Determinants of Capital Structure: A Case of Listed Energy Sector Companies in Pakistan

IntroductionTwo financing options available to all firms: Debt and Equity

The Managers Objective: to achieve optimal capital structure

Academic research has focused on why firms choose to use more/ less amount of debt; which companies/ industries are more leverage and why?

Why energy sectorImportant for the whole economy / business sector

Significant portion of Karachi Stock Exchanges total market capitalization

Research ObjectivesTo ascertain whether the determinants used by Rajan and Zingales (1995) and others apply to capital structure decisions made by listed firms in Pakistans energy sector

To find out which of the capital structure theories better explains the capital structure of these firms

Literature ReviewImportant Studies

Titman and Wessels (1988) Found no evidence that debt ratios are related with a firms expected growth, tax shields, volatility or tangibility of assets. However, they found profitability to be negatively associated with firms debt.

Harris and Raviv (1990) Argued that managers do not always act in the best interests of the shareholders and debt provides a mechanism that helps keep things in order

Rajan and Zingales (1995)Studied companies in the G-7. Found differences across different countries while some variables were found to be having same relationship with leverage across all countries (e.g. tangibility)

Literature Review (continued)

Drobetz and Fix (2003)used Swiss data to study the predictions of Static Tradeoff and Pecking order theories. Found that Swiss firms tended to use comparatively less leverage (compared with Anglo-American countries) and more profitable firms also exhibited less reliance on debt

Tahir and Hijazi (2006)Studied the capital structure of listed cement companies in Pakistan Their aim was to study the unique attributes of this sector and how its capital structure decisions differ from other listed firms. They found that growth, tangibility and profitability had significant impact on leverage, whereas size did not seem to impact leverage considerably

Theories of capital structureStatic Trade-off TheoryFirms target an optimal debt ratio believing that such ratio will maximize the value of the firm. The optimal point is achieved when the marginal benefit of issuing debt equals the increase in the costs associated with issuing more debt

Pecking Order Theoryfirms prefer to finance their investments with internally generated funds as opposed to external financing. When external financing is required, managers tend to prefer debt financing over equity

Agency TheoryThis theory states that an optimum capital structure results from minimization of the costs arising from conflicts between shareholders and debt-holders

Data and VariablesData mainly obtained from Balance Sheet Analysis of Joint Stock Companies compiled by State Bank of Pakistan for the period 2004-2008 (five years)

Data and Variables (continued)Leverage: total debt to total assets

Tangibility: Fixed Assets (net)/ Total Assets

Size: Log of total sales

Profitability: Earnings before taxes/ total assets

Growth: Percentage change in total assets over the previous year

SectorsSectors in the energy sector:Oil & Gas Marketing CompaniesOil & Gas Exploration CompaniesRefineriesPower Generation Companies

Research MethodologyRegression analysis using the following model:

L = 1 (T) + 2 (S) + 3 (G) + 4 (P) +

WhereL = Leverage T = Tangibility of assetsS = Size of the firm G = Growth P = Profitability = the error term

Results

VariableObserved RelationshipExpected Relationship in Static Trade-off TheoryExpected Relationship in Pecking Order TheoryTangibilityPositivePositiveNegativeSizePositivePositiveNegativeGrowthPositiveNegativePositive/ Negative*ProfitabilityNegativePositiveNegative

ConclusionPredictive capability of these capital structure theories is rather mixed, as no single theory completely explains the behavior of financial decision makers in the listed firms in Pakistani energy sector.

In Pakistan, power sector firms with more tangible assets use greater debt which may be due to the collateral value of their assets and ease of obtaining financing

For Pakistani energy sector firms, size was found to be positively associated with leverage suggesting that larger firms tend to use higher leverage. The reasons could be lower bankruptcy risks in larger firms, more diversified portfolio and ease of obtaining financing

Growth, was found to be positively associated with leverage which supports the simple version of pecking order theory (which states that growth firms would finance the expanding operations by incurring more debt)

Conclusion

Profitability - was found to be negatively associated with leverage supporting the view of Pecking Order Theory that profitable firms tend to have less leverage due to availability of internally generated funds

As no single model completely explains the behavior of managers in the Pakistani energy sector companies with regard to capital choice decisions, it could be deduced that capital choice decisions are more complex than predicted by these theories and there is a need for further research to come up with a model that better explains these decisions.

Areas for further researchUsing different measures of leverage e.g. Short term and Long term debt

Incorporating both book value and Market value of debt

Including a larger sample of companies and doing intra-sector comparisons

Differentiating between different ownership structures

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