Sheikh Nadeem Ahmed

Managerial FinanceDeterminants of capital structure: An empirical study of firms in manufacturing industryof PakistanNadeem Ahmed Sheikh Zongjun Wang

Article information:To cite this document:Nadeem Ahmed Sheikh Zongjun Wang, (2011),"Determinants of capital structure", Managerial Finance,Vol. 37 Iss 2 pp. 117 - 133Permanent link to this document:http://dx.doi.org/10.1108/03074351111103668

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Determinants of capital structureAn empirical study of firms in manufacturing

industry of Pakistan

Nadeem Ahmed SheikhSchool of Management, Huazhong University of Science and Technology,

Wuhan, Peoples Republic of China andInstitute of Management Sciences, Bahauddin Zakariya University,

Multan, Pakistan, and

Zongjun WangSchool of Management, Huazhong University of Science and Technology,

Wuhan, Peoples Republic of China

Abstract

Purpose The aim of this empirical study is to explore the factors that affect the capital structureof manufacturing firms and to investigate whether the capital structure models derived fromWestern settings provide convincing explanations for capital structure decisions of the Pakistanifirms.

Design/methodology/approach Different conditional theories of capital structure are reviewed(the trade-off theory, pecking order theory, agency theory, and theory of free cash flow) in order toformulate testable propositions concerning the determinants of capital structure of the manufacturingfirms. The investigation is performed using panel data procedures for a sample of 160 firms listed onthe Karachi Stock Exchange during 2003-2007.

Findings The results suggest that profitability, liquidity, earnings volatility, and tangibility(asset structure) are related negatively to the debt ratio, whereas firm size is positively linked to thedebt ratio. Non-debt tax shields and growth opportunities do not appear to be significantly related tothe debt ratio. The findings of this study are consistent with the predictions of the trade-off theory,pecking order theory, and agency theory which shows that capital structure models derived fromWestern settings does provide some help in understanding the financing behavior of firms inPakistan.

Practical implications This study has laid some groundwork to explore the determinants ofcapital structure of Pakistani firms upon which a more detailed evaluation could be based.Furthermore, empirical findings should help corporate managers to make optimal capital structuredecisions.

Originality/value To the authors knowledge, this is the first study that explores the determinantsof capital structure of manufacturing firms in Pakistan by employing the most recent data. Moreover,this study somehow goes to confirm that same factors affect the capital structure decisions of firms indeveloping countries as identified for firms in developed economies.

Keywords Capital structure, Stock exchanges, Manufacturing industries, Pakistan

Paper type Research paper

The current issue and full text archive of this journal is available at

www.emeraldinsight.com/0307-4358.htm

The authors are thankful to Dr Don Johnson, Dr Muhammad Azeem Qureshi, and twoanonymous reviewers for their detailed comments and suggestions that substantially improvedthe paper. They are also thankful to Ms Lisa Averill and Mr Javed Choudary for theircomprehensive editing of the manuscript.

Determinantsof capitalstructure

117

Managerial FinanceVol. 37 No. 2, 2011

pp. 117-133q Emerald Group Publishing Limited

0307-4358DOI 10.1108/03074351111103668

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1. IntroductionDecisions concerning capital structure are imperative for every business organization.In the corporate form of business, generally it is the job of the management to makecapital structure decisions in a way that the firm value is maximized. However,maximization of firm value is not an easy job because it involves the selection of debt andequity securities in a balanced proportion keeping in view of different costs and benefitscoupled with these securities. A wrong decision in the selection process of securities maylead the firm to financial distress and eventually to bankruptcy. The relationshipbetween capital structure decisions and firm value has been extensively investigatedin the past few decades. Over the years, alternative capital structure theories have beendeveloped in order to determine the optimal capital structure. Despite the theoreticalappeal of capital structure, a specific methodology has not been realized yet, whichmanagers can use in order to determine an optimal debt level. This may be due to the factthat theories concerning capital structure differ in their relative emphasis; for instance,the trade-off theory emphasizes taxes, the pecking order theory emphasizes differencesin information, and the free cash flow theory emphasizes agency costs. However, thesetheories provide some help in understanding the financing behavior of firms as well asin identifying the potential factors that affect the capital structure.

The empirical literature on capital structure choice is vast, mainly referring toindustrialized countries (Myers, 1977; Titman and Wessels, 1988; Rajan and Zingales,1995; Wald, 1999) and a few developing countries (Booth et al., 2001). However, findingsof these empirical studies do not lead to a consensus with regard to the significantdeterminants of capital structure. This may be because of variations in the use oflong-term versus short-term debt or because of institutional differences that existbetween developed and developing countries.

The lack of consensus among researchers regarding the factors that influence thecapital structure decisions and diminutive research to describe the financing behavior ofPakistani firms are few reasons that have evoked the need for this research. We hope thatfindings of this empirical study will not only fill this gap but also provide somegroundwork upon which a more detailed evaluation could be based.

The rest of the paper is structured as follows. In Section 2, the most prominenttheoretical and empirical findings are surveyed. In Section 3, the potential determinantsof capital structure are summarized, and theoretical and empirical evidence concerningthese determinants are provided. Section 4 is the empirical part of the paper whichdescribes the data and methodology employed in this study. Section 5 is devoted toresults and discussion, and finally Section 6 presents the conclusions of this study.

2. Review of capital structure theoriesThe modern theory of capital structure was developed by Modigliani and Miller (1958).They proved that the choice between debt and equity financing has no material effectson the firm value, therefore, management of a firm should stop worrying about theproportion of debt and equity securities because in perfect capital markets anycombination of debt and equity securities is as good as another. However, Modiglianiand Millers debt irrelevance theorem is based on restrictive assumptions which do nothold in reality, when these assumptions are removed then choice of capital structurebecomes an important value-determining factor. For instance, considering taxes in theiranalysis Modigliani and Miller (1963) proposed that firms should use as much debt

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as possible due to tax-deductible interest payments. Moreover, the value of a leveredfirm exceeds that of an unlevered firm by an amount equal to the present value of the taxsavings that arise from the use of debt.

Miller (1977) has presented an alternative theory by incorporating three different taxrates in his analysis (corporate tax rate, personal tax rate on equity income, and theregular personal tax rate which applies to interest income). Miller proposed that net taxsavings from corporate borrowings can be zero when personal as well as corporate taxesare considered. Since interest income is not taxed at the corporate level but taxed at thepersonal level, whereas equity income is taxed at the corporate level but may largelyescape personal taxes when it comes in the form of capital gains. So the effective personaltax rate on equity income is usually less than the regular personal tax rate on interestincome. This factor reduces the advantage of debt financing. In Millers analysis, thesupply of corporate debt expands as long as the corporate tax rate exceeds the personaltax rate of investors absorbing the increased supply. The level of supply which equatesthese two tax rates establishes an optimal debt ratio.

In contrast to the tax benefits on the use of debt finance DeAngelo and Masulis (1980)proposed that companies have ways other than the interest on debt to shelter incomesuch as depreciation, investment tax credits, tax loss carry forwards, etc. The benefitof tax shields on interest payments encourages firms to take on more debt, but alsoincreases the probability that earnings in some years may not be sufficient to offset all taxdeductions. Therefore, some of them may be redundant including the tax deductibility ofinterest payments. So firms with large non-debt tax shields relative to their expectedcash flow include less debt in their capital structure. This view suggests that non-debttax shields are the substitute of the tax shields on debt finance, and therefore, therelationship between non-debt tax shields and leverage should be negative.

Although the benefit of tax shields may encourage the firms to employ more debt thanother external sources available to them, this mode of finance is not free from costs. Twopotential costs, namely, the bankruptcy costs and the agency costs are associated withthis source of finance. Bankruptcy is merely a legal mechanism allowing the creditors totake over when the decline in the value of assets triggers a default. Thus, bankruptcycosts are the costs of using this mechanism. The costs of bankruptcy discussed in theliterature are of two kinds: direct and indirect. Direct costs include fees of lawyers andaccountants, other professional fees, the value of the managerial time spent inadministering the bankruptcy. Indirect costs include lost sales, lost profits, and possiblythe inability of a firm to obtain credit or to issue securities except under especiallyunfavorable terms. While analyzing the data of 11 railroad bankruptcies which occurredbetween 1930 and 1955, Warner (1977) observed that the ratio of direct bankruptcy coststo the market value of the firm appeared to fall as the value of the firm increased. The costof bankruptcy is on the average about 1 percent of the market value of the firm prior tobankruptcy. Furthermore, direct costs of bankruptcy, such as legal fees, seem to decreaseas a function of the size of the bankrupt firm. Thus, these findings suggest that directbankruptcy costs are less important for capital structure decisions of large firms. In orderto investigate the impact of both direct and indirect bankruptcy costs, Altman (1984)collected the data related to retail and industrial firms failure in the USA. Altmanobserved that bankruptcy costs are not trivial. In many cases, bankruptcy costsexceeded 20 percent of the value of the firm measured just before the bankruptcy andeven in some cases measured several years before. On average, bankruptcy costs ranged


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from 11 to 17 percent of the firm value up to three years before the bankruptcy. Moreover,bankruptcy gobbles up a larger fraction of the assets value for small companies than forlarge ones. These findings suggest that the financial distress costs differ with respect tothe size of the firm and are relevant in determining the capital structure of the firm.

The use of debt in the capital structure of a firm also leads to agency costs. Theagency costs refer to the costs generated as the result of conflicts of interest. Therefore,agency costs stem as a result of the relationships between managers and shareholders,and those between debt holders and shareholders ( Jensen and Meckling, 1976). Conflictsbetween managers and shareholders arise because managers hold less than 100 percentof the residual claim. Owing to this, managers may invest less effort in managing thefirms resources and may be able to transfer the firms resources for their own personalbenefits. The managers bear the entire costs of refraining from these activities, butcapture only a fraction of the gain. As a result, managers overindulge in these pursuitsrelative to the level that would maximize the firms value. This inefficiency is reducedwhen a large fraction of the firms equity is owned by the managers.

According to Myers (2001), conflicts between debt holders and shareholders onlyarise when there is a risk of default. If debt is totally free of default risk, debt holders haveno interest in the income and the value or risk of the firm. However, if the chance ofdefault is significant and managers also act in the interest of shareholders, thenshareholders can attain benefits at the expense of debt holders. The managers can bringinto play numerous options while transferring value from debt holders to shareholders.For instance, managers can invest funds in riskier assets. The managers can borrowmore and pay out cash to shareholders. The managers can cut back equity-financedcapital investments. Finally, the managers may postpone immediate bankruptcy orreorganization by obscuring financial problems from the creditors. However, debtholders might also be aware of these temptations and strive to confine the opportunisticbehavior of managers by writing the debt contracts accordingly.

Bankruptcy and financial distress costs and agency costs constitute the basics of thetrade-off theory. The trade-off theory states that firms borrow up to the point where the taxsavings from an extra dollar in debt are exactly equal to the costs that come from theincreased probability of financial distress. Under the trade-off theory framework, a firm isviewed as setting a target debt to equity ratio and gradually moving toward it whichindicates that some form of optimal capital structure exist that can maximize the firmvalue. The trade-off theory has strong practical appeal. It rationalizes moderate debt ratios.It is also consistent with certain obvious facts, for instance, companies with relatively safetangible assets tend to borrow more than companies with risky intangible assets.

An alternative to trade-off theory is the pecking order theory of Myers and Majluf(1984) and Myers (1984). The pecking order theory is based on two prominentassumptions. First, the managers are better informed about their own firms prospectsthan are outside investors. Second, managers act in the best interests of existingshareholders. Under these conditions, a firm will sometimes forgo positive net presentvalue projects if accepting them forces the firm to issue undervalued equity to newinvestors. This in turn provides a rationale for firms to value financial slack, such aslarge cash and unused debt capacity. Financial slack permits the firms to undertakeprojects that might be declined if they had to issue new equity to investors. Morespecifically, pecking order theory predicts that firms prefer to use internal financingwhen available and choose debt over equity when external financing is required.

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In summary, the trade-off theory underlines taxes while the pecking order theoryemphasizes on asymmetric information.

Another important conditional theory of capital structure is the theory of free cashflow which states that high leverage leads to a rise in the value of a firm despite the threatof financial distress, when a firms operating cash flow exceeds its profitable investmentopportunities (Myers, 2001). Conflicts between shareholders and managers over payoutpolicies are especially severe when a firm generates free cash flow. The problem is howto motivate the managers to distribute the free cash among the shareholders instead ofinvesting it at below the cost of capital or wasting it on organizational inefficiencies.According to Jensen (1986), debt can be used as a controlling device that commits themanagers to pay out free cash among shareholders that cannot be profitably reinvestedinside the firm. Grossman and Hart (1982) observed that debt can create an incentive formanagers to work harder, consume fewer perquisites, make better investment decisions,etc. when bankruptcy is costly for them, perhaps they may lose the benefits of controland reputation. These findings suggest that a high debt ratio may be dangerous for afirm, but it can also add value by putting the firm on a diet.

Several studies have examined the empirical validity of the theories of capitalstructure, but no consensus has been reached so far even within the context of developedeconomies. This may be because of the fact that these theories differ in their emphasis,for example, the trade-off theory emphasizes taxes, the pecking order theory emphasizesdifferences in information, and the free cash flow theory emphasizes agency costs. Thus,there is no universal theory of debt-equity choice and no reason to expect one (Myers,2001). However, there are several useful conditional theories that can provide support inunderstanding the financing behavior of firms.

3. Determinants of capital structureThis section briefly explains the attributes, suggested by the different conditional theoriesof capital structure (as explained above), which may affect the firms capital structuredecisions. These attributes are denoted as profitability, size, non-debt tax shields,tangibility (asset structure), growth opportunities, earnings volatility, and liquidity. Theattributes and their relationship to the optimal capital structure choice are discussed below.

ProfitabilityThe trade-off theory suggests a positive relationship between profitability and leveragebecause high profitability promotes the use of debt and provides an incentive to firms toavail the benefit of tax shields on interest payments. The pecking order theory postulatesthat firms prefer to use internally generated funds when available and choose debt overequity when external financing is required. Thus, this theory suggests a negativerelationship between profitability (a source of internal funds) and leverage. Severalempirical studies have also reported a negative relationship between profitability andleverage (Toy et al., 1974; Titman and Wessels, 1988; Rajan and Zingales, 1995; Wald,1999; Booth et al., 2001; Chen, 2004; Bauer, 2004; Tong and Green, 2005; Huang and Song,2006; Zou and Xiao, 2006; Viviani, 2008; Jong et al., 2008; Serrasqueiro and Rogao, 2009).

SizeSeveral reasons are given in the literature concerning the firm size as an importantdeterminant of capital structure. For instance, Rajan and Zingales (1995) in their study


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of firms in G-7 countries observed that large firms tend to be more diversified and,therefore, have lower probability of default. Rajan and Zingales argument is consistentwith the predictions of the trade-off theory which suggests that large firms shouldborrow more because these firms are more diversified, less prone to bankruptcy, andhave relatively lower bankruptcy costs. Furthermore, large firms also have lower agencycosts of debt, for example, relatively lower monitoring costs because of less volatile cashflow and easy access to capital markets. These findings suggest a positive relationshipbetween the firm size and leverage. On the other hand, the pecking order theory suggestsa negative relationship between firm size and the debt ratio, because the issue ofinformation asymmetry is less severe for large firms. Owing to this, large firms shouldborrow less due to their ability to issue informationally sensitive securities like equity.

Empirical findings on this issue are still mixed. Wald (1999) has shown a significantpositive relationship between size and leverage for firms in the USA, the UK, and Japanand an insignificant negative relationship for firms in Germany and a positiverelationship for firms in France. Chen (2004) has shown a significant negativerelationship between size and long-term leverage for firms in China. Several empiricalstudies have reported a significant positive relationship between leverage and firm size(Marsh, 1982; Bauer, 2004; Deesomsak et al., 2004; Zou and Xiao, 2006; Eriotis et al., 2007;Jong et al., 2008; Serrasqueiro and Rogao, 2009).

Non-debt tax shieldsTax shields benefit on the use of debt finance may either be reduced or even eliminatedwhen a firm is reporting an income that is consistently low or negative. Consequently,the burden of interest payments would be felt by the firm. DeAngelo and Masulis (1980)proposed that non-debt tax shields are the substitute of the tax shields on debt financing.So firms with larger non-debt tax shields, ceteris paribus, are expected to use less debtin their capital structure. Empirical findings are mixed on this issue. Bradley et al. (1984)have shown a strong direct relationship between leverage and the relative amount ofnon-debt tax shields. Titman and Wessels (1988) have found no support for an effecton debt ratios arising from non-debt tax shields. Wald (1999) and Deesomsak et al. (2004)reported a significant negative relationship between leverage and non-debt tax shields.Viviani (2008) has shown a significant negative relationship only between short-termdebt ratio and non-debt tax shields. Bauer (2004) has shown a negative but lesssignificant relationship between non-debt tax shields and the measures of leverage.

TangibilityMyers and Majluf (1984) argued that firms may find it advantageous to sell secured debtbecause there are some costs associated with issuing securities about which the firmsmanagers have better information than outside shareholders. Thus, issuing debtsecured by the property with known values avoids these costs. This finding suggests apositive relationship between tangibility and leverage because firms holding assets cantender these assets to lenders as collateral and issue more debt to take the advantage ofthis opportunity. Furthermore, the findings of Jensen and Meckling (1976) and Myers(1977) suggest that the shareholders of highly leveraged firms have an incentive toinvest suboptimally to expropriate wealth from the firms debt holders. However, debtholders can confine this opportunistic behavior by forcing them to present tangibleassets as collateral before issuing loans, but no such confinement is possible for those

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projects that cannot be collateralized. This incentive may also induce a positiverelationship between leverage and the capacity of a firm to collateralize its debt. Severalempirical studies have reported a positive relationship between tangibility and leverage(Wald, 1999; Chen, 2004; Huang and Song, 2006; Zou and Xiao, 2006; Viviani, 2008;Jong et al., 2008; Serrasqueiro and Rogao, 2009).

However, the tendency of managers to consume more than the optimal level ofperquisites may produce a negative correlation between collateralizable assets andleverage (Titman and Wessels, 1988). The firms with less collateralizable assets(tangibility) may choose higher debt levels to stop managers from using more than theoptimal level of perquisites. This agency explanation suggests a negative associationbetween tangibility and leverage. Booth et al. (2001) have reported a negative relationshipbetween tangibility and leverage for firms in Brazil, India, Pakistan, and Turkey. Someother empirical studies have also reported a negative relationship between tangibilityand leverage (Ferri and Jones, 1979; Bauer, 2004; Mazur, 2007; Karadeniz et al., 2009).

Growth opportunitiesAccording to trade-off theory, firms holding future growth opportunities, which are aform of intangible assets, tend to borrow less than firms holding more tangible assetsbecause growth opportunities cannot be collateralized. This finding suggests a negativerelationship between leverage and growth opportunities. Agency theory also predicts anegative relationship because firms with greater growth opportunities have moreflexibility to invest suboptimally, thus, expropriate wealth from debt holders toshareholders. In order to restrain these agency conflicts, firms with high growthopportunities should borrow less. Several empirical studies have confirmed thisrelationship, i.e. Deesomsak et al. (2004), Zou and Xiao (2006) and Eriotis et al. (2007). Wald(1999) has shown that the USA is the only country where high growth is associated withlower debt/equity ratio. This finding confirms the predictions of Myerss (1977) modelthat ongoing growth opportunities imply a conflict between debt and equity interests.This conflict also causes the firms to refrain from undertaking net positive value projects.

Earnings volatilitySeveral empirical studies have shown that a firms optimal debt level is a decreasingfunction of the volatility of its earnings. The higher volatility of earnings may indicatethe greater probability of a firm being unable to meet its contractual claims as they comedue. A firms debt capacity may also decrease with an increase in its earnings volatilitywhich suggests a negative association between earnings volatility and leverage. Variousempirical studies have shown a significant negative relationship between leverageand earnings volatility (Bradley et al., 1984; Booth et al., 2001; Fama and French, 2002;Jong et al., 2008).

LiquidityThe trade-off theory suggests that companies with higher liquidity ratios should borrowmore due to their ability to meet contractual obligations on time. Thus, this theorypredicts a positive linkage between liquidity and leverage. On the other hand, thepecking order theory predicts a negative relationship between liquidity and leverage,because a firm with greater liquidities prefers to use internally generated funds while


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financing new investments. A few empirical studies have shown their results consistentwith the pecking order hypothesis (Deesomsak et al., 2004; Mazur, 2007; Viviani, 2008).

4. Data and methodologyDataThis study investigates the determinants of capital structure for manufacturing firms,listed on the Karachi Stock Exchange (KSE) Pakistan during 2003-2007, using the datapublished by the State Bank of Pakistan (SBP). The data published by SBP providesuseful information on key accounts of the financial statements of all non-financial firmslisted on KSE[1]. Moreover, it allows for the calculation of many variables that are knownto be relevant from studies of firms in developed countries. The final sample, afterconsidering any missing data, consists of a balanced panel of 160 firms over a period offive years. Firms under analysis represent the driving industrial force in Pakistan, and itis expected that the sample may do well in capturing aggregate leverage in the country.

On the basis of research objectives of this study, variables used in this study and theirmeasurements are largely adopted from existing literature, for the meaningfulcomparison of our findings with prior empirical studies in developed and developingcountries. The dependent variable is the debt ratio; the explanatory variables includeprofitability, size, non-debt tax shields, tangibility, growth opportunities, earningsvolatility, and liquidity. Their definitions are listed in Table I. All the variables aremeasured using book values because the data employed in this study come fromfinancial statements only.

This study used the debt ratio as a measure of leverage, defined as book value of totaldebt divided by the book value of total assets. The total debt is the sum of short-term andlong-term debt. Although, the strict notion of capital structure refers exclusively tolong-term debt, we have included short-term debt as well because of its significantproportion in the make up of total debt. On average short-term debt represents 76 percentof the total debt employed by the companies included in our sample[2]. The profounddependence of Pakistani firms on short-term debt confirms the findings of Demirguc-Kuntand Maksimovic (1999) that a major difference between developing and developedcountries is that developing countries have substantially lower amounts of long-term debt.

Variables Definition

Dependent variableDebt ratio (DRit) Ratio of total debt to total assetsExplanatory variablesProfitability (PROFit) Ratio of net profit before taxes to total assetsSize (SIZEit) Natural logarithm of salesNon-debt tax shields (NDTSit) Ratio of depreciation expense to total assetsTangibility (TANGit) Ratio of net-fixed assets to total assetsGrowth opportunities (GROWit) Ratio of sales growth to total assets growth (due to the absence of

data related to advertising expense, research and developmentexpenditures, and market-to-book ratio)

Earnings volatility (EVOLit) Ratio of standard deviation of the first difference of profit beforedepreciation, interest, and taxes to average total assets

Liquidity (LIQit) Ratio of current assets to current liabilities

Table I.Definition of variables

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MethodologyThis study employed panel data procedures because sample contained data across firmsand overtime. The use of panel data increases the sample size considerably and is moreappropriate to study the dynamics of change. In order to estimate the effects ofexplanatory variables on the debt ratio (a measure of leverage), we used three estimationmodels, namely, pooled ordinary least squares (OLS), the random effects, and the fixedeffects. Under the hypothesis that there are no groups or individual effects among thefirms included in our sample, we estimated the pooled OLS model.

Since panel data contained observations on the same cross-sectional units overseveral time periods there might be cross-sectional effects on each firm or on a set ofgroup of firms. Several techniques are available to deal with such type of problem buttwo panel econometric techniques, the fixed and the random effects models, are veryimportant. The fixed effects model takes into account the individuality of each firm orcross-sectional unit included in the sample by letting the intercept vary for each firm butstill assumes that the slope coefficients are constant across firms. The random effectsmodel estimates the coefficients under the assumption that the individual or groupeffects are uncorrelated with other explanatory variables and can be formulated. Thisstudy also employed the Hausman (1978) specification test to determine whichestimation model, either fixed or random effects, best explains our estimation.

The description of three estimation models pooled OLS, the fixed effects, and therandom effects is given below:

DRit b0 b1PROFit b2SIZEit b3NDTSit b4TANGit b5GROWit b6EVOLit b 7LIQit 1it

DRit b0i b1PROFit b2SIZEit b3NDTSit b4TANGit b5GROW it b6EVOLit b7LIQit m it

DRit b0 b1PROFit b2SIZEit b3NDTSit b4TANGit b5GROWit b6EVOLit b7LIQit 1it m it

where:

DRit debt ratio of firm i at time t.PROFit profitability of firm i at time t.SIZEit size of firm i at time t.NDTSit non-debt tax shields of firm i at time t.TANGit tangibility of firm i at time t.GROWit growth opportunities of firm i at time t.EVOLit earnings volatility of firm i at time t.LIQit current ratio of firm i at time t.b0 common y-intercept.b1-b7 coefficients of the concerned explanatory variables.1it stochastic error term of firm i at time t.


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b0i y-intercept of firm I.mit error term of firm i at time t.1i cross-sectional error component.

5. Empirical results and discussionsEmpirical resultsThis section presents the various estimation results and discusses the implications of theempirical findings. The summary statistics of the dependent and explanatory variablesover the sample period are presented in Table II, reflecting the capital structures of theanalyzed firms. The debt ratio indicates that 60.78 percent of the firms assets arefinanced with total debt during the study period. This ratio, in comparison with firms inG-7 and developing countries, indicates that Pakistani firms seem to be more leveraged(Table III) than those in the Canada, the UK, the USA, Brazil, Jordan, Malaysia, Mexico,

Variables Observations Mean SD Minimum Maximum

DRit 800 0.607852 0.156759 0.115851 0.891286PROFit 800 0.055274 0.110648 21.001851 1.240773SIZEit 800 7.376455 1.178565 1.435085 11.01449NDTSit 800 0.038546 0.032315 0.000699 0.201533TANGit 800 0.518880 0.190491 0.020310 0.926522GROWit 800 20.165196 72.85970 21705.662 1,008.796EVOLit 800 0.547126 1.006701 0.008834 9.821189LIQit 800 1.148879 0.665056 0.157232 6.666245

Table II.Summary statistics

Country No. of firms Time period Total debt ratio (%)

Developing countries dataBrazil 49 1985-1991 30.3India 99 1980-1990 67.1Jordan 38 1983-1990 47.0Malaysia 96 1983-1990 41.8Mexico 99 1984-1990 34.7South Korea 93 1980-1990 73.4Thailand 64 1983-1990 49.4Turkey 45 1983-1990 59.1Zimbabwe 48 1980-1988 41.5G-7 countries dataCanada 318 1991 56.0France 225 1991 71.0Germany 191 1991 73.0Italy 118 1991 70.0Japan 514 1991 69.0UK 608 1991 54.0USA 2580 1991 58.0

Source: Data of debt ratios of firms in developing countries are adopted from Booth et al. (2001),whereas data of debt ratios of firms in G-7 countries are taken from Rajan and Zingales (1995)

Table III.Debt ratios

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Thailand, Turkey, and Zimbabwe, while less leveraged than those in the France,Germany, Italy, Japan, India, and South Korea. This comparison indicates that onaverage Pakistani firms show similar financing behavior as observed for firms indeveloping and G-7 countries.

Prior to estimating the coefficients of the model, the sample data were also tested formulticollinearity. Results are presented in Table IV, which show that mostcross-correlation terms for the explanatory variables are fairly small, thus giving nocause for concern about the problem of multicollinearity among the explanatory variables.

Under the hypothesis that there are no groups or individual effects among the firmsincluded in our sample, we estimated the pooled OLS model. The estimation results arepresented in Table V, which indicates that profitability, size, non-debt tax shields,tangibility, and liquidity proved to be significant in confidence level of 5 percent.Earnings volatility found less significant while the variable growth opportunities foundhighly insignificant. The OLS regression has high adjusted R 2 and appears to be able toexplain variations in the debt ratio. Furthermore, the F-statistic confirms thesignificance of the OLS regression model.

Since our sample contained data across firms and overtime there might becross-sectional effects on each firm or on a set of group of firms. In order to deal withthose effects, two panel econometric techniques, namely, the fixed effects and randomeffects estimation models, are employed. Results of these estimation modelsare presented in Tables VI and VII. Under both estimations models profitability, size,

Variables DRit PROFit SIZEit NDTSit TANGit GROWit EVOLit LIQit

DRit 1.0000PROFit 20.3222 1.0000SIZEit 0.1382 0.2054 1.0000NDTSit 20.0739 20.0281 20.0391 1.0000TANGit 0.0692 20.3182 20.2681 0.1841 1.0000GROWit 20.0195 0.0082 20.0134 20.0310 0.0005 1.0000EVOLit 20.2316 0.0722 20.6007 0.0917 20.0154 0.0078 1.0000LIQit 20.6302 0.3929 0.1351 20.0703 20.5182 0.0276 0.1014 1.0000

Table IV.Pearson correlation

coefficient matrix

Variables Coefficient SE t-statistic Prob.

C 0.825937 0.040538 20.37416 0.0000PROFit 20.223053 0.038392 25.809910 0.0000SIZEit 0.020456 0.004402 4.647338 0.0000NDTSit 20.299191 0.119903 22.495272 0.0128TANGit 20.263211 0.024567 210.71404 0.0000GROWit 7.17 1026 5.18 1025 20.138361 0.8900EVOLit 20.007898 0.004972 21.588466 0.1126LIQit 20.177752 0.000694 225.58635 0.0000

Notes: R 2 0.541291; mean dependent variable 0.607853; adjusted R 2 0.537236; SD- dependentvariable 0.156759; SE of regression 0.106638; sum of squared residual 9.006391;F-statistic 133.5120; Prob. . F-statistic 0.000000

Table V.The effect of explanatory

variables on the debtratio (DRit) using the OLS

estimation model


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tangibility, earnings volatility, and liquidity proved to be significant with a confidencelevel of 5 percent. Non-debt tax shields proved significant only under the random effectsestimation model. Growth opportunities remained highly insignificant under bothestimation models. The adjusted R 2 for the fixed effects estimation model is higher thanfor the simple pooling model, indicating the existence of the omitted variables.The results of the Hausman specification test are reported in Table VIII. The test isasymptotically x 2 distributed with 7 df. Results indicate that the null hypothesis isrejected and we may be better off using the estimation of the fixed effects model.



Notes: R 2 0.392376; SE of regression 0.075322; adjusted R 2 0.387006; sum of squaredresidual 4.493354; F-statistic 73.06263; Prob. . F-statistic 0.000000

Table VII.The effect of explanatoryvariables on the debt ratio(DRit) using the randomeffects estimation model



Notes: R 2 0.825745; SE of regression 0.073519; adjusted R 2 0.780047; sum of squaredresidual 3.421363; F-statistic 18.06989; Prob. . F-statistic 0.000000

Table VI.The effect of explanatoryvariables on the debt ratio(DRit) using the fixedeffects estimation model

Variables Fixed effects Random effects Var. (Diff.) Prob.

PROFit 20.149226 20.165676 0.000128 0.1464SIZEit 0.031443 0.020262 0.000039 0.0741NDTSit 20.134187 20.192198 0.000655 0.0234TANGit 20.302437 20.246056 0.000958 0.0685GROWit 20.000001 20.000003 0.000000 0.6038EVOLit 20.021170 20.013829 0.000044 0.2697LIQit 20.121057 20.143623 0.000017 0.0000

Notes: Wald x 2(7 df) 46.333298; Prob. . x 2 0.0000000Table VIII.Fixed and random effectstest comparison

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DiscussionAccording to empirical findings, profitability and liquidity have a negative andsignificant relationship with the debt ratio, which confirms that firms finance theiractivities following the financing pattern implied by the pecking order theory. Moreover,high cost of raising funds might also restrict the Pakistani firms to rely on internallygenerated funds because of relatively limited equity markets combined with lower levelsof trading. This finding also confirms that information asymmetry is especially relevantin the capital structure decisions of the firms listed on KSE.

The variable size has a positive and significant impact on the debt ratio. This findingis consistent with the implications of the trade-off theory suggesting that larger firmsshould operate at high debt levels due to their ability to diversify the risk and to take thebenefit of tax shields on interest payments. The estimated coefficient of earningsvolatility has the predicted negative sign and is statistically significant. This findingconfirms the predictions of the trade-off theory which suggests that firms with lessvolatile earnings should operate at high debt levels due to their ability to satisfy theircontractual claims on due date. Pakistani firms mainly rely on bank debt because ofsmall and undeveloped bond market. Furthermore, majority of these banks areprivatized and disinclined to issue loans on favorable terms particularly to firms withvolatile earnings. For this reason, firms with volatile earnings borrow less. This studyshows contradictory results concerning the variable non-debt tax shields. The total andrandom effects estimation models accept this variable but the fixed effects model doesnot. This controversy suggests that further analysis with a comprehensive data setwould be a promising area for future study. Growth opportunities found to be highlyinsignificant in all estimation models.

Theoretically, the expected relationship between the debt ratio and tangibility (assetstructure) is positive. However, based on the results of this study, the relationship isnegative. Some empirical studies for developing countries, i.e. Booth et al. (2001), Bauer(2004), Mazur (2007) and Karadeniz et al. (2009), have shown a negative relationship,whereas empirical studies for developed countries have reported a positive relationshipbetween tangibility and leverage, include Titman and Wessels (1988) Rajan andZingales (1995) and Wald (1999). Although this result does not sit well with the trade-offhypothesis, which suggests that companies with relatively safe tangible assets tend toborrow more than companies with risky intangible assets. However, this finding isconsistent with the implications of the agency theory suggesting that the tendency ofmanagers to consume more than the optimal level of perquisites may produce an inverserelationship between collateralizable assets and the debt levels (Titman and Wessels,1988). The pecking order theory also predicts a negative relationship between tangibilityand short-term debt ratio (Karadeniz et al., 2009).

Although manufacturing firms in Pakistan heavily rely on short-term debt eitherbecause of small and undeveloped bond market or due to high-cost long-term bank debt.However, it is difficult to be certain that this negative relationship is the outcome ofprofound dependency of firms on short-term debt, because short-tem debt ratio is notemployed independently in this study as an explained variable. This negativerelationship may possibly be the outcome of excessive liquidity maintained by the firmswhich encourage managers to consume more than the optimal level of perquisites.Consequently, firms with less collateralizable assets may choose higher debt levels tolimit their managers consumption of perquisites.


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The agency explanation seems to be more valid for firms in Pakistan due to the factthat firms uphold excessive liquidity that may encourage managers to consume morethan the optimal level of perquisites.

In summary, the difference in long-term versus short-term debt is much pronouncedin Pakistan; this might limit the explanatory power of the capital structure modelsderived from Western settings. However, the results of this empirical study suggest thatsome of the insights from modern finance theory are portable to Pakistan becausecertain firm-specific factors that are relevant for explaining capital structures indeveloped countries are also relevant in Pakistan.

6. ConclusionsThis empirical study attempted to explore the determinants of capital structure of160 manufacturing firms listed on the KSE Pakistan during 2003-2007. The investigationis performed using panel econometric techniques, namely, pooled OLS, fixed effects, andrandom effects. This study has employed the debt ratio (a measure of leverage) as anexplained variable. The debt ratio includes both long-term and short-term debt.Although, the strict notion of capital structure refers exclusively to long-term debt, wehave included short-term debt as well because of its significant proportion in the make upof total debt of the firms included in our sample.

According to the results of empirical analysis, profitability and liquidity are negativelycorrelated with the debt ratio. This finding is consistent with the pecking order hypothesisrather than with the predictions of the trade-off theory. The firm size is positivelycorrelated with the debt ratio. This finding supports the view of firm size as an inverseproxy for the probability of bankruptcy. The debt ratio is negatively correlated withearnings volatility, which is consistent with theoretical underpinnings of the trade-offtheory. The tangibility (asset structure) is negatively correlated with the debt ratio. Thisfinding is in contradiction with the predictions of the trade-off theory; however, it is in linewith the implications of the agency theory suggesting that firms with less collateralizableassets may choose higher debt levels to limit the managers consumptions of perquisites.Moreover, a significant negative impact of liquidity on the debt ratio indicates that firmsmaintained excessive liquidity which may encourage managers to consume more than theoptimal level of perquisites. Consequently, firms with less collateralizable assets borrowmore to confine the opportunistic behavior of the managers. Contradictory results arefound concerning the variable non-debt tax shields. The total and random effects modelaccepts this variable with a negative sign but the fixed effects model does not.No significant relationship is found between the debt ratio and growth opportunities.

Finally, the difference in long-term versus short-term debt might limit theexplanatory power of the capital structure models derived from Western settings.However, the results indicate that these models provide some help in understanding thefinancing behavior of Pakistani firms.

Notes

1. The publication entitled Balance Sheet Analysis of Joint Stock Companies listed on KarachiStock Exchange 2002 2 2007 is prepared by the SBP on the basis of information given in theannual reports, made by the companies at the end of each accounting period. This ismandatory for every public limited company to make financial statements in accordance withthe approved accounting standards as applicable in Pakistan. Approved accounting standards

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comprise of such International Financial Reporting Standards issued by the InternationalAccounting Standard Board as are notified under the Companies Ordinance 1984.

2. The total debt is the sum of long-term and short-term debt. On average long-term debtrepresents 24 percent while short-term debt represents 76 percent of the total debt employedby the companies included in our sample. The reasons for heavy dependence of firms onshort-term debt include relatively high cost of long-term bank loans, and a limited andundeveloped bond market in Pakistan.

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About the authorsNadeem Ahmed Sheikh is a Senior Lecturer of Accounting and Finance at the Institute ofManagement Sciences, Bahauddin Zakariya University, Multan, Pakistan. At present, he isenrolled as Doctoral degree candidate, in the programme of Business Administration (Finance), inSchool of Management, Huazhong University of Science and Technology, Wuhan (Hubei) PeoplesRepublic of China. He earned the degree of Bachelor of Commerce (BCom) in 1996 fromGovernment College of Commerce, Multan, Pakistan. He stood first in BCom Examination andBahauddin Zakariya University awarded him a Gold Medal in 1997. He has earned the degree ofMaster in Business Administration (Finance) in 1999. He secured third position in financespecialization and Department of Business Administration awarded him a Certificate of Honor. Inyear 2000, on account of his excellent academic credentials, he attained a position as Lecturer ofAccounting and Finance at Department of Business Administration, Bahauddin ZakariyaUniversity. In 2005, Bahauddin Zakariya University has recommended him for Star ExcellenceAward (awarded by South Asia Publications) as a result of his ranking as the best teacher in theinstitute. Nadeem Ahmed Sheikh is the corresponding author and can be contacted at:[email protected]

Zongjun Wang is University Professor at Huazhong University of Science and Technology,Wuhan, Peoples Republic of China. He is the Director of the Department of Management Sciencesand Technology, and the Director of the Institute of Enterprise Evaluation. He is also the AssistantDean of the School of Management. Zongjun Wang has earned his Bachelor degree in ComputerScience in 1985 from Beijing Institute of Technology, Beijing, China. He has earned the degree ofDoctor of Philosophy in System Engineering in 1993 from Hauzhong University of Science andTechnology, Wuhan, Peoples Republic of China. He joined the Arizona State University as aSenior Visiting Scholar during 2004-2005 under the assistanceship of Fulbright Foundation, USAand the Montreal University, Canada in 2001 as a senior fellow. He has published more than150 articles in different journals (Chinese and international journals) related to the field of systemengineering, integrated evaluation methodology and applications, corporate governance,management, corporate finance, etc.

To purchase reprints of this article please e-mail: [email protected] visit our web site for further details: www.emeraldinsight.com/reprints


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