Managerial Finance

Determinants of capital structure: An empirical study of firms in manufacturing industry

of Pakistan
Nadeem Ahmed Sheikh Zongjun Wang
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Nadeem Ahmed Sheikh Zongjun Wang, (2011),"Determinants of capital structure", Managerial Finance,
Vol. 37 Iss 2 pp. 117 - 133
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Determinants of capital structure
An empirical study of rms in manufacturing
industry of Pakistan
Nadeem Ahmed Sheikh
School of Management, Huazhong University of Science and Technology,
Wuhan, Peoples Republic of China and
Institute of Management Sciences, Bahauddin Zakariya University,
Multan, Pakistan, and
Zongjun Wang
School 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 structure
of manufacturing rms and to investigate whether the capital structure models derived from
Western settings provide convincing explanations for capital structure decisions of the Pakistani
rms.
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 ow) in order to
formulate testable propositions concerning the determinants of capital structure of the manufacturing
rms. The investigation is performed using panel data procedures for a sample of 160 rms listed on
the Karachi Stock Exchange during 2003-2007.
Findings The results suggest that protability, liquidity, earnings volatility, and tangibility
(asset structure) are related negatively to the debt ratio, whereas rm size is positively linked to the
debt ratio. Non-debt tax shields and growth opportunities do not appear to be signicantly related to
the debt ratio. The ndings 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 from
Western settings does provide some help in understanding the nancing behavior of rms in
Pakistan.
Practical implications This study has laid some groundwork to explore the determinants of
capital structure of Pakistani rms upon which a more detailed evaluation could be based.
Furthermore, empirical ndings should help corporate managers to make optimal capital structure
decisions.
Originality/value To the authors knowledge, this is the rst study that explores the determinants
of capital structure of manufacturing rms in Pakistan by employing the most recent data. Moreover,
this study somehow goes to conrm that same factors affect the capital structure decisions of rms in
developing countries as identied for rms 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 two
anonymous reviewers for their detailed comments and suggestions that substantially improved
the paper. They are also thankful to Ms Lisa Averill and Mr Javed Choudary for their
comprehensive editing of the manuscript.
Determinants
of capital
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Managerial Finance
Vol. 37 No. 2, 2011
pp. 117-133
qEmerald Group Publishing Limited
0307-4358
DOI 10.1108/03074351111103668
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1. Introduction
Decisions concerning capital structure are imperative for every business organization.
In the corporate form of business, generally it is the job of the management to make
capital structure decisions in a way that the rm value is maximized. However,
maximization of rmvalue is not an easy job because it involves the selection of debt and
equity securities in a balanced proportion keeping in viewof different costs and benets
coupled with these securities. Awrong decision in the selection process of securities may
lead the rm to nancial distress and eventually to bankruptcy. The relationship
between capital structure decisions and rm value has been extensively investigated
in the past few decades. Over the years, alternative capital structure theories have been
developed in order to determine the optimal capital structure. Despite the theoretical
appeal of capital structure, a specic methodology has not been realized yet, which
managers can use in order to determine an optimal debt level. This may be due to the fact
that theories concerning capital structure differ in their relative emphasis; for instance,
the trade-off theory emphasizes taxes, the pecking order theory emphasizes differences
in information, and the free cash ow theory emphasizes agency costs. However, these
theories provide some help in understanding the nancing behavior of rms as well as
in identifying the potential factors that affect the capital structure.
The empirical literature on capital structure choice is vast, mainly referring to
industrialized countries (Myers, 1977; Titman and Wessels, 1988; Rajan and Zingales,
1995; Wald, 1999) and a fewdeveloping countries (Booth et al., 2001). However, ndings
of these empirical studies do not lead to a consensus with regard to the signicant
determinants of capital structure. This may be because of variations in the use of
long-term versus short-term debt or because of institutional differences that exist
between developed and developing countries.
The lack of consensus among researchers regarding the factors that inuence the
capital structure decisions and diminutive research to describe the nancing behavior of
Pakistani rms are fewreasons that have evoked the needfor this research. We hope that
ndings of this empirical study will not only ll this gap but also provide some
groundwork upon which a more detailed evaluation could be based.
The rest of the paper is structured as follows. In Section 2, the most prominent
theoretical and empirical ndings are surveyed. In Section 3, the potential determinants
of capital structure are summarized, and theoretical and empirical evidence concerning
these determinants are provided. Section 4 is the empirical part of the paper which
describes the data and methodology employed in this study. Section 5 is devoted to
results and discussion, and nally Section 6 presents the conclusions of this study.
2. Review of capital structure theories
The modern theory of capital structure was developed by Modigliani and Miller (1958).
They proved that the choice between debt and equity nancing has no material effects
on the rm value, therefore, management of a rm should stop worrying about the
proportion of debt and equity securities because in perfect capital markets any
combination of debt and equity securities is as good as another. However, Modigliani
and Millers debt irrelevance theorem is based on restrictive assumptions which do not
hold in reality, when these assumptions are removed then choice of capital structure
becomes an important value-determining factor. For instance, considering taxes in their
analysis Modigliani and Miller (1963) proposed that rms should use as much debt
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as possible due to tax-deductible interest payments. Moreover, the value of a levered
rmexceeds that of an unlevered rmby an amount equal to the present value of the tax
savings that arise from the use of debt.
Miller (1977) has presented an alternative theory by incorporating three different tax
rates in his analysis (corporate tax rate, personal tax rate on equity income, and the
regular personal tax rate which applies to interest income). Miller proposed that net tax
savings fromcorporate borrowings can be zero when personal as well as corporate taxes
are considered. Since interest income is not taxed at the corporate level but taxed at the
personal level, whereas equity income is taxed at the corporate level but may largely
escape personal taxes whenit comes inthe formof capital gains. So the effective personal
tax rate on equity income is usually less than the regular personal tax rate on interest
income. This factor reduces the advantage of debt nancing. In Millers analysis, the
supply of corporate debt expands as long as the corporate tax rate exceeds the personal
tax rate of investors absorbing the increased supply. The level of supply which equates
these two tax rates establishes an optimal debt ratio.
In contrast to the tax benets on the use of debt nance DeAngelo and Masulis (1980)
proposed that companies have ways other than the interest on debt to shelter income
such as depreciation, investment tax credits, tax loss carry forwards, etc. The benet
of tax shields on interest payments encourages rms to take on more debt, but also
increases the probabilitythat earnings insome years maynot be sufcient tooffset all tax
deductions. Therefore, some of themmay be redundant including the tax deductibility of
interest payments. So rms with large non-debt tax shields relative to their expected
cash ow include less debt in their capital structure. This view suggests that non-debt
tax shields are the substitute of the tax shields on debt nance, and therefore, the
relationship between non-debt tax shields and leverage should be negative.
Although the benet of taxshields mayencourage the rms to employ more debt than
other external sources available to them, this mode of nance is not free fromcosts. Two
potential costs, namely, the bankruptcy costs and the agency costs are associated with
this source of nance. Bankruptcy is merely a legal mechanismallowing the creditors to
take over when the decline in the value of assets triggers a default. Thus, bankruptcy
costs are the costs of using this mechanism. The costs of bankruptcy discussed in the
literature are of two kinds: direct and indirect. Direct costs include fees of lawyers and
accountants, other professional fees, the value of the managerial time spent in
administering the bankruptcy. Indirect costs include lost sales, lost prots, and possibly
the inability of a rm to obtain credit or to issue securities except under especially
unfavorable terms. While analyzing the data of 11 railroad bankruptcies which occurred
between 1930 and 1955, Warner (1977) observed that the ratio of direct bankruptcy costs
to the market value of the rmappeared to fall as the value of the rmincreased. The cost
of bankruptcy is on the average about 1 percent of the market value of the rm prior to
bankruptcy. Furthermore, direct costs of bankruptcy, suchas legal fees, seemto decrease
as a function of the size of the bankrupt rm. Thus, these ndings suggest that direct
bankruptcycosts are less important for capital structure decisions of large rms. Inorder
to investigate the impact of both direct and indirect bankruptcy costs, Altman (1984)
collected the data related to retail and industrial rms failure in the USA. Altman
observed that bankruptcy costs are not trivial. In many cases, bankruptcy costs
exceeded 20 percent of the value of the rm measured just before the bankruptcy and
even in some cases measured several years before. On average, bankruptcy costs ranged
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from11 to 17 percent of the rmvalue up to three years before the bankruptcy. Moreover,
bankruptcy gobbles up a larger fraction of the assets value for small companies than for
large ones. These ndings suggest that the nancial distress costs differ with respect to
the size of the rm and are relevant in determining the capital structure of the rm.
The use of debt in the capital structure of a rm also leads to agency costs. The
agency costs refer to the costs generated as the result of conicts 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). Conicts
between managers and shareholders arise because managers hold less than 100 percent
of the residual claim. Owing to this, managers may invest less effort in managing the
rms resources and may be able to transfer the rms resources for their own personal
benets. The managers bear the entire costs of refraining from these activities, but
capture only a fraction of the gain. As a result, managers overindulge in these pursuits
relative to the level that would maximize the rms value. This inefciency is reduced
when a large fraction of the rms equity is owned by the managers.
According to Myers (2001), conicts between debt holders and shareholders only
arise when there is a risk of default. If debt is totally free of default risk, debt holders have
no interest in the income and the value or risk of the rm. However, if the chance of
default is signicant and managers also act in the interest of shareholders, then
shareholders can attain benets at the expense of debt holders. The managers can bring
into play numerous options while transferring value from debt holders to shareholders.
For instance, managers can invest funds in riskier assets. The managers can borrow
more and pay out cash to shareholders. The managers can cut back equity-nanced
capital investments. Finally, the managers may postpone immediate bankruptcy or
reorganization by obscuring nancial problems from the creditors. However, debt
holders might also be aware of these temptations and strive to conne the opportunistic
behavior of managers by writing the debt contracts accordingly.
Bankruptcy and nancial distress costs and agency costs constitute the basics of the
trade-off theory. The trade-off theorystates that rms borrowupto the point where the tax
savings from an extra dollar in debt are exactly equal to the costs that come from the
increased probability of nancial distress. Under the trade-off theory framework, a rmis
viewed as setting a target debt to equity ratio and gradually moving toward it which
indicates that some form of optimal capital structure exist that can maximize the rm
value. The trade-off theoryhas strongpractical appeal. It rationalizes moderate debt ratios.
It is also consistent with certain obvious facts, for instance, companies with relatively safe
tangible 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 prominent
assumptions. First, the managers are better informed about their own rms prospects
than are outside investors. Second, managers act in the best interests of existing
shareholders. Under these conditions, a rm will sometimes forgo positive net present
value projects if accepting them forces the rm to issue undervalued equity to new
investors. This in turn provides a rationale for rms to value nancial slack, such as
large cash and unused debt capacity. Financial slack permits the rms to undertake
projects that might be declined if they had to issue new equity to investors. More
specically, pecking order theory predicts that rms prefer to use internal nancing
when available and choose debt over equity when external nancing is required.
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In summary, the trade-off theory underlines taxes while the pecking order theory
emphasizes on asymmetric information.
Another important conditional theory of capital structure is the theory of free cash
owwhich states that high leverage leads to a rise in the value of a rmdespite the threat
of nancial distress, when a rms operating cash owexceeds its protable investment
opportunities (Myers, 2001). Conicts between shareholders and managers over payout
policies are especially severe when a rm generates free cash ow. The problem is how
to motivate the managers to distribute the free cash among the shareholders instead of
investing it at below the cost of capital or wasting it on organizational inefciencies.
According to Jensen (1986), debt can be used as a controlling device that commits the
managers to pay out free cash among shareholders that cannot be protably reinvested
inside the rm. Grossman and Hart (1982) observed that debt can create an incentive for
managers to work harder, consume fewer perquisites, make better investment decisions,
etc. when bankruptcy is costly for them, perhaps they may lose the benets of control
and reputation. These ndings suggest that a high debt ratio may be dangerous for a
rm, but it can also add value by putting the rm on a diet.
Several studies have examined the empirical validity of the theories of capital
structure, but no consensus has been reached so far even within the context of developed
economies. 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 emphasizes
differences in information, and the free cash owtheory 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 in
understanding the nancing behavior of rms.
3. Determinants of capital structure
This section briey explains the attributes, suggested by the different conditional theories
of capital structure (as explained above), which may affect the rms capital structure
decisions. These attributes are denoted as protability, size, non-debt tax shields,
tangibility (asset structure), growth opportunities, earnings volatility, and liquidity. The
attributes andtheir relationshiptothe optimal capital structure choice are discussedbelow.
Protability
The trade-off theory suggests a positive relationship between protability and leverage
because high protability promotes the use of debt and provides an incentive to rms to
avail the benet of tax shields oninterest payments. The pecking order theory postulates
that rms prefer to use internally generated funds when available and choose debt over
equity when external nancing is required. Thus, this theory suggests a negative
relationship between protability (a source of internal funds) and leverage. Several
empirical studies have also reported a negative relationship between protability and
leverage (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).
Size
Several reasons are given in the literature concerning the rm size as an important
determinant of capital structure. For instance, Rajan and Zingales (1995) in their study
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of rms in G-7 countries observed that large rms tend to be more diversied and,
therefore, have lower probability of default. Rajan and Zingales argument is consistent
with the predictions of the trade-off theory which suggests that large rms should
borrow more because these rms are more diversied, less prone to bankruptcy, and
have relatively lower bankruptcy costs. Furthermore, large rms also have lower agency
costs of debt, for example, relatively lower monitoring costs because of less volatile cash
ow and easy access to capital markets. These ndings suggest a positive relationship
between the rmsize and leverage. On the other hand, the pecking order theory suggests
a negative relationship between rm size and the debt ratio, because the issue of
information asymmetry is less severe for large rms. Owing to this, large rms should
borrow less due to their ability to issue informationally sensitive securities like equity.
Empirical ndings on this issue are still mixed. Wald (1999) has shown a signicant
positive relationship between size and leverage for rms in the USA, the UK, and Japan
and an insignicant negative relationship for rms in Germany and a positive
relationship for rms in France. Chen (2004) has shown a signicant negative
relationship between size and long-term leverage for rms in China. Several empirical
studies have reported a signicant positive relationship between leverage and rm 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 shields
Tax shields benet on the use of debt nance may either be reduced or even eliminated
when a rm is reporting an income that is consistently low or negative. Consequently,
the burden of interest payments would be felt by the rm. DeAngelo and Masulis (1980)
proposed that non-debt tax shields are the substitute of the tax shields on debt nancing.
So rms with larger non-debt tax shields, ceteris paribus, are expected to use less debt
in their capital structure. Empirical ndings are mixed on this issue. Bradley et al. (1984)
have shown a strong direct relationship between leverage and the relative amount of
non-debt tax shields. Titman and Wessels (1988) have found no support for an effect
on debt ratios arising fromnon-debt tax shields. Wald (1999) and Deesomsak et al. (2004)
reported a signicant negative relationship between leverage and non-debt tax shields.
Viviani (2008) has shown a signicant negative relationship only between short-term
debt ratio and non-debt tax shields. Bauer (2004) has shown a negative but less
signicant relationship between non-debt tax shields and the measures of leverage.
Tangibility
Myers and Majluf (1984) argued that rms may nd it advantageous to sell secured debt
because there are some costs associated with issuing securities about which the rms
managers have better information than outside shareholders. Thus, issuing debt
secured by the property with known values avoids these costs. This nding suggests a
positive relationship between tangibility and leverage because rms holding assets can
tender these assets to lenders as collateral and issue more debt to take the advantage of
this opportunity. Furthermore, the ndings of Jensen and Meckling (1976) and Myers
(1977) suggest that the shareholders of highly leveraged rms have an incentive to
invest suboptimally to expropriate wealth from the rms debt holders. However, debt
holders can conne this opportunistic behavior by forcing them to present tangible
assets as collateral before issuing loans, but no such connement is possible for those
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projects that cannot be collateralized. This incentive may also induce a positive
relationship between leverage and the capacity of a rmto collateralize its debt. Several
empirical 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 of
perquisites may produce a negative correlation between collateralizable assets and
leverage (Titman and Wessels, 1988). The rms with less collateralizable assets
(tangibility) may choose higher debt levels to stop managers from using more than the
optimal level of perquisites. This agency explanation suggests a negative association
betweentangibilityandleverage. Boothet al. (2001) have reporteda negative relationship
between tangibility and leverage for rms in Brazil, India, Pakistan, and Turkey. Some
other empirical studies have also reported a negative relationship between tangibility
and leverage (Ferri and Jones, 1979; Bauer, 2004; Mazur, 2007; Karadeniz et al., 2009).
Growth opportunities
According to trade-off theory, rms holding future growth opportunities, which are a
form of intangible assets, tend to borrow less than rms holding more tangible assets
because growth opportunities cannot be collateralized. This nding suggests a negative
relationship between leverage and growth opportunities. Agency theory also predicts a
negative relationship because rms with greater growth opportunities have more
exibility to invest suboptimally, thus, expropriate wealth from debt holders to
shareholders. In order to restrain these agency conicts, rms with high growth
opportunities should borrow less. Several empirical studies have conrmed this
relationship, i.e. Deesomsaket al. (2004), ZouandXiao (2006) andEriotis et al. (2007). Wald
(1999) has shown that the USAis the only country where high growth is associated with
lower debt/equity ratio. This nding conrms the predictions of Myerss (1977) model
that ongoing growth opportunities imply a conict between debt and equity interests.
This conict also causes the rms to refrain fromundertaking net positive value projects.
Earnings volatility
Several empirical studies have shown that a rms optimal debt level is a decreasing
function of the volatility of its earnings. The higher volatility of earnings may indicate
the greater probability of a rmbeing unable to meet its contractual claims as they come
due. A rms debt capacity may also decrease with an increase in its earnings volatility
which suggests a negative association between earnings volatility andleverage. Various
empirical studies have shown a signicant negative relationship between leverage
and earnings volatility (Bradley et al., 1984; Booth et al., 2001; Fama and French, 2002;
Jong et al., 2008).
Liquidity
The trade-off theory suggests that companies with higher liquidity ratios should borrow
more due to their ability to meet contractual obligations on time. Thus, this theory
predicts a positive linkage between liquidity and leverage. On the other hand, the
pecking order theory predicts a negative relationship between liquidity and leverage,
because a rm with greater liquidities prefers to use internally generated funds while
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nancing newinvestments. Afewempirical studies have shown their results consistent
with the pecking order hypothesis (Deesomsak et al., 2004; Mazur, 2007; Viviani, 2008).
4. Data and methodology
Data
This study investigates the determinants of capital structure for manufacturing rms,
listed on the Karachi Stock Exchange (KSE) Pakistan during 2003-2007, using the data
published by the State Bank of Pakistan (SBP). The data published by SBP provides
useful information on key accounts of the nancial statements of all non-nancial rms
listedonKSE[1]. Moreover, it allows for the calculationof manyvariables that are known
to be relevant from studies of rms in developed countries. The nal sample, after
considering any missing data, consists of a balanced panel of 160 rms over a period of
ve years. Firms under analysis represent the driving industrial force in Pakistan, and it
is 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 their
measurements are largely adopted from existing literature, for the meaningful
comparison of our ndings with prior empirical studies in developed and developing
countries. The dependent variable is the debt ratio; the explanatory variables include
protability, size, non-debt tax shields, tangibility, growth opportunities, earnings
volatility, and liquidity. Their denitions are listed in Table I. All the variables are
measured using book values because the data employed in this study come from
nancial statements only.
This study used the debt ratio as a measure of leverage, dened as book value of total
debt divided by the book value of total assets. The total debt is the sumof short-termand
long-term debt. Although, the strict notion of capital structure refers exclusively to
long-term debt, we have included short-term debt as well because of its signicant
proportion in the make up of total debt. On average short-termdebt represents 76 percent
of the total debt employed by the companies included in our sample[2]. The profound
dependence of Pakistani rms onshort-termdebt conrms the ndings of Demirguc-Kunt
and Maksimovic (1999) that a major difference between developing and developed
countries is that developingcountries have substantiallylower amounts of long-termdebt.
Variables Denition
Dependent variable
Debt ratio (DR
it
) Ratio of total debt to total assets
Explanatory variables
Protability (PROF
it
) Ratio of net prot before taxes to total assets
Size (SIZE
it
) Natural logarithm of sales
Non-debt tax shields (NDTS
it
) Ratio of depreciation expense to total assets
Tangibility (TANG
it
) Ratio of net-xed assets to total assets
Growth opportunities (GROW
it
) Ratio of sales growth to total assets growth (due to the absence of
data related to advertising expense, research and development
expenditures, and market-to-book ratio)
Earnings volatility (EVOL
it
) Ratio of standard deviation of the rst difference of prot before
depreciation, interest, and taxes to average total assets
Liquidity (LIQ
it
) Ratio of current assets to current liabilities
Table I.
Denition of variables
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Methodology
This study employed panel data procedures because sample contained data across rms
and overtime. The use of panel data increases the sample size considerably and is more
appropriate to study the dynamics of change. In order to estimate the effects of
explanatory variables on the debt ratio (a measure of leverage), we used three estimation
models, namely, pooled ordinary least squares (OLS), the random effects, and the xed
effects. Under the hypothesis that there are no groups or individual effects among the
rms included in our sample, we estimated the pooled OLS model.
Since panel data contained observations on the same cross-sectional units over
several time periods there might be cross-sectional effects on each rm or on a set of
group of rms. Several techniques are available to deal with such type of problem but
two panel econometric techniques, the xed and the random effects models, are very
important. The xed effects model takes into account the individuality of each rm or
cross-sectional unit included in the sample by letting the intercept vary for each rmbut
still assumes that the slope coefcients are constant across rms. The random effects
model estimates the coefcients under the assumption that the individual or group
effects are uncorrelated with other explanatory variables and can be formulated. This
study also employed the Hausman (1978) specication test to determine which
estimation model, either xed or random effects, best explains our estimation.
The description of three estimation models pooled OLS, the xed effects, and the
random effects is given below:
DR
it
b
0
b
1
PROF
it
b
2
SIZE
it
b
3
NDTS
it
b
4
TANG
it
b
5
GROW
it
b
6
EVOL
it
b
7
LIQ
it
1
it
DR
it
b
0i
b
1
PROF
it
b
2
SIZE
it
b
3
NDTS
it
b
4
TANG
it
b
5
GROW
it
b
6
EVOL
it
b
7
LIQ
it
m
it
DR
it
b
0
b
1
PROF
it
b
2
SIZE
it
b
3
NDTS
it
b
4
TANG
it
b
5
GROW
it
b
6
EVOL
it
b
7
LIQ
it
1
it
m
it
where:
DR
it
debt ratio of rm i at time t.
PROF
it
protability of rm i at time t.
SIZE
it
size of rm i at time t.
NDTS
it
non-debt tax shields of rm i at time t.
TANG
it
tangibility of rm i at time t.
GROW
it
growth opportunities of rm i at time t.
EVOL
it
earnings volatility of rm i at time t.
LIQ
it
current ratio of rm i at time t.
b
0
common y-intercept.
b
1
-b
7
coefcients of the concerned explanatory variables.
1
it
stochastic error term of rm i at time t.
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b
0i
y-intercept of rm I.
m
it
error term of rm i at time t.
1
i
cross-sectional error component.
5. Empirical results and discussions
Empirical results
This sectionpresents the various estimation results anddiscusses the implications of the
empirical ndings. The summary statistics of the dependent and explanatory variables
over the sample period are presented in Table II, reecting the capital structures of the
analyzed rms. The debt ratio indicates that 60.78 percent of the rms assets are
nanced with total debt during the study period. This ratio, in comparison with rms in
G-7 and developing countries, indicates that Pakistani rms 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
DR
it
800 0.607852 0.156759 0.115851 0.891286
PROF
it
800 0.055274 0.110648 21.001851 1.240773
SIZE
it
800 7.376455 1.178565 1.435085 11.01449
NDTS
it
800 0.038546 0.032315 0.000699 0.201533
TANG
it
800 0.518880 0.190491 0.020310 0.926522
GROW
it
800 20.165196 72.85970 21705.662 1,008.796
EVOL
it
800 0.547126 1.006701 0.008834 9.821189
LIQ
it
800 1.148879 0.665056 0.157232 6.666245
Table II.
Summary statistics
Country No. of rms Time period Total debt ratio (%)
Developing countries data
Brazil 49 1985-1991 30.3
India 99 1980-1990 67.1
Jordan 38 1983-1990 47.0
Malaysia 96 1983-1990 41.8
Mexico 99 1984-1990 34.7
South Korea 93 1980-1990 73.4
Thailand 64 1983-1990 49.4
Turkey 45 1983-1990 59.1
Zimbabwe 48 1980-1988 41.5
G-7 countries data
Canada 318 1991 56.0
France 225 1991 71.0
Germany 191 1991 73.0
Italy 118 1991 70.0
Japan 514 1991 69.0
UK 608 1991 54.0
USA 2580 1991 58.0
Source: Data of debt ratios of rms in developing countries are adopted from Booth et al. (2001),
whereas data of debt ratios of rms 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 on
average Pakistani rms show similar nancing behavior as observed for rms in
developing and G-7 countries.
Prior to estimating the coefcients of the model, the sample data were also tested for
multicollinearity. Results are presented in Table IV, which show that most
cross-correlation terms for the explanatory variables are fairly small, thus giving no
cause for concernabout the problemof multicollinearityamongthe explanatoryvariables.
Under the hypothesis that there are no groups or individual effects among the rms
included in our sample, we estimated the pooled OLS model. The estimation results are
presented in Table V, which indicates that protability, size, non-debt tax shields,
tangibility, and liquidity proved to be signicant in condence level of 5 percent.
Earnings volatility found less signicant while the variable growth opportunities found
highly insignicant. The OLS regression has high adjusted R
2
and appears to be able to
explain variations in the debt ratio. Furthermore, the F-statistic conrms the
signicance of the OLS regression model.
Since our sample contained data across rms and overtime there might be
cross-sectional effects on each rm or on a set of group of rms. In order to deal with
those effects, two panel econometric techniques, namely, the xed effects and random
effects estimation models, are employed. Results of these estimation models
are presented in Tables VI and VII. Under both estimations models protability, size,
Variables DR
it
PROF
it
SIZE
it
NDTS
it
TANG
it
GROW
it
EVOL
it
LIQ
it
DR
it
1.0000
PROF
it
20.3222 1.0000
SIZE
it
0.1382 0.2054 1.0000
NDTS
it
20.0739 20.0281 20.0391 1.0000
TANG
it
0.0692 20.3182 20.2681 0.1841 1.0000
GROW
it
20.0195 0.0082 20.0134 20.0310 0.0005 1.0000
EVOL
it
20.2316 0.0722 20.6007 0.0917 20.0154 0.0078 1.0000
LIQ
it
20.6302 0.3929 0.1351 20.0703 20.5182 0.0276 0.1014 1.0000
Table IV.
Pearson correlation
coefcient matrix
Variables Coefcient SE t-statistic Prob.
C 0.825937 0.040538 20.37416 0.0000
PROF
it
20.223053 0.038392 25.809910 0.0000
SIZE
it
0.020456 0.004402 4.647338 0.0000
NDTS
it
20.299191 0.119903 22.495272 0.0128
TANG
it
20.263211 0.024567 210.71404 0.0000
GROW
it
7.17 10
26
5.18 10
25
20.138361 0.8900
EVOL
it
20.007898 0.004972 21.588466 0.1126
LIQ
it
20.177752 0.000694 225.58635 0.0000
Notes: R
2
0.541291; mean dependent variable 0.607853; adjusted R
2
0.537236; SD- dependent
variable 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 debt
ratio (DR
it
) using the OLS
estimation model
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tangibility, earnings volatility, and liquidity proved to be signicant with a condence
level of 5 percent. Non-debt tax shields proved signicant only under the randomeffects
estimation model. Growth opportunities remained highly insignicant under both
estimation models. The adjusted R
2
for the xed effects estimation model is higher than
for the simple pooling model, indicating the existence of the omitted variables.
The results of the Hausman specication test are reported in Table VIII. The test is
asymptotically x
2
distributed with 7 df. Results indicate that the null hypothesis is
rejected and we may be better off using the estimation of the xed effects model.
Variables Coefcient SE t-statistic Prob.
C 0.775204 0.049631 15.61935 0.0000
PROF
it
20.165676 0.032329 25.124703 0.0000
SIZE
it
0.020262 0.005608 3.612828 0.0003
NDTS
it
20.192198 0.094844 22.026479 0.0431
TANG
it
20.246056 0.030305 28.119214 0.0000
GROW
it
23.14 10
26
3.91 10
25
20.080284 0.9360
EVOL
it
20.013829 0.006345 22.179607 0.0296
LIQ
it
20.143623 0.007102 220.22313 0.0000
Notes: R
2
0.392376; SE of regression 0.075322; adjusted R
2
0.387006; sum of squared
residual 4.493354; F-statistic 73.06263; Prob. . F-statistic 0.000000
Table VII.
The effect of explanatory
variables on the debt ratio
(DR
it
) using the random
effects estimation model
Variables Coefcient SE t-statistic Prob.
C 0.696930 0.067591 10.31093 0.0000
PROF
it
20.149226 0.034256 24.356266 0.0000
SIZE
it
0.031443 0.008405 3.741148 0.0002
NDTS
it
20.134187 0.098235 21.365980 0.1724
TANG
it
20.302437 0.043316 26.982158 0.0000
GROW
it
21.10 10
26
4.00 10
25
20.027499 0.9781
EVOL
it
20.021170 0.009192 22.303169 0.0216
LIQ
it
20.121057 0.008192 214.77790 0.0000
Notes: R
2
0.825745; SE of regression 0.073519; adjusted R
2
0.780047; sum of squared
residual 3.421363; F-statistic 18.06989; Prob. . F-statistic 0.000000
Table VI.
The effect of explanatory
variables on the debt ratio
(DR
it
) using the xed
effects estimation model
Variables Fixed effects Random effects Var. (Diff.) Prob.
PROF
it
20.149226 20.165676 0.000128 0.1464
SIZE
it
0.031443 0.020262 0.000039 0.0741
NDTS
it
20.134187 20.192198 0.000655 0.0234
TANG
it
20.302437 20.246056 0.000958 0.0685
GROW
it
20.000001 20.000003 0.000000 0.6038
EVOL
it
20.021170 20.013829 0.000044 0.2697
LIQ
it
20.121057 20.143623 0.000017 0.0000
Notes: Wald x
2
(7 df) 46.333298; Prob. . x
2
0.0000000
Table VIII.
Fixed and random effects
test comparison
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Discussion
According to empirical ndings, protability and liquidity have a negative and
signicant relationship with the debt ratio, which conrms that rms nance their
activities following the nancing pattern implied by the pecking order theory. Moreover,
high cost of raising funds might also restrict the Pakistani rms to rely on internally
generated funds because of relatively limited equity markets combined with lower levels
of trading. This nding also conrms that information asymmetry is especially relevant
in the capital structure decisions of the rms listed on KSE.
The variable size has a positive and signicant impact on the debt ratio. This nding
is consistent with the implications of the trade-off theory suggesting that larger rms
should operate at high debt levels due to their ability to diversify the risk and to take the
benet of tax shields on interest payments. The estimated coefcient of earnings
volatility has the predicted negative sign and is statistically signicant. This nding
conrms the predictions of the trade-off theory which suggests that rms with less
volatile earnings should operate at high debt levels due to their ability to satisfy their
contractual claims on due date. Pakistani rms mainly rely on bank debt because of
small and undeveloped bond market. Furthermore, majority of these banks are
privatized and disinclined to issue loans on favorable terms particularly to rms with
volatile earnings. For this reason, rms with volatile earnings borrow less. This study
shows contradictory results concerning the variable non-debt tax shields. The total and
random effects estimation models accept this variable but the xed effects model does
not. This controversy suggests that further analysis with a comprehensive data set
would be a promising area for future study. Growth opportunities found to be highly
insignicant in all estimation models.
Theoretically, the expected relationship between the debt ratio and tangibility (asset
structure) is positive. However, based on the results of this study, the relationship is
negative. 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 relationship
between tangibility and leverage, include Titman and Wessels (1988) Rajan and
Zingales (1995) and Wald (1999). Although this result does not sit well with the trade-off
hypothesis, which suggests that companies with relatively safe tangible assets tend to
borrow more than companies with risky intangible assets. However, this nding is
consistent with the implications of the agency theory suggesting that the tendency of
managers to consume more than the optimal level of perquisites may produce an inverse
relationship between collateralizable assets and the debt levels (Titman and Wessels,
1988). The pecking order theory also predicts a negative relationshipbetween tangibility
and short-term debt ratio (Karadeniz et al., 2009).
Although manufacturing rms in Pakistan heavily rely on short-term debt either
because of small and undeveloped bond market or due to high-cost long-termbank debt.
However, it is difcult to be certain that this negative relationship is the outcome of
profound dependency of rms on short-term debt, because short-tem debt ratio is not
employed independently in this study as an explained variable. This negative
relationship may possibly be the outcome of excessive liquidity maintained by the rms
which encourage managers to consume more than the optimal level of perquisites.
Consequently, rms with less collateralizable assets may choose higher debt levels to
limit their managers consumption of perquisites.
Determinants
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The agency explanation seems to be more valid for rms in Pakistan due to the fact
that rms uphold excessive liquidity that may encourage managers to consume more
than the optimal level of perquisites.
In summary, the difference in long-term versus short-term debt is much pronounced
in Pakistan; this might limit the explanatory power of the capital structure models
derived fromWestern settings. However, the results of this empirical study suggest that
some of the insights from modern nance theory are portable to Pakistan because
certain rm-specic factors that are relevant for explaining capital structures in
developed countries are also relevant in Pakistan.
6. Conclusions
This empirical study attempted to explore the determinants of capital structure of
160 manufacturingrms listedonthe KSEPakistanduring2003-2007. The investigation
is performed using panel econometric techniques, namely, pooled OLS, xed effects, and
random effects. This study has employed the debt ratio (a measure of leverage) as an
explained 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, we
have includedshort-termdebt as well because of its signicant proportioninthe make up
of total debt of the rms included in our sample.
Accordingto the results of empirical analysis, protabilityandliquidityare negatively
correlatedwiththe debt ratio. This ndingis consistent withthe peckingorder hypothesis
rather than with the predictions of the trade-off theory. The rm size is positively
correlated with the debt ratio. This nding supports the view of rm size as an inverse
proxy for the probability of bankruptcy. The debt ratio is negatively correlated with
earnings volatility, which is consistent with theoretical underpinnings of the trade-off
theory. The tangibility (asset structure) is negatively correlated with the debt ratio. This
nding is in contradiction with the predictions of the trade-off theory; however, it is in line
with the implications of the agency theory suggesting that rms with less collateralizable
assets may choose higher debt levels to limit the managers consumptions of perquisites.
Moreover, a signicant negative impact of liquidity on the debt ratio indicates that rms
maintainedexcessive liquiditywhichmayencourage managers to consume more thanthe
optimal level of perquisites. Consequently, rms with less collateralizable assets borrow
more to conne the opportunistic behavior of the managers. Contradictory results are
found concerning the variable non-debt tax shields. The total and random effects model
accepts this variable with a negative sign but the xed effects model does not.
No signicant relationship is found between the debt ratio and growth opportunities.
Finally, the difference in long-term versus short-term debt might limit the
explanatory power of the capital structure models derived from Western settings.
However, the results indicate that these models provide some help in understanding the
nancing behavior of Pakistani rms.
Notes
1. The publication entitled Balance Sheet Analysis of Joint Stock Companies listed on Karachi
Stock Exchange 2002 2 2007 is prepared by the SBP on the basis of information given in the
annual reports, made by the companies at the end of each accounting period. This is
mandatory for every public limited company to make nancial statements in accordance with
the approvedaccountingstandards as applicable inPakistan. Approvedaccountingstandards
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comprise of such International Financial Reporting Standards issued by the International
Accounting Standard Board as are notied under the Companies Ordinance 1984.
2. The total debt is the sum of long-term and short-term debt. On average long-term debt
represents 24 percent while short-term debt represents 76 percent of the total debt employed
by the companies included in our sample. The reasons for heavy dependence of rms on
short-term debt include relatively high cost of long-term bank loans, and a limited and
undeveloped bond market in Pakistan.
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About the authors
Nadeem Ahmed Sheikh is a Senior Lecturer of Accounting and Finance at the Institute of
Management Sciences, Bahauddin Zakariya University, Multan, Pakistan. At present, he is
enrolled as Doctoral degree candidate, in the programme of Business Administration (Finance), in
School of Management, Huazhong University of Science and Technology, Wuhan (Hubei) Peoples
Republic of China. He earned the degree of Bachelor of Commerce (BCom) in 1996 from
Government College of Commerce, Multan, Pakistan. He stood rst in BCom Examination and
Bahauddin Zakariya University awarded him a Gold Medal in 1997. He has earned the degree of
Master in Business Administration (Finance) in 1999. He secured third position in nance
specialization and Department of Business Administration awarded hima Certicate of Honor. In
year 2000, on account of his excellent academic credentials, he attained a position as Lecturer of
Accounting and Finance at Department of Business Administration, Bahauddin Zakariya
University. In 2005, Bahauddin Zakariya University has recommended him for Star Excellence
Award (awarded by South Asia Publications) as a result of his ranking as the best teacher in the
institute. Nadeem Ahmed Sheikh is the corresponding author and can be contacted at:
shnadeem@hotmail.com
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 Sciences
and Technology, and the Director of the Institute of Enterprise Evaluation. He is also the Assistant
Dean of the School of Management. Zongjun Wang has earned his Bachelor degree in Computer
Science in 1985 from Beijing Institute of Technology, Beijing, China. He has earned the degree of
Doctor of Philosophy in System Engineering in 1993 from Hauzhong University of Science and
Technology, Wuhan, Peoples Republic of China. He joined the Arizona State University as a
Senior Visiting Scholar during 2004-2005 under the assistanceship of Fulbright Foundation, USA
and the Montreal University, Canada in 2001 as a senior fellow. He has published more than
150 articles in different journals (Chinese and international journals) related to the eld of system
engineering, integrated evaluation methodology and applications, corporate governance,
management, corporate nance, etc.
To purchase reprints of this article please e-mail: reprints@emeraldinsight.com
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