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Excutive summary :



Capital structure theory is one of the most puzzling issues in the corporate finance literature.
Numerous empirical studies have shown that announcements of seasoned equity offerings (SEOs) cause negative price reactions, whereas the news of an additional debt issue is followed by an increase in stock prices. The majority of these studies use capital structure arguments emphasizing the importance of tax shield benefits from debt financing, as the explanation for this phenomenon. In this paper we investigate whether differences in tax regimes, in the relative size of the issues, the pre -offer debt-to-equity ratio, the underlying property type and operational performance can account for the price reactions to issue announcements that occurred in various European property share markets over the last decade. The idea to test whether tax arguments can account for market reactions to the news of security issues by investigating tax-exempt companies is not novel. Howe and Shilling (1988) investigated the stock price reactions to the announcements of new security issues, both debt and equity, of tax-exempt Real Estate Investment Trusts (REITs). They found both the classical positive price reaction on debt issue announcements and the negative price reaction on equity issues. Documenting these typical price reactions in the absence of corporate taxation caused them to attribute these market reactions to the alternative negative signaling explanations. Ghosh, Nag and Sirmans (1999, 2000) repeated this effort by investigating a larger and more recent REIT -sample and reported results that corroborate with those of Howe and Shilling. But although the issue has been analyzed frequently over the years, some of the most fundamental questions on the cause of price reactions remain unanswered.

Capital structure is essential for a firm as a high proportion of debt or a high proportion

of equity may lead to low performance and low growth. In developing countries such as India, financing is a major concern due to asymmetric information (external financing) and having low internal financing. So the options for capital structure are few and far between as compared to developed countries. The policies of government affect the interest charged on debt and other modes of external financing. In addition to this, cultural differences also affect the development of economy. The studies of Singh and Hamid (1992) and Singh (1995) show contrasting results, they argue that developing countries rely heavily on external financing in capital structure. It

was also found that firms in developing countries prefer debt financing which seems a bit striking, as the stock markets are not that well developed to rely heavily on. Many researchers have analyzed capital structure for the past fifty years with the first notable work done by Miller and Modigliani in 1958. A number of researchers reached to the conclusion that capital structure as common roots in different environments (countries) but further study is required to identify the factors that affect capital structure positively or negatively in a certain environment. In current studied an attempt is being made to explore the determinants of capital structure in . The textile sector has been considered due to the fact that it is the largest sector in the country.

The capital structure refers to the way that a firm finances its assets through some

combination of financing sources. The first choice is internal financing which is the using of profit or retained earnings as a source of capital for new investment. The second choice is external financing which is the usage of new money, such as equity, debt, hybrid securities, from outside of the firm brought in for investment. Based on different kinds of financial decisions, the capital structures of firms could be shaped differently. Eventually, it is an important issue for managers how to minimize financial costs and maximize shareholders equity. The Modigliani-Miller theorem (Modigliani and Miller, 1958), the first relevant theory of capital structure, states that the value of a firm is irrelevant to how that firm is financed in a perfect market. However, the real world reflects the firms value is relevant with its bankruptcy costs, agency costs, taxes, information asymmetry and so on. That is why a firms value is affected by the capital structure it employs.

Therefore, since Modigliani and Millers irrelevance proposition, researchers have

investigated firms decisions about how to finance their operations. Based on the practical contradiction of the Modigliani-Miller theorem, two traditional theories of capital structure, the trade-off theory and the pecking order theory, are developed. The trade-off theory considers that firms have a target capital structure that is determined by the marginal benefits of debt, for example, tax advantage of debt and costs associated with debt, such as bankruptcy costs and agency costs (Jensen and Meckling, 1976; Myers, 1977). In other words, trade-off theory implies that firms adjust their capital structure in response to the temporary shocks that cause their leverage to deviate from the target. The pecking order theory is based on asymmetric information (Myers and Majluf, 1984; Myers, 1984), when a manager makes financial decisions by external funds, investors would see this behavior as the firm is overvalued. Therefore, investors tend to sell their stocks and the value of the firm will fall. For this reason, firms follow a financing hierarchy; descends from internal funds, to debt and finally to external equity. Recently, a new theory, the market timing theory of capital structure which was first introduced

by Baker and Wurgler (2002), develops a different kind of view about capital structure. The market timing theory suggests that managers are able to identify certain time periods during which equity issuance is less costly due to the high valuation of companys stock. It means, firms are more likely to issue equity when their market values are high, relative to book and post market values and to repurchase equity when their market values are low. As a consequence, current capital structure is strongly related to historical market values. This result provides the theory that capital structure is the cumulative outcome of past attempts to time the equity market. However, Hovakimian (2005), Flannery and Rangan (2006), Alti (2006) and Kayhan and Titman (2007) disagree with Baker and Wurgler on the persistence of the effect on capital structure because the importance of historical average market-to-book ratios in leverage regressions does not influence the past equity market timing. Kayhan and Titman (2007) make the point that the significance of the historical market-to-book series in leverage regressions may be due to the noise in the current market-to-book ratio. Specifically, Kayhan and Titman decompose the external finance weighted average market-to-book ratio into the mean market-to book ratio, the covariance between the market-to-book ratio, and the financing deficit. They show that the persistence result of Baker and Wurgler is mainly driven by the persistence of the average market-to-book ratio rather than the covariance between the market-to-book ratio and the financing deficit. In finance, capital structure refers to the way a firm finances its assets through some combination of sources. Based on many kinds of financial decisions, firms could shape different capital structures. Data of previous studies are from the United States, G7 or Dutch firms. According to most of the findings, firms from all countries rebalance their leverage in response to the temporary shocks. These results are more in line with the dynamic trade-off theory rather than the equity market timing or pecking order hypothesis of capital structure. In our study, we tend to examine financing behaviours in the advanced and highincome economies in Asia region and compare the results of G7. We select the samples including Four Asian Tigers and Japan. These regions were noted for maintaining high growth rates and rapid industrialization between the early 1960s and 1990s. The value of a firm depends upon its expected earnings stream and the rate used to discount earnings stream is the firms required rate of return or the cost of capital.Thus the capital structure decision can affect the value of the firm either by changing the expected earnings or the cost of capital or both.Leverage cannot change the total expected earnings of the firm, but it can affect the residual earnings of the shareholders.The effect of leverage on cost of capital is not very clear.Conflicting opinions have been expressed on this issue.In fact, this issue is the most contentious area in the theory of finance, and perhaps more theoretical and empirical work

has been done on this subject than any other. Raising of funds to finances the firms investments is an important function of the financial manager. In practice, it is observed that financial managers use different combinations of dedt and equity. A practical question therefore is : What motivates them to do so? More fundamental questions to be answered are: (1)Does use of debit create a value?(2) If so, do firms gravitate towards an optimum mix of debt and equity? In theory, it is argued that the financing decision is irrelevant under perfect capital markets. When, within the framework of perfect capital markets, taxes and bankruptcy costs are assumed, the financial economists argue that an optimum capital structure, which maximizes the market value of the firm( or minimizes cost of capital), can exist .Firms in developing countries like India, are found following different financing policies-some aggressive and some conservative. One needs to investigate into the causes of this behavior. We would refer to two Indian studies on the relationship between the cost of capital and the capital structure. Sarma and Rao (1968) following Modigliani and Millers (M-Ms) 1966 article, employed a two-stage least square method on the data of 30 Indian engineering firms for three years. In their estimates, the leverage variable had a coefficient greater than the tax rate. Thus, agreeing with the traditional view, they concluded that the cost of capital is affected by debt apart from its tax advantages.

Literature Review

Over the years numerous studies on capital structure theory have appeared. Modigliani and
Miller (1958) were the first who theorized the issue by posing their M&M capital structure irrelevance proposition. By stating the circumstances under which capital structure does not influence firm value, the authors isolate factors that can explain why daily observations of reality prove the opposite. In a comment that followed five years later Modigliani and Miller (1963) showed how the relaxation of one of their crucial initial assumptions, the absence of corporate taxation, could attribute to the understanding of empirical findings, which typically exhibit negative price reactions on equity offering announcements. These two classical publications triggered a stream of studies and hypotheses over time, which contributed to the clarification of the capital structure puzzle

A) Capital Structure Theories. Modigliani-millers theorem:

The Modigliani-Millers theorem

(Modigliani and Miller, 1958) is the first relevant theory of

capital structure. They assume that a perfect capital market has no transaction or bankruptcy costs and people receive perfect information. However, the real world reflects the firms value is relevant with its bankruptcy costs, agency costs, taxes, information asymmetry and so on. That is why a firms value is affected by the capital structure it employs. For this reason, since Modigliani and Millers irrelevance proposition, researchers have investigated firms decisions about how to finance their operations. Two traditional theories of capital structure, the trade-off theory and the pecking order theory, are developed. These theories guide most of the capital structure studies. The modern theory of capital structure was established by Modigliani and Miller (1958). Thirty-seven years later, Rajan and Zingales (1995, p. 1421) stated: Theory has clearly made some progress on the subject. We now understand the most important departures from the Modigliani and Miller assumptions that make capital structure relevant to a firms value. However, very little is known about the empirical relevance of the different theories. Similarly, Harris and Raviv (1991, p. 299) in their survey of capital structure theories claimed: The models surveyed have identified a large number of potential determinants of capital structure. The empirical work so far has not, however, sorted out which of these are important in various contexts. Thus, several conditional theories of capital structure exist (none is universal), but very little is known about their empirical relevance

a) Trade-off theory:

The trade-off theory refers to the idea that a firm chooses how much debt finance and how
much equity finance to use by balancing the costs and benefits. An important purpose of the theory is to explain the fact that firms usually are financed partly with debt and partly with equity. The marginal benefit of further increases in debt declines as debt increases, while the marginal cost increases, so that a firm that is optimizing its overall value will focus on this trade-off when choosing how much debt and equity to use for financing. Under the tradeoff theory, deviations from target capital structure are only temporary. In a dynamic setting, firms make financing choices to adjust the debt ratio to the long-term optimum which implies that no systematic relation between debt ratio and the firms investment opportunities is predicted. However, if costs of financial distress varies across firms, a cross sectional variation in optimum capital structure is expected. For example, high-growth firms that are more sensitive to fluctuations in business outlook and are therefore more vulnerable due to the costs of financial distress, choose to use less debt financing. Highly profitable firms, on

the other hand, can risk higher debt ratios. The findings in Smith and Watts (1992) and Barclay, Morellec, and Smith (2001) are consistent with this notion.

The term trade-off theory is used by different authors to describe a family of related theories. In all of these theories, a decision maker running a firm evaluates the various costs and benefits of alternative leverage plans. Often it is assumed that an interior solution is obtained so that marginal costs and marginal benefits are balanced. The original version of the trade-off theory grew out of the debate over the Modigliani-Miller theorem. When corporate income tax was added to the original irrelevance, this created a benefit for debt in that it served to shield earnings from taxes. Since the firm's objective function is linear, and there is no offsetting cost of debt, this implied 100% debt financing. Several aspects of Myers' definition of the trade-off merit discussion. First, the target is not directly observable. It may be imputed from evidence, but that depends on adding a structure. Different papers add that structure in different ways. Second, the tax code is much more complex than that assumed by the theory. Depending on which features of the tax code are included, different conclusions regarding the target can be reached. Graham (2003) provides a useful review of the literature on the tax effects. Third, bankruptcy costs must be deadweight costs rather than transfers from one claimant to another. The nature of these costs is important too. Haugen and Senbet (1978) provide a useful discussion of bankruptcy costs. Fourth, transaction costs must take a specific form for the analysis to work. For the adjustment to be gradual rather than abrupt, the marginal cost of adjusting must increase when the adjustment is larger. Leary and Roberts (2005) describe the implications of alternative adjustment cost assumptions. This theory has static and dynamic versions as follows.

The static trade-off theory:

The static trade-off theory affirms that firms have optimal capital structures, which they
determine by trading off the costs against the benefits of the use of debt and equity. One of the benefits of the use of debt is the advantage of a debt tax shield. One of the disadvantages of debt is the cost of potential financial distress, especially when the firm relies on too much debt. Already, this leads to a trade-off between the tax benefit and the disadvantage of higher risk of financial distress. But there are more cost and benefits involved with the use of debt and equity. One other major cost factor consists of agency costs. Agency costs stem from conflicts of interest between the different stakeholders of the firm and because of ex post asymmetric information (Jensen and Meckling (1976) and Jensen (1986)). Hence, incorporating agency costs into the static trade-off theory means that a firm determines its capital structure by trading off the tax

advantage of debt against the costs of financial distress of too much debt and the agency costs of debt against the agency cost of equity. Many other cost factors have been suggested under the trade-off theory, and it would lead to far to discuss them all. Therefore, this discussion ends with the assertion that an important prediction of the static trade-off theory is that firms target their capital structures, i.e. if the actual leverage ratio deviates from the optimal one, the firm will adapt its financing behaviour in a way that brings the leverage ratio back to the optimal level. Modigliani and Miller (1963) argue that a firm would raise its value by financing debt because of a debt tax shield. However, one of the disadvantages of debt is the cost of potential financial distress, especially when the firm relies on too much debt. In static trade-off theory (Myers, 1977), the agency costs of financial distress and the tax deductibility of debt finance generate an optimal capital structure. Therefore, firms capital structures are optimal when they determine by comparison off the costs against the benefits of the use of debt and equity. The costs of monitoring or solving agent problems are defined as agent costs. Incorporating agency costs into the static trade-off theory means that a firm determines its capital structure by trading off the tax advantage of debt against the costs of financial distress of too much debt and the agency costs of debt against the agency cost of equity (Jensen and Meckling, 1976; Jensen, 1986).

Dynamic trade-off theory:

The dynamic trade-off theory has been proposed by Fischer et al. (1989). They argue a model
of dynamic Optimal capital structure choice in the presence of recapitalization costs. This implies the firms capital structures may not always coincide with their target leverage ratios. In a dynamic model, the correct financing decision typically depends on the financing margin that the firm anticipates in the next period. Gradually, the capital structure will approach the optimal target. The firm undertakes capital structure adjustments when leverage reaches either of the two boundaries defining the range. The levels of the boundaries vary cross-sectional with firm characteristics such as the volatility of cash flows, the profitability of assets, interest rates and bankruptcy costs. The type of adjustment cost determines how much the firm adjusts their capital structure. An important precursor to modern dynamic trade-off theories was Stiglitz (1973), who examines the effects of taxation from a public finance perspective. Stiglitz's model is not a trade-off theory since he took the drastic step of assuming away uncertainty. The first dynamic models to consider the tax savings versus bankruptcy cost trade-off are Kane etal. (1984) and Brennan and Schwartz (1984). Both analyzed continuous time models with uncertainty, taxes, and bankruptcy costs, but no transaction costs. Since firms react to adverse

shocks immediately by rebalancing costlessly, firms maintain high levels of debt to take advantage of the tax savings. Dynamic trade-off models can also be used to consider the option values embedded in deferring leverage decisions to the next period. Goldstein et al. (2001) observe that a firm with low leverage today has the subsequent option to increase leverage. Under their assumptions, the option to increase leverage in the future serves to reduce the otherwise optimal level of leverage today. Strebulaev (2007) analyzed a model quite similar to that of Fischer et al. (1989) and Goldstein et al. (2001). Again, if firms optimally finance only periodically because of transaction costs, then the debt ratios of most firms will deviate from the optimum most of the time. In the model, the firm's leverage responds less to short-run equity fluctuations and more to long-run value changes.

b) Pecking order theory:


(1984) and Myers and Majluf (1984) set the viewpoint of adverse selection into

pecking order theory. The key idea is that the owner-manager of the firm knows the true value of the firm's assets and growth opportunities. Outside investors can only guess these values. If the manager offers to sell equity, then the outside investor must ask why the manager is willing to do so. In many cases, the manager of an overvalued firm will be willing to sell equity, while the manager of an undervalued firm will not. Therefore, when managers issue equity instead of riskless debt, outside investors rationally discount the firms stock price. To avoid this discount, managers will follow a pecking order theory of finance. This theory maintains that businesses adhere to a hierarchy of financing sources and prefer internal financing (that is, retained earnings and excess liquid assets or slack) when available and debt is preferred over equity if external financing is required. Shyam-Sunder and Myers (1999) assess the non-nested capital structure models by Hsu and Hsu 6529 examining debt financing patterns through time. They show that, under the pecking order theory, a regression of debt financing on the firm's deficitof-funds, that is, real investment and dividend commitments less internal funds should yield a slope coefficient close to unity. Fama and French (2005) find firms issue or retire equity each year and the issues are on average large and not typically done by firms under duress. The pecking order theory does not take an optimal capital structure as a starting point, but instead asserts the empirical fact208 that firms show a distinct preference for using internal finance (as retained earnings or excess liquid assets) over external finance. If internal funds are not enough to finance investment opportunities, firms may or may not acquire external financing, and if they

do, they will choose among the different external finance sources in such a way as to minimise additional costs of asymmetric information. The latter costs basically reflect the lemon premium(Akerlof, 1970) that outside investors ask for the risk of failure for the average firm in the market. The resulting pecking order of financing is as follows: internally generated funds first, followed by respectively low-risk debt financing and share financing. In Myers and Majluf model (1984), outside investors rationally discount the firm's stock price when managers issue equity instead of riskless debt. To avoid this discount, managers avoid equity whenever possible. The Myers and Majluf model predicts that managers will follow a pecking order, using up internal funds first, then using up risky debt, and finally resorting to equity. In the absence of investment opportunities, firms retain profits and build up financial slack to avoid having to raise external finance in the future.
Fama and French (2002) present a comprehensive analysis of the complementary and contrasting implications of the tradeoff and pecking order theories for both dividend payout and leverage ratios. They identify profitability and investments and the interaction thereof as the key determinants of financing and dividend decisions. Consistent with both trade off and dynamic pecking order theories, they find firms with more investments are less levered. Next, their finding that more profitable firms have less leverage supports the pecking order, and contradicts the trade off story. Further support for the pecking order theory draws from the evidence that for dividend paying firms, short-term variation in investment and earnings is mostly absorbed by debt.


Market timing theory

The market timing theory of capital structure argues that firms time their equity issues in the
sense that they issue new stock when the stock price is perceived to be overvalued, and buy back own shares when there is undervaluation. Consequently, fluctuations in stock prices affect firms capital structures. There are two versions of equity market timing that lead to similar capital structure dynamics. The market timing theory is brought up by Baker and Wurgler (2002). They use the market-tobook ratio to measure the market timing opportunities perceived by managers. Otherwise, they construct a historical marketto- book ratio (external finance weighted-average marketto- book ratio, EFWAMB) to capture firms past equity market timing attempts. As claimed by its proponents of the United States between 1968 and 1999, Baker and Wurgler find out that firms prefer external equity when the cost of equity is low, and prefer debt vice versa. Besides, this

market timing of equity issues have long-lasting effects on capital structure. Hovakimian (2005), Flannery and Rangan (2006), Alti (2006), Kayhan and Titman (2007) disagree with Baker and Wurgler on the persistence of the effect on capital structure. Hovakimian (2005) finds that the importance of historical average market-to-book ratios in leverage regressions is not due to past equity market timing. Flannery and Rangan (2006) find strong evidence that non-financial firms identified and pursued target capital ratios during the l966 to 2001 period. Alti (2006) uses a dummy variable called HOT to measure the market timing effect whether the IPO takes place in a hot issue market, characterized by high IPO volume in terms of the number of issuers, or a cold one. According to empirical outcome, he finds that market timing depresses the leverage ratio significantly in the very short run, but also finds that the timing effect on leverage quickly reverses. Kayhan and Titman (2007) examines how cash flows, investment expenditures, and stock price histories affect debt ratios between 1960 and 2003 in the United States. They find that these variables have a substantial influence on changes in capital structure. Specifically, stock price changes and financial deficits (that is, the amount of external capital raises) have strong influences on capital structure changes, but in contrast to previous conclusions, they find that over long horizons their effects arepartially reversed. Bie and Haan (2007) examine market timing and its effects on capital structure for a sample of Dutch listed firms and a sub-sample of Dutch IPO firms. Their result yield evidence of market timing. The stock price run-ups increase the probabilities of equity and dual issues. Further, the effects of stock price run-ups on the choices between issuance of debt, equity or both are consistent with the predictions of the market timing hypothesis. Baker and Wurgler (2002) provide evidence that equity market timing has a persistent effect on the capital structure of the firm. They define a market timing measure, which is a weighted average of external capital needs over the past few years, where the weights used are market to book values of the firm. They find that leverage changes are strongly and positively related to their market timing measure, so they conclude that the capital structure of a firm is the cumulative outcome of past attempts to time the equity market. In summary, while the three theories have several overlapping implications, they also make some predictions that can be useful to infer which one best fits observed capital structure choices. We highlight the aspects of each theory that is unique. The trade off theory predicts a target capital structure that firms regress to in the long run, implying that any relation between capital structure and profitability or investments is transient. Neither the pecking order theory nor the market timing theory identifies an optimum capital structure. For dividend-paying (non dividend-paying) firms, the pecking order theory predicts a long run positive (negative) relation

between market to book value ratio and leverage ratio. The market timing theory leads to a long run positive relation between market to book value ratio and leverage ratio for all classes of firms.

B) Test of Capital Structure Theory

As Harris and Raviv (1991, p. 334) state: Several studies shed light on the specific characteristics
of firms and industries that determine leverage ratios. [...] These studies generally agree that leverage increases with fixed assets, non-debt tax shields, growth opportunities, and firm size and decreases with volatility, advertising expenditures, research and development expenditures bankruptcy probability, profitability and uniqueness of the product. However, the results of both theoretical and empirical studies are not always unambiguous. Based on the data availability, the following determinants of capital structure are analysed in this paper: size, profitability, tangibility, growth opportunities, tax, non-debt tax shields, volatility, and industry classification.
a) Size:-

From the theoretical point of view, the effect of size on leverage is ambiguous. As Rajan and Zingales (1995, p. 1451) claim: Larger firms tend to be more diversified and fail less often, so size (computed as the logarithm of net sales) may be an inverse proxy for the probability of bankruptcy. If so, size should have a positive impact on the supply debt. However, size may also be a proxy for the information outside investors have, which should increase their preference for equity relative to debt. Also empirical studies do not provide us with clear information. Some authors find a positive relation between size and leverage, for example Huang and Song (2002), Rajan and Zingales (1995) and Friend and Lang (1988). On the other hand, some studies report a negative relation, for example (Kester, 1986), (Kim Sorensen, 1986) and (Titman Wessels, 1988). Moreover, the results are very often weak as far as the level of statistical significance is concerned.To proxy for the size of a company, the natural logarithm of sales is used in this study (as it is in most studies of similar character). Another possibility is to proxy the size of a company by the natural logarithm of total assets. In this study there is a high correlation between the natural logarithm of total assets and the natural logarithm of sales (0.68 in 2000, 0.70 in 2001), therefore the use of the natural logarithm of total assets as a proxy variable for the size of a company should lead to similar results.

Profitability:There are no consistent theoretical predictions on the effects of profitability on leverage. From the point of view of the trade-off theory, more profitable companies should have higher leverage because they have more income to shield from taxes. The free cash-flow theory would suggest that

more profitable companies should use more debt in order to discipline managers, to induce them to pay out cash instead of spending money on inefficient projects. However, from the point of view of the pecking-order theory, firms prefer internal financing to external. So more profitable companies have a lower need for external financing and therefore should have lower leverage. Most empirical studies observe a negative relationship between leverage and profitability, for example (Rajan Zingales, 1995)8, (Huang Song, 2002), (Booth et al., 2001), (Titman Wessels, 1988), (Friend Lang, 1988) and (Kester, 1986). In this study, profitability is proxied by return on assets (defined as earnings before interest and taxes divided by total assets).
c) Tangibility:-

It is assumed, from the theoretical point of view, that tangible assets can be used as collateral. Therefore higher tangibility lowers the risk of a creditor and increases the value of the assets in the case of bankruptcy. As Booth et al. (2001, p. 101) state: The more tangible the firms assets, the greater its ability to issue secured debt and the less information revealed about future profits. Thus a positive relation between tangibility and leverage is predicted. Several empirical studies confirm this suggestion, such as (Rajan Zingales, 1995), (Friend Lang, 1988) and (Titman Wessels, 1988) find. On the other hand, for example Booth et al. (2001) and Huang and Song (2002) experience a negative relation between tangibility and leverage. In this study, tangibility is defined as tangible assets divided by total assets.
d) Growth Opportunities:-

According to Myers (1977), firms with high future growth opportunities should use more equity financing, because a higher leveraged company is more likely to pass up profitable investment opportunities. As Huang and Song (2002, p. 9) claim: Such an investment effectively transfers wealth from stockholders to debtholders. Therefore a negative relation between growth opportunities and leverage is predicted. As market-to-book ratio is used in order to proxy for growth opportunities, there is one more reason to expect a negative relation as Rajan and Zingales (1995, p. 1455) point out: The theory predicts that firms with high market-to-book ratios have higher costs of financial distress, which is why we expect a negative correlation. Some empirical studies confirm the theoretical prediction, such as (Rajan Zingales, 1995), (Kim Sorensen, 1986) or (Titman Wessels, 1988) report. However, for example, Kester (1986) and Huang and Song (2002) demonstrate a positive relation between growth opportunities and leverage. In this study, the P/B ratio (market-tobook ratio) is used as a proxy for growth opportunities.
e) Tax:-

According to the trade-off theory, a company with a higher tax rate should use more debt and therefore should have higher leverage, because it has more income to shield from taxes. However, for

example Fama and French (1998) declare that debt has no net tax benefits. As MacKie-Mason (1990,p. 1471) claims: Nearly everyone believes taxes must be important to financing decision, but little support has been found in empirical analysis. As he also points out (MacKie-Mason, 1990, p. 1471): This paper provides clear evidence of substantial tax effects on the choice between issuing debt or equity; most studies fail to find significant effects. [...] Other papers miss the fact that most tax shields have a negligible effect on the marginal tax rate for most firms. New predictions are strongly supported by an empirical analysis; the method is to study incremental financing decisions using discrete choice analysis. Previous researchers examined debt-equity ratios, but tests based on incremental decisions should have greater power. As he adds, debt-equity ratios are the cumulative result of years of sepa-rate decisions. Tests based on a single aggregate of different decisions are likely to have low power for effects at the margin. (MacKie-Mason, 1990,p. 1472). However, as data to perform similar analysis as (MacKie-Mason, 1990) is not available in the Czech Republic, the average tax rate defined as the difference between earnings before taxes and earnings after taxes, scaled by earnings before taxes, is used as a proxy variable to analyse the tax effects on leverage in this study. f) Non-debt Tax Shields:Other items apart from interest expenses, which contribute to a decrease in tax payments, are labelled as non-debt tax shields (for example the tax deduction for depreciation). According to Angelo Masulis (1980, p. 21): Ceteris paribus, decreases in allowable investment-related tax shields (e.g., depreciation deductions or investment tax credits) due to changes in the corporate tax code or due to changes in inflation which reduce the real value of tax shields will increase the amount of debt that firms employ. In cross-sectional analysis, firms with lower investment related tax shields (hol-ding before-tax earnings constant) will employ greater debt in their capital structures. So they argue that non-debt tax shields are substitutes for a debt-related tax shield and therefore the relation between non-debt tax shields and leverage should be negative. Some empirical studies confirm the theoretical prediction, for example Kim and Sorensen (1986, p. 140) declare: DEPR9 has a significantly negative coefficient. [...] This is consistent with the notion that depreciation is an effective tax shield, and thus offsets the tax shield benefits of leverage. A negative relation between non-debt tax shields and leverage is also found by (Huang Song, 2002) and (Titman Wessels, 1988). However, for example Bradley et al. (1984) and Chaplinsky and Niehaus (1993) observe a positive relationship between non-debt tax shields and leverage. Depreciation divided by total assets is used in order to proxy for non-debt tax shields in this study.



Volatility may be understood as a proxy for risk of a firm (probability of bankruptcy). Therefore it is assumed that volatility is negatively related to leverage. However, as Huang and Song (2002, p. 9) state based on findings of Hsia (1981): As the variance of the value of the firms assets increases, the systematic risk of equity decreases. So the business risk is expected to be positively related to leverage. The positive relation between volatility and leverage is confirmed by (Kim Sorensen, 1986) and (Huang Song, 2002). Conversely, a negative relation is found by (Bradley et al., 1984) and (Titman Wessels, 1988). In this study, standard deviation of return on assets is used as a proxy for volatility.

h) Industry Classification:Some empirical studies identify a statistically significant relationship between industry classification and leverage, such as (Bradley et al., 1984), (Long Malitz, 1985), and (Kester, 1986). As Harris and Raviv (1991, p. 333) claim, based on a survey of empirical studies: Drugs, Instruments, Electronics, and Food have consistently low leverage while Paper, Textile Mill Products, Steel, Airlines, and Cement have consistently large leverage. To estimate the effect of industry classification on leverage, firms in our sample are divided into groups according to the Industrial Classification of Economic Activities of the Czech Statistical Office. The following classification is used in order to create reasonably large groups of firms: C Mining of Raw Materials, D Manufacturing, and E Production and Distribution of Electricity, Gas, and Water. Firms not belonging to any of these groups make up the reference group. Titman (1984) and Titman and Wessels (1988) point out that firms manufacturing machines and equipment should be financed with relatively less debt. Because group D is sufficiently large, it is possible to drop the firms that belong to sub-industry 29 (Manufacturing and Repair of Machines and Equipment) and create from these firms the group D1. Capital structure has been the subject under consideration on numerous occasions over the last 50 years. 1. The first study to state that capital structure did not affect the performance and value of the firm stated thatalthough the day to day observations show the influence on firms performance but it is not so (Modigliani and Miller, 1958). 2.The same authors, after five years in 1963 further elaborated that in the absence of taxes and a few assumptions stated in their early study could reveal the insignificance of capital structure to the overall value of the firm.

3.Capital structure of the firms greatly depends upon the operations and the size of the firm. Large firms and public firms require debt financing while SMEs require equity financing to be prevalent. Equity financing should be encouraged in the initial phases of a firms existence, which will give a sound base in order to expand by debt financing (Joshua Abor, 2008). 4.Asset tangibility was considered in many researches (Harris and Raviv, 1990; Scott, 1977; Ozkan, 2002; Titman and wessels, 1988) and it was concluded that tangibility of assets is directly related to leverage of the firm but a study conducted on textile firm capital structure showed that tangibility of assets has no impact on the capital structure of the firms. This result is in contradiction with the earlier studies conducted by a number of researchers on different countries. 5..In Maturity matching principle was used in the study of capital structure, which states Length of the loans should be matched to the length of the life of the assets (Myers, 1977). 6.Asset tangibility has a direct relation with long term debt whilea negative relation with the short-term debt (Sogorb-Mira, 2005). 7.There is a positive impact of leverage on profitability due to tax exemption from debt equity. A research in contradiction to this statement (Myers and Majluf, 1984) stated that firms go for internal financing due to information asymmetry. This research shows negative impact of leverage on profitability. Negative relation has been found to be true for firms in recent studies (Rajan and Zingles, 1995; Boot et al, 2005). 8 .The capital structure of a firm in developing countries has shown dependency on a number of factors such as tangibility, interest rate, inflation, and growth (Tugba bas, Gulnur Muradoglu, Kate Phylaktis, 2009). 9. Growth of the economy shows positive signs on the leverage (Myers, 1977). If an economy grows, investments increase for the firms (Smith and Watts, 1992). Hence, a positive relation between growth and leverage can be concluded. 10. The major concern in debt financing has always been asymmetric information, which has restricted firms with potential to succeed by not taking debt for their operations (Myers, 1984). The research is firmly based on Pecking order theory which suggests, Firms will rely on internal financing due to information asymmetry. If sufficient information is available, then the firms might be tempted into borrowing. The growing tax rates in economies have also led to increase in debt financing. Some policies allow firms to deduct interest from their profit to cover debt financing. In this case, interest from profits would lead to enabling the business to run completely on debt. This fact was analyzed and concluded to be true (Miller, 1977) but

increase in debt can lead to a rise in the bankruptcy chances of a firm as the cost of borrowing rises (Modigliani and Miller, 1963). Debt financing is an effective way to lower tax costs but a greater portion of debt in the capital structure can result in a higher probability of bankruptcy, thus decreasing the value of the firm and making it unattractive to invest in. Agency costs, which are the costs incurred due to relation between the shareholders, managers, debt holders and shareholders also rise with the rise in debt equity (Jensen and Meckling, 1976). If the agent decides not to maximize the profit of the principle while maximizing his/her cost at the same time, there might arise a conflict between the interests of the manager and the shareholder (Harris and Raviv, 1990). A probable solution to the agency costs suggested that these costs can be greatly reduced by shaping the capital structure in such a way which can reduce the maturity period of the debt and enhance the provision of call option on bonds before the maturity (Barnea et al, 1980). Risk is the main concern in debt financing to the creditors. If a firms debt is greater than its earning, the firm would definitely lose its value in the market (Litzenberger, 1973). If the creditors see the value of the firm decline, they will lose their confidence in the firm and avoid investment, which would lead to loss of a major portion of the capital structure and thus lead to a decline in the growth and operations of the firm. In developing countries, creditors prefer low risk rather than higher returns. Due to this reason, investors in developing countries almost always invest in firms with higher stability than in the firms with higher return. The reason for this is that once a firm defaults on its debt, then it might take a long time for the compensation of the creditors or they might never get compensated as the legal proceedings are quite slow in such countries (Attaullah shah and Safiullah khan, 2007). Research regarding the size of the firm and the capital structure (Titman and Wessels, 1988) stated that debt financing might be large for small firms and small for large firms. This case can be true only if small firms take debts for short periods thus decreasing the overall cost of borrowing. The existence of highly levered small firms can only be true if borrowing is in short term. It is improbable otherwise. Endogenous Investment and the Substitution between Internal and External Financing The empirical capital structure literature document a negative association between firm profitability and external financing. While most of the literature focuses on the relation between profitability and leverage levels (e.g., Rajan and Zingales (1995)), the negative association between the availability of internal funds and the use of external finance also holds for flow measures of external financing. Leary and Roberts (2005), for example, find that firms that have high cash flows or high cash balances are less likely to issue (and are more likely to retire) both debt and equity. Leary and Roberts (2005), like much


of the literature, interpret the existing findings as evidence supporting the pecking order theory (see, e.g., Myers (1993) and Fama and French (2002)). According to the pecking order argument, firms prefer to finance investments with internal funds,because asymmetric information increases external financing costs (Myers and Majluf (1984) and Myers (1984)). A preference for internal over external funds would then generate a negative relation between internal cash flows and external financing: more profitable firms require less external financing, and should thus show lower security issuance activity. This observed negative relation would seem inconsistent with standard arguments based on the tradeoff theory of capital structure, which predicts that because of tax shields more profitable firms should use external funds (i.e., debt) to finance investments (see, e.g., Graham (2000)). Recent literature, however, suggests that the negative relation between profitability and external financing could be due to the presence of (possibly small) adjustment costs (see Strebulaev (2007)). Arguably, all firms face some direct flotation costs when accessing external markets, which lead to relatively infrequent refinancing decisions. Strebulaev presents evidence that the presence of firms that do not readjust their capital structure (inactive firms) in random samples generates the well known negative cross-sectional relation between profits and leverage ratios. In his paper, leverage ratios decrease mechanically with profitability for inactive firms, given that equity values are positively related to profitability. Transaction costs can also generate a negative relation between profitability and issuance activity. In particular, profitable firms may choose, on the margin, to finance investments with internal funds so as to save on transaction costs. In addition to standard adjustment costs, some firms are also subject to potentially more substantial costs of external financing. These distinct, additional costs arise from issues such as agency problems, informational asymmetries, contracting imperfections, and lack of collateral. We call these costs financing constraint costs. Financing constraint costs, when considered on top of small adjustment costs, can lead to pronounced distortions in the firms investment policy. As a result, for firms subject to financial constraint costs (financially constrained firms), investment and financing decisions become interconnected. For example, a constrained firms ability to access debt financing at a fair cost might depend on the amount of collateral that the firm can provide to lenders, which in turn depends on the amount of investment that the firm can make. Interactions between investment and financing have been largely ignored in the standard tests of the pecking order argument. Consistent with the assumption of exogenous (unconstrained) investment, various previous papers use capital expenditures as an explanatory variable in the right-hand side of regressions that explain capital structure (as part of the firms

financing deficit). This testing approach, which follows from Shyam-Sunder and Myers (1999), implicitly assumes that observed investment is equal to desired investment even when the firm faces capital market frictions. In contrast to this, we argue that the endogeneity of financing and investment decisions influence the substitution between internal and external funds. To develop these implications in greater detail, we draw on the literature that examines the impact of capital markets imperfections on investment. First, if firms investments are lower than desired levels because of capital markets imperfections (i.e., if firms are financially constrained), then their spending should be related to the availability of internal funds. Essentially, firms with high internal funds will find it advantageous to direct some of those funds towards incremental investment which have high marginal product as opposed to cutting down on external financing. Conversely, if internal funds decrease, a constrained firm 3Hennessy and Whited (2005) and Lewellen and Lewellen (2006) also offer an explanation for the negative relation between profits and external financing that is not based upon asymmetric information. In their work, debt-related tax benefits are less attractive when the firm can finance investments with internal funds, because internal financing allows the firm to defer taxes on payments to equity holders. As a consequence, more profitable firms may optimally issue less external finance (i.e., debt) than firms that are less profitable (which must choose between debt and outside equity). might be forced to cut down investment because the alternative i.e., leaving investment constant and raising additional external funds might not be feasible. This investmentfinancing tradeoff works to mitigate any potential substitution effect between external and internal funds. This first mechanism underlies the tests of financing constraints first proposed by Fazzari et al. (1988), and motivates a large empirical literature in economics and finance (see Hubbard (1998) and Stein (2003) for comprehensive reviews of early literature, and Rauh (2006) for recent empirical evidence). It is important to note that recent research has pointed to difficulties with the strategy of looking at the empirical correlation between real and financial variables, stemming from measurement problems in the control for investment opportunities (see, e.g., Erickson and Whited (2000), Gomes (2001), and Cummins et al. (2006)). Our test design avoids the explicit modeling of real variables, and our estimations recognize the possibility that well-known biases could underlie inferences with the sorts of empirical models we estimate. Among other expedients, we adopt empirical strategies that directly address the measurement error problem (e.g., Cummins et al. (2006)). The second mechanism is related to the effect of future investment on current financing choices. A firm that faces costly external financing should worry not only about current investment needs, but also about future ones. One way that the firm can secure future investment spending

is by increasing its holdings of cash, securities, and other liquid assets that can be used to smooth out the investment process (e.g., working capital). For constrained firms, holdings of liquid assets are an additional competing use of internal funds. In other words, firms that face high costs of external financing may find it optimal to direct cash flows towards liquid assets when they observe high profitability (see Fazzari and Petersen (1993) and Almeida et al. (2004) for evidence). Conversely, if profitability is low, constrained firms may draw down their stocks of liquid assets to avoid raising costly external financing. The optimal management of liquid assets is another reason why constrained firms should display a lower propensity to use cash flows towards the reduction of external financing.

In order to test whether external financing and liquid asset holdings are simultaneously determined, we estimate a system of regressions in which both these variables are endogenous. This approach allows us to test the hypothesis that those firms that avoid using external financing to absorb changes in internal funds also direct internal funds towards holdings of liquid assets.The third mechanism affecting the substitution between internal and external financing is related to the firms capacity to raise external finance. Constrained firms ability to raise external financing is likely to covary positively with variations in internal cash flows, either because external financing costs decrease when cash flows are high (Bernanke and Gertler (1989)), or because the value of col-4Our tests on liquid asset holdings draw on Almeida et al. (2004). However, while Almeida et al. use only cash on the left-hand side of their empirical models, the tests of this paper use a broader measure of liquid asset holdings that also include working capital items (such as inventory and accounts receivables). This modification is important to consider because cash and working capital can be close substitutes (see, for example, Bates et al. (2006)).lateral increases with internal cash flows (Kiyotaki and Moore (1997)). Following a positive income shock, firms invest more, therefore increasing their holdings of tangible assets. These assets create new collateral, which in turn allow the firm to raise more external finance (credit multiplier). The credit multiplier mechanism suggests that internal funds and external finance should become more complementary for firms that are financially constrained. This mechanism provides yet another reason why the relation between internal funds and external finance should be less negative than what one would expect in the absence of an endogenous link between investment and financing decisions. Our empirical analysis also explores the rationale behind the credit multiplier by identifying situations in which this mechanism is more likely to become important. First, the credit multiplier mechanism should be stronger for firms that have more tangible assets, because an

increase in cash flow will have a greater impact on collateral value for this group of firms (see Almeida and Campello (2007)). Accordingly, internal funds and external finance should be even more complementary for constrained firms that have highly tangible assets. Second, prior research also suggests that the credit multiplier matters more during recessions and monetary contractions, when financing constraints are more likely to bind (see, e.g., Kashyap et al. (1994), Gertler and Gilchrist (1994), and Calomiris et al. (1995)). Accordingly, we examine the extent to which the sensitivity of external financing to internal funds varies with the business cycle for different types of firms. Presumably, it is more likely that internal funds and external finance become complementary under economic conditions that are associated with tighter financing constraints. The theories of interest for our analysis (pecking order, adjustment costs, and endogenous investment driven by financing constraints) have distinct predictions for the substitutability between internal and external funds across constrained and unconstrained firm samples. Lets summarize these predictions. Unconstrained Firms. The adjustment costs argument suggests that even in the absence of high costs of external financing there should be a negative relation between profitability and the use of external finance (cf. Strebulaev (2007)). The presence of adjustment costs which are relevant for all firms implies that the relation between profitability and external financing might be negative for financially unconstrained firms: on the margin, these firms finance their profitable investment projects with internal (as apposed to external) funds, thereby economizing on transactions costs. Neither the pecking order nor financial constraints arguments make clear predictions about financially unconstrained firms, since these firms should be characterized by low asymmetry of information and exogenous investment. Greater substitutability between internal and external funds for unconstrained firms would be more consistent with the adjustment costs arguments. Constrained Firms. The standard pecking order story with exogenous investment would suggest that the relation between profits and external financing should become more strongly negative when firms are financially constrained, since these firms are more likely to suffer from information asymmetry. In contrast, as discussed above, if investment and external financing are endogenously determined, then internal funds and external finance should become more complementary, relative to a situation in which firms are financially unconstrained. The predictions of the adjustment cost argument for the constrained samples depend on whether adjustment costs are higher or lower for constrained firms. We are unaware of any evidence suggesting that constrained firms have lower adjustment costs. On the contrary, the existing empirical literature suggests that adjustment costs are higher for the types of firms that are typically classified as financially constrained. Greater Complementarily between internal and

external funds for constrained firms would be more consistent with evidence of an endogenous link between investment and financing decisions. To provide evidence for these arguments we perform the following sets of tests: (1) Single-Equation Tests: We relate the sensitivity of external financing (debt and equity issuance) to innovations in profitability (cash flows), both for constrained and unconstrained firms. If investment and external financing are jointly determined, then we expect this sensitivity to be less negative for constrained firms than for unconstrained firms. (2) System-Equation Tests: We relate both external financing and liquid asset holdings to innovations in cash flows in a system of seemingly unrelated regressions (SUR), separately for constrained and unconstrained firms. If investment and external financing are jointly determined, then the same set of constrained firms that display a less negative sensitivity of external financing to cash flow innovations should also display a more positive sensitivity of liquid asset holdings (cash, inventory, etc.) to cash flows, relative to unconstrained firms. (3) Credit Multiplier Tests: We examine whether asset tangibility affects the sensitivity of external financing to innovations in profitability both for constrained and unconstrained firms. If investment and external financing are jointly determined, then we expect tangibility to increase the complementarity between internal and external funds for constrained firms, but not for unconstrained ones. (4) Differences-in-Differences Tests: We examine the time-series properties of the cash flow sensitivity of external financing of constrained and unconstrained firms. If investment and external For example, Altinkilic and Hansen (2000) find that smaller and riskier firms face higher adjustment costs for both debt and outside equity (see also Kim et al. (2003)). Fischer et al. (1989) argue that because small issues incur larger proportional adjustment costs, and because issue size is correlated with firm size, small firms should have higher adjustment costs. They report evidence that the range of observed debt ratios is higher for small firms, which is consistent with higher adjustment costs. On the other hand, Corwin (2003) does not find a clear link between SEO underpricing and firm size.

III. Objectives

The objectives of this research are


To find out the determinants of the capital structure for textile sector. A comparative analysis of the textile sub sectors comprised of spinning, composite, and weaving. To determine if the proportion of debt to equity enables an entity to create wealth without unduly jeopardizing the firm

IV. Theoretical Considerations of Capital Structure Theory

The tradeoff theory of capital structure predicts that firms will choose their mix of debt and
equity to balance the costs and benefits of debt. Tax benefits and control of free cash flow problems are argued to push firms to use more debt, while bankruptcy and other agency costs provide firms with incentives to use less leverage. The theory describes a firms optimal capital structure as the mix of financing that equates the marginal costs and benefits of debt. In static versions of the tradeoff model these forces determine an optimal capital structure. In dynamic versions of the model (e.g. Fisher, Heinkel, and Zechner (1989)) the optimum is characterized as an interval, and violation of the endpoints of the interval lead to revisions in the firms financing mix. Myers (1984), based on Myers and Majluf (1984), presents a pecking order theory of financing choice. The defining prediction of the model is that firms will not have an optimal capital structure, but will instead follow a pecking order of incremental financing choice that places internally generated funds at the top of the order, followed by debt, and finally, when the firm reaches its debt capacity, external equity. This theory is based upon costs derived from asymmetric information between managers and the market and the assumption that tradeoff theory costs and benefits of debt financing are of second order importance when compared to the costs of issuing new securities in the presence of asymmetric information. The development of a pecking order based upon costs of adverse selection requires an ad hoc specification of the managers incentive contract (Dybvig and Zender (1991)) and a limitation on the types of financing strategies that may be pursued (e.g. Brennan and Kraus (1987)). Despite these theoretical criticisms, the pecking order remains a predominant theory of financing choice. Dynamic versions of the pecking order hypothesis result in firms saving debt capacity for future possible needs. (Myers (1984) loosely describes the dynamic version while Vishwanath (1993) and Chang and Dasgupta (2003) present formal developments of the theory.) The extent of this savings behavior will depend on how changes in the firms investment opportunity set and changes in the asymmetry of information are modeled.

Regardless of the specific modelling choices, the qualitative predictions of dynamic models concerning financing behavior remain the same. On average, firms requiring outside financing will use a mix of debt and equity in which the weights will depend on their current leverage, the amount of unused debt capacity, the current level of investment (growth), and expectations of these characteristics in the future. All else equal, those firms expecting little or no growth, having low current leverage and a large untapped debt capacity, will finance predominantly with debt while high growth firms or those at or near their debt capacities will rely more heavily on equity. Intermediate firms will use a mix of the two securities with the weights being determined by the likelihood of reaching their debt capacity based on their current and expected future requirements for external financing. In a recent set of papers, tests designed to distinguish between the pecking order and tradeoff theories have been developed. Shyam-Sunder and Myers (1999) introduce a test of the pecking order theory. Their test is based on the pecking orders prediction for the type of financing used to fill the financing deficit. The financing deficit is defined, using the cash flow identity, as the growth in assets less the growth in current liabilities (except the current portion of long term debt) less the growth in retained earnings. According to the identity, this deficit must be filled by the (net) sale of new securities. Shyam-Sunder and Myers argue that, except for firms at or near their debt capacity, the pecking order predicts that the deficit will be filled entirely with new debt issues. The empirical specification of their test is: it PO it it D = + DEF + (1) where is the net debt issued by firm i in period t, and DEFit is the corresponding financing deficit. Changes in the use of debt should be driven by the deficit and not consideration of an optimal capital structure. The test itself, however, ignores the issue of debt capacity. it D Shyam-Sunder and Myers argue that the simple or static version of the pecking order predicts = 0 and = 1 PO . Intuitively, the slope coefficient in this regression indicates the extent to which debt issues cover the financing deficit. They acknowledge that PO may be less than 1 for firms near their debt capacity, however, the large mature firms in their sample are not likely to face such a constraint. They find = 0.75 PO with an R2 of 0.68 (see column 2 of their Table 2) when they estimate equation (1). They interpret this as evidence that the pecking order is an excellent first-order descriptor of corporate financing behavior (Shyam-Sunder and Myers (1999) pg.242) for their sample. They also find that a target adjustment model based on the tradeoff theory has little power to explain the changes in debt financing for these firms. This paper has generated an interesting discussion. Chirinko and Singha (2000) illustrate, via several examples, that the Shyam-Sunder and Myers test has little power to distinguish between

plausible alternative financing hierarchies. Frank and Goyal (2003) question the conclusions drawn by Shyam-Sunder and Myers (1999) on several fronts. The most interesting challenges are whether the Shyam-Sunder and Myers findings hold for a broader sample of firms, whether the results hold over a longer time horizon (in particular including the 1990's) and whether their findings hold for subsamples of firms predicted to have high levels of asymmetric information. For an expanded sample of firms, Frank and Goyal show that the prediction PO in equation (1) is much smaller than one and is even smaller in the 1990's. Moreover, they find that the pecking order performs the worst in small firms, which they argue should have the greatest degree of asymmetric information and therefore should have the strongest incentives to follow the pecking order. Fama and French (2002) examine many of the predictions of the tradeoff and the pecking order theories with respect to capital structure and dividend policy. They argue that for the majority of the predictions the two theories agree and generally report findings consistent with these shared predictions. Consistent with Shyam-Sunder and Myers (1999), Fama and French (2002) find that debt is used to address variations in investment and earnings in the short-term. However, they also find, as in Frank and Goyal (2003), that small, high-growth companies issue most of the equity (see also Fama and French (2005)). Fama and French join Frank and Goyal in arguing that this finding contradicts the pecking order theory. Similarly, Leary and Roberts (2007) also question the ability of the pecking order to explain financing decisions. Using a different empirical approach, they find little support for the pecking order, even for subsamples of firms for which they argue the pecking order should be most likely to hold. Determining what lies behind these contrasting findings is important for furthering our understanding of capital structure and financing choices of firms. We provide new evidence in an attempt to reconcile some of these findings by focusing on the role of debt capacity. This is an important element of the pecking order hypothesis that has been largely ignored in empirical tests.

A. Empirical Strategy
According to Myers (2001, p. 81), there is no universal theory of the debt-equity choice, and no reason to expect one. However, there are several useful conditional theories3, each of which helps to understand the debt-to- equity structure that firms choose. These theories can be divided into two groups either they predict the existence of the optimal debt-equity ratio for each firm (so-called static trade-off models) or they declare that there is no well-defined target capital structure (pecking-order hypothesis). Static trade-off models understand the optimal capital structure as an optimal solution of a trade-off, for example the trade-off between a tax shield

and the costs of financial distress in the case of trade-off theory. According to this theory the optimal capital structure is achieved when the marginal present value of the tax shield on additional debt is equal to the marginal present value of the costs of financial distress on additional debt. The trade-off between the benefits of signaling and the costs of financial distress in the case of signaling theory implies that a company chooses debt ratio as a signal about its type. Therefore in the case of a good company the debt must be large enough to act as an incentive compatible signal, i.e., it does not pay off for a bad company to mimic it. In the case of agency theory the trade-off between agency costs4 stipulates that the optimal capital structure is achieved when agency costs are minimized. Finally, the trade-off between costs of financial distress and increase of efficiency in the case of free cash-flow theory, which is designed mainly for firms with extra-high free cash-flows, suggests that the high debt ratio disciplines managers to pay out cash instead of investing it below the cost of capital or wasting it on organisational inefficiencies. On the other hand, the pecking-order theory suggests that there is no optimal capital structure. Firms are supposed to prefer internal financing (retained earnings) to external funds. When internal cash-flow is not sufficient to finance capital expenditures, firms will borrow,rather than issue equity. Therefore there is no well-defined optimal leverage, because there are two kinds of equity, internal and external, one at the top of the pecking order and one at the bottom.

As discussed above, the Shyam-Sunder and Myers test, while very intuitive, has little power to distinguish between alternative hypotheses. Accordingly, we modify the ShyamSunder and Myers test in two ways. First we separately examine firms that are expected to be constrained by concerns over debt capacity and those that are not. In this way we exploit the cross sectional heterogeneity in debt capacity in the sample. The contrast between these two groups is an important aspect of our empirical design. Second, we include as an additional independent variable; the square of the financing deficit: it PO it it it D = + DEF +DEF 2 + (2) As Chirinko and Singha (2000) illustrate, under the pecking order the relation between the change in debt and the financing deficit when firms face debt capacity constraints is concave. We include the square of the financing deficit to capture the concave nature of the relation and to more fully identify the nature of the financing hierarchy by considering the differences in financing choice between large and small deficits. For firms that follow the pecking order and are unconstrained by concerns over debt capacity, the original Shyam-Sunder and Myers test (equation (1)) should perform very well (a PO coefficient estimate near 1 and a high R-squared). Furthermore, there should be little change in

results when equation (2) is instead estimated. In contrast, for pecking order firms that are constrained by concerns over debt capacity, the test in equation (1) should perform poorly with an estimate of PO that is far from 1 (see Chirinko and Singha (2000)) and a low Rsquared. For such firms, however, estimating equation (2) should result in an estimate of the coefficient that is negative and significant, an increase in the estimate of the PO coefficient, and an increase in the R-squared of the regression relative to equation (1). These predictions follow as pecking order firms that are constrained by debt capacity use debt to fill small financing deficits (those that do not violate the firms debt capacity constraint) but for larger deficits such firms will turn to equity financing. Note that the sign the coefficient indicates the nature of the financing hierarchy. To demonstrate the ability of our tests to identify pecking order behavior in the presence of concerns over debt capacity we provide evidence generated using simulated data. We closely follow Leary and Roberts (2007) in simulating the financing behavior of firms. We simulate data for two sets of firms. The first set of firms is relatively unconstrained by concerns over debt capacity, while the second set of firms faces more binding debt capacity constraints. To make the simulations directly comparable to our empirical results we use the actual financing deficits in the data and simulate debt capacities and financing behavior. Specifically, for each firm-year observation of the financing deficit we simulate a value for the firms unused debt capacity. To simulate financing behavior we compare the size of the financing deficit to the simulated value of the firms debt capacity. If the size of the financing deficit is less than the remaining debt capacity, the deficit is assumed to be filled entirely with debt. If the financing deficit exceeds the remaining debt capacity of the firm, then the firm is assumed to issue debt up to the point where the firms debt capacity is exhausted and is assumed to fill the remainder of the deficit using equity. The parameters of the simulations are chosen to match the characteristics of the actual data for firms in our analysis that we classify as having high and low debt capacity.

Note that our financing scheme differs slightly from that used by Leary and Roberts (2007) to simulate pecking order behavior in their paper. In their simulations, Leary and Roberts treat debt capacity by assuming that if by covering the deficit for a firm entirely with debt will violate that firms debt capacity, the entire deficit is covered with an equity issue instead. Such an assumption can be justified if the fixed cost of financing overwhelms the incremental costs generated by the asymmetric information problem motivating the pecking order. However this assumption does not correspond to the predictions of the simple or the dynamic pecking order, nor does it comport with the actual financing behavior of firms.1 We

note, however, that our inferences remain similar to those reported here if we instead adopt the financing scheme proposed by Leary and Roberts in our simulations. As a basis for comparison we also simulate financing behavior under the assumption that financing policies are simply random in the sense that a coin flip determines whether the firm issues either debt or equity, where the probability of a debt issue in a given year is simply set to match the average frequency of debt issues in the two subsamples. For this financing scheme, the coefficient on the square of the financing deficit should be insignificant as the size of the deficit is unrelated to the choice of security the firm will issue. Leary and Roberts also examine this nave financing policy as an alternative to pecking order behaviour and financing data. For each financing arrangement (pecking order and random) firms are separated into two groups, those with high levels of debt capacity and those with low levels of debt Dual issues make up a significant portion of the issues in our sample. Leary and Roberts (2007), on the other hand, report that only a tiny fraction of the issues in their sample are dual issues. This appears to be due to their identification scheme requiring an issue of debt or equity to amount to a change in assets of at least 5%. A dual issue is therefore a firm raising new capital in excess of 10% of existing assets, making them a very rare event. We then estimate equations (1) and (2) to illustrate the impact of controlling for the level of debt capacity and for the square of the financing deficit. Panel A presents the results for the firms assumed to be following the pecking order. The first and third columns present the estimates for the original Shyam-Sunder and Myers test (equation (1)). Two features are worth noting. First, the model fits much better for the set of firms with high levels of debt capacity. For this set of firms, the R-squared of the regression is 0.82 and the slope coefficient on the financing deficit is 0.772. The results of the simulation closely match the findings of Shyam- Sunder and Myers (1999). Second, also as predicted, for the firms with a tight debt capacity constraint this model fits much worse. The R-squared is 0.34 and the slope coefficient is only 0.316. This result closely matches the findings for small firms presented in Frank and Goyal. Panel B presents the results based on random financing. Comparing these results to the same columns in Panel A illustrates the critique of the Shyam-Sunder and Myers test raised by Chirinko and Singha (2000). In particular, the coefficient estimates on the financing deficit for both groups of firms mirror those presented in Panel A. Estimating equation (1) alone has no power to distinguish pecking order from other financing behavior. The second and fourth columns in Panels A and B present the results of estimating equation (2) using the simulated data. As seen in the table, the addition of the square of the financing deficit as an explanatory variable in the regression results in a test that can distinguish pecking order behavior from random financing. For the low debt capacity firms that follow the

pecking order, the addition of the square of the financing deficit has two effects. First, the coefficient on the financing deficit increases substantially rising from 0.316 (column 1) to 0.538 (column 2). This indicates that, as constructed, smaller deficits are more likely to be filled using debt because smaller deficits are unlikely to violate the firms debt capacity constraint. Second, the coefficient on the square of the deficit is -0.226 and is statistically significant, indicating a concave relation between net debt issues and the financing deficit. The concavity in this relationship arises because firms facing debt capacity constraints fill larger deficits with issues of equity.2 When firms follow random financing, the addition of the squared deficit has little effect on the results obtained using the basic Shyam-Sunder and Myers specification in equation (1). For the firms with high levels of debt capacity (column 4) the addition of the square of the financing deficit has almost no impact. The coefficient on the financing deficit does not change appreciably and the coefficient on the square of the deficit, while negative is economically small and is not significantly different from zero. For firms with high debt capacities, both small and large deficits tend to be filled using debt issues. Finally, note that the coefficient on the squared deficit can also discriminate pecking order behavior from two other financing alternatives described by Chirinko and Singha (2000). First, if the financing hierarchy is reversed, such that small financing deficits are filled using equity and large deficits are filled with debt, then the relationship between debt issues and the financing deficit will be convex and the coefficient on the square of the financing deficit will be positive. Second, if the firm always issues debt and equity in fixed proportions, then the size of the deficit does not affect financing and the coefficient on the square of the deficit will be zero. In summary, the simulations demonstrate the importance of controlling for the level of debt capacity in the Shyam-Sunder and Myers test and the usefulness of including the square of the financing deficit as an additional explanatory variable in providing the test with the power to discriminate amongst competing hypotheses for incremental financing decisions. Leary and Roberts (2007) also find that the coefficient on the square of the financing deficit is negative when a sufficient fraction of firms in their simulations are assumed to follow the pecking order. In their simulations, however, they do not examine differences in this coefficient as a function of debt capacity, which is our focus.

B. Debt Capacity
Debt capacity was originally defined by Myers (1977) as the point at which an increase in

the use of debt reduces the total market value of the firms debt. More recently, Myers (1984), Shyam-Sunder and Myers (1999) and Chirinko and Singha (2000) define it as sufficiently high debt ratios such that costs of financial distress curtail further debt issues. The combination of debt capacity defined in these terms and the pecking order theory suggests that costs of adverse selection are dominant for low to moderate leverage levels but that tradeoff-theorylike forces become primary motivators of financing decisions at high levels of leverage. This definition of debt capacity makes it more difficult to distinguish between the competing theories. This definition also has no obvious empirical implementation. The only guidance given is that debt capacity is a point at which the cost of issuing additional debt increases rapidly (the expected costs of distress take a preeminent role in the financing decision for the firm at this point). In general, a firms debt capacity may be driven by demand and/or supply side considerations. On the demand side, firms with more uncertain cash flows and those whose value is derived primarily from growth opportunities (Myers (1977)) have relatively low demand for debt financing. On the supply side, in addition to these same characteristics, lenders may ration borrowers when there is asymmetric information between the firm and investors regarding the riskiness of the firm (Stiglitz and Weiss (1981)).To attempt to empirically measure debt capacity we model the likelihood that, based on observable characteristics, the firm can access public debt markets (i.e. whether the firm could issue rated debt). These firms have cash flows that are sufficiently stable, sufficiently large 3Hellman and Stiglitz (2003) model the impact of asymmetric information on the debt and equity markets. pools of existing collateral, and sufficient informational transparency to allow access to relatively large amounts of arms-length debt. These firms are willing to comply with the strict disclosure requirements and are able to satisfy the scrutiny of an investment bank so that it will certify a public bond offering. They also borrow in a market for which the interest rate equilibrates the supply and demand for capital. This is the implicit assumption concerning the debt market made by Myers and Majluf (1984) and so firms that are able to issue rated debt most closely conform to the assumptions underlying the pecking order. Firms without the ability to access public debt markets do not share these characteristics, and must (for the most part) borrow via loans from banks or other financial intermediaries. These firms are smaller, with more volatile cash flows and less tangible assets, and thus are likely to demand lower levels of debt financing compared to firms with rated debt. Furthermore, firms that borrow from relationship lenders are also the types of firms that are most likely to be subject to an externally imposed debt capacity in the form of credit rationing (e.g., Faulkender and Petersen (2006)) or to face high reorganization costs. For example, Cantillo and

Wright (2000) argue that financial intermediaries are more efficient at reorganizing firms as compared to arms length investors. They predict that the firms able to obtain bond ratings and borrow in the public debt markets are those with lower expected costs associated with financial distress (e.g.,those with more tangible assets, fewer growth opportunities, and low cash flow volatility). The idea that access to public debt markets is a useful proxy for debt capacity is also suggested by Bolton and Freixas (2000). They present a model of capital structure and financing choice. In their model, firms may raise external financing using equity, bank debt, or via the bond market. There is an informational dilution cost to issuing equity in the presence of asymmetric information as in Myers and Majluf (1984). When issuing debt, firms may choose between bank debt and public bonds. Banks have an advantage in minimizing costs of financial distress but face their own intermediation costs that are passed onto the borrower so bank debt is nominally more expensive than public debt. Bonds carry a lower interest rate but borrowers in the public debt market face higher costs if they become distressed. Their model results in a market segmentation in which the safest firms use the public debt market for financing, these firms have the greatest capacity to borrow, a very low probability of distress and so avoid the intermediation costs incurred with bank debt. More risky firms with a lower capacity to borrow use the more flexible but more expensive bank debt, and the riskiest use equity. While the presence (or absence) of rated debt for a firm provides an indication of the extent to which the firm has access to relatively low cost borrowing and so suggests a relatively large (or small) debt capacity, the use of the actual presence or absence of a bond rating as a measure of debt capacity is problematic. We are particularly worried about firms without bond ratings that have chosen to rely on equity financing (perhaps for reasons outside of the pecking order) despite having the capacity to issue rated debt. To identify such firms as being constrained by concerns over debt capacity is a mistake, and would bias our results in favor of the pecking order. To address these concerns we use a predictive model of whether a firm has rated debt outstanding as the primary indication of the extent of a given firms debt capacity. A final complication is that dynamic versions of the pecking order suggest that it is the distance a firm is from its debt capacity that is of interest. This distance is difficult to measure, and the likelihood of having rated debt is a noisy proxy of this quantity. However, to the extent that our proxy misclassifies firms with a large debt capacity but high current leverage as being Whited (1992) uses the existence of a bond rating as an empirical measure of whether firms are effectively constrained from using the external financial markets. Unconstrained by concerns over debt capacity or firms with small debt capacity but little or no leverage as being

constrained, its use will generate a bias against the predicted outcomes. Section 5 presents empirical results that further support the use of the likelihood of having a bond rating as a measure of debt capacity. As robustness checks we also perform all analysis using two alternative indicators of the size of a firms debt capacity, the volatility of a firms stock returns in a given year (as a proxy for the volatility of the firms cash flows) and firm age. As discussed above, cash flow volatility should be an indication of both the extent to which a firm desires to borrow and the desirability of that firm as a borrower. Firm age is used as a measure of the informational transparency of the firm and the predictability of its cash flow, indications of lenders willingness to lend. Both of these proxies are also suggested by Bolton and Freixas (2000) as measures of debt capacity.

V. Research Methodology

Textile sector was chosen due to the fact that it is the most prominent and largest sector . The
Capital structure of three sub sectors i.e. spinning, composite and weaving was analyzed together as well as separately. There were a total of 172 firms in these three sectors. 32 firms were not selected in this study due to lack of sufficient data. The maximum numbers of firms belong to the spinning sector. Data for the research were taken from secondary sources i.e. from websites of the respective companies as well as State Bank balance sheet analysis. The time period was 2003-2008. Panel data regression models were used for the analyses through Statistical software Gretel. The regression model is given as it = a + it + eit Y = long term debt i = firms (142) t= time period (six years) Xi = age of firm, growth in sales, size of firm, asset structure, profitability. DEPENDENT VARIABLE TEXTILE SECTOR SPINNING COMPOSITE WEAVING


Hypotheses The following hypotheses were formed on the basis of objectives and literature review. H1: Age of the firm is positively related to long term debt. H2: Growth in sales is negatively related to long term debt H3: Size of the firm is positively related to long term debt. H4: Profitability is negatively related to long term debt. H5: Asset structure is positively related to long term debt

Statistical Analysis

The data were analyzed for all the sub sectors. Altogether there were 142 firms. Fixed and
random effect model was selected with the help of Hausman statistics. The tables given below contain TABLE 1. Textile sector Model: Random-effects (GLS), using 852 observations Included 142 cross-sectional units Time-series length = 6 Dependent variable: long_term_debt

Coefficient Const Age of firm Growth sales in -2139.09 7.13582 0.00686089

Std. Error 179.242 2.53757 0.100674

T-Ratio -119341 2.8121 0.0681

P-Value <0.00001 0.00504 0.94568


Size of firm Profitability Asset

757.986 -44.6026 168.101

49.659 106.248 64.3594

15.2638 -0.4198 2.6119

<0.00001 0.67474 0.00916

structure Adjusted R-square = 0.256574 Hausman test Null hypothesis: GLS estimates are consistent Asymptotic test statistic: Chi-square (5) = 2.40967 With p-value = 0.790033

A combined analysis of composite, spinning and weaving indicates that the dependent variable which is long term debt in the capital structure mix depends on three factors (variables). These variables are age of firm, size of firm and asset structure with p values of 00504, 00001 and 00916 respectively with coefficients of 7.13582, 757.986 and 168.101. The significant variables are positively related as indicated by the coefficients. Growth in sales is directly related to longterm debt (coefficient of.00686089) while profitability is indirectly related (coefficient of 44.6026). Both are insignificant. The results indicate that long term debt can be increased for a firm if the business is growing at a steady rate and if the assets are at a higher level. An established firm can also afford to lend more due to its credibility and efficiency in the operations. TABLE 2. Composite Model: Random-effects (GLS), using 252 observations Included 42 cross-sectional units Time-series length = 6 Dependent variable: long_term_debt

Coefficient Const Age of firm Growth in -5208.61 -4.64577 0.512288 1045.37

Std. Error 680.233 4.99153 0.89406 310.935


T-Ratio -119341 -0.9307 0.5730 3.3620

P-Value <0.00001 0.35290 0.56717 0.00090

sales Size of firm

Profitability Asset structure

1612.72 138.5

150.937 495.85

10.6847 0.2793

<0.00001 0.78024

Adjusted R-square = 0.287895 Hausman test Null hypothesis: GLS estimates are consistent Asymptotic test statistic: Chi-square (5) = 4.82279 P-value = 0.437888

When the composite sub sector was taken separately, regression results using random analysis showed that asset structure and size of firm were the significant variables having a positive relation and p values of.00090 and.00001 respectively (coefficients being 1045.37 and 1612.78). Along with the significant variables, profitability and growth in sales are also directly related to the composite sub sector but are insignificant. The only variable showing negative relation with long-term debt is age of firm. Results indicate that the portion of long term debt in the capital structure depend mainly upon the fixed assets that a firm has. Increase in fixed assets would enable the firm to increase its debt portion. In addition to that, a firm, which is diversified or working at a large scale, can borrow more as it can cover for its losses from one segment through gains of another segment. The insignificant variables have coefficient values of 138.5 for profitability, -4.64577 for age of firm,.512288 for growth in sales. TABLE 3. Spinning Model: Random-effects (GLS), using 546 observations Included 91 cross-sectional units Time-series length = 6 Dependent variable: long_term_debt

Coefficient Const Age of firm Growth in -1012.12 11.1109 -0.0139566 40.2137

Std. Error 119.954 5.98412 0.0332712 23.45381


T-Ratio -8.4376 1.8567 -0.4195 1.7157

P-Value 0.00001 0.063389 0.67503 0.08678

sales Size of firm

Profitability Asset structure

357.592 -56.7551

22.7529 43.1514

15.7163 -1.3153

0.00001 0.18898

Adjusted R- square = 0.346622 Hausman test Null hypothesis: GLS estimates are consistent Asymptotic test statistic: Chi-square (5) = 2.91245 P-value = 0.713481

Statistical analysis of the spinning sub sector indicates that Age of firm, asset structure and size of firm are the significant variables and positively related. Growth in sales and profitability are negatively related but statistically insignificant. The result once again shows the importance of assets in the firm structure. Apart from assets, the dependent variable is also affected by age of firm and size of firm. Conclusions can be drawn from these results that a large business which has a considerable share in the market for a while can benefit from long term debt as compared to the smaller firms. The p-values and coefficient of significant variables for age of firm it is 11.1109 and 0.06389 for asset structure we have 40.2137 and 0.08678, for size of firm we have 357.592 and 0.00001. While growth in sales and profitability are insignificant with their coefficients -0.0139566 and -56.7551.

TABLE 4. Weaving Model: Random-effects (GLS), using 54 observations Included 9 cross-sectional units Time-series length = 6 Dependent variable: long_term_debt

Coefficient Const Age of firm Growth in -323.289 4.73946 -0.434954 -50.5551

Std. Error 167.158 5.23301 0.962374 76.4201


T-Ratio -1.9340 0.9057 -0.4520 -0.6615

P-Value 0.05902 0.36963 0.65333 0.51143

sales Size of firm

Profitability Asset structure

214.354 -71.8427

48.7612 109.592

4.3960 -0.6555

0.00006 0.51524

Adjusted R-square = 0.257796 Hausman test Null hypothesis: GLS estimates are consistent Asymptotic test statistic: Chi-square (5) = 3.05861 With p-value = 0.69095 Statistical analysis results show that size of the firm is the significant variable, which has been the case throughout most of the analyses (p-value is.00006 while coefficient is 214.354). Growth in sales, Profitability and asset structure are the negatively related variables but insignificant and their coefficients are -.434954, -50.5551 and -71.8427 respectively. The other insignificant variable is age of firm that is positively related and coefficient is 4.73946.

TABLE 5. Summary Table Complete analyses information is given below. The lowest r squared value is.257 for weaving because of the small sample size while spinning r squared value is the highest due to the largest sample size of the three sub sectors.





P-VALUE 0.00504 0.00001 0.00916 0.00001 0.00090 0.06389 0.00001 0.08678 0.00006










VI. Synthesis And Discussion

The main findings may be summarized as follows: 1. The significantly negative coefficient for tangible assets and the non-significance of size and profitability in the contemporaneous regression contradicts the trade off theory. The persistently significant relation between market to book value ratio and leverage in the long-term regression is inconsistent with the trade off theory as well. 2. Pecking order theory receives weak support from the contemporaneous regression in the positive relation between leverage and market to book ratio. The strongest support for the pecking order story draws from significant relation between market to book ratio and change in leverage through asset growth. The persistent impact of market to book value ratio in the long term regression also shows REITs follow pecking order in financing decisions. 3. In the contemporaneous model, the negative coefficient for market to book ratio contradicts the market timing theory. The evidence of persistently positive impact of weighted market to book in the long term regression strengthens the conclusion.

VII. Conclusion
The outcome of regression is that larger the firm, higher the long term debt and vice versa. Large firms indicate low level of risk and a steady return to the creditors due to which large firms can borrow more. The credibility of the firm is higher due to its low chances of default. The reason for this is that as the firms resources increase, it can cover its losses to a greater extent thus enabling itself to borrow more. Borrowing would also significantly reduce the taxes but a certain feasible region is necessary to extract maximum performance from the firms business. Even if sufficient resources back up a firm, an increase in the long-term debt beyond the capabilities of the firm can lead to severe consequences. Thus the firms should analyze their respective position in the market and alter their capital structure accordingly. Resources and steady growth would help in optimal performance only if the firm can understand how to design their financing structure. Joshua, Abor (2008) also reported the positive relation of firm size and long-term debt, The negative impact of size on profitability was reported by Attaullah Shah and Tahir Hijazi(2004) thus in contrad iction with the findings of the current research. A negative relation between growth and long-term debt was found by Joshua Abor (2008), which is in harmony with the weaving and composite analyses and against the combined as well as spinning analyses. Age of firm and asset structure also have a significant effect on the long-term

debt. Established firm has the benefit of a good reputation while large asset structure means that sufficient resources can be allocated at each level. The focus of this research has been to pinpoint the determinants that make a viable capital structure for a firm depending upon the perimeter of its operations. The study involved selection of variables that prevail in India which are directly affecting the capital structure of businesses. After analyzing the data, determinants, which led to capital structure decisions, were obtained. The results were similar to the work of Joshua Abor (2008), who conducted such an analysis for the Ghanaian firms. Size of firm has been the variable that was significant in each of the analysis. The four analyses also included other significant determinants but size of firm was consistent in each case The study, therefore, can be easily concluded by a simple statement that increase in the size of a firm increases its long term debt in the capital structure and vice versa. The current research indicates that the capital structure debt-equity mix relies highly on the assets that a firm possesses along with the growth in business being important to a certain extent. Thus we can recommend from the above findings that long-term debt in the capital structure increases as the firm expands its business and becomes more self-sufficient. The economic conditions of Pakistan changes from time to time, so the factors that affect the capital struct ure in various sectors should be in harmony with the prevalent economic scenario.

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