Determinants of Capital Structure: Evidence from Pakistani Firm’s

By Syed Ali Danish Bukhari Fa10-Mba-004 E.mail:

January 2012

Profitability. short term debt. Leverage. Thus we can say every company’s financial decisions rest on the decision of capital structure. project expansion and starting. We used tangibility. We used leverage in accordance with previous researches as dependent variable because it leads to least cost of capital that is the basis of optimal capital structure. Capital structure is defined as a mix of long term debt.Determinants of Capital Structure: Evidence from Pakistani Firm’s Abstract: We tried to found out the factors which have a role a determination of optimal capital structure. dividend policies and merger decisioins. These decisions include portfolio investment. Our research was backed by the tradeoff theory and pecking order theory and model used to measure the variables is fixed effect model. According to the research paper we used as a model paper. common and preferred stock. the result was that tangibility and profitability were negatively related to debt ratio and size proved to be insignificant at 5 percent level. it’s basic to understand that what capital structure is.The . profitability and size as independent variable and then apply regression to find their relationship. Key words: Capital Structure. Tangibility. Decisioning regarding Capital structure is most critical in any company because it has direct influence on other financial decisions. Size Field of research: Finance Introduction: In order to understand the determinants of capital structure.

After that much research has been done in this area following the footsteps of Miller and Modigliani.goal behind every financial decision is to maximize shareholders value by lowering coast of capital. the capital structure of a company has nothing to do with the value of a company i.e. This creates a situation that whether the results acquired from the research in developing countries are applicable in developing countries as well. One drawback of these researches is that most researchers have done their research on capital structure of developed countries and very few have been done in developing countries. According to the factors affecting emerging economies and those of developed countries have some common characteristics. 1958). 1963) accounted for the impact of taxes on firm’s value and capital structure and found that debt financing proves to be cheaper than equity financing because of the tax shield benefits that arises through the use of debt financing. F. According to (Modigliani. Later (Modigliani & Miller. & Miller. This leads us to the trade-off theory which means that benefit from the use of debt financing is limited up to the optimal level and after that various costs declines the benefits of using debt financing. Thus it is necessary for a researcher to assist in finding the right mix of debt financing and equity financing in order to find an optimal capital structure at which there is lest coast of capital. Thus in order to acquire . any mix of debt and equity financing does not increase or decrease firm’s value. It is the assets that create the value of firm irrespective of their acquisition through debt or equity.H. Miller and Modigliani were the first researchers who conducted ground breaking research on capital structure in 1958. However this is subject to perfect capital market. Similarly are the factors affecting the capital structure in developing countries are the same as in developing countries. M.

2002). 2002. Our study of research will then be to looking the determinants of debt adjustment that will lead to optimal debt level at which cost of capital is least as in accordance with (Rajan and Zingales. One of these theories is trade-off theory according to which optimal debt adjustment is affected by the taxes. 1975. the cost of debt financing becomes more than the tax shield benefit. Another theory provided against MM theory is agency theory. Literature Review: The very first research article written on capital structure was by Modigliani and Miller (1958). Fama and French. The rest of the research article is organized as follows: Section 2 summarizes the literature related to past researches in this regard. Taggart. Ang. When the debt financing exceeds ascertain level. Section 3 defines the data and methodology. (Lev and Pekelman. cost of distress and bankruptcy cost. 1977. 1984). As there is no existence of perfect conditions thus this leads to generation of more theories.Accodeing to agency theory an optimal debt level can be achieved by reducing the agency cost of a optimal capital structure one has to look an optimal debt level or ratio that minimizes the cost of capital. One of these techniques according to Jensen and Meckling (1976) is to . This also increases bankruptcy cost as more and more debt is applied the debt providers will demand higher rate of return due to increased uncertainty of debt repayment Baxter (1967). 1995. DeAngelo and Masulis (1980) provided more insight on the model of Modigliani and Miller and included tax advantages and other non cash advantages such as depreciation charges and founded that every firm has internal optimal capital structure.According to them there is no relationship between firm’s value and capital structure mix provided that there is perfect capital market in which there is no transaction cost no taxes and no bankruptcy cost. Baker and Wurgler. To pursue this. various techniques are applied. Jalilvand and Harris. 1976.

In contrast to trade-off theory.According to them debt usage in capital structure is better because in many cases mangers don’t provide right information to owners and sometimes also hide the information related to liquidation of firm. it disperse a good news to the market that company financial health is good that it can generate cash flows to cater the debt cost which is interest payment and principle amount payment. there is pecking order theory according to which information level about the firm’s position is different of management and outsiders Myers and Majluf (1984) When firms acquire more debt financing and issue debt. Increasing the debt financing part will empower the bondholders as they will more in-depth understanding of the firm’s inner matters and can take over firm in case of default.provide more ownership to the managers of a firm so that their obligation will become more directed towards achieving owner’s goals as their land owner’s goals will be aligned. . 1982). Amihud and Lev (1981) also state that managers want to ensure their employment by reducing the unemployment risk and thus want to go for their own interest only. They do so because they want to prolong their employment and receive remuneration from the firm. Debt usage in firm is supported by Harris and Reviv (1990). Another method is to use more of debt financing which will decrease equity part of capital structure and this intern will increase the ownership of managers thus again aligning their interest to the interest of the owners of the company. Agency cost can also be reduced by using more debt financing which increases bankruptcy chances and hence managers will be more cautious to reduce the risk and fear of job loss will demand them to increase their efforts and less consumption of firm’s resources (Grossman and Hart. Thus it increases the firm’s value by increasing the confidence level of investors Ross (1977).

Thornhill et al. 2009) H1: A firm with higher percentage of fixed assets will have higher debt ratio . 2004. Rajan and Zingales 1995). 1988). 2009).. they can be used as collateral.2009) Tangibility of Asset (TG): The trade-off theory suggests a positive relationship between tangibility and leverage. Firm size are small and they can’t guarantee long-term debt therefore large part of debt in Pakistan is short term debt as same case goes with developing countries (Arko. The reason is the difference between the maturity level of fixed assets and short term debt financing (Acaravcı. Mostly debt financing comes through commercial banks.We are taking here the total value do debt in Book value of debt because in we will take data from Pakistani firms and Pakistani firms mostly take short term debt financing.Thus after going through various articles we are able to determine the variables for this research which are leverage as our dependent variable and tangibility. (Harris and Raviv. 2004. we will use ratio of total fixed asset to total asset ratio. Williamson.e. 2006).. Myers. 1977. Myers and Majluf. size and profitability as independent variables Leverage: Debt to total asset ratio is used to measure the leverage of firm (Bokpin and Arko. 1984.In contrast to this pecking order theory showed negative relationship between the two variables. Sayılgan et al.In order to measure the tangibility of asset. The reason is that more number of fixed assets can be used as a security for obtaining more debt i. 1991. Different researches used book value or market value methods for determining leverage (Titman and Wessels 1988.Net amount of fixed assets means that depreciation in subtracted from cost to come at net amount of fixed assets (Erdinc Karadeniz & Onal.

Antoniou et al. 2009). The pecking order theory shows a negative relationship between the two variables (Rajan and Zingales. 1984. 2005. Allen. 1999). (Benito. Tong and Green. 2003. 1992.According to trade-off theory more profitability leads to more ability of obtaining debt and pecking order argues that more profitable firms use more of internal financing rather than debt financing.The reason is asymmetry of information in large firms is less severe. Qian et al. 1984. Barton and Gordon. 2002.Emperical results show negative relationship (Acaravcı. Wiwattanakantang. Sayılgan et al. Krasker... Zou and Xiao. 2006. Profitability (P) In the case of profitability. 2002.. Sayılgan et al. Narayanan. Huang and Song. 2006. Myers. 2009). Huang and Song. Chen. Homaifar et al. Gaud et al. H2: There is negative relationship between size and leverage of the firm.. Pandey. 1991. Wiwattanakantang. Pandey. Qian et al. 2006).We will apply log of total assets to better compare variance among all the values of sales (Joshua Abor. Bevan and Danbolt. (Ang. 2007. 2004. 2004..Size (S) In trade-off theory again there is a positive relationship between the firm size and the leverage. Myers and Majluf. 2002. 1994. 2005. However empirical studies have shown positive relationship (Dalbor and Upneja. 2006. the pecking order theory and trade-off theory again shows opposite results. . 1988.The reason is large size of firm allow them to diversify which reduces the bankruptcy cost which help to gain more leverage. Pecking order theory shows a negative relationship and trade-off theory shows a positive relationship between profitability and leverage. 2006). 1986.. 2004. 2004. 1999) while some studies show insignificant relationship Tang and Jang (2007)In order to measure the profitability of the firm we will use the ratio of profitability (Joshua Abor. 2007). 1988.. 1995.

We excluded all firms in financial sector as the capital structure of these firms is not comparable to capital structures of firms in non financial sector. Therefore we excluded all banks. insurance companies and investment companies and other financial institutions.H3: Firms with higher profitability will have lesser leverage Independent Variable Dependent Variable Data & Methodology • The research is based on data extracted from publications of State Bank of Pakistan which include financial statement analysis and provides important information regarding financial accounts of listed companies on Karachi Stock Exchange. State Bank of .

Pakistan publications ‘Financial statement analysis of Non financial sector 2006-2010’ is used for data extraction related to research. Model to be used in this research is the fixed effect model and variables are defined in this model as ∆ LV = β1 + β2∆Tg + β3∆S + β4∆P + µ Where LV T S P µ = Leverage = Tangibility = Size = Profitability =Error term .

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