI), Pakistan is
something of an institutional void[1]. Pakistan currently has listed capital of around
US$12bn and market capitalization of around US$74bn, whereas its listed debt capital is
only US$150m[2]. These figures clearly suggest that Pakistan is a bank-based capital
market which is underdeveloped, and, as such, raising bank debt is easy for firms
compared to raising equity. Higher leverage ratios in Table VII (mean of 0.799 during
VOL. 10 NO. 3 2016 JOURNAL OF ASIA BUSINESS STUDIES PAGE 277

growth stages, 0.828 during mature stages and 0.643 during decline stages) also confirm
it. Another plausible explanation for these higher leverage ratios may be the use of political
connections by firms to borrow from banks, especially government-owned banks.
According to an empirical study carried out in Pakistan, politically well-connected firms
borrow 45 per cent more than their peers (Khwaja and Mian, 2005) and studies use
financial leverage as a proxy to measure capital structure. Accordingly, more borrowing by
politically connected firms means higher financial leverage and a higher probability of
bankruptcy. Moreover, higher average short-term leverage ratios (Table VII) during all three
life-cycle stages (mean ⫽ 0.566, 0.646 and 0.526) compared to average long-term
leverage ratios (mean ⫽ 0.232, 0.173 and 0.119) suggest that short-term debt financing is
easier to avail compared with long-term debt financing. We argue that Pakistan’s weak
judicial system does not have the ability to protect creditors’ rights and, as a result,
creditors shy away from the provision of risky long-term debt (Sheikh and Qureshi, 2014).
Higher corruption levels, weak governance systems, political instability (WGI) and political
connections differentiate Pakistan and create a research gap there. Accordingly, it seemed
quite interesting to study the financing behavior of firms and find out their leverage
adjustment rates during different life-cycle stages, working in a bank-based economy,
relying on short-term financing and intertwined by socioeconomic networks.
The results of this study will contribute to the literature by helping policymakers in Pakistan.
For example, Pakistan’s non-financial firms are highly leveraged during their growth (mean
of total leverage ⫽ 0.799) and mature stages (mean of total leverage ⫽ 0.828), and higher
leverage means there is a higher probability of bankruptcy. Therefore, the Government of
Pakistan needs to improve the equity market in Pakistan to provide more financing options
to these firms so that they may be able to lower their financial leverage ratios and reduce
their probability of bankruptcy. These results will also help policymakers in other Asian
economies where firms have similar levels of financial leverage ratios such as Indonesia,
Malaysia and Thailand (Alves and Francisco, 2015)[3]. What is more, the operating
environment of Pakistan is uncertain because of its erratic economic conditions; therefore,
even growing and mature firms use short-term debt as a main financing source to avoid
uncertainty. The government needs to develop policies to stabilize economic conditions in
Pakistan to reduce uncertainty and improve leverage adjustment rates. Furthermore, high
leverage ratios during the growth stages of businesses demonstrate that Pakistani financial
markets lack venture capital because of higher information asymmetry and its weak legal
system (that is unable to protect creditors’ rights). The government needs to improve
corporate governance mechanisms and strengthen its judicial system, which will be helpful
for the development of Pakistani capital markets. These results would also help
policymakers in other Asian economies with similar or lower levels of capital market
development and macroeconomic conditions, such as Thailand, Turkey, Indonesia and
Malaysia (Alves and Francisco, 2015)[4].
Apart from the introduction presented in Section 1, we have organized the rest of the paper
in the following manner. Section 2 discusses the theoretical framework for this work. Section
3 describes the data and introduces the methodology used. Section 4 presents the
empirical results and discusses them and, finally, Section 5 draws conclusions and
suggests policy implications. We have provided references at the end.
2. Theoretical framework
2.1 Theories about firm life cycle and target capital structure
The concept that the firm progresses through a set of life-cycle stages starting from birth
and ending at death is well established in extant literature. However, different theorists
describe different numbers of life-cycle stages for firms. For example, some suggest that
strategies and the structures of firms vary during their growth, maturity and declining
stages (Chandler, 1962; Anthony and Ramesh, 1992). Others have suggested four
life-cycle stages including birth, growth, maturity and revival (Miller and Friesen, 1980), and
PAGE 278 JOURNAL OF ASIA BUSINESS STUDIES VOL. 10 NO. 3 2016

five life-cycle stages including birth, growth, maturity, revival and decline (Dickinson,
2011). While they have their differences, most the life-cycle theories agree upon there
being growth, maturity and decline stages. On the other hand, theories also differ in their
opinion about the existence of target capital structure. Accordingly, the following review of
the relevant literature will cover what capital structure theories explain about the target
capital structure and financing preferences of firms during their growth, maturity and
decline stages.
Based on information asymmetry and profitability, pecking order theory (POT) proposes a
specific order for financing investments where internal funds, being less costly, are
considered most preferable; external debt is seen as second best; and equity is viewed as
an option of last resort (Myers, 1984; Myers and Majluf, 1984). Following this reasoning,
firms do not have any strong reason to pursue a target capital structure, instead of a
specific pattern of financing. Moreover, as firms evolve over time, their opacity of
information asymmetry, levels of profitability and financial needs also change and,
accordingly, firms adjust their capital structures. During the early stages of a firm’s life
cycle, the problem of information asymmetry is higher and profitability is lower, whereas
conditions may reverse during later stages. Accordingly, during growth stages, firms may
have little or no retained earnings to finance their higher investment needs and, as such,
firms in their growth stages raise the maximum available debt before they raise external
equity. However, firms in their mature stages may generate retained earnings that are
substantially higher compared to those of their growth stages because of their relatively
lower investment needs and, therefore, they need less debt compared to what they needed
during their growth stages. Furthermore, during mature stages, information asymmetry is
lower compared to its condition during the growth stages and, therefore, firms may raise
external equity instead of raising debt. During the decline stages, retained earnings will
decrease and firms have to take on debt again. Accordingly, POT suggests a high–low–
high pattern of leverage ratio over a firm’s life cycle. Consequently, we have developed our
first hypothesis as follows:
H1. There exists a high–low– high pattern of leverage ratio over a firm’s life cycle.
On the other hand, POT’s rival theory, i.e. TOT, explains that an optimal capital structure is
a tradeoff between costs and benefits associated with leverage in a perfect market
environment. Firms take this optimal capital structure as their target and strive for it, the
concept for which is also known as static TOT. Moreover, an optimal capital structure is a
function of a number of endogenous and exogenous factors. These factors change over
time because of the changing nature of the environments in which firms carry out their
activities. Consequently, firms adjust their optimal capital structures according to their
dynamic environments, the concept for which is known as dynamic TOT (Fischer et al.,
1989). Theoretically, firms should seek to increase their debt financing as much as possible
to gain tax shield benefits, irrespective of their life-cycle stage. However, bankruptcy costs
also increase with any increase in debt levels and they put an upper limit on debt levels (i.e.
the breakeven point of tax shield benefits and bankruptcy costs). Furthermore, bankruptcy
costs are expected to be higher during the growth and decline stages when compared with
the maturity stage. Consequently, firms may choose less debt financing during their growth
and decline stages to avoid bankruptcy, even though the debt tax shield benefits are there.
Accordingly, TOT (Modigliani and Miller, 1958, 1963) suggests a low– high–low pattern of
debt ratio over a firm’s life cycle, which we present as our second hypothesis:
H2. There exists a low– high–low pattern of leverage ratio over a firm’s life cycle.
Agency conflicts between managers and equity-holders arise because of the use of firms’
resources by managers for their own benefits. Organizations generating substantial
amounts of free cash flows are expected to face this conflict more severely. Use of debt up
to an optimum point may solve this conflict, as debt repayments reduce the available
amounts of free cash flows for managers and prevent them from engaging in

value-decreasing activities (Jensen and Meckling, 1976). Having higher investment
opportunities, growing firms are expected to have less free cash flows available.
Alternatively, mature firms have higher free cash flows available with fewer investment
opportunities. Furthermore, the control function of debt is most important during decline
stages when firms need to shrink. Accordingly, agency theory suggests a low– high– high
pattern of leverage ratio over a firms’ life cycle (Jensen, 1986) but does not clearly explain
optimal or target capital structure. This gives us the following third hypothesis:
H3. There exists a low– high– high pattern of leverage ratio over a firm’s life cycle.
Corporate reputation may explain the financing choices of firms over their life cycles
(Diamond, 1989). According to Diamond, young firms have lower debt capacities
compared to mature firms because young firms do not have past track records, while
mature firms do have past history, past profitability and credit ratings that may have built
good reputation for them. Good reputation can mitigate the problem of information
asymmetry and increase debt capacity for mature firms. Accordingly, Diamond postulates
a low– high– high pattern of leverage ratio over a firms’ life cycle, which we present as our
fourth hypothesis. This theory is also silent about the existence of optimal or target capital
structures:
H4. There exists a low– high– high pattern of leverage ratio over a firm’s life cycle.
Another famous theory, known as market timing theory, explains capital structure as a
function of market conditions. Following this theory, managers decide between the
issuance of debt and equity according to market conditions. Consequently, capital
structure can be explained as a function of stock and bond market development (Baker
and Wurgler, 2002). This theory too remains silent about the existence of optimal or target
capital structures, as well as leverage preferences over a firms’ life cycle.
Table I presents the pattern of leverage ratio during three life-cycle stages as suggested by
capital structure theories.
2.2 Determinants of target capital structure (leverage)

Empirical studies carried out in different economies and during different time spans explain
three categories of factors that clarify target leverage, i.e. firm, industry and
macroeconomic factors (Rajan and Zingales, 1995; Booth et al., 2001; Jong et al., 2008;
Joeveer, 2013), as well as adjustment rates toward target leverage (Drobetza and
Wanzenried, 2006; Tongkong, 2012; Getzmann et al., 2014).
2.2.1 Firm-level variables
2.2.1.1 Taxes, bankruptcy costs and business risk. TOT explains optimal (target) capital
structure as a tradeoff between the costs (bankruptcy cost) and the benefits (tax shield
benefits) associated with leverage (Modigliani and Miller, 1958, 1963). Accordingly, a
direct relationship is expected to exist between interest tax shield, target leverage and
adjustment rates toward target leverage, irrespective of a firm’s life-cycle stage. However,
growing firms with greater investment opportunities are expected to raise more debt to
enjoy higher tax shield benefits compared to mature and declining firms. Empirical studies
have measured tax shield as tax payments over earnings before taxes or tax payments over
Table I Leverage pattern during three life-cycle stages as suggested by theories

Leverage pattern
Theory Growth Mature Decline
Pecking order theory High Low High

Tradeoff theory Low High Low
Agency cost theory Low High High
Diamond’s theory Low High High
Market timing theory ? ? ?

gross profit. We have used the latter as a proxy to measure tax shield. The results of
empirical studies explain this relationship as either insignificant (Chen and Strange, 2005)
or relatively weak (Rajan and Zingales, 1995). Empirical studies carried out in Pakistan
have given mixed results (Qureshi et al., 2012; Sheikh and Qureshi, 2014).
Studies (Gomariz and Ballesta, 2014; Eisdorfer et al., 2013) use Altman’s Z-score[5]
(Altman, 1968) to represent bankruptcy probability, and we have also used that in this
study. The Z-score measures the health of a firm. The higher the Z-score, the lower is the
bankruptcy probability. Stronger firms may have more internal funds to finance their
projects. Therefore, POT suggests a negative relationship between Z-scores and leverage.
On the one hand, stronger firms are considered less risky by creditors and hence TOT
advocates a positive relationship between Z-scores and leverage. Having both options
available, firms with higher Z-scores can meet their leverage targets very easily. Therefore,
these firms are expected to adjust their leverage targets more quickly than firms with lower
Z-scores, irrespective of a firm’s life-cycle stage. Moreover, studies have used earnings or
income volatility as a proxy by which to measure business risk (Delcoure, 2007; Al-Najjar
and Taylor, 2008). In our study, we have calculated income volatility as a percentage
change in net profit before tax over total assets. Firms with higher income volatility are not
certain about their future cash flows. Therefore, it is very important for these firms to stay
close to their leverage targets. Being closer to their target leverage means these firms may
adjust quickly toward target leverage. On the other hand, higher income volatility may
create hurdles that hinder firms achieving their target leverage levels, such as higher costs
of external financing, and that may slow down their adjustment rate toward target leverage.
2.2.1.2 Non-debt tax shield. Non-debt tax shield (NDTS) that includes investment tax credit
and depreciation expenses may substitute the benefits of a tax shield (Sheikh and Qureshi,
2014). Therefore, firms with higher levels of NDTS may use less debt financing (DeAngelo
and Mesulis, 1980). Accordingly, an inverse relationship is expected between NDTS and
leverage, irrespective of a firm’s life-cycle stage. Empirical studies have used annual
depreciation expenses over total assets as a proxy to measure NDTS, which we have also
adopted for this study. Contrary to the theoretical relationship explained above, empirical
studies carried out in transitional economies (Delcoure, 2007; Bayrakdaroğlu et al., 2013)
have described a positive relationship, while for America (Titman and Wessels, 1988) and
for Pakistan (Qureshi, 2009; Sheikh and Wang, 2011; Qureshi et al., 2012), the results are
insignificant. However, a recent study of Pakistan found the substitution of long-term debt
by depreciation (Sheikh and Qureshi, 2014) and another for Asian economies supported
TOT (Getzmann et al., 2014).
2.2.1.3 Agency costs. Agency conflicts may lead toward non-productive uses of firms’
resources. There are two types of agency conflict. First, there is the conflict between
managers and equity-holders that arises because of inefficient uses of firms’ resources by
managers for their own benefits. Organizations generating substantial amounts of free cash
flows (used to pay dividends, retained to finance future projects or spent on managerial
perks) may face this conflict more severely. Use of debt may solve this conflict, as debt
repayments reduce available amounts of free cash flows for managers and prevent them
from indulging in value-decreasing activities (Jensen and Meckling, 1976). Mature firms
with higher retained earnings are expected to have more free cash flows available.
Accordingly, agency theory expects a more significant direct relationship between agency
costs and leverage during the mature stages of business development. Researchers
measure this agency conflict by the asset utilization ratio (sales over total assets) (Pantzalis
and Park, 2014) and by the expense ratio (operating expense over sales) (Ang et al., 2000).
We chose operating expenses over sales as a proxy to measure the management–
equity-holders’ agency conflict. A previous empirical study carried out in Pakistan
suggested a direct relationship between the management– equity-holders’ agency conflict
and leverage (Qureshi et al., 2012). Second, the agency conflict between equity-holders
and debt-holders arises because equity-holders may invest in highly risky projects owing

to their limited liability. The success of these projects can make money for equity-holders
but the debt-holders will bear the consequences of failure. As equity-holders at growing
firms have more opportunities to invest in highly risky projects at the expense of
debt-holders, a direct relationship is expected to exist between growth and firm leverage,
specifically during firms’ growth stages (Jensen and Meckling, 1976, Myers, 1977). We
used percentage change in total assets as a proxy to measure growth. Using this proxy,
empirical results for Turkish and Dutch firms have explained a positive significant
relationship between growth and firm leverage (Bayrakdaroğlu et al., 2013). Moreover, as
they have more investment opportunities growing firms need more financing to be able to
avail themselves of opportunities, and they are expected to alter their capital structure
easily by changing the composition of new issuances. Therefore, growing firms may adjust
speedily toward their leverage targets. The results of an empirical study for Italian firms
found a significant positive relationship between growth opportunities and leverage during
the growth and mature stages of businesses, but not during their declining stages (Rocca
et al., 2011).
2.2.1.4 Profitability (current/past). According to POT, internal funds are the first financing
choice of profitable firms. These internal funds depend upon past profitability or retained
earnings. Accordingly, POT hypothesizes an inverse relationship between firm leverage
and current/past profitability (Fama and French, 2002), specifically for mature firms with
higher retained earnings. On the other hand, TOT argues that profitable firms may issue
cheaper debt because lenders perceive them as being less risky. Consequently, TOT
suggests a direct relationship between firm leverage and profitability, specifically for
mature firms with higher profitability. Following most of the empirical studies (Bokpin, 2009;
Bayrakdaroğlu et al., 2013), we have also measured profitability as the return on assets.
Furthermore, we use retained earnings over total assets to measure past profitability. The
results of most of the empirical studies for all three life-cycle stages support POT’s
underpinnings (Rocca et al., 2011; Rocha, 2005). Moreover, the availability of both the
financing options to profitable firms makes it easy for them to adjust toward their target
leverage ratios. As such, we have argued that mature firms with higher retained earnings
may adjust their leverage targets quickly compared to growing and declining firms.
2.2.1.5 Liquidity. Highly liquid firms may have a better supply of internal financing and
therefore an inverse relationship is postulated between a firm’s leverage and its liquidity
using a POT strand of argument (Myers and Majluf, 1984). Contrary to this, TOT argues that
highly liquid firms may issue cheaper debt because lenders perceive them as financially
strong. Consequently, TOT hypothesizes a direct relationship between firm leverage and
liquidity. During their mature stages, firms are expected to be more liquid. Therefore, the
significance of positive/negative relationships explained by TOT/POT might be higher
during a firm’s mature stage. Empirical studies have used a number of proxies, including
current assets over current liabilities (Liu et al., 2013), to measure liquidity which we have
adopted for this study. Similar to profitability, most of the empirical evidence supports the
POT strand of argument on liquidity (Titman and Wessels, 1988; Qureshi et al., 2012).
2.2.1.6 Tangibility and collateral value. Firms with large amounts of tangible assets are
considered as less risky by lenders because these assets can be used as collateral. As
such, a direct relationship is expected between tangibility/collateral value and corporate
leverage, specifically for mature firms with more tangible assets. Empirical studies, in this
context, have used gross fixed assets at cost over total assets as a proxy to measure
collateral value, and used net fixed assets over total assets as a proxy for measuring
tangibility. We have also adopted these two proxies. Empirical studies carried out for
Italian, Portuguese and Spanish firms described a direct relationship between corporate
leverage and tangibility during all three life-cycle stages (Rocha, 2005; Rocca et al., 2011).
In developing countries, we also expect an inverse relationship between corporate
leverage and tangibility because tangible assets provide poor collateral value because of
poor governance and inefficient legal systems. Empirical evidence for developing

countries such as Pakistan (Sheikh and Wang, 2011; Qureshi et al., 2012), as well as for
Poland (Mazur, 2007), has confirmed this inverse relationship. However, other studies
carried out in Pakistan have also shown a mix of direct and inverse relationships for
different sectors/proxies of leverage (Qureshi, 2009; Sheikh and Qureshi, 2014).
2.2.1.7 Firm size. Large firms are considered to be less risky because of their large
amounts of tangible assets, revenues and their diversification ability. Accordingly, a direct
relationship between corporate leverage and firm size is expected following the TOT strand
of argument. On the other hand, large firms also have the ability to generate better cash
flows, which reduces their reliance on external funds and accordingly an inverse
relationship between corporate leverage and firm size is also hypothesized by POT (Rajan
and Zingales, 1995). Empirical studies have used the natural logarithm of total sales and
the natural logarithm of total assets as proxies to measure firm size. For the purpose of our
study, we have taken the natural logarithm of total assets as a proxy to measure it. Mature
firms are expected to have more assets, and accordingly this positive/negative
relationship, as explained by TOT/POT, might be more significant during a firm’s mature
stage. Empirical evidence has explained the direct relationship between firm size and
corporate leverage for Italian firms during all three of their life-cycle stages (Rocca et al.,
2011), while another study has explained their positive relationship during the growth and
maturity stages and their negative relationship during the decline stage (Rocha, 2005). For
Pakistan, studies have explained direct/inverse relationships in different sectors and for
different proxies of leverage (Qureshi, 2009; Sheikh and Qureshi, 2014), but they have
done so without considering corporate life-cycle stages. Moreover, adjustment toward
target leverage involves adjustment costs and these costs might be smaller for larger firms;
therefore, larger firms are expected to adjust speedily toward leverage targets.
2.2.1.8 Age of business. With the passage of time, firms learn from their experiences and
develop a market knowledge base that helps them accumulate market power. The rival
theories hypothesized the effect of these resources upon the corporate capital structure
policy of firms. According to POT, the market knowledge and market power of older/
experienced firms may enable them to generate enough cash flows to meet their financial
needs internally compared with their newer or less experienced counterparts. Accordingly,
POT expects an inverse relationship between corporate leverage and firm age. On the
other hand, TOT explains that the older/experienced firms may use their market knowledge,
market power and good reputations to borrow more cheaply. Accordingly, TOT postulates
a direct relationship between corporate leverage and business age. Firms during their
mature and declining stages are older and more experienced compared to growing
businesses, so the positive/negative relationship postulated by TOT/POT is expected to be
more significant during the mature and declining stages. Following most of the empirical
studies in this context, we have taken the natural logarithm of the number of years, as a firm
has been listed as a proxy to measure the age of businesses (Rocca et al., 2011; Chen and
Strange, 2005). A study using the same proxy has found a direct relationship between
corporate leverage and business age in China (Chen and Strange, 2005). Another study
has found this relationship to be inverse in Pakistan (Qureshi et al., 2012).
2.2.2 Second-tier (industry-level) variables. Industries/sectors differ from each other due to
some industry-level factors, e.g. technology used, competition levels, exit/entry barriers,
risk levels, product types and peer characteristics. These industry-/sector-level factors are
known as industry/sector fixed effects and these industry/sector fixed effects have
implications for the corporate leverage policies of firms. For example, firms belonging to the
same industry/sector exhibit more similar financial behavior compared to firms belonging to
different industries/sectors (Bradley et al., 1984). This inter-industry heterogeneity has also
been observed in empirical studies carried out in transitional economies (Joeveer, 2013),
as well as in Pakistan (Qureshi, 2009). POT does not have any clear predictions about these
industry/sector fixed effects, but, as per TOT, firms do have a target/optimal leverage level,
and this target/optimal leverage level may depend upon the attributes of the industry or the

sector in which these firms operate. In our data set, we did not have information about
differentiating industry/sector attributes and accordingly we assumed that the classification
of firms in various industries/sectors might not fulfill the desired purpose. As such, we
followed another study (Joeveer, 2013) and took mean industry leverage as the target/
optimal leverage. We also used mean industry profitability to find if there was any
relationship between corporate leverage levels and their respective industry leverage/
profitability.
2.2.3 Third-tier (country-level) variables
2.2.3.1 Inflation and exchange rate. Inflation is believed to be a social ill for economies
because it imposes welfare costs. Furthermore, unanticipated inflation is considered to be
more dangerous than anticipated inflation because of its ability to distort income and wealth
distribution (Fischer, 1981). Moreover, inflation uncertainty increases the volatility of the
cost/price structures of firms and, as a result, sales, earnings and cash flow volatilities
increase. Consequently, these increased volatilities also increase business risk for firms. To
cope with these volatile conditions, firms may choose equity finance instead of debt finance
to avoid defaulting on future debt repayments and running the risk of increased bankruptcy
probability. Accordingly, an inverse relationship between inflation uncertainty and
corporate leverage has been expected and found (Hatzinikolaoua et al., 2002). Moreover,
a direct relationship between corporate leverage and interest tax shield has been
postulated following the core concept of TOT (Modigliani and Miller, 1963). In line with this,
the inflation rate is expected to be directly correlated with corporate leverage because of
increased tax deductions on debt, and growing firms with more investment opportunities
are expected to raise more debt to enjoy higher tax shield benefits. The results of empirical
studies carried out in transitional economies (Joeveer, 2013) as well as emerging
economies have explained both the direct and inverse relationships between inflation and
corporate leverage (Bokpin, 2009). Moreover, firms may find it easier to adjust the (nominal)
book value of their financial ratios and so may adjust speedily toward their target leverage
during higher inflationary periods. For the purpose of our study, we have taken the inflation
rate (annual consumer prices) obtained from the World Development Indicators (WDI)
database as a proxy for inflation.
Further, exchange rates can increase/decrease business risks and ultimately can
increase/decrease the borrowing costs of firms that have exchange rate exposure. In
Pakistan, banks are the major lenders to firms. Having systems and resources, banks
have access to more information about their client firms as well as their operational
environments. Accordingly, banks respond to the exchange rate exposure of firms and
reflect it in their loan pricing criteria (Diamond, 1984; James, 1987). For example,
domestic currency appreciation may affect exporting firms negatively and decrease the
likelihood of their timely debt repayments and the same is possible for importing firms
suffering from domestic currency depreciation. In our case, the majority of firms import
their plant and machinery and export their products. Therefore, changes in exchange
rates may affect their cash flows for operations, investment and financing. To
investigate the nature of this relationship in Pakistan, we used the natural logarithm of
value to measure the exchange rate of Pakistani rupees in terms of US dollars, as
obtained from WDI.
2.2.3.2 Economic growth and capital formation. Growing economies provide firms with an
environment where they can find more growth opportunities and increase their revenues.
Having more opportunities available, growing firms need more external financing and
according to the TOT strand of arguments, profitable firms can borrow with cheaper interest
rates. Consequently, economic growth is expected to have a direct relationship with
corporate leverage in general and specifically for growing firms. On the other hand, the
POT strand of arguments postulates an inverse relationship of profitability with corporate
leverage. Following this, economic growth is likely to have an inverse relationship with
corporate leverage in general and specifically for mature firms with higher profitability.

Results of recent empirical studies have explained the direct (Jong et al., 2008) and inverse
relationships (Bokpin, 2009) between corporate leverage and economic growth. Moreover,
empirical studies have also found that firms adjust speedily toward their leverage targets in
good economic conditions (Cook and Tang, 2010). We have used the annual per capita
gross domestic product (GDP) growth rate obtained from WDI as a proxy to measure
economic growth in Pakistan. Moreover, we have argued that superior infrastructure and
fixed capital formation in the country are signs of a helpful business environment, and to
measure this we used the gross-capital-formation-to-GDP ratio as a proxy. By having a
helpful business environment, firms are expected to adjust faster toward their respective
leverage targets. Accordingly, we accepted a positive relationship between capital
formation ratio and leverage adjustment rate.
2.2.3.3 Variables’ description and their expected relationship with leverage. We have taken
financial leverage as a representative of the capital structure (dependent variable) of firms,
as it has been used by many other empirical studies (Tian et al., 2015; Sheikh and Qureshi,
2014; Delcoure, 2007) and measured financial leverage with three proxies: short-term
leverage (STLit) as the ratio of short-term liabilities to total assets; long-term leverage (LTLit)
as the ratio of long-term liabilities to total assets; and total leverage (TLit) as the ratio of total
liabilities to total assets. We have presented the independent variables used in this study
in Table II along with the proxies and their expected relationships with leverage as
predicted by the theories.
3. Data and methodology

To examine capital structure choices in Pakistan, we developed a unique data set of all
Pakistani non-financial firms listed at the Pakistan Stock Exchange taken the from State
Bank of Pakistan (SBP) publications for the period from 1972 to 2010 (SBP 1972-2010). The
time (years) and space (firms) dimensions made it an unbalanced panel data set
comprising 13 sectors and 13,375 firm-year observations.
To classify firms into different life-cycle stages, we chose multivariate methodology
(Anthony and Ramesh, 1992) instead of univariate because it is more reliable, and
analysis has proven that their methodology is not driven by firm size effect, risk
differences and measurement errors. Moreover, similar studies have used this
Table II Explanatory variables, their description and expected relationship with leverage
Model Effect on Effect on
Variable level Variable name name Proxy debt (⫹/⫺/?) adjustment rate
Firm level Tax shield TSit Tax payments over gross profit ⫹ ⫹
Bankruptcy risk Zit Altman’s Z-score. ⫹/⫺ ⫹
Business risk BRit % Change in (net profit before tax over total assets) ⫹/⫺ ⫹/⫺
Non-debt tax shield NDit Depreciation expenses over total assets ⫺ ?
Agency cost ACit Operating expenses over sales ⫹ ?
Growth GRit Percentage change in total assets ⫹/⫺ ⫹
Current profitability CPit Net profit before tax over total assets ⫹/⫺ ⫹
Past profitability PPit Retained earnings over total assets ⫹/⫺ ⫹
Liquidity Lit Current assets over current liabilities ⫹/⫺ ⫹
Tangibility TANit Net fixed assets over total assets ⫹ ?
Collateral value CVit Gross fixed assets at cost over total assets ⫹ ?
Firm size Sit Natural logarithm of total assets ⫹/⫺ ⫹
Age of business Ait Natural logarithm of number of years since listing ⫹/⫺ ⫹
Industry level Industry leverage ILjt Mean industry leverage ⫹ ⫹
Industry profit IPjt Mean industry net profit before tax over total assets ? ?
Country level Inflation Rate INFt Annual inflation (consumer prices) rate ⫹ ⫹
Exchange rate EXRt Natural logarithm of yearly average exchange rate PKR/USD ? ?
Economic growth EGRt Annual per capita GDP growth rate ⫹/⫺ ⫹
Capital formation CFt Gross capital formation over GDP ? ?
Life cycle stages LCSt Growth ⫽ 1; Mature ⫽ 2; Decline ⫽ 3

methodology (Rocha, 2005; Jenkins et al., 2004). We used the following three
classification variables: dividend payout ratio (dividend paid/net profit before tax);
sales growth (% change in annual sales); and age (natural logarithm of number of years
since a firm was listed). We calculated the dividend payout ratios and sales growth for
each year and firm included in our data, and then we measured the median values of
these variables based on the prior five years’ data. Then, we grouped three
classification variables (median of dividend payout ratio, median of sales growth and
age) into three life-cycle stages according to the criteria presented in Table III.
Based on Table III, each firm-year observation was assigned a group and given a score
(growth ⫽ 1, mature ⫽ 2, decline ⫽ 3). Further, we summed up scores for three individual
variables to classify them into three life-cycle stages. The minimum summed-up score was
3 and the maximum summed-up score was 9; therefore, the total number of internals was
7[6]. We classified the summed-up scores according to the following criteria:
Growth stage: A firm-year observation has been classified as growth stage if the
composite score is less than or equal to 4 (first two intervals).
Mature stage: A firm-year observation has been classified as mature stage if the
composite score is between 5 and 7 (middle three intervals).
Decline stage: A firm-year observation has been classified as decline stage if the
composite score is greater than or equal to 8 (last two intervals).
Table IV[7] presents the descriptive statistics of life-cycle classification variables. The
mean value of median sales growth had a decreasing trend, while the mean value of
median dividend payout had an increasing trend from growth to decline. Firm age also
increased through growth to the decline stage and confirmed our classification criteria
described in Table III.
Table III Life-cycle variables and classification method

Life-cycle stages Dividend payout Sales growth Age
Growth Low High Young

Mature Medium Medium Adult
Decline High Low Old
Notes: Dividend payout is annual dividend paid over net profit before tax; sales growth is percentage change in annual sales; and age
is natural logarithm of number of years since a firm is listed
Table IV Descriptive statistics for life cycle variables used to classify firms
Variable Observations Mean SD
Growth stage
Median dividend payout 1,713 0.0107 0.0439
Median sales growth 1,713 0.2580 0.3216
Age 1,713 2.5070 0.3564
Mature stage
Median dividend payout 6,255 0.1495 0.2242
Median sales growth 6,255 0.0808 0.1662
Age 6,255 2.9674 0.5086
Decline stage
Median dividend payout 451 0.3734 0.1856
Median sales growth 451 0.0340 0.0895
Age 451 3.3558 0.3339
Notes: The table presents the descriptive statistics of the three variables used to classify firms into growth, mature and decline stage.
Median dividend payout is the median value of annual dividend paid over net profit before tax based on prior five-years’ data; Median
sales growth is the median value of percentage change in annual sales based on prior five-years’ data; age is natural logarithm of
number of years since a firm is listed

Because of the use of five years’ prior data to calculate median values for dividend
payout ratio and sales growth, our total number of firm-year observations reduced from
13,375 to 8,419. The summary in Table V indicates that we have 1,713 firm-year
observations for the growth stage; 6,255 firm-year observations for the mature stage;
and 451 firm-year observations for the decline stage.
The textile sector had the largest number of firm-year observations in total (3,297)
and in individual life-cycle stages as well, while the tobacco sector had the smallest
number of firm-year observations (111) in total. We considered panel data analysis
to be an appropriate method that has also been used in similar studies (Tian et al.,
2015). Of the two competing models, FEM and the random-effects model, we used
FEM which had no problem dealing with unbalanced panel data (Wooldridge, 2015),
especially when time T ⬎ 30 (Judsona and Owenb, 1999), as in our case. Moreover,
the results of the Hausman specification test for three life-cycle stages also favored
FEM (Table VI).
Finally, the objective of this study was to find out the variations in the leverage
adjustment rate during different life-cycle stages and we used data for all the listed
Pakistani non-financial firms instead of drawing firms randomly from a large
population, which is why FEM was best suited for our study (Baltagi, 2008).
Following Getzmann et al. (2014), we developed our model:
Table V Sector and life cycle stage-wise number of firms-year observations

Sr. no. Sector Growth Mature Decline Total % of total number of observations
1 Cement 81 188 25 294 3.49

2 Chemical 101 467 14 582 6.91
3 Engineering 173 610 48 831 9.87
4 Fuel and energy 29 268 47 344 4.09
5 Jute 26 134 5 165 1.96
6 Miscellaneous 183 790 73 1046 12.42
7 Paper and board 28 199 8 235 2.79
8 Sugar 126 564 44 734 8.72
9 Textile 842 2,337 118 3,297 39.16
10 Textile ancillary products 51 325 32 408 4.85
11 Tobacco 05 76 30 111 1.32
12 Transport and communications 20 92 01 113 1.34
13 Vanaspati 48 205 06 259 3.08
Total 1,713 6,255 451 8,419
Table VI Hausman specification test

Models Chi2 statistic Degrees of freedom Prob.⬎Chi2
Growth stage
Short-term leverage (STLit) 146.42 19 0.000
Long-term leverage (LTLit) 173.04 19 0.000
Total leverage (TLit) 184.55 19 0.000
Mature stage
Decline stage
Notes: The table presents the results of Hausman specification test for three leverage ratios for growth, mature and decline stage
separately; STLit is the ratio of short-term debt over total assets; LTLit is the ratio of long-term debt over total assets; TLit is the ratio of
total debt over total assets

LEVit* ⫽ ␣0t ⫹ ␤Xi,t⫺1 ⫹ ␮it (1)
where ␣0t is constant term, LEV is the target capital structure or leverage ratio for the ith
it
*
firm at time t, ␤Xi,t⫺1 is the vector of a firm, industry and macroeconomic lagged variables
and ␮it is the error component for ith firm at time t.
Optimally, a firm should operate at its target leverage. However, tradeoffs between
adjustment costs and benefits may force firms to delay their adjustment processes.
Moreover, the target leverage ratio of firms depends upon a number of endogenous and
exogenous factors that change over time because of dynamic environments. Therefore,
firms continuously strive toward their dynamic optimal target leverage, but at the same time,
adjustment costs deviate the firms away from their target leverage (Fischer et al., 1989) and
slow down their adjustment rates (Myers, 1984). Consequently, firms may adjust their
actual leverage partially toward the target leverage. We put forward our partial adjustment
model as:
LEVit ⫺ LEVi,t⫺1 ⫽ ␦(LEVitⴱ ⫺ LEVi,t⫺1) (2)
or:
LEVit ⫽ (1 ⫺ ␦) LEVi,t⫺1 ⫹ ␦LEVitⴱ (3)
where LEVit is the actual leverage ratio for the ith firm at time t and ␦ is an adjustment
parameter. ␦ ⫽ 1; means full adjustment has been achieved by the firm within one
accounting period. The adjustment rate depends upon adjustment cost and adjustment
cost itself depends upon the determinants of the target capital structure of a firm. By
combining equations (1) and (3), we get the following:
LEVit ⫽ ␣0t ⫹ (1 ⫺ ␦)LEVi,t⫺1 ⫹ ␦␤Xi,t⫺1 ⫹ ␮it (4)
where ␣0t is a constant term, LEVit is one of the three measures of leverage (i.e. TLit, LTLit
and STLit) for the ith firm at time t; ␦ is a partial adjustment parameter; 1 ⫺ ␦ is the
adjustment rate; Xi,t⫺1 is the vector of firm, industry and macroeconomic lagged variables
for ith firm at time t-1; ␤ is the impact of firm, industry and macroeconomic factors on target
leverage; and ␮it is the error component for the ith firm at time t.
We included a life-cycle measure proposed by Anthony and Ramesh (1992) in equation (4)
to determine the adjustment rate during different life-cycle stages:
LEVit ⫽ ␣0t ⫹ (1 ⫺ ␦) LEVi,t⫺1 ⫹ ␦␤Xi,t⫺1(life cycle) ⫹ ␮it (5)
Equation (5) presents the econometric model to test the hypotheses developed in Section
2.1 empirically and to carry out the analysis in Section 4 that considers both the leverage
adjustment rate and the firm life cycle.
4. Empirical results and their discussion

4.1 Descriptive statistics
Descriptive statistics (Table VII) explain that STLit (mean of 0.566 during the growth stage;
0.646 during the mature stage; and 0.526 during the decline stage) is a dominant mode of
financing throughout the life cycle of Pakistani firms conforming with earlier studies in
Pakistan (Qureshi, 2009; Sheikh and Qureshi, 2014). Meanwhile, LTLit is a small portion
(mean of 0.232 during the growth stage, 0.173 during the mature stage and 0.119 during
the decline stage) of total financing and decreases as the firms mature and decline. The
highest mean values of STLit (mean ⫽ 0.646) during the mature stage and LTLit (mean ⫽
0.232) during the growth stage suggested that mature firms consider short-term debt, while
growing firms consider long-term debt as capital structure policy tools. The mean of TLit
the decline stage) represented a low– high–low leverage pattern during the growth, maturity
and decline stages, in line with TOT (H2). The corporate arena in Pakistan is laden with high
information asymmetry along with a weak legal system (that is unable to protect creditors
rights) and such an environment may lack a venture capital market (Berger and Udell,

Table VII Descriptive statistics of dependent and explanatory variables during different life-cycle stages
Variables STLit LTLit TLit TSit Zit BRit NDit ACit Git CPit PPit Lit TANit CVit Sit Ait ISTLit ILTLit ITLit IPit INFit EXRit EGRit CFit
Growth stage (1,713 number of observations)

Mean 0.566 0.232 0.799 0.060 1.511 ⫺0.359 0.044 0.380 0.121 0.025 ⫺0.026 0.944 0.550 0.890 5.942 2.507 0.596 0.207 0.810 0.019 0.086 3.590 0.022 0.185
SD 0.326 0.231 0.366 0.105 1.761 3.221 0.021 0.490 0.262 0.098 0.416 0.610 0.210 0.344 1.531 0.356 0.121 0.075 0.136 0.047 0.041 0.637 0.020 0.018
25% 0.368 0.058 0.601 0.000 0.682 ⫺1.009 0.029 0.087 ⫺0.027 ⫺0.028 ⫺0.127 0.613 0.403 0.661 4.916 2.197 0.519 0.143 0.726 ⫺0.007 0.056 3.078 0.011 0.172
Median 0.512 0.175 0.742 0.035 1.499 ⫺0.314 0.042 0.149 0.051 0.019 0.076 0.871 0.556 0.894 5.955 2.485 0.597 0.210 0.830 0.015 0.083 3.808 0.019 0.185
75% 0.684 0.328 0.893 0.079 2.327 0.296 0.056 0.730 0.208 0.068 0.203 1.122 0.705 1.098 6.842 2.773 0.666 0.276 0.876 0.049 0.118 4.090 0.037 0.191
Mature stage (6,255 number of observations)

Mean 0.646 0.173 0.828 0.079 1.637 ⫺0.183 0.038 0.498 0.108 0.028 ⫺0.044 1.107 0.484 0.869 5.991 2.967 0.601 0.190 0.799 0.026 0.085 3.603 0.023 0.186
SD 0.500 0.222 0.575 0.125 2.725 2.757 0.022 0.738 0.253 0.131 0.718 0.825 0.230 0.438 1.782 0.509 0.143 0.077 0.160 0.051 0.042 0.646 0.020 0.019
25% 0.376 0.012 0.541 0.000 0.688 ⫺0.710 0.022 0.085 ⫺0.031 ⫺0.036 ⫺0.061 0.638 0.306 0.560 4.792 2.565 0.504 0.130 0.698 ⫺0.006 0.047 3.078 0.011 0.170
Median 0.525 0.099 0.697 0.044 1.828 ⫺0.148 0.036 0.162 0.052 0.028 0.157 0.984 0.484 0.839 5.955 2.944 0.597 0.194 0.823 0.025 0.079 3.902 0.020 0.185
75% 0.716 0.245 0.867 0.121 3.036 0.297 0.051 0.897 0.189 0.094 0.298 1.322 0.662 1.091 7.079 3.367 0.669 0.243 0.866 0.058 0.114 4.099 0.040 0.191
Decline stage (451 number of observations)

Mean 0.526 0.119 0.643 0.075 2.494 ⫺0.208 0.034 0.339 0.086 0.007 0.225 1.327 0.398 0.728 6.310 3.356 0.602 0.191 0.803 0.021 0.085 3.449 0.022 0.186
SD 0.257 0.140 0.268 0.112 1.706 2.673 0.018 0.489 0.179 0.067 0.311 0.773 0.209 0.358 1.604 0.334 0.163 0.069 0.174 0.043 0.037 0.639 0.019 0.016
25% 0.381 0.008 0.514 0.000 1.566 ⫺0.755 0.021 0.070 ⫺0.026 0.002 0.130 0.942 0.225 0.470 5.269 3.178 0.505 0.142 0.705 ⫺0.005 0.056 2.891 0.011 0.177
Median 0.520 0.075 0.651 0.045 2.184 ⫺0.304 0.032 0.125 0.059 0.025 0.228 1.134 0.388 0.710 6.226 3.434 0.601 0.189 0.794 0.017 0.083 3.455 0.021 0.185
75% 0.653 0.185 0.749 0.100 3.142 0.137 0.045 0.465 0.173 0.046 0.313 1.430 0.558 0.969 7.371 3.584 0.670 0.226 0.855 0.052 0.118 4.065 0.037 0.190
Notes: The table presents the descriptive statistics of dependent and explanatory variables used in this study during growth, mature and decline stage. STLit is the ratio of short-term debt over total assets;
LTLit is the ratio of long-term debt over total assets; TLit is the ratio of total debt over total assets; TSit is the ratio of tax payments over gross profit; Zit is Altman’s Z-score; BRit is the ratio of percentage change
VOL. 10 NO. 3 2016

in net profit before tax over total assets; NDit is the ratio of depreciation expenses over total assets; ACit is the ratio of operating expenses over sales; Git is percentage change in total assets; CPit is the ratio
of net profit before tax over total assets; PPit is the ratio of retained earnings over total assets; Lit is the ratio of current assets over current liabilities; TANit is the ratio of net fixed assets over total assets; CVit
is the ratio of fixed assets at cost over total assets; Sit is natural logarithm of total assets; Ait is natural logarithm of number of year since a firm is listed; ISTLjt is mean industry short-term leverage; ILTLjt is
mean industry long-term leverage; ITLjt is mean industry total leverage; IPjt is mean industry net profit before tax over total assets; INFt is annual inflation (consumer prices) rate; EXRt is natural logarithm of
yearly average exchange rate PKR/USD; EGRt is annual per capita GDP growth rate; CFt is the ratio of gross capital formation over GDP
JOURNAL OF ASIA BUSINESS STUDIES

PAGE 289
1998). Therefore, external debt is the only option for those firms to finance their business
activities as is depicted by their high leverage ratios.
We observed low tax payments during growth stages with a mean of 0.060, but it increases
during maturity (mean ⫽ 0.079) and then decreases in the decline stage (mean ⫽ 0.075).
Furthermore, we observed high variations (SD of 1.761 during the growth stage, 2.725
during the mature stage and 1.706 during the decline stage) in Zit and BRit (SD of 3.221
during the growth stage, 2.757 during the mature stage and 2.673 during the decline stage)
throughout a firm’s life cycle, suggesting that Pakistani firms face quite a volatile business
environment throughout their life cycles. Still, Pakistani firms have witnessed a very good
and stable growth rate (mean of 0.121 during the growth stage, 0.108 during the mature
stage and 0.086 during the decline stage) during their growth and maturity stages. Firms
are highly profitable during maturity with a mean value of 0.028 for CPit and they have
higher retained earnings during their decline stages with a mean value of 0.225 for PPit.
Pakistani firms maintain higher mean liquidity (mean of 0.944 during the growth stage,
1.107 during the mature stage and 1.327 during the decline stage) throughout their life
cycles.
The industry average (mean of 0.569 during the growth stage, 0.601 during the mature
stage and 0.602 during the decline stage) short-term leverage and the industry average
the decline stage) long-term leverage also suggest that Pakistani firms rely heavily on
short-term debt throughout their life cycles to finance their business needs. The data (mean
of 0.019 during the growth stage, 0.026 during the mature stage and 0.021 during the
decline stage) also suggest poor profitability at the industry level throughout the life cycle
of Pakistani firms.
Pakistani firms face high INFt (mean of 0.086 during the growth stage, 0.085 during the
mature stage and 0.085 during the decline stage), but they enjoy a good and stable CFt
rate (mean of 0.185 during the growth stage, 0.186 during the mature stage and 0.186
during the decline stage), and quite low (mean of 0.022 during the growth stage, 0.023
during the mature stage and 0.022 during the decline stage) as well as stagnant (SD of
0.020 during the growth stage, 0.020 during the mature stage and 0.019 during the decline
stage) economic growth (EGRt) throughout their life cycles.
4.2 Robustness and sensitivity analysis

First, we carried out analysis of variance (ANOVA) for all the variables (Table VIII). The
analysis rejected the null hypothesis (H0: means of different groups are equal) for all
dependent, firm-level explanatory variables and most of the industry- and country-level
explanatory variables and this illustrated that these variables are significantly[8] different
during the different life-cycle stages.
Then, we carried out multicollinearity analysis to make sure that our database did not face
any multicollinearity issues. We found a variation inflation factor (VIF) greater than 10 for
past profitability. Therefore, we excluded past profitability from the analysis. For the
remaining variables, our analysis (Tables IX–XI)[9] found a highest VIF of 5.03 and a
Z-score of 6.02 during the growth and maturity stages, respectively. TANit was 7.12 during
the decline stage. Accordingly, multicollinearity was not an issue (Nachane, 2006).
Moreover, to ensure the validity and robustness of the results, we carried out some
post-estimation tests such as a modified Wald test for group-wise heteroskedasticity in a
fixed-effect regression model and a Wooldridge test for autocorrelation in panel data. As a
remedy for autocorrelation, we also used robust standard errors adjusted for
heteroskedasticity and clustered robust standard errors, adjusted for clusters, in panels
(firms).
We argue that the multivariate classification approach is better than a univariate
approach. Using firm age as a proxy for life cycle, we assumed that a firm moves

Table VIII Analysis of variance
Stages F-Statistics
Variable Growth Mature Decline F-value p⬎F
STLit 0.566 0.646 0.526 31.07 0.000

LTLit 0.232 0.173 0.119 68.28 0.000
TLit 0.799 0.828 0.643 26.55 0.000
TSit 0.060 0.079 0.075 17.30 0.000
Zit 1.511 1.637 2.494 28.14 0.000
BRit ⫺0.359 ⫺0.183 ⫺0.208 2.55 0.078
NDit 0.044 0.038 0.034 66.63 0.000
ACit 0.380 0.498 0.339 28.48 0.000
Git 0.121 0.108 0.086 3.70 0.025
CPit 0.025 0.028 0.007 6.80 0.001
PPit ⫺0.026 ⫺0.044 0.225 35.95 0.000
Lit 0.944 1.107 1.327 51.72 0.000
TANit 0.550 0.484 0.398 100.65 0.000
CVit 0.890 0.869 0.728 27.70 0.000
Sit 5.942 5.991 6.310 8.33 0.000
Ait 2.507 2.967 3.356 862.53 0.000
ISTLjt 0.596 0.601 0.602 0.85 0.429
ILTLjt 0.207 0.190 0.191 34.11 0.000
ITLjt 0.810 0.799 0.803 3.70 0.025
IPjt 0.019 0.026 0.021 14.01 0.000
INFt 0.086 0.085 0.085 1.32 0.267
EXRt 3.590 3.603 3.449 11.91 0.000
EGRt 0.022 0.023 0.022 3.21 0.040
CFt 0.185 0.186 0.186 0.02 0.979
Observations 1,713 6,255 451
Notes: The table presents the results of ANOVA carried out for dependent and explanatory variables
used in this study during growth, mature and decline stage. STLit is the ratio of short-term debt over
total assets; LTLit is the ratio of long-term debt over total assets; TLit is the ratio of total debt over total
assets; TSit is the ratio of tax payments over gross profit; Zit is Altman’s Z-score; BRit is the ratio of
percentage change in net profit before tax over total assets; NDit is the ratio of depreciation
expenses over total assets; ACit is the ratio of operating expenses over sales; Git is percentage
change in total assets; CPit is the ratio of net profit before tax over total assets; PPit is the ratio of
retained earnings over total assets; Lit is the ratio of current assets over current liabilities; TANit is the
ratio of net fixed assets over total assets; CVit is the ratio of fixed assets at cost over total assets; Sit
is natural logarithm of total assets; Ait is natural logarithm of number of year since a firm is listed;
ISTLjt is mean industry short term leverage; ILTLjt is mean industry long-term leverage; ITLjt is mean
industry total leverage; IPjt is mean industry net profit before tax over total assets; INFt is annual
inflation (consumer prices) rate; EXRt is natural logarithm of yearly average exchange rate PKR/USD;
EGRt is annual per capita GDP growth rate; CFt is the ratio of gross capital formation over GDP
chronologically through its life cycle from birth to decline. However, a firm may have
many products or product lines with different life-cycle stages. Accordingly, product
innovation, new market development or structural changes may drive firms to move
across life-cycle stages non-chronologically (Ayres and Steger, 1985; Dickinson,
2011). Furthermore, identifying firm life cycle stages in a deterministic way, such as
classifying young firms as being less than five years old, or mature firms as being
between 15 and 20 years old, can be misleading because firms of the same age may
have different learning rates. Furthermore, the resource-based theory postulates that
firms may skip, curtail, lengthen or move back to their previous life-cycle stages by
exploiting their unique resources and empirical studies have also approved this notion
(Wernerfelt, 1984; Reuer, 2000). Additionally, we cross-checked the occurrence of
non-chronological life-cycle stages and, out of 8,419 firm-year observations, we found
only 487 non-chronological occurrences. Further, out of those 487 non-chronological
occurrences, 357 were due to fluctuating sales growth, 36 were due to both sales
growth and dividend payout ratio and the remaining 94 were due to dividend payout
only. Descriptive statistics in Table VII revealed high and fluctuating inflation and
exchange rates, as well as low economic growth, during the period under study.

Table IX Pair-wise correlation matrix and variation inflation factor (growth stage)
PAGE 292 JOURNAL OF ASIA BUSINESS STUDIES

Variables STLit LTLit TLit TSi,t-1 Zi,t-1 BRi,t-1 NDi,t-1 ACi,t-1 Gi,t-1 CPi,t-1 Li,t-1 TANit CVi,t-1 Si,t-1 Ai,t-1 ISTLj,t-1 ILTLj,t-1 ITLj,t-1 IPj,t-1 INFt-1 EXRt-1 EGRt-1 CFt-1 VIF
STLit 1.00
LTLit ⫺0.18 1.00
TLit 0.77 0.48 1.00
TSi,t-1 ⫺0.10 ⫺0.12 ⫺0.16 1.00 1.09
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Zi,t-1 ⫺0.47 ⫺0.42 ⫺0.69 0.23 1.00 5.03
BRi,t-1 ⫺0.02 ⫺0.02 ⫺0.03 ⫺0.02 0.06 1.00 1.02
NDi,t-1 ⫺0.02 0.21 0.11 ⫺0.04 ⫺0.16 0.03 1.00 1.76
ACi,t-1 0.01 0.06 0.04 ⫺0.04 ⫺0.19 0.03 0.00 1.00 2.28
Gi,t-1 ⫺0.09 ⫺0.06 ⫺0.12 0.02 0.09 ⫺0.01 ⫺0.29 ⫺0.13 1.00 1.22
CPi,t-1 ⫺0.30 ⫺0.29 ⫺0.45 0.17 0.68 0.11 ⫺0.14 ⫺0.16 0.18 1.00 2.18
Li,t-1 ⫺0.35 ⫺0.19 ⫺0.43 0.11 0.61 0.05 ⫺0.23 ⫺0.01 0.10 0.41 1.00 2.06
TANi,t-1 ⫺0.24 0.38 0.03 ⫺0.11 ⫺0.35 ⫺0.03 0.43 0.16 ⫺0.13 ⫺0.28 ⫺0.49 1.00 3.66
CVi,t-1 ⫺0.06 0.32 0.15 ⫺0.10 ⫺0.30 ⫺0.01 0.59 0.16 ⫺0.30 ⫺0.23 ⫺0.37 0.74 1.00 3.44
Si,t-1 ⫺0.34 0.05 ⫺0.28 0.09 0.00 ⫺0.01 ⫺0.14 0.11 0.11 0.00 0.00 0.25 ⫺0.03 1.00 2.49
Ai,t-1 0.09 ⫺0.04 0.05 ⫺0.01 0.03 0.01 ⫺0.19 ⫺0.11 0.10 0.06 0.01 ⫺0.13 ⫺0.06 0.14 1.00 1.29
ISTLj,t-1 0.28 ⫺0.05 0.22 ⫺0.05 0.01 ⫺0.02 ⫺0.07 ⫺0.08 ⫺0.01 ⫺0.03 ⫺0.05 ⫺0.26 ⫺0.13 ⫺0.47 0.01 1.00 1.58
ILTLj,t-1 ⫺0.12 0.21 0.03 ⫺0.03 ⫺0.11 0.04 0.20 0.01 ⫺0.03 ⫺0.12 ⫺0.18 0.30 0.26 0.20 0.05 ⫺0.18 1.00 1.67
ITLj,t-1 0.17 0.08 0.20 ⫺0.06 ⫺0.05 0.00 0.04 ⫺0.05 ⫺0.03 ⫺0.09 ⫺0.14 ⫺0.05 0.02 ⫺0.29 0.04 0.80 0.43 1.00 1.72
IPj,t-1 ⫺0.02 ⫺0.10 ⫺0.08 0.06 0.19 0.03 ⫺0.17 0.03 0.08 0.35 0.19 ⫺0.17 ⫺0.13 ⫺0.01 0.09 ⫺0.21 ⫺0.49 ⫺0.48 1.00 1.83
INFt-1 ⫺0.01 ⫺0.01 ⫺0.02 0.05 0.00 ⫺0.04 ⫺0.02 ⫺0.47 0.05 ⫺0.07 ⫺0.01 ⫺0.04 ⫺0.09 0.14 0.15 ⫺0.09 0.04 ⫺0.08 ⫺0.13 1.00 1.70
EXRt-1 ⫺0.24 0.02 ⫺0.19 0.09 ⫺0.06 ⫺0.01 ⫺0.05 0.39 ⫺0.04 ⫺0.07 ⫺0.02 0.29 0.19 0.68 0.18 ⫺0.38 0.18 ⫺0.22 ⫺0.02 0.03 1.00 2.76
EGRt-1 0.11 ⫺0.09 0.04 ⫺0.01 0.01 0.00 ⫺0.10 ⫺0.11 0.11 0.07 0.01 ⫺0.04 ⫺0.02 ⫺0.10 0.14 0.13 ⫺0.20 0.00 0.23 ⫺0.12 ⫺0.16 1.00 1.18
CFt-1 0.05 ⫺0.09 ⫺0.02 0.05 0.02 ⫺0.04 ⫺0.06 ⫺0.55 0.11 0.03 ⫺0.03 ⫺0.08 ⫺0.11 0.13 0.28 ⫺0.02 ⫺0.15 ⫺0.11 0.08 0.53 ⫺0.01 0.11 1.00 1.91
Note: The table presents the results from correlation analysis and variation inflation factor for all the dependent and one-year lagged explanatory variables used in this study during growth stage
Table X Pair-wise correlation matrix and VIF (mature stage)
STLit 1.00
LTLit ⫺0.01 1.00
TLit 0.90 0.40 1.00
TSi,t-1 ⫺0.19 ⫺0.20 ⫺0.25 1.00 1.24
Zi,t-1 ⫺0.68 ⫺0.38 ⫺0.79 0.36 1.00 6.02
BRi,t-1 ⫺0.01 ⫺0.02 ⫺0.01 0.03 0.04 1.00 1.01
NDi,t-1 ⫺0.01 0.17 0.06 ⫺0.10 ⫺0.11 0.01 1.00 1.60
ACi,t-1 0.23 0.10 0.25 ⫺0.15 ⫺0.35 0.02 0.00 1.00 1.67
Gi,t-1 ⫺0.18 ⫺0.03 ⫺0.18 0.11 0.17 ⫺0.03 ⫺0.18 ⫺0.13 1.00 1.18
CPi,t-1 ⫺0.41 ⫺0.30 ⫺0.50 0.39 0.66 0.07 ⫺0.07 ⫺0.25 0.22 1.00 2.24
Li,t-1 ⫺0.45 ⫺0.26 ⫺0.51 0.28 0.64 0.02 ⫺0.21 ⫺0.16 0.08 0.46 1.00 2.03
TANi,t-1 0.00 0.42 0.18 ⫺0.26 ⫺0.40 ⫺0.04 0.45 0.20 ⫺0.08 ⫺0.28 ⫺0.47 1.00 3.09
CVi,t-1 0.28 0.33 0.40 ⫺0.22 ⫺0.48 ⫺0.02 0.53 0.21 ⫺0.24 ⫺0.28 ⫺0.41 0.71 1.00 3.41
Si,t-1 ⫺0.38 0.05 ⫺0.34 0.13 0.26 0.01 0.00 ⫺0.08 0.21 0.19 0.12 0.06 ⫺0.22 1.00 2.03
Ai,t-1 0.02 0.05 0.05 ⫺0.02 ⫺0.02 ⫺0.01 ⫺0.12 ⫺0.02 0.04 ⫺0.04 0.01 0.01 0.03 0.19 1.00 1.16
ISTLj,t-1 0.26 ⫺0.05 0.21 ⫺0.06 ⫺0.13 0.00 ⫺0.12 ⫺0.01 ⫺0.03 ⫺0.15 ⫺0.14 ⫺0.14 ⫺0.05 ⫺0.30 ⫺0.01 1.00 1.47
ILTLj,t-1 ⫺0.04 0.29 0.09 ⫺0.16 ⫺0.15 0.00 0.19 0.00 ⫺0.04 ⫺0.18 ⫺0.17 0.32 0.27 0.06 0.09 ⫺0.18 1.00 1.50
ITLj,t-1 0.23 0.10 0.25 ⫺0.13 ⫺0.20 ⫺0.01 ⫺0.03 ⫺0.01 ⫺0.05 ⫺0.23 ⫺0.21 0.03 0.09 ⫺0.24 0.05 0.86 0.33 1.00 1.75
IPj,t-1 ⫺0.12 ⫺0.14 ⫺0.16 0.21 0.22 0.05 ⫺0.07 ⫺0.02 0.10 0.40 0.20 ⫺0.14 ⫺0.14 0.08 ⫺0.02 ⫺0.37 ⫺0.43 ⫺0.57 1.00 1.88
INFt-1 ⫺0.04 0.07 ⫺0.01 ⫺0.01 ⫺0.01 ⫺0.02 ⫺0.07 ⫺0.33 0.04 ⫺0.04 ⫺0.02 0.00 ⫺0.06 0.09 0.10 ⫺0.03 0.03 ⫺0.01 ⫺0.09 1.00 1.56
EXRt-1 ⫺0.07 0.08 ⫺0.03 ⫺0.04 ⫺0.05 ⫺0.02 0.03 0.28 ⫺0.02 ⫺0.01 0.02 0.19 0.12 0.52 0.25 ⫺0.18 0.10 ⫺0.10 ⫺0.02 0.03 1.00 1.85
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EGRt-1 0.03 ⫺0.07 0.00 0.06 0.01 0.01 ⫺0.05 ⫺0.05 0.09 0.06 0.01 ⫺0.01 ⫺0.02 ⫺0.03 ⫺0.01 0.09 ⫺0.15 0.01 0.18 ⫺0.11 ⫺0.15 1.00 1.13
CFt-1 0.01 0.01 0.01 0.00 ⫺0.01 ⫺0.02 ⫺0.07 ⫺0.38 0.05 0.00 ⫺0.01 ⫺0.01 ⫺0.04 0.07 0.13 0.07 ⫺0.13 0.01 0.03 0.54 ⫺0.01 0.10 1.00 1.61
Note: The table presents the results from correlation analysis and VIFs for all the dependent and one-year lagged explanatory variables used in this study during mature stage
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PAGE 293
Table XI Pair-wise correlation matrix and VIF (decline stage)

STLit 1.00
LTLit ⫺0.03 1.00
TLit 0.88 0.45 1.00
TSi,t1 ⫺0.11 ⫺0.16 ⫺0.18 1.00 1.31
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Zi,t-1 ⫺0.33 ⫺0.50 ⫺0.54 0.25 1.00 2.16
BRi,t-1 0.00 0.01 0.01 ⫺0.06 ⫺0.01 1.00 1.07
NDi,t-1 ⫺0.24 0.24 ⫺0.10 ⫺0.08 ⫺0.18 ⫺0.04 1.00 2.52
ACi,t-1 0.15 0.03 0.14 ⫺0.11 ⫺0.28 ⫺0.01 0.02 1.00 4.37
Gi,t-1 ⫺0.06 0.18 0.04 0.10 ⫺0.10 ⫺0.02 ⫺0.13 ⫺0.10 1.00 1.28
CPi,t-1 ⫺0.23 ⫺0.07 ⫺0.25 0.36 0.38 0.06 ⫺0.04 ⫺0.14 0.14 1.00 1.66
Li,t-1 ⫺0.44 ⫺0.13 ⫺0.48 0.22 0.45 ⫺0.02 ⫺0.21 ⫺0.10 ⫺0.11 0.32 1.00 2.63
TANi,t-1 ⫺0.41 0.48 ⫺0.14 ⫺0.11 ⫺0.27 ⫺0.06 0.62 0.04 0.09 ⫺0.06 ⫺0.27 1.00 7.12
CVi,t-1 ⫺0.09 0.45 0.11 ⫺0.08 ⫺0.33 ⫺0.05 0.71 0.10 ⫺0.09 ⫺0.05 ⫺0.23 0.78 1.00 5.86
Si,t-1 ⫺0.12 0.12 ⫺0.04 0.07 ⫺0.05 0.08 ⫺0.06 0.03 0.26 0.02 ⫺0.07 0.13 ⫺0.10 1.00 1.99
Ai,t-1 0.02 0.03 0.03 0.05 0.04 0.05 0.00 0.04 0.09 0.03 ⫺0.03 0.05 0.08 0.36 1.00 1.37
ISTLj,t-1 0.28 ⫺0.03 0.23 ⫺0.24 0.00 0.07 ⫺0.20 ⫺0.01 ⫺0.05 ⫺0.08 ⫺0.06 ⫺0.22 ⫺0.15 ⫺0.22 ⫺0.04 1.00 1.60
ILTLj,t-1 ⫺0.02 0.24 0.09 0.11 ⫺0.19 0.07 0.18 0.10 0.01 ⫺0.03 ⫺0.01 0.24 0.29 0.09 0.23 ⫺0.37 1.00 1.38
ITLj,t-1 0.23 0.03 0.20 ⫺0.21 0.01 0.11 ⫺0.13 0.00 ⫺0.05 ⫺0.09 ⫺0.05 ⫺0.13 ⫺0.07 ⫺0.16 0.07 0.88 0.08 1.00 1.62
IPj,t-1 ⫺0.02 0.09 0.03 0.14 0.13 ⫺0.05 ⫺0.08 0.05 0.07 0.38 0.07 0.02 ⫺0.01 0.16 ⫺0.06 ⫺0.34 ⫺0.21 ⫺0.42 1.00 1.70
INFt-1 ⫺0.15 0.09 ⫺0.09 0.10 0.12 0.03 ⫺0.05 ⫺0.55 0.13 0.08 0.15 0.05 ⫺0.01 0.13 0.10 ⫺0.07 ⫺0.02 ⫺0.05 0.08 1.00 1.92
EXRt-1 ⫺0.02 ⫺0.01 ⫺0.03 0.03 ⫺0.03 0.02 0.00 0.48 0.08 ⫺0.03 0.03 0.08 0.09 0.49 0.41 ⫺0.18 0.20 ⫺0.09 0.05 0.00 1.00 3.06
EGRt-1 0.00 ⫺0.01 0.00 ⫺0.08 ⫺0.05 0.13 ⫺0.01 ⫺0.12 0.07 0.01 ⫺0.05 0.01 ⫺0.01 ⫺0.03 ⫺0.06 0.13 ⫺0.13 0.06 0.04 ⫺0.12 ⫺0.24 1.00 1.19
CFt-1 ⫺0.19 0.00 ⫺0.17 0.05 0.20 0.04 ⫺0.01 ⫺0.65 0.14 0.12 0.18 0.05 0.02 0.14 0.13 0.00 ⫺0.09 ⫺0.01 0.05 0.56 ⫺0.02 0.07 1.00 2.50
Note: The table presents the results from correlation analysis and VIFs for all the dependent and one-year lagged explanatory variables used in this study during decline stage
Therefore, the sales growth (the main reason of non-chronological occurrences) of the
firms operating in such erratic conditions can easily be affected.
4.3 Empirical results

Table XII[10] presents the results of the FEM for three proxies of leverage during three
different life-cycle stages. We compared the results of 1,684 firm-year observations
during the growth stage, 6,164 firm-year observations during the maturity stage and
445 firm-year observations during the decline stage. Our models for STLit, LTLit and TLit
explained 69-82, 66-74 and 81-90 per cent of the leverage variations during three
different life-cycle stages.
4.3.1 Rate of adjustment. The estimated coefficients of the lagged leverage for all three
leverage ratios and during all three life-cycle stages were significant (p ⫽ 0.01),
indicating the existence of target leverage for listed non-financial firms in Pakistan
during their growth, maturity and decline stages. The adjustment rate of growing firms
was 47.9, 49.3 and 37.9 per cent for STLit, LTLit and TLit, respectively. The adjustment
rate of mature firms was 31.3, 35.5 and 17.5 per cent for STLit, LTLit and TLit,
respectively. Finally, the adjustment rate of declining firms was 20.8, 22.2 and 15.1 per
cent for STLit, LTLit and TLit, respectively. The results show that listed Pakistani
non-financial firms partially adjust their target leverages and try to close the gap
between actual and target leverages to enjoy the benefits of their target (optimal)
leverage. Growing firms have the highest adjustment rate, while declining firms have
the lowest adjustment rate for all three leverage ratios. The plausible reason may be
that, by having more investment opportunities, growing firms need more financing to
avail themselves of these opportunities and they easily alter their capital structures by
changing the composition of their new issuances. Conversely, it is very difficult for
declining firms with the least investment opportunities to alter the composition of their
capital structure. Furthermore, these adjustment rates are in line with the studies
carried out in Asian economies including Pakistan where a study, without considering
corporate life cycles, found adjustment rates between 24-45 per cent (Getzmann et al.,
2014).
4.3.2 Determinants of target leverage and adjustment rate. In this section, we will explain the
role[11] of the variables included in our model to determine short-term, long-term and total
target leverage ratios and adjustment rates. The positive relationship between TSit and
STLit during the mature stage suggests that mature Pakistani firms increase debt to gain tax
shield benefits. However, the negative association between TSit and LTLit is due to an
inverse relationship between short- and long-term debt (Table X). Mature firms increase
short-term debt financing by increasing TSit and pay out for long-term debt due to
increased short-term debt financing and that seems to be one of the reasons for the higher
adjustment rate of mature firms toward LTLit compared with their adjustment rate toward
STLit. The negative association of Zit with STLit for mature firms and of LTLit for growing and
mature firms suggests that growing and mature firms prefer to finance business projects
internally and this preference reduces their adjustment rate toward their respected
leverage targets. The negative association of BRit with STLit for mature firms indicates that
higher earnings volatility slows down the adjustment rate even at the mature stage. The
negative association of NDit with LTLit and TLit and its coefficients for declining firms
indicates that during their declining stages, firms in Pakistan enjoy considerable NDit
benefits. Declining firms use these non-debt tax shield benefits as an alternative to tax
shield benefits because, having least investment opportunities, these firms may be unable
to raise debt.
We found a positive association of ACit with TLit by mature firms. This implies that when
firms become mature and have higher free cash flows, they try to reduce agency conflicts
by committing to debt and consequently reducing future free cash flows to discipline the
spending behavior of managers as advocated by TOT. On the other hand, the negative

Table XII Adjustment rate toward target capital structure during different life-cycle stages in Pakistan

Leverage STLit LTLit TLit
Firm stage Growth Mature Decline Growth Mature Decline Growth Mature Decline
Variables Coefficient p⬎ t Coefficient p⬎ t Coefficient p⬎ t Coefficient p⬎ t Coefficient p⬎ t Coefficient p⬎ t Coefficient p⬎ t Coefficient p⬎ t Coefficient p⬎ t
Adjustment
rate (%) 47.9 31.3 20.8 49.3 35.5 22.2 37.9 17.5 15.1
Leveragei,t-1 0.521 0.000 0.687 0.000 0.792 0.000 0.507 0.000 0.645 0.000 0.778 0.000 0.621 0.000 0.825 0.000 0.849 0.000
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TSi,t-1 0.065 0.027 ⫺0.048 0.008
Zi,t-1 ⫺0.014 0.007 ⫺0.016 0.001 ⫺0.009 0.000
BRi,t-1 ⫺0.002 0.099
NDi,t-1 ⫺0.824 0.044 ⫺0.819 0.072
ACi,t-1 ⫺0.025 0.043 0.019 0.017
Gi,t-1 ⫺0.040 0.017 ⫺0.039 0.001 0.020 0.070 0.025 0.000
CPi,t-1 ⫺0.256 0.004 ⫺0.165 0.005 ⫺0.263 0.005 ⫺0.282 0.000
TANi,t-1 0.125 0.028
CVi,t-1 0.193 0.000 0.190 0.000
Si,t-1 ⫺0.027 0.000 ⫺0.010 0.062 ⫺0.017 0.002
Ai,t-1 0.057 0.004 0.033 0.025
INFt-1 ⫺0.338 0.016 ⫺0.466 0.000 0.325 0.000 0.229 0.036
EXRt-1 ⫺0.048 0.021
EGRt-1 0.805 0.000 0.388 0.006 ⫺0.659 0.000 ⫺0.491 0.000
CFt-1 0.725 0.009 0.294 0.045 0.626 0.019 0.508 0.005
Constant 0.152 0.004 0.196 0.000 ⫺0.020 0.471 0.154 0.000 0.064 0.000 0.053 0.199 0.351 0.000 0.060 0.106 0.007 0.753
R2 0.6910 0.8147 0.7885 0.6723 0.6681 0.7379 0.8145 0.8928 0.8734
No. of 1684 6164 445 1684 6164 445 1684 6164 445
observations
No. of firms 379 549 133 379 549 133 379 549 133
Notes: First, we run fixed-effects analysis including all the variables for three models (STLit, LTLit and TLit) and for each life-cycle stage, separately to find out leverage adjustment rate during different
life-cycle stages. Second, we exclude all the insignificant variables and repeat the analysis again including only significant variables to find out determinants of leverage adjustment rate during different
life-cycle stages; further, use of lagged explanatory variables to find out adjustment rate, reduces number of observations from 1,713 to 1,684 during the growth stage, 6,255 to 6,164 during the mature
stage and 451 to 445 during the decline stage
association of ACit with LTLit for growing firms indicates that the excess use of debt creates
underinvestment problems in firms that have high growth opportunities and, to resolve this
underinvestment problem, the firms may reduce their liabilities.
In line with POT, we found a negative relationship between Git and STLit and a positive one
with LTLit during the growth and mature stages, showing that growing and mature firms do
have enough funds available to finance short-term investments internally but, on the other
hand, these firms finance their long-term business projects by raising long-term debt. This
may be another reason for the higher adjustment rates of growing and mature firms toward
LTLit as compared to their adjustment rates toward STLit.
Further, in line with POT, we found a negative relationship between CPit and STLit and TLit
during the growth and mature stages, suggesting that growing and mature firms prefer to
finance short-term investments internally. The coefficients suggest that profitability is the
major tool that affects capital structure adjustment processes. Furthermore, we found a
positive relationship during the decline stage between TANit and LTLit and between CVit
and STLit, as well as TLit, suggesting that higher tangibility/collateral value lowers the
agency cost of debt (Frank and Goyal, 2009). That is very important to banks in Pakistan
to minimize the possibility of their credit being written off, especially in the cases of firms in
their last stages. Moreover, Lit is not a significant determinant regarding any of the leverage
adjustment processed in any of the three life-cycle stages. This finding, along with the
positive relationship between TANit and CVit suggests that, due to Pakistan’s institutional
void, creditors there do not consider current assets to be securities to minimize risk, but
they see them instead as fixed assets.
In line with POT, we found a negative association of Sit with STLit and TLit for mature firms
and with LTLit for declining firms. We also found a positive association in line with TOT
between Ait and STLit and TLit for mature firms, suggesting that older/experienced mature
firms adjust quickly toward their leverage targets.
We observed that industry variables such as industry average leverage ratios and industry
average profitability did not play any role in leverage adjustment processes.
Moreover, the negative association of INFit with STLit for growing and mature firms
explained that higher inflation rates hurt the leverage adjustment rates of growing and
mature firms toward short-term leverage targets very badly. There again, positive
associations between INFit and LTLit for mature and declining firms explained that higher
inflation rates help those firms to adjust the (nominal) book values of their leverage ratios
and consequently increase their adjustment rates. Furthermore, a negative association
between EXRit and TLit for growing firms indicated that unfavorable exchange rates
increase the cost of debt and consequently slow down the adjustment rates of growing
firms.
We found positive associations between economic growth and STLit for growing and
mature firms, while the relationship of economic growth with LTLit was negative. We also
found a positive association of capital formation between STLit and TLit for growing and
mature firms. These findings explained that good economic conditions provide an
opportunity for growing and mature firms to adjust their term structures and also to increase
their leverage adjustment rates in line with other studies (Cook and Tang, 2010).
5. Conclusions and policy implications

This is the first empirical study that has analyzed 39 years (1972-2010) of unbalanced
panel data to determine adjustment rates for listed Pakistani non-financial firms
throughout their life cycles. Pakistan is a developing country with weak financial and
judicial institutions and high levels of corruption where crony capitalism is well-known.
Furthermore, the financial market in Pakistan is bank-based where debt is easily
available compared to equity, and short-term debt is the main source of financing. In
addition, firms use their political connections to borrow loans. All of these attributes of

the Pakistani economy make it an interesting case. We used a multivariate approach to
classify firms into growth, mature and decline stages and applied FEM to determine the
adjustment rate of listed Pakistani non-financial firms toward target capital structure, as
well as factors influencing target capital structure. We found that during one accounting
period, growing listed Pakistani non-financial firms closed the gap between actual and
target leverage by 47.9, 49.3 and 37.9 per cent for short-term, long-term and total
leverage, respectively; mature firms closed the gap between actual and target leverage
by 31.3, 35.5 and 17.5 per cent for short-term, long-term and total leverage,
respectively; and declining firms closed the gap between actual and target leverage by
20.8, 22.2 and 15.1 per cent for short-term, long-term and total leverage, respectively.
Further, we found that growing firms have the highest leverage adjustment rates for all
three leverage ratios. What is more, the adjustment rates of growing, mature and
declining firms towards long-term leverage targets were higher compared to their
adjustment rates toward short-term leverage targets. We also found that profitability is
a major tool that affects the capital structure adjustment processes of growing and
mature firms. Furthermore, in good economic conditions, these firms adjust very easily
toward their leverage targets. Moreover, we observed a low– high–low leverage pattern
during the growth, maturity and decline stages, as indicated by TOT.
In addition, erratic macroeconomic conditions (inflation, exchange rates, economic growth)
create uncertain business environments. To cope with this uncertainty, firms raise
short-term debt as and when any business opportunity arises. Governments should
introduce long-term policies to stabilize the business environment and to strengthen
Pakistan’s financial and judicial institutions so that firms may have long-term investment
opportunities and access to more options to raise external financing. This will create a
healthy and competitive business environment.
Notes
1. www.govindicators.org
2. www.psx.com.pk
3. According to Alves and Francisco (2015), the mean short-term leverage ratio for firms in Indonesia
is 0.56; for firms in Malaysia, it is 0.63; and for firms in Thailand, it is 0.61. These short-term
leverage ratios are very much in line with the short-term leverage ratios during the growth, maturity
and declining stages (mean ⫽ 0.566, 0.646 and 0.526) of firms in Pakistan.
4. According to Alves and Francisco (2015), Pakistan has a 0.52 score for capital market
development (total value of shares traded as a percentage of GDP) and 0.04 for GDP growth
(annual percentage growth rate of GDP), while Thailand has a 0.50 score for capital market
development and 0.04 for GDP growth. Turkey has a 0.43 score for capital market development
and 0.05 for GDP growth. Indonesia has a 0.14 score for capital market development and 0.05 for
GDP growth and Malaysia has a 0.43 score for capital market development and 0.05 for GDP
growth. These scores for capital market development and GDP growth explain how firms in these
Asian economies face very similar, or even severe, capital market and economic conditions.
5. Z-score ⫽ 1.2 ⫻ (Working capital/Total assets) ⫹ 1.4 ⫻ (Retained earnings/Total assets) ⫹ 3.3 ⫻
(Earnings before interest and taxes/Total assets) ⫹ 0.6 ⫻ (Market value of equity/Book value of
total liabilities) ⫹ 0.999 ⫻ (Sales/Total assets).
6. We assigned the first two intervals to the growth stage, the middle three intervals to the mature
stage and the last two intervals to the decline stage following Anthony and Ramesh (1992).
7. After multivariate classification of 8,419 firm-year observations into growth, maturity and decline
stages, we found that the majority of the firm-year observations (6,255) fell into the mature stage,
while the number of firm-year observations during the growth (1,713) and decline stages (451) was
relatively smaller. Considering the study period (1972-2010) and the fact that Pakistan came into
being in 1947, the Pakistani market is not very old and that may be one reason for a small number
of firm-year observations in the decline stage. Furthermore, we observed a spike in newly listed
firms after the economic liberalization program of the Government of Pakistan began in the early
1990s. To cross-check our reasoning, we summarized the number of firms by their respective
ages and found only 97 firms older than 50 years and 1,088 firms that were less than 10 years of

age. These findings are consistent with our reasoning and the results of the multivariate
methodology used for the classification purpose.
8. The ANOVA test rejects H0 at a significance level of 0.10 for BRit, at a significance level of 0.05 for
Git, ITLjt, EGRt and at a significance level of 0.01 for all other variables, except ISTLjt, INFt and CFt.
9. We ran VIF separately for three models (STLit, LTLit and TLit) and for each life-cycle stage and
found a highest VIF of 5.03 and a Z-score of 6.02 for the TLit model, and TANit of 7.12 for the STLit
model during the growth, mature and decline stages respectively. Therefore, we present VIF
results for the TLit model in Tables IX and X and for the STLit model in Table XI.
10. First, we ran fixed-effects analysis including all the variables for three models (STLit, LTLit, TLit) and
for each life-cycle stage, separately. Second, we excluded all the insignificant variables and
repeated the analysis again, including only significant variables. Further, the use of lagged
explanatory variables reduced the number of observations from 1,713 to 1,684 during the growth
stage, from 6,255 to 6,164 during the mature stage and from 451 to 445 during the decline stage.
11. The sign of a coefficient indicates the direction of a relationship, whereas the value of a coefficient
suggests the amount of adjustment per year.
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How do they adjust their capital structure

along their life cycle? An empirical study

Tanveer Ahsan is a PhD Abstract

1.1 Why Pakistan?

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2.2 Determinants of target capital structure (leverage)

Table I Leverage pattern during three life-cycle stages as suggested by theories

Pecking order theory High Low High

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3. Data and methodology

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Table III Life-cycle variables and classification method

Growth Low High Young

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Table V Sector and life cycle stage-wise number of firms-year observations

1 Cement 81 188 25 294 3.49

Table VI Hausman specification test

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4. Empirical results and their discussion

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Growth stage (1,713 number of observations)

Mature stage (6,255 number of observations)

Decline stage (451 number of observations)

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4.2 Robustness and sensitivity analysis

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STLit 0.566 0.646 0.526 31.07 0.000

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4.3 Empirical results

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5. Conclusions and policy implications

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Delcoure, N. (2007), “The determinants of capital structure in transitional economies”, International

Fischer, S. (1981), “Towards an understanding of the costs of inflation: II”, Carnegie-Rochester

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Wooldridge, J.M. (2015), Introductory Econometrics: A Modern Approach, Nelson Education.

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