Professional Documents
Culture Documents
The Determinants of Capital Structure: A Case from Pakistan Textile Sector (Spinning Units)
Pervaiz Akhtar
National University Of Modern Languages, Islamabad
Muhammad Husnain
University Of Agriculture Faisalabad
Muhammad Ahsan Mukhtar
Muhammad Ali Jinnah University, Islamabad
Abstract
Capital structure decisions are among the most important and crucial decisions for any business
because of their effect on value and cost of the company. In this paper we have discussed the
determinants of capital structure of Pakistani firms. The sample comprised 30 Pakistani textile
sector companies. Size, growth, financial cost, profitability, and tangibility are used as
independent variables, while leverage is the dependent variable. For analysis purpose descriptive
statistics, correlation and regression analysis are used. The results imply that the spinning sector
companies are small in size and capitalization so these companies prefer internal financing as
compare to external financing.
Introduction
In Recent Years, At International Level, Several Authors On Capital Structure Have Proposed
To Identify And Explain Many Great Potential Attributes That Influence The Financial Decision
In Selecting The Right Debt To Equity Variations Across A Firms Capital Structure.
The Link Between A Firms Capital Structure And The Factors That Influence A Firms Debt
Equity Mix Took On Added Importance As A Result Of The Path Breaking Debate Pioneered
By Modigliani And Miller (1958).
Capital Structure Remains To Be A Conventional Issue In Modern Finance. The Path Breaking
Work Of Modigliani And Miller (1958) On The Irrelevance Theorem Served As A Great
Foundation For Many Work To Be Carried Out On The Subject And Pointed Direction That
Such Theories Would Show Under Different Conditions From The Duo Is Capital Structure
Irrelevant.
These Changes Adapted From The Original Assumptions Took Precedence After Modigliani
And Miller (1963) Theory Demonstrates The Benefits Of Debt By Introducing Taxes. Millers
(1977) Discovery Of The Effect Of The Inclusion Of Personal And Corporate Tax On Firm
Value And Two Theories On Pecking Order Which Consist Of Bankruptcy Costs (Titman,
1984), Agency Cost Theory, Jensen And Meckling, (1976); Myers, (1977) And The Trade Off
Theory Dominate The Literature Of Capital Structure.
Theories Have Been Developed To Explain The Right Debt And Equity Combination For A
Firm To Adapt In Order To Achieve The Optimum Level Of Capital Mix. Traditional Theory Is
In Favour Of Borrowing More For Financing. This Is Mainly Because Of The Tax Advantage
That Is Enjoyed By Debt Whilst Equity Is Not. This Makes Equity More Expensive To Consider.
According To Myers And Majluf (1984), Managers Are Reluctant In The Issuing Of Equity
Because Of The Unwillingness Of Investors As Equity Yields A Return That Is Counted To The
Investors Of Scarce Resource As Their Opportunity Cost, Thus The Issuing Of Equity Should
Only Occur If Equity Is Moderately Priced Or Overpriced.
In Pakistan The Firms Capital Structure Is Generally Decided By The Funds Available In The
Financial Sector Of The Country. The Domestic Savings Are Not So Much Huge Which Can Be
Used To Fulfill The Financial Needs Of The Different Sectors Of The Economy. So Ultimately
The Economy Is Dependent On The Foreign Debts And Aids Related Funds Available In The
Financial Market. The Determinants Of The Capital Structure Gets Change Over The Time On
The Condition Of Available Funds In The Economy.
In General, This Study Covers Each And Every Aspect Of The Subject But Specifically It Is
Related To Capital Structure Of Textile Sector Companies (Spinning Firms) Listed In Karachi
Stock Exchange And Their Financing Decision Making. It Explores A Variety Of Factors That
Influence The Determinants Of Capital Structure And Manipulate The Financial Decision Taken
By The Manager As Well The Success Or The Failure To These Decisions.
This Research Study Is Based On The Data Taken From The State Bank Of Pakistan Publication
Balance Sheet Analysis Of Textile Sector Companies Listed On The Karachi Stock Exchange
Volume-II 2004-2009.The Research Initially Includes 32 Spinning Units Out Of 101 Textile
Companies Listed On KSE. Time Period Of The Data Is From 2004 To 2009
Size, Growth Rate, Financial Cost, Profitability And Tangibility Are Used As Independent
Variables, While Leverage Is The Dependent Variable. For Analysis Purpose Panel Data
Analysis, Correlation And Regression Analysis Are Used.
To Analyze Which Are The Main Determinants That Influence The Financing
Decision In The Choice Of Capital Structure In Pakistan Economy?
This Study Will Try To Identify And Analyze The Determinants Of Capital Structure In A
Systematic Way. Study Will Provide The Applicable And Practical Teaching To Anyone Who
Wishes To Understand The Topic. In General This Study Will Cover Many Aspects Of The
Topic But Specifically It Will Try To Determine The Capital Structure Of The Spinning Sector
Firms Listed On Karachi Stock Exchange. This Study Will Help The Managers To Take The
Financing Decision For Their Firms. The Creditors Can Also Take The Benefit To Minimize
Their Risk, In Funding A Specific Sector Firms.
The Objective Of This Chapter Is To Examine Existing Research On Capital Structure And Its
Determinants With Relative Emphasis On The Different Sectors Of The Pakistan Economy. This
Is So As To Discover And Provide An Insight On The Theoretical Models Used To Explain
Capital Structure And Its Determinants.
The Literature Review Seeks To Offer Clear Understanding On The Theories Of Capital
Structure And To Look At Its Determinants, How They Can Be Influenced By These Theories
And How They Are Related To Gearing.
The Theoretical Foundation For This Research Will Be Established Through Literature Review
Of Relevant Research. Priority Will Be Given To The Most Recent Work, Building Upon Earlier
Works.
The Equity And Debt Value Used By The Company In Its Operation Will Constitute Its Capital
Structure. The Capital Structure Decision Is Therefore A Very Important One Because Of The
Impact Such A Decision Has On The Firms Ability To Deal With Its Competitive Environment.
It Is Often Debated Whether Commonly Perceived "Good Industry Is Defined By Its
Determinants That Can Point Towards The Right Mixture To Be Used To Achieve Optimum
Capital Structure. Leverage Ratios Of Specific Industries Have Been Documented And Their
Results Are In Broad Agreement And Show That Highly Geared Industries Have Consistently
High Leverage.
In 50 Years Since The Pioneering Work Of Modigliani And Miller (1958), Vast Amount Of
Academic Effort Of Research Has Been Devoted To Models Explaining Capital Structure. The
Extensive Literature On The Subject Matter Is Of High Interest And Has Shown Its Popularity In
The Corporate Finance Circles.
The Genesis Of The Theory Of Capital Structure Received Maximum Attention After The
Seminal Work Of Modigliani And Miller (1958) On Capital Structure Irrelevance Theory
Often Referred To As MMI. This Paper Served As A Great Foundation For Many Of The Recent
Work Carried On The Subject. The Enormous Criticism Received After The Publication Of
MMI Gave Rise To MMII In (1963) Which Included Tax, A Component Absent In The Former.
Debt Is Borrowed Money That A Fixed Payment In The Future (Interest Payments And
Repaying Principal) Is Made. Equity On The Other Hand Is The Leftover After Debt Payments
Have Been Made. Combining Debt With Equity Gives The Gearing Or Leverage Position Of
The Company. Debt Can Be Short Term Or Long Term. Equity Financing Entails Issuing
Common Stocks Or Preferred Shares To Investors. In Return For The Money Paid, Shareholders
Receive Ownership Interest In The Corporation. This Is Referred To Share Capital.
In An Attempt To Avoid Bankruptcy, Robicheck And Myers (1966) Propose That The Addition
Of Debt May Force A Firm To Have Its Future Strategy In Order To Finance Promised
Payments On Outstanding Debt. However, The Firm Is Likely To Incur Costs Which Are
Associated With This Sort Of Action.
The Implications Of This Analysis Generated Enormous Criticism. Stiglitz, (1962); Baumol And
Malkiel, (1967); Rubinstein (1973) And Scott (1976), Share A General Consensus That This
Traditional Theory Fails To Consider The Damaging Effects Of Increased Debt On Firm.
Stiglitz (1962) Demonstrated That If Debt Is Traded In A Separate Market In Which Investors
Are More Pessimistic About The Firm Than Its Equity Holders, Then A Sufficiently Large
Increase In Debt Can Lower The Total Value Of A Firm. More Reasonably, Robichecks And
Meyers (1966) And Baxter (1967), Have Argued That Debt Policy Is Not Relevant And That An
Internal Optimal Capital Structure Can Exist.
Baumol And Malkiel (1967) Have Argued That Capital Structure Will Not Be Irrelevant If
Investors Incur Transaction Costs When Engaging In Arbitrage Activities. Rubinstein (1973)
Shows That If Security Markets Are Partially Segmented, Where Traders Are More Risk Averse
Than Investors, Then A Sufficiently Large Increase In Debt Can Lower The Total Value Of The
Firm.
According To Scott (1976), The Use Of The Traditional Theory In Such A Manner Can Have
Negative Implications On A Firm Value Because It Fails To Consider The Effects Of Increased
Debt On A Firm. Same Are The Findings Of Hatfield Al Et (1994) Who Suggest That Firms
Prefer An Optimum Level Of Debt And They Increase Or Decrease That Level To Enhance
Their Value In The Market. The Firms Want That Level Of Debt Where They Can Beat Other
Industry In Battle Of Market Value.
There Are Many Variables Which Can Influence The Firms Leverage Ratio And Can Have A
Positive Or Negative Impact On The Value Of The Firm. Harris And Raviv (1995) Identify
Variables That Are Considered To Influence The Firms Leverage Ratio Such As: Size,
Tangibility, Tax Shields, Growth Opportunities, Bankruptcy Probability And Assets.
According To Stewart (2000), Equity Financing Is Better Option When Cash Flows And Assets
Are Not Predictable. This Means That Investors Have Enforceable Rights To The Firms Assets,
But Cannot Prevent Insiders (Managers Or Entrepreneurs) From Capturing Cash Flow. Insiders
Must Co Invest And Pay In Each Period A Dividend Sufficient To Ensure Outside Investors
Participation For At Least One More Period. Shah And Hijazi (2004) Found That The Larger
Firms Employ More Debt Because They Have More Strength To Absorb The Risk Of
Bankruptcy. If Larger Firm Defaults In Any Case The Bankruptcy Costs For Such Firm Will Be
Low As Proportion Of Their Total Worth, Which Is The Prime Reason Of Taking More Debt By
Larger Firms. The Smaller Firms Take Less Debt Because Of Their Fear To Become Bankrupt If
They Are Unable To Repay Their Debt On Time.
Song (2005) Initiates That Capital Structure Determinants Are Dependent On The Nature Of
Debt Taken By The Firms. The Different Determinants Have Different Impact On Short Term
And Long Term Debt. This Study Finds Positive Relation Of Tangibility Of Assets Value With
Long Term Debt While It Is Negatively Related With Short Term Debt. Size Is Positively
10
Related With Short Term Debt And It Is Negatively Related With The Long Term Debt Of The
Firm.
There Is Also Difference In The Capital Structure Of Private And Public Owned Firms.
Dewaelheyns & Hulle (2009) Argue That In Private Sector Companies The Capital Structure Of
The Firms Is Not Driven Only By The Internal Financing But The External Financing Do Have
An Impact On The Decision. Although The Private Firms Have Limited Access To Debt
Financing But Still They Continue To Expand In Many Parts Of The World Because They
Follow Pecking Order Theory (Mayers 1984), Which Suggests That Firms Prefer Internal
Financing Until They Funds Are Sufficient To Meet Their Needs.
11
1. Leverage (Debt/Equity)
1. Size
2. Growth
3. Financing Cost
4. Profitability
5. Tangibility
3.3 Hypotheses
Total Five Variables Have Been Used In This Study. The Only Dependent Variable Of The
Study Is Leverage And Independent Variables Were Hypothesized As Follow:
H1:
H2:
H3:
H4:
H5:
12
This Research Study Is Based On The Data Taken From The State Bank Of Pakistan Publication
Balance Sheet Analysis Of Textile Sector Companies Listed On The Karachi Stock Exchange
Volume-II 2004-2009.The Research Initially Includes 32 Spinning Units Listed On KSE. Time
Period Of The Data Is From 2004 To 2009.
We Present In Our Design Both Theoretical And Quantitative Analyses. For Quantitative
Analysis We Use Two Methods: First: Correlations Is Used To Find Out The Association
Between The Variables Under Consideration. Second: Regression Analysis Is Used To Further
Measure The Relationship Of The Dependent And Independent Variable Accurately.
Correlation
Regression
Where As
PFT = Profitability
SZ = Size
G = Growth Opportunities
FC = Financial Cost
TG = Tangibility Of Assets
13
Table.01
20 Pakistani Firms, 2004 2009, 5 Years 120 Observations
Financial
Size
Growth
Leverage
Profitability Tangibility
Cost
Mean
560.7
1388.66
1386.3
113.885
17.687
1190
Median
291.4
1094
1110.95
58.8
16.6
997.4
Deviation
2122
977.167135
998.353
163.478
104.76
787.2
Sample Variance
4503936
954855.61
996708
26725
10975
6E+05
Range
23246
4264.8
4337.5
856.9
1088.9
3583
Count
120
120
120
120
120
120
Standard
14
Table.02
20 Pakistani Firms, 2004 2009, 5 Years 120 Observations
Leverage
Size
Growth
Financial Cost
Profitability
Leverage
Size
-0.08
Growth
-0.08
0.85434047
Financial Cost
0.276
0.41992973
0.32594
Profitability
-0.03
0.00757611
0.0331
-0.0087
Tangibility
0.05
0.91191437
0.85641
0.43823
0.0369
0.348447854
R Square
0.121415907
Adjusted
Square
0.082881517
Standard
Error
2032.398447
Observations
120
4.4 Anova
Df
SS
MS
Significance F
Regression
65075095.05
13015019
3.150845
0.010588304
Residual
114
470893352.8
4130643
Total
119
535968447.8
Tangib
15
Upper
Lower
Upper
Coefficients
Standard Error
T Stat
P-Value
Lower 95%
95%
95.0%
95.0%
Intercept
723.1610393
339.9231641
2.127425
0.03554
49.77589121
1396.5
49.776
1396.55
Size
-0.488615758
0.498764338
-0.97965
0.329332
-1.476664038
0.4994
-1.477
0.49943
Growth
-0.039483809
0.388897454
-0.10153
0.91931
-0.809886644
0.7309
-0.81
0.73092
Cost
4.829305568
1.281641817
3.768062
0.000262
2.290383083
7.3682
2.2904
7.36823
Profitability
-0.430654912
1.78430111
-0.24136
0.809711
-3.965341553
3.104
-3.965
3.10403
Tangibility
0.023919891
0.631077504
0.037903
0.969831
-1.226239744
1.2741
-1.226
1.27408
Financial
Analysis Of All Firms Shows That Total 12% Variation In Dependent Variable I.E. Leverage Or
Debt To Equity Is Related To The Values Of All Five Independent Variables Of The Study As
Evidenced In R-Square Value In Other Words 12 % Variation In Leverage Decision Of The
Firm Is Explained By Profitability, Size, Tangibility, Growth, And Cost Of Financing. Rest Of
The 88% Is Due To Extraneous Variables. Overall Significance And Goodness Of The Model Is
Relatively Low Just Because Of The Unavailability Of Data Or Incomplete Data Available
Through Different Sources Which Is Unable To Use In This Study.
5.1.1 Size
From The Theoretical Point Of View, The Effect Of Size On Leverage Is Unclear. As Rajan And
Zingales (1995,) Claim: Larger Firms Tend To Be More Diversified And Fail Less Often, So
Size (Computed As The Logarithm Of Net Sales) May Be An Inverse Proxy For The Probability
Of Bankruptcy. If So, Size Should Have A Positive Impact On The Supply Debt. Some Authors
16
Find A Positive Relation Between Size And Leverage, For Example Huang And Song (2002),
Rajan And Zingales (1995).
In Our Study Size Of The Firms Also Suggests Accepting The Negative Hypothesis And
Rejecting The Hypothesis That With Increase In Size Of The Firm, The Leverage Of The Firm
Also Increases As This Test Is Statistically Insignificant.
5.1.2 Growth
According To Myers (1977), Firms With High Future Growth Opportunities Would Use More
Equity Financing, Because A Higher Leveraged Company Is More Likely To Pass Up Profitable
Investment Opportunities. As Huang And Song (2002) Claim: Such An Investment Effectively
Transfers Wealth From Stockholders To Debt Holders. Therefore A Negative Relation Between
Growth Opportunities And Leverage Is Predicted. As Market-To-Book Ratio Is Used In Order
To Proxy For Growth Opportunities, There Is One More Reason
Growth Of The Firm Is Negatively Related To Debt/Equity Ratio In Our Study As The
Regression Analysis Shows Negative Relationship With Debt To Equity Ratio So We Accept
The Hypothesis Generated In Our Study That Is Growth Is Negatively Related With Our
Dependent Variable.
Financial Cost Is Positively Related With Debt To Equity Ratio Which Simply Means That
When The Debt Ratio Of Any Company Will Increase There Will Also Be Sure Increase In The
17
Financing Cost Of The Company. The Positive Hypothesis Is Accepted Which Was Suggested In
The Start Of Our Study In Theoretical Framework And Hypotheses Generation Section.
5.1.4 Profitability
There Are No Reliable Theoretical Predictions On The Effects Of Profitability On Leverage. The
Trade Off Theory Suggests That The Firms With More Profit Should Take More Debt. The Free
Cash-Flow Theory Propose That More Profitable Firms Should Employ More Liability In Order
To Control Managers, To Tempt Them To Pay Out Cash As A Substitute Of Spending Money
On Incompetent Projects. However, Pecking-Order Theory Claims, Firms Prefer Internal
Financing Over External.
5.1.5 Tangibility
It Is Assumed, From The Hypothetical Point Of View, That Tangible Assets Are Used As
Guarantee. Therefore It Lowers The Risk Of Creditors In Case Of Bankruptcy. As Booth Et Al.
(2001,) State: The More Tangible The Firms Assets, The Greater Its Ability To Issue Secured
Debt And The Less Information Revealed About Future Profits. Thus A Positive Relation
Between Tangibility And Leverage Is Assumed.
Several Empirical Studies Confirm This Suggestion, Such As (Rajan Zingales,1995), (Friend
Lang, 1988) And (Titman Wessels, 1988) Find. On The Other Hand, For Example Booth Et
18
Al. (2001) And Huang And Song (2002) Experience A Negative Relation Between Tangibility
And Leverage.
There Is A Positive Relationship Between Tangibility And Firms Leverage. In Both Regression
Techniques This Test Is Significant.
Conclusion
This finds that capital structure determination is not a science so the firms analyze a number of
factors to choose a best mix of debt and equity. In Pakistan as well there are different factors that
affect a firm's capital structure decision. The results suggest that in Pakistan most of the firms
prefer internal funds over the external financing. In Pakistan the main source of funding is
banking sector which generally prefers the larger firms while funding. So the larger firms can
take loan very easily because of the banking sector preferences. As most of the Pakistani firms
are of medium size, therefore these firms are unable to take loans for their future projects. One
more possible reason of taking less loans can be the legal procedures and obligations involved in
the process of debt financing. The last reason which is not proved yet could be the religious
teaching about the interest, which is forbidden in Islam.
19
References
Dewaelheyns And Hulle (2009),Capital Structure, Journal Of Economic Perspectives, Vol. 11,
No. 2, Pp 8-10.
Harris, M And Raviv A, (1991), The Theory Of Capital Structure, Journal Of Finance, Vol. 46,
Pp. 297-
355.
Lima, (2009), The Determinants Of Capital Structure, Journal Of Finance, Vol. Pp 1- 19.
Modigliani F And Miller H, (1958), The Cost Of Capital, Corporation Finance And The Theory
Of Investment, American Economic Review Pp. 261-297.
Modigliani F And Miller H, (1963), Corporation Income, Taxes And The Cost Of Capital: A
Correction, American Economic Review
Murinde V And Woldie A, (2003), African Business Finances Development Policy, Haworth
Press.
Myers S (1984), The Capital Structure Puzzle, Journal Of Finance, 39, Pp 572-92
Myers S (2001), Capital Structure, Journal Of Economic Perspectives, Vol. 15, No. 2, Pp 81-102.
Myers S And Majluf N (1984), Corporate Financing And Investment Decisions, When Firms
20
Have Information Investors Do Not Have, Journal Of Financial Economics, Vol. 13, Pp
187-221.
Pinches And Mingo K, (1973), Multivariate Analysis Of Industrial Bond Ratings, Journal Of
Finance, Vol. 28
Rajan And Zingales, (1995), What Do We Know About Capital Structure? Some Evidence From
International Data, Journal Of Finance, Vol. 50, No. 5 Pp 1421-60.
Robichecks A And Meyers S (1966), Problems In The Theory Of Optimal Capital Structure,
Journal Of Financial And Quantitative Analysis, Vol. 1, Pp.1-35.
Remmers, Stonehill, Wright And Beekhusein (1975), Industry And Size As Debt Ratio
Determinants In Manufacturing Internationally, Financial Management, Vol. 3
Harris, M And Raviv A, (1991), The Theory Of Capital Structure, Journal Of Finance, Vol. 46,
Pp. 297-355.
Modoulge F, (2009), Problems In The Theory Of Optimal Capital Structure, Journal Of Financial
And Quantitative Analysis, Vol. 1, Pp.1-20.
Saunders M, Lewis P And Thornhill A, (2003), Research Methodology For British Students, 3rd
Edition, Financial Times, Prentice Hall.
Scott D And Martin J, (1976), Industry Influence On Financial Structure, Financial Management
21
Vol. 1
Scott J (1976), A Theory Of Optimal Capital Structure, Bell Journal Of Economics, 8, Pp 33-54.
Scott J, (1977), Bankruptcy, Secured Debt And Optimal Structure, Journal Of Finance, Vol. 33,
Pp 1-20.
Song A, (2005), The Theory Of Capital Structure, Journal Of Finance, Vol. 46, Pp. 297-355.
Shah ,Hijazi T (2004), The Theory Of Capital Structure, Journal Of Finance, Vol. 46, Pp. 297355
Shyam-Sundler L And Myers, 1999, Testing Static Tradeoff Against Pecking Order Models Of
Capital Structure, Journal Of Financial Economics, Vol. 51, Pp 219-44.
Stwert H (2000), Capital Structure, Journal Of Economic Perspectives, Vol. 15, No. 2, Pp 8-12.
Stiglitz J (1972), A Re-Examination Of The Modigliani-Miller Theorem; Vol. 59, 5, Pp. 784793.
Titman S And Wessels R, (1988), The Determinants Of Capital Structure, Journal Of Finance,
Vol. Pp 1- 19.
22