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CAPITAL STRUCTURE DETERMINANTS: AN EMPIRICAL STUDY OF FOOD & PERSONAL CARE INDUSTRY OF PAKISTAN

Pervez Ahmed Memon Sukkur Institute of Business Administration Abdul Khaliq Sukkur Institute of Business Administration Salma Akbar Sukkur Institute of Business Administration Ghulam Abbas Sukkur Institute of Business Administration

ABSTRACT
This paper is an attempt to determine the capital structure of listed firms in the Food & Personal Care Industry of Pakistan. The study covers the sample of 16 firms in the sector, listed at the Karachi Stock Exchange, for the period 2001-2008 and analyzed the data by using pooled regression adjusted with cross sectional variation .Six variables i.e. firm size tangibility of assets, profitability ,growth, tax rate and earning volatility were tested as determinants of the leverage. The regression model is found to be significant and these six variables determine 89% of leverage .Only two variables- growth and size of firms were found significant and have positive relationship with leverage. So, capital structure of firms in F&PC industry mainly depends upon their sizes and growth opportunities. The paper is divided into five parts- Introduction and Literature Review, Objectives of Study, Data & Methodology, Results and Discussion, and Conclusion.

Keywords: Capital Structure, Food and Personal Care, Pakistan

they concluded that a firm’s value is unaffected by the level of debt used. Higher the profitability the lower the expected costs of distress and higher the tax benefit of using leverage. with equity. At higher level of debt the chances of bankruptcy increase. Two major sources of financing that are available to firms are debt and equity. non debt tax shields. Bradley. The level of debt used varies across the industries and firms. states that capital structure is driven by firm's desire to finance new investments. After the contributions made by the MM in the area of capital structure. Lot of research studies have been conducted on the issue of capital structure. asset structure. The cost of financial distress is also determined by the type of assets used. 1977) suggests that the firms want to trade-off the benefits of debt with the expected cost of bankruptcy. This article ignored the cost of bankruptcy. and lenders and rating agencies attitude etc. The mixture of debt and equity is called capital structure. MM considered the corporate taxes and concluded that due to tax deductibility of interest. first internally. on the basis of certain unrealistic assumptions like zero taxes. where the firms’ value is maximized and cost of capital is minimized. the use of debt increases the value of the firm. Pecking Order Theory. The factors that are considered by the firms while making capital structure decisions are: sales stability. market conditions. there have been lot of empirical studies conducted to understand the determinants of capital structure. Myers and Majluf (1984). the firms prefer internal financing to external financing. The first scientific study conducted in the field of capital structure is of Franco Modigliani and Merton Miller (1958). In their second article in 1963. Firm’s optimal debt ratio is one where the tax advantage of borrowing is equal to the expected cost of bankruptcy. profitability.INTRODUCTION AND LITERATURE REVIEW Firms require capital to expand or support their sales. Alderson & Betker . They would like to have optimal capital structure. then with low-risk debt. So the firms can use 100% debt. taxes. In their study. Therefore. and finally if all fails. They usually use mix of both debt and equity. control issues. growth rates. Worth mentioning are Rajan Zingles (1995). Firms can use any of these two sources to finance their operations. Financial managers are concerned with the level of debt and equity. Jarrell and Kim (1984). Trade-off theory (Scott.

Rajan and Zingles in that study found tangibility and sales to be positively related and market to book ratio and profitability to be negatively correlated with debt. the market-to-book ratio. safiullah khan (2007). Jordan. Barclay. J. firm size. Atta. Harris and Raviv (1991) Bevan. tangibility. Shah Atta. (1995). Yasir and Hijazi (2006) conducted the empirical study on the determinants of capital structure in cement industry of Pakistan. (1998).. They found growth. Wiwattanakantang (1999). tangibility. and tangibility to be negatively correlated with debt. and profitability and growth are negatively correlated with the leverage. Profitability and size were found to be . which is inconsistent with the theory. They found all variables significant. Lowe. growth. They found tangibility and size positively correlated with leverage and profitability and growth negatively correlated with leverage. Jarrell and Kim (1984) found that earning volatility. volatility. E and French. growth and profitability as the independent variables. A. Yasir (2006). R. and profitability. and Hijazi (2004). uniqueness of the product and non-debt tax shields. and Watts. and profitability.W. and Wolfgang Drobetz and Roger Fix ( 2003) Rajan and Zingles (1995) in their study used four determinants (independent variables).(1995). Some of them which are known to us are Shah. and Danbolt. Following the Rajan. Bradley. They found that tangibility and size are positively correlated. Taylor (1998). sales. They found that industry classification is also relevant in capital structure decisions. Hijazi. market to book ratio. and Jasir ilyas (200X). and Fama. investment on R&D and advertising are negatively related to leverage and significant. They also found that the non debt tax shield is positively related with leverage.J. Booth et al (2001).R. profitability. So far as the determinants of capital structure in Pakistani firms are concerned. Smith C. They used tangibility. size. Wolfgang Drobetz and Roger Fix (2003) in their study used six variables: tangibility of assets. and Hijazi (2004) conducted the empirical study on determinants of capital structure of stock exchange listed non financial firms of Pakistan.L. M. Hussain (1997). several empirical studies have been conducted. Zingles (1995) they used four independent variables of size. K.. 2000. Titman & Wessels (1988). Attaullah shah.

growth. They found that Tangibility is significantly related to debt. 1. Profitability. Profitability was found to be the most significant explanatory variable and negatively related to leverage. 2. non debt tax shield. and profitability. Growth variable was found to be negatively correlated with and significant at 10% level. Attaullah Shah. They were tangibility. H5: A firm with higher taxes will have higher debt ratio H6: A firm with high income variation will have lower debt. size. The impact of earning volatility on debt was found insignificant. Safiullah Khan (2007). tangibility of assets. measured by natural log of sale. As mentioned there are some studies for non financial firms as whole but we are lacking in sector wise studies. Size. conducted another empirical study on determinants of capital structure of the Karachi Stock Exchange listed non financial firms.negatively correlated with debt (leverage). H2: A firm with large size will have higher debt ratio. There is limited number of research articles in area of capital structure for Pakistani market/firms. tax rates. Earning volatility. H3: A firm with higher percentage of fixed assets will have higher debt ratio. and Growth of the firm. In this study they used six independent variables. 1.1 Objectives of The Study The objective of our study is to identify the determinants of capital structure in Food& Personal care industry of Pakistan. H4: A firm with higher growth is expected to have higher debt ratio. Non debt tax shield (depreciation). DATA AND METHODOLOGY Most of the research in the field of finance suggests that ratio of debt and equity vary . We have used seven variables: Size of the firm. has a positive correlation with leverage but is insignificant.2 Hypothesis of the Study The hypotheses of our study are: 1 2 3 4 5 6 H1: A firm with higher profitability/ return is expected to have lower debt ratio. earning volatility.

3. 3. a document annually published by the State Bank of Pakistan from 2000-2008. The firms having incomplete information are excluded from the sample. Furthermore. The sample consists of 16 firms from food and personal care products industry listed on Karachi Stock Exchange. the determinants and variables of capital structure can be categorized into dependent and independent determinants (variables). volatility. tangibility. Simple regression model has been run to uncover the firms financing behavior in this industry and 126 firm year observations have been used in this analysis. a dependant variable deals with debt and equity.1 Dependent and Independent Variables The previously discussed dependent and independent variables. Capital structure of any firm depends upon its specific characteristics (discussed later in the document) as well as on the cost and benefit analysis of debt and equity. the most crucial factors for determining the capital structure of any firm. medium or small needs some capital or financial resources. Leverage. This study is based on the secondary data. the problem of multicollinearity has been addressed in this study which was not discussed so far in the existing literature as per researchers’ knowledge. are elaborated further in the following discussion. Previous studies of capital structure indicate a strong dependence of debt ratio on the nature of the concerned industry.from industry to industry and it is because of certain characteristics of different industries. tax and non-debt tax shield are the independent variables. These financial resources could be owned resources or in form of debt which organization borrows from creditors. profitability. extracted from the “Balance Sheet Analysis”. i) Measure of Leverage The widely known fact of profit maximization in corporate finance puts responsibility on the finance manager of every business organization to make efforts for stockholder wealth . Whereas the size of the firm. DETERMINANTS OF CAPITAL STRUCTURE For continuing its operations every Business enterprise whether big. Moreover.

an efficient manager can effectively maximize the value of the firm. iii) Growth opportunities Different researchers have used different tools for measuring growth opportunities. On the other hand research claims that firm size and leverage are negatively related. What causes the firms with more growth opportunities to be less intended towards external financing? The reason behind this phenomenon is a generally accepted perception that the firms having enough resources to meet their operation have no logical grounds to borrow from creditors. a manager can turn this goal into reality.1988) and (Kim – Sorensen. for example Rajan and Zingales (1995).It has to rely on a mix of debt and equity. larger firms are less inclined to bankruptcy (Titman and Wessels 1988) and this implies the less probability of bankruptcy and lower bankruptcy costs. One theory suggest that firms having high growth opportunities tend to have less leverage because they have stronger incentives to avoid under. An optimal level of leverage is determined by the tradeoff between the costs and benefits of debt and equity financing. and Friend and Lang (1988) and theories try to draw the picture of this relation. Further. (Titman – Wessels. Many researcher. 1986) . Our scale for measurement of growth is percentage increase in total assets. Only after encountering a series of tough spots and quick decision making. ii) Size Two contradictory theories exist in literatures that relate firm size to its leverage. 1986). In other words.maximization. Huang and Song (2002). There are also two different approaches to analyze the relationship between growth opportunities and leverage.investment and asset substitution that can arise from stockholder-bondholder agency conflicts (Drobetz and Fix 2003). have easy access to the capital market. The prime benefit of leverage is the saved cash generated because of the debt-tax shield. By achieving this goal. often referred to as leverage in literature. bankruptcy cost theory is one of them and all of these depict that there is a positive relation between the capital structure and size of a firm. firms with high growth opportunities tend to keep their debt ratios at low levels. This attitude also preserves their credit capacity for difficult times. The large firms are more diversified (Remmers and others 1974). receive higher credit ratings for debt issues. for this purpose. and pay lower interest rate on debt capital (Pinches and Mingo 1973). (Kester. . None of the organization has all of the resources to carry on its operations .

ceteris paribus. This ratio of higher fixed assets serves creditors as guarantee of repayment. Those firms with fewer fixed assets are more likely to depend upon external financing. Hence highly profitable firm relies on internal financing than external debt financing. In our study profitability is calculated by dividing net income by total sales. One school of thought claims that there is a direct relation between leverage and tangibility. Other set of opinions drives another relation which claims that tangibility and leverage are negatively related. putting assets as collateral is one of them. Contradictorily. it prefers debt financing to equity financing (Myers 1984). An increase in assets of the firm results in an increase in debt financing. Some studies specify a positive relation and emphasize on perception that firm having enough internal funds prefer internal financing rather than external debt financing because debt financing consist of some risk factor. Gonedes and others (1988) show the negative relation between the level of debt in capital structure and profitability. . a greater reliance on external financing through the preferred source of debt. and hence they are more oriented towards committing their assets. Friend and Lang (1988). iv) Profitability Profitable firms face less risk as compared to less profitable ones. v) Tangibility The process of borrowing also imposes some limitations. in case of business borrowing. Friend and Hasbrouck (1988). If the internal funds are not enough to fulfill financial requirements of the firm. and. firms with higher fixed assets have higher choices of debt financing. Research suggests that there are two totally different points of view regarding this relationship.But the other side of picture represents another perception which states that a higher growth rate implies a higher demand for funds. research work of Titman and Wessels (1988). When we take into account the relationship between tangibility and leverage two viewpoints prevail. Kester (1986). So as per the previous studies and theories on capital structure there is a relation between firm’s profitability and leverage. Likewise.

For example Fama and French (1998) declare that debt has no net tax benefits.. 1986). vi) Tax The empirical analysis on determinates of capital structure has also shed some light on the impact of tax on corporate capital structure. Constant Coefficient Model. Therefore the equation for our regression model will be: LG = ß0 + ß1 (R) + ß2 (GT) + ß3 (SZ) + ß4 (TX) + ß5 (TG) + ß6 (V) + e Where LG = Leverage R= Return on Assets . ECONOMETRIC MODEL Pooled regression analysis. however. 1984) and (Titman – Wessels. is employed to regress the leverage on those theoretical tentative factors. (Huang – Song. Trade-off theory says that organization with higher tax rate should use more debt in order to get benefit from it. but little support has been found in empirical analysis. As MacKie-Mason (1990. p. Any unexpected change in earnings can drastically affect a company’s financial security. The cross section company data and time series data are pooled together in a single column assuming that there is no significant cross section or inter temporal effects. On the other hand ‘agency cost theory’ and (Kim Sorensen. ‘Pecking order theory’ estimates a negative relation between leverage and volatility of earnings.” vii) Volatility Business without risk is unheard of. 1471) claims: “Nearly everyone believes taxes must be important to financing decision. this inherited amount of risk increases many folds when a firm incurs a very high ratio of debt. some researchers are also of reverse attitude regarding tax impact on debt ratio. Same relationship between leverage and volatility is found by (Bradley et al.We have calculated tangibility with the division of fixed assets by total assets. 1988). 2002) herald a positive relation between leverage and earning volatility. Conversely. ignoring the time and cross-sectional influences.

049331 0. 0.161962 2. Regression Model results Variable C RETURN GROWTH SIZE TAX TANGIB EARNVOLITILITY Coefficient Std. this means that choice of capital structure is mainly defined by these six variables.111536 0.161472 0.151381 5.105871 -0. of six proposed variables statistically define the leverage.581688 -0. only two variables. Both size and growth have significant positive relationship with leverage.011514 -0. So.82E-10 Weighted Statistics R-squared 0.870352 -1.233396 -1.039582 0.326237 Prob. The model explains almost 87% of variation in leverage. could not support first.1615 0. Table1. more definitely by two variable. Error 0. third. with significant F-statistic.1 Regression Model Results Table presents the results of pooled regression analysis.growth and size. Table 2 shows the results of hypothesis that we tested.213526 -1.0644 0. fifth and sixth hypothesis.GT = Growth SZ = Firm Size TX= Tax TG = Tangibility of assets V= Earnings Volatility e = the error term 4.0131 0.187624 0. in which GLS method is employed to eliminate the heteroscedasticity due to panel data.674706 -0.845664 0.410527 -0.044157 0.525921 2.0088 0.size and growth.8159 0.7449 -1.690499 . Results are in favor of second and fourth hypothesis.58E-10 t-Statistic -1.2480 0.897079 Mean dependent var 0.

E. Tax Earning Volatility 1- Observed relationship Positive Negative Positive Positive1 Negative Negative Positive Positive1 Tax rate Deviation from mean Negative Negative Negative Negative significant at 1% level.559175 Unweighted Statistics R-squared Sum squared resid 0.542104 Mean dependent var Durbin-Watson stat 0. The highest correlation is positive 60% between size and return.81785 0. .D. second highest is negative 44% between tax and tangibility. dependent var Sum squared resid Durbin-Watson stat 0.Adjusted R-squared S.2 Multicollinearity To check for presence of multicollinearity between explanatory variables. of regression F-statistic Prob(F-statistic) 0.000000 S.551383 1. Expected and Observed Relationship Expected Determinant Measure (proxy) relationship with leverage Size Return Tangibility Log of Sales NI/Total Assets Total Gross Fixed Assets/Total Assets Growth Annual Percentage Change in Total Assets. 4. spearman’s correlation between them is given below in Table 3.117791 30.373594 1.867970 0.324171 1.787267 1.450217 Table 2.

097219 0.000000 0. lesser the chance of their bankruptcies.302071 -0.417643 -0.000000 -0. This confirms our earlier hypothesis about growth opportunities.124112 0. The results are not consistent with Pecking Order Theory as supported by Rajan and Zingales (1995) view of less asymmetric information about large firms suggesting that new equity issues will not be underpriced and thus large firms will issue more equity.050489 0.441886 1.124112 -0. leverage. The results are not only in favor our hypothesis but also reject any significant relationship between leverage and profitability.007831 0.111. Table 1) but it is statistically insignificant. The results of the Food and Personal Care Industry confirms The static Trade off approach supported by Shah and Hijazi (2005).304575 -0.007831 1.205740 0.005689 0. .187624.000000 0. However the negative direction favors our hypothesis but it is not precise.493243 0.121400 1.304575 -0. higher their credit rating.092510 -0.072001 0. One possible reason for this is: in order to grow in the sector. Friend and Lang( 1988). which a growing firm may not be able to meet through internal sources only and therefore they have to rely on debt.097219 0.493243 -0.302071 -0. Titman and Wessels (1988).000000 0. The size of the firms is positively correlated with leverage (ß3 =-0.072001 -0.092510 -0. huge cash flows are needed. lesser they cost of borrowing and ultimately higher their leverage ratio.611832 1.000000 -0.This suggests that growing firms in the Pakistani Food and Personal care industry use more debt than equity to finance the new projects. Correlation Matrix of Independent Variables LEVERAGE LEVERAGE GROWTH TANGIB TAX RETURN SIZE GROWTH TANGIB TAX RETURN SIZE 1. Pinches and Mingo ( 1973) that larger the firms.e.441886 -0.050489 1.417643 -0.005689 -0. On the other hand Shah and Hijazi (2005) found a negative relationship. The growth of firms is positively correlated with leverage(ß2 =0.205740 -0.611832 -0. This suggests that leverage does not depend upon profitability of firm.000000 4.10.121400 -0.3 Discussion Profitability/return is negatively correlated with leverage (ß1 =-0. Table 1).Table 3. The sign of the coefficient confirms the direction of our relationship of size with the degree of indebtedness i. Table 1).

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