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Capital Structure Determinants of KSE Listed Pharmaceutical Companies

By Maryam Masnoon, CFA Level III Candidate, MPhil Candidate Senior Lecturer Bahria University & Farrukh Anwar, Bahria University, Karachi Campus Abstract Capital structure of KSE listed pharmaceutical companies have been studied by taking leverage as the dependant variable. Regression is run by considering six explanatory variables that include firm's size, tangibility, growth, earnings volatility, profitability and tax rate. Further, this model is reduced to only four explanatory variables by removing tax rate and earning volatility to deal with the problem of multicollinearity. The proxies used in this study are total debt ratio for leverage, gross fixed assets for tangibility, effective tax rate for tax, natural log of sales for size, percentage in net profit margin for earnings volatility, sustainable growth rate for growth and operating profit margin for profitability. The time horizon selected for the study is from 2008-2011. It is found that growth and tangibility have positive relation while profitability and size have a negative relation with leverage. All 4 variables are found statistically significant at a significance level of 10%. VIF also comes out to be low, which indicates low multicollinearity in the model. The model explains 50% of the variation in leverage is significant at 1% significance level. Keywords: Capital Structure, Leverage, Determinants, Pakistan, Pharmaceutical Sector, KSE. 1. Introduction Capital structure decision has remained one of the key concerns for corporate finance managers. The primary goal of capital structure decision is to determine appropriate level of financial leverage that maximizes the value of the firm. Subsequently, optimal capital structure is a mix of debt and equity in such a way that the weighted average cost of capital (WACC) of a firm is minimized. Financing decisions have become more complex now as the firms are becoming global. The cross-country differences have added a new dimension for researchers to investigate further in order to determine country specific factors influencing capital structure. Earlier studies have identified several country and company factors that influence the capital structure of a firm. Bancel and Mittoo (2004) find that the financing decisions of the firms are influenced by both firm specific and country specific factors. Importance of country specific factors can be assessed by the following statement; Michelle, et al. (2012) wrote in their book named "Corporate Finance" that the country specific factors have similar or even more explanatory power as compared to firm specific factors. Fan, et al. (2004) and Demirguc-Kunt and Maksimovic (1998) identified 3 major types of factors explaining the differences in capital structure across countries that include institutional and legal environment, financial market and banking sector and Macroeconomic environment. GMJACS Volume 2 Number 1 2012 19

Countries with weak legal system use more debt because of ineffective enforcement of laws1. Moreover, Porta, et al. (2000) found that countries with legal system based on common law use lesser debt as opposed to legal system based on civil law2 . The effect of taxes on capital structure differs from one country to another. Fan, et al. (2004) wrote in his study that unfavorable taxes on dividends3 influence the debt in capital structure by increasing the amount of debt. Demirguc-Kunt and Maksimovic (1998) has found that the existence of active and liquid market for corporate debt can increase firms' use of leverage. Furthermore, they concluded that the corporations in a country having bank based economy have higher leverage than those in market based economy. Demirguc-Kunt and Maksimovic (1998), Fan, et al. (2004) and Domowitz, et al. (2000) evaluated the impact of macroeconomic factors in their study. According to these different studies, countries having high inflation tend to have lower debt as compared to low inflation countries. They also found that countries with high GDP growth rate uses lower debt in their capital structure. The company specific factors are also of paramount importance having considerable influence on capital structure decision. Jiraporn, et al. (2011) found that a firm's corporate governance and leverage are negatively related implying that the firm having good corporate governance policies will enjoy lower net agency cost of equity and hence lower debt. The firm-specific factors in focus for this study, likely to exhibit significant relationship with firm's capital structure, include firm's growth, tangibility of assets, tax rate, earning volatility, profitability and firm's size. The purpose of this study is to find out the determinants of capital structure of KSE listed pharmaceutical companies of Pakistan. Capital structure of various industries in Pakistan has been addressed in earlier studies; however that of pharmaceutical industry remains untested. Pharmaceutical companies have small percentage of tangible assets (Michelle, et al, 2012) as their assets mainly comprise of intangibles like patents, human capital, etc. A firm can obtain more funds from bank if they have collateral to serve as a guarantee against loan. Hence, we can make our first hypothesis: H0 : There is a negative relation between tangibility of assets and leverage Ha : There is a positive relation between tangibility of assets and leverage Titman and Wessels (1988) and many other researchers4 reported existence of a positive relation between tangibility and leverage.

1 Actually equity investors don't want to hold equity securities due to lesser legal protection. 2 According to research, common law offers more protection to both capital providers 3 Compared to corporate taxes 4 Discussed in section 2

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Our second hypothesis will check the relation of profitability with debt of the sample. According to pecking order theory, a profitable firm will use lesser debt as it has more retained earnings to finance the projects. Contrary to pecking order theory, static trade off theory says that higher profitability will lead to higher debt due to lower bankruptcy probability and higher debt ratings. Both theories have some support; however, evidence has shown greater support for pecking order theory. Therefore, our second hypothesis is: H0 : There is a positive relation between profitability and leverage Ha : There is a negative relation between profitability and leverage Our third hypothesis will test relation between tax rate and leverage. According to static trade off theory, higher tax rate would lead to higher level of debt. Thus, our hypothesis is: H0 : There is a negative relation between tax rate and leverage Ha : There is a positive relation between tax rate and leverage Our next hypothesis is about growth of the firm. Assuming that the firm growth is higher than it could be supported with retained earnings, a positive relation exists between growth of the firm and leverage. H0 : There is a negative relation between growth and leverage Ha : There is a positive relation between growth and leverage Our fifth hypothesis inspects the relation of the size of the firm and the leverage. Titman and Wessels (1988) argued that the bigger the firm, the easier the access to external financing. Since larger firms have lower probability of bankruptcy due to bigger product portfolio, larger market share and greater collateral, we hypothesize that there is a positive relation between size and leverage. H0 : There is a negative relation between size and leverage Ha : There is a positive relation between size and leverage Our last hypothesis tests the relation between earning volatility and leverage. Higher volatility in earning translates into higher business risk that may lead to financial distress. This would become difficult for the firm to raise loans on favorable terms. Hence, in order to avoid cost of capital to rise too much, firms use internally generated funds to finance operations till they exhaust. H0 : There is a positive relation between volatility and leverage Ha : There is a negative relation between volatility and leverage This study has been conducted on a sample comprising of six listed pharmaceutical companies of Karachi Stock Exchange. This study has taken into account data sample of these selected companies from 2008-2011. In this study, we determine industry specific factors influencing capital structure and do not consider any country specific factors. GMJACS Volume 2 Number 1 2012 21

2. Empirical Literature Finding an optimal capital structure has always been an area of interest to many entities and researchers. To date, many studies and theories are proposed describing the determinants of capital structure. However, the debate over capital structure started with MM theory of capital structure irrelevance. MM propose their theory in 1958, stating that the capital structure decisions are irrelevant as the pie will remain same anyhow. It means whether companies finance their assets with debt or equity, the value of the firm will remain same under any combination of debt and equity. The theory was based on few assumptions which were highly criticized on being unrealistic, leading to revision of MM theory in 1963. MM included effect of taxes to revise their capital structure irrelevance theory. In 1963 revised edition, inclusion of taxes dramatically changed their prior conclusion of capital structure irrelevance to 100% debt as an optimal capital structure. Yet again, it was viewed with high degree of skepticism. Baxter (1967) has argued that MM theory is quite unrealistic even after adjusting it for taxes. His argument was based on the logic that creditors require cushion and it is not possible for any organization to finance its activities by only borrowing. There is a point beyond which increasing debt would increase cost of capital. Thus, he argued that the effect of bankruptcy cost is relevant for studying capital structure of a company. Indeed, bankruptcy cost is significant to consider while making financing decisions. The direct cost and indirect cost of bankruptcy could significantly change leverage decisions of a firm. Sliglitz (1972), Kraus and Litzenberger (1973), Kim (1978) have also found bankruptcy cost relevant to capital structure decisions. In response to the criticism, Miller (1977) published his new research paper, "Debt and Taxes" alluding that the tax shield from leverage would be of no advantage taking personal taxes in account. In 1980, DeAngelo and Masulis argued that even if the corporate tax shield on debt is of no benefit, the firms can enjoy tax shield on depreciation, amortization, investment tax credits, losses etc. Thus, optimal capital structure exists and varies with industry. Another shortcoming of MM theory is that they did not include inevitable agency cost of capital. To fill the gap in capital structure research, Jensen and Meckling (1976) introduced their theory, "Agency cost and ownership structure". They argued that capital structure is optimal at a point where agency cost of a firm is minimized. Agency theory suggests that agents might not act in best interest of principals (shareholders) which can cost firm in several ways. They pointed out three types of agency cost in his research paper; Monitoring cost incurred by shareholders, bonding cost incurred by agents to get closer to principals and residual loss which is inevitable even if we eliminate the other two. Further, he recommended higher debt in order to reduce net agency cost of equity; thereby reducing agents' freedom to squander cash. With higher leverage, managers are forced to work efficiently to pay return to capital providers; thereby reducing free cash flow and eventually, management discretion to misuse cash (Jensen, 1986). Harvey, et al. (2004) observed that managers in emerging markets have a tendency to overinvest, thus emerging markets have higher agency cost. To mitigate higher agency cost, McKnight and Weir (2008) also suggested higher debt to agency cost.

5 Please note that not all studies mentioned here showed significant relation with each variable. However, all the variables

have shown significance in one study or the other.

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Michelle, et al (2012) suggested another method to reduce agency cost. According to their proposition, good corporate governance practices can reduce agency cost as it aligns interest of managers with the interest of shareholders. McKnight and Weir (2008) found mix evidence about good corporate governance practices and agency cost. He stated that certain corporate governance practices increases agency cost while board structure reduces agency cost. Jensen and Meckling (1976) also pointed out that higher leverage would increase probability of going bankrupt; however, he witnessed cost of bankruptcy cost to be insignificant in his sample. They recommended compensation of agents to be tied with the value of the firm. However, Baker, et al (1988) argued that binding managers' compensation with overall value of the firm would provide incentives to mangers to increase the size of the firm without evaluating target performance and synergies with acquirer. Bradley, et al. (1984) and Titman (1984) found evidence in empirical research that bankruptcy cost is one of the determinants of capital structure while Long and Malitz (1985) empirically found agency cost to be significant determinant of capital structure. Earlier research also highlighted that level of information might affect the capital structure decisions. Myers and Majluf (1984) suggested that managers have more knowledge about the risk and return of the firm than the investors do. Some level of information asymmetry does exist between managers and investors about the future cash flow of the firm. They are of the view that information asymmetry affects the capital structure of the firm as managers prefer a financing source that has least information content because investors carefully monitor the action of managers to get insight about the company. Hence, they identified a hierarchy of preferred financing methods and the theory is commonly known as Pecking order theory. Hierarchy of preferred methods of financing begins with internal equity, followed by debt financing, preferred stock and the least preferred common equity. Michelle, et al. (2012) wrote that investors carefully scrutinize the equity offering by a firm because they are skeptical about the firm's future. If the firm is going to achieve higher cash flows then why would existing principals dilute their returns? Hence, equity offering is considered as a negative signal and company doesn't have sufficient profitable projects to support the cash outflow. According to Ross (1977), leverage is positively related with the value of the firm. The underlying notion is that a firm's issue of debt gives positive signal to the market about the firm's confidence in its future earnings. Thus, increasing leverage will increase equity investors' confidence about the firm future prospects, thereby increasing the value of the firm. Putting together the bankruptcy cost, agency cost and information asymmetry with MM theory of capital structure irrelevance; a competitor of pecking order theory was formed, known as static trade off theory. According to static order theory, leverage should be adopted to the level where benefit of debt tax shield is equal or greater than the cost associated with higher leverage. Shyam-Sunder and Myer (1999) however, found pecking order theory have more explanatory power than static trade off theory. Having critically reviewed the theories of capital structure, we now review our hypothesized determinants of capital structure in the lights of global and local research papers. The GMJACS Volume 2 Number 1 2012 23

variables selected in this study are already used in several local and foreign studies. Bradley, et al. (1984), Titman and Wessels (1988), Shah and Hijazi (2004), Sayilgan, et al. (2006), Sheikh and Wang (2011), Sabir and Malik (2012), Hijazi and Tariq (2006), Saeed (2007), Shah and Khan (2007), Akhtar (n.d.), Rafiq, et al. (2008), Ahmed, et al. (2010), Awan, et al. (2011), Ali (2011) and Afza and Hussain (2011) showed that the selected variables for this study have a significant impact on capital structure of the firm. Tangibility of assets is measured by the proportion of gross fixed assets in the total assets of the firm. Gross fixed assets are used in order to minimize distortion caused by difference in accounting of long lived assets. This is broadly consistent with the findings of Shah and Hijazi (2004). Our hypothesized positive relation of tangibility with leverage is consistent with the static trade off theory as higher collateral value can serve as guarantee against loan. However, empirical evidence about the relation has come up with mixed results. Awan, et al (2011), Sabir and Malik (2012), Hijazi and Tariq (2006), Ali (2011) and Shah and Khan (2007) found significant positive relation of leverage with tangibility during their research on Pakistan's industry where as Titman and Wessels (1988) and Rajan and Zingales (1995) found similar result in foreign setting. It is worthwhile to mention that research work on Pharmaceutical industry of India by Kumar, et al. (2012) also reported similar result. The empirical evidence against positive relationship between tangibility and leverage is supported by Afza and Hussain (2011), Sheikh and Wang (2011) and Sayilgun, et al. (2006). They found negative relationship while researching on Electrical goods sector of Pakistan, manufacturing sector of Pakistan and Turkish firms' sample respectively. Our next variable in this study is profitability, which we measure through operating profit margin. Shah and Hijazi (2004) cite in their research paper that operating profit margin has been consistently used as a proxy for profitability. Our hypothesis that profitability is negatively related with leverage is broadly consistent with pecking order theory (Myers and Majluf, 1984). Conversely, static trade off theory has an opposite view advocating that profitability and leverage is positively related. Empirical evidences found enormous support for pecking order theory both in national and international settings. In Pakistan, Hijazi and Tariq (2006), Shah and Khan (2007), Shah and Hijazi (2007), Saeed (2007), Rafiq, et al. (2008), Ahmed, et al. (2010), Ali (2011), Awan, et al. (2011), Afza and Hussain (2011), Sheikh and Wang 2011, and Sabir and Malik (2012) witnessed negative relation of profitability with leverage. Similarly, Sayilgan, et al. (2006) and Titman and Wessels (1988) found negative relation in International settings. These enormous evidences may suggest dominance of pecking order theory over static trade off theory; however, it doesn't mean that static trade off theory is of no use. Another variable used in this study to explain capital structure is tax rate. We measure tax rate by effective tax rate which is congruent with Afza and Hussain (2011) study on manufacturing sector of Pakistan. All the theories discussed above are of the view that higher tax rate gives incentive to borrow more. It is argued by Miller (1977) that personal tax rate would make tax saving on debt of no use. Evidence to support tax rate's positive relation with leverage is, however, limited. Afza and Hussain (2011) found tax rate to be positively related with leverage and Ozkan (2000) found tax rate to be an insignificant determinant of capital structure.
6 Sustainable growth rate is calculated as ROE x b. where ROE stands for return on equity and b is retention ratio.

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Growth is yet another variable used in this study. We measure growth rate as sustainable growth rate . The relation between growth and leverage has always been subject to debate. Jensen and Meckling (1976) suggested that growth is negatively related with the leverage. The idea is that the bondholders don't want to invest in a firm where there is significant uncertainty about the future cash flows. On the other hand, pecking order theory suggests positive relation between leverage and growth. Drobetz and Fix (2003) explained relationship suggested by pecking order theory. According to their point of view, high growth firm is less likely to be supported by internally generated funds. This brings us to the next level in hierarchy to debt financing, hence higher leverage. Both the relationships explained by these theories are supported by some evidence in National and International settings. Titman and Wessels (1988), Opler and Titman (1994), Barclay, et al. (1995), Rajan and Zingales (1995), Ozkan (2000), Shah and Hijazi (2004) and Sayilgan, et al. (2006) witnessed negative relation of growth with leverage. Thus, found agency theory to be appropriate in those firms. On the other hand, Hijazi and Tariq (2006), Saeed (2007), Rafiq, et al (2008), Ali (2011) and Sabir and Malik (2012) found significant positive relation between growth and leverage. Size of the firm has been frequently used as an independent variable in such studies. We measure size of the firm by taking natural log of sales, which is consistent with Shah and Hijazi (2004) and Titman and Wessels (1988). Yet again, there are two schools of thought. Titman and Wessels (1988) argued that there is a positive relationship between size of the firm and leverage. They supported their proposition by stating that since large firms are more diversified, they have lower chances of going bankrupt. Moreover, the direct bankruptcy cost doesn't significantly influence leverage in large firms as direct bankruptcy cost is usually fixed and reduces as firm size increases. On the other hand, Rajan and Zingales (1995) argue that larger firms find it cheap to issue equity partly because floatation cost is distributed among large equity offering. Also, asymmetric information in large public firm is lower which gives incentive to issue equity. Thus, they develop a negative relation between size of the firm and leverage. Empirical evidence exists for both the schools of thought. Booth, et al. (2001) and Rajan and Zingales (1995) found negative relation of firm's size with leverage while Ahmed, et al. (2010), Rafiq, et al. (2008), Sabir and Malik (2012), Saeed (2007), Sayilgan, et al. (2006), Sheikh and Wang (2011), Shah and Hijazi (2007), Titman and Wessels (1988), Memon, et al (n.d.) and Ali (2011) witnessed positive relation between size of the firm and leverage. Contradictory evidence might suggest cross country differences. Many studies conducted in Pakistan showed positive relationship of size of the firm with leverage. This can be interpreted as higher information asymmetry and lesser transparency due to which investors are skeptical about the firms' equity issuance. Last variable of this study is the volatility of the earnings. We measure volatility of earnings by change in net profit margin. Both pecking order theory and agency theory suggest negative relation of earnings volatility with leverage. Earnings volatility either comes from operating leverage or from poor management. Whatever the case is, it always brings cynicism in the mind of investors about the firms' ability to sustain cash flows to satisfy capital providers. Faced with the higher risk, lenders often demands premium to accept risk.
7 Reduces as a percentage of firm value 8 This variable has been found significant at a level of 10%. All the other studies have found this variable significant at 5%. 9 It is also called business risk.

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Firms always want to minimize the cost of capital. Hence, they prefer to use internally generated funds which in turn mean lower leverage. However, a contradictory view is presented by Cool. According to Cool (1993), agency theory suggest positive relation with income variability. His logic was based on the point that earning volatility reduces underinvestment problem thus reduces agency cost. There isn't much empirical evidence behind it. Few studies have found it significant. Rafiq, et al. (2008) observed positive relation of earning volatility and leverage in chemical industry of Pakistan. On the other hand, Sheikh and Wang (2011) and Bradley, et al. (1984) observed negative relationship between earnings volatility and leverage in National and International settings respectively. 3. Research Design Determinants of capital structure of KSE listed Pharmaceutical companies is a qualitative research aimed to test relation between six explanatory variables and leverage. The independent variables include tangibility of assets, growth, profitability, tax rate, size of the firm and volatility of returns. Despite vast existing literature pertaining to capital structure determinants, pharmaceutical companies of Pakistan remain unexplored in this regard. This study has been conducted on selected listed pharmaceutical companies of Karachi Stock Exchange. The six companies selected as proxy for Pharmaceutical industry include GlaxoSmithKline Pakistan Limited, Wyeth Pakistan Limited, Searle Pakistan Limited, Sanofi Aventis Pakistan Limited, Highnoon laboratories Limited and Abbott Pakistan. Ferozsons (lab) ltd and Otsuka Pak have not been included in this study. IBL healthcare is a subsidiary of SearlePak so consolidated financial statement SearlePak is used instead. This study has taken into account data sample of these selected companies from 20082011. Shorter time period is selected in order to increase the accuracy of the time series model. Extending time period might distort our findings. In this study, we determine industry specific factors influencing capital structure and do not consider any country specific factors. This research paper is based on the assumption that the companies included in the sample have presented their true economic picture in their financial statements. Moreover, there isn't any need to adjust the financial statements to reflect true position of the companies. Result could change dramatically if the financial statements are not reflecting true accounting and economic position of the sample companies. It is also important to mention here that this study considers significance level of 10% or otherwise mentioned. Data is primarily collected from the financial statements of sample companies. This study uses OLS techniques to test the relationship among variables. Correlation test is used to detect existence of multicollinearity amongst independent variables. 3.1 Regression Model Below is the equation used to analyze the effect of various factors on leverage. The proxy used for leverage is total debt ratio.

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The proxy used for tangibility of assets in this study is gross fixed assets divided by total assets. Total assets are also adjusted upward by accumulated depreciation to minimize any distortion10. Natural log of Sales is the proxy for firm size in this study. Sales are transformed to natural log of sales in order to avoid model misspecification. It also narrows down huge difference in sales between firms that can cause distortion. Operating profit margin11 has been used as a proxy for profitability, sustainable growth rate12 as a proxy for growth and percentage change in net profit margin as a proxy for earnings volatility. 4. Results and Discussion This section includes the results from the tests conducted for our analysis. Besides running regression, multicollenearity test is also performed to detect any correlation amongst the explanatory variables. The regression tests are again conducted with a revised model, having removed the variables found insignificant in the initial model. We begin by providing a snapshot of the descriptive statistics of variables under consideration. Table 1 exhibits the summary of all the variables used in this study. It includes data set of 6 companies from 2008-2011. Notice that there is one potential outlier in taxes and earning volatility. For a multiple regression analysis to be meaningful, it is important that the independent variables are not correlated with each other. In order to check for multicollinearity, correlations among all the independent variables are checked. Table 2 gives a summary of this correlation matrix. Table 2 clearly indicates that tax rate exhibited mild positive correlation with all the variables and it can possibly distort our analysis. Earnings volatility has also shown mild correlation with growth and tangibility. Profitability, however, has shown average correlation with size. The regression analysis will further indicate any existence of multicollinearity in the model. Profitability and size have shown average negative correlation with leverage where as tax, tangibility and growth have shown mild positive correlation with leverage. However, correlation between earnings volatility and leverage is close to zero and it can be said that there is no correlation between the two variables.

10 Net book value of fixed assets might come too low which can distort our calculations. 11 Operating profit margin = EBIT/ net sales 12 Sustainable growth rate = Return on Equity x Retention ratio.

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Table 1: Descriptive Statistics of Variables

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Table 2: Correlation Matrix

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In order to determine the impact of independent variables13 - Tax, Tangibility, Size, Growth, Profitability and Earning Volatility - on leverage, regression analysis is employed. The summary of the test is shown in Table 3. Table 3: Regression results from Equation (1)

The result shows that there is a positive relation of tangibility and taxes with leverage. It is congruent with our hypothesis. However, the result is not significant at a level of 10%. Hence, we are not able to conclude any relationship of tangibility and taxes with leverage. Ahmed, et al (2010), Akhtar (n.d.), Rafiq, et al. (2008), Awan, et al. (2011), Sabir and Malik (2012), Afza and Hussain (2011), Hijazi and Tariq (2006), Saeed (2007), Sayilgan, et al. (2006), Sheikh and Wang (2011), Shah and Khan (2007), Shah and Hijazi (2007) and Titman and Wessels (1988) also found tangibility statistically "not significant" in their studies. Size has shown negative relation with leverage and it is against our expectation but we can't confirm the relation because it is insignificant at 10% significance level. Awan, et al. (2011) also found negative relation but it was not significant. Earning volatility comes out to be negatively related with leverage which is in line with our hypothesis. However, it is not significant at 10% significance level. Shah and Khan (2007) and Titman and Wessels (1988) also found this relationship insignificant. Growth has shown positive relationship with leverage and it is consistent with our hypothesis. The coefficient of growth has come out to be 0.64 which means that 1 unit increase in

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growth will increase leverage by 0.64 units. We can conclude that there is a positive relation of growth with leverage at 10% significance level. Our result is consistent with pecking order theory and research work done by Hijazi and Tariq (2006), Saeed (2007), Rafiq, et al (2008), Ali (2011) and Sabir and Malik (2012). However, evidence of negative relation is also found by Titman and Wessels (1988), Opler and Titman (1994), Barclay, et al. (1995), Rajan and Zingales (1995), Ozkan (2000), Shah and Hijazi (2004) and Sayilgan, et al. (2006). One possible reason to explain the instances inconsistent with literature could be country specific differences. It must be noted that all the research studies congruent with our hypothesis are performed on Pakistani firms14. Profitability is negatively related with leverage and has a coefficient of -1.18, which is in line with our expectation. This result is reliable at a significance level of 5%. Our result is consistent with pecking order theory. Research work performed in Pakistan by Hijazi and Tariq (2006), Shah and Khan (2007), Shah and Hijazi (2007), Saeed (2007) and others15 have also witnessed negative relation between profitability and leverage. International research has also supported the same result. Sayilgan, et al. (2006) and Titman and Wessels (1988) found negative relation in International settings. Vast empirical evidence on this relation may suggest that companies prefer to maintain a stable dividend in order to minimize any negative signal to the market. Since stable dividends with higher profitability make it possible for the companies to finance the activities through internal equity, hence lower leverage. Our model has an explanatory power of 56% implying that 56% of the variation in leverage is explained through the independent variables identified in this study. The model is also significant at a significance level of 5%. However tangibility, size, growth and earnings volatility are not significant at 5% significance level. Variance Inflation Factor (VIF16) also confirmed the absence of severe multicollinearity in the model, as shown in Table 4. Table 4: Multicollinearity test from Equation (1)

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In order to mitigate the multicollinearity problem, the variables of taxes and earnings volatility are removed from the model and regression is run again.

Dropping variables from the original model resulted in dramatically different outcome, which indicates the existence of multicollinearity problem in the original model. The result obtained from our revised model with four independent variables, namely; Tangibility, size, growth and profitability, is shown in Table 5. Table 5: Regression results from Equation (2)

The results from Table 5 show that all independent variables are significant at 10% significance level. Tangibility, size, growth and profitability explain 50% of the variation in leverage. Adjusted R Square comes out to be 39%. Overall model is significant at a significance level of 1%. The relationship of growth and profitability with leverage doesn't change but the coefficient of each variable is reduced to 0.47 and -0.835 respectively. The variable tangibility shows a positive relation with leverage which is consistent with our hypothesis. The relationship between tangibility and leverage is significant at 5% level of significance. GMJACS Volume 2 Number 1 2012 32

Awan, et al (2011), Sabir and Malik (2012), Hijaza and Tariq (2006), Ali (2011) and Shah and Khan (2007) found significant positive relation of leverage with tangibility during their research on Pakistan's industry where as Titman and Wessels (1988) and Rajan and Zingales (1995) found similar result in foreign setting. Kumar, et al. (2012) also reported positive relation between tangibility and leverage in his study on Pharmaceutical industry of India. The empirical evidence against positive relationship between tangibility and leverage is supported by Afza and Hussain (2011), Sheikh and Wang (2011) and Sayilgun, et al. (2006). They found negative relationship while researching on Electrical goods sector of Pakistan, manufacturing sector of Pakistan and Turkish firms' sample respectively. The difference might be due to industry specific factors influencing capital structure. We cannot indicate any particular factor that causes differences in results. Further, research in this area is needed to determine the reason of such difference. Our result indicates size to be negatively related with leverage with significance level of 10%. The result shows that the level of information asymmetry is low. The result is consistent with earlier studies done by Rajan and Zingales (1995) and Booth et.al. (2001). Contrary to our result, Ahmed, et al. (2010), Rafiq, et al. (2008), Sabir and Malik (2012), Saeed (2007), Sayilgan, et al. (2006), Sheikh and Wang (2011), Shah and Hijazi (2007), Titman and Wessels (1988), Memon, et al (n.d.) and Ali (2011) witnessed positive relation between size of the firm and leverage. Although research carried out in Pakistani settings have shown positive relation of size with leverage, however, the difference may suggest higher transparency and good corporate governance practices in Pharmaceutical industry which reduces information asymmetry. It is also to be noted that large public firms find it cheap to issue equity as flotation cost per share decline under large equity offerings. Table 6: Multicollinearity test from Equation (2)

It is necessary to mention that this model might be affected by low multicollinearity. Table 6 indicates VIF 18 as low in this model and better than the original model. Even if there is presence of low multicollinearity in the model, it won't make much impact on our inference at 10% significance level as multicollinearity increases p-value.

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5. Conclusion and Managerial Significance In attempt to determine the capital structure of KSE listed Pharmaceutical companies of Pakistan, six companies are selected from KSE. The time horizon selected for the study is from 2008-2011. In this study, the influence of six independent variables is used to determine leverage of Pharmaceutical companies of Pakistan using OLS technique. Due to existence of multicollinearity in the original model, explanatory variables are reduced to four; tangibility, size, growth and profitability, after dropping tax rate and earning volatility. Hence, we make our second model for regression. Both the models are statistically significant at 5% alpha but only second model with four independent variables is statistically significant at 1% alpha. It is also worthwhile to mention that the R-square for the first model is 56% while the second model has an explanatory power of 50%. While testing the models, tax and earning volatility are not statistically significant. Thus, we are not able to conclude any relationship of tax and earnings volatility with leverage. Tangibility, size, growth and profitability are found statistically significant at a level of 10% in our study. We have witnessed positive relation of tangibility with leverage at significance level of 5%. This result is consistent with the static trade off theory and other researches mentioned in earlier section. Growth has also shown positive relation with leverage our model which is consistent with pecking order theory. Size and profitability however are found to be negatively related with leverage. The result of profitability is consistent with pecking order theory. It may mean that firms follow stable dividend policy or residual dividend policy because companies are financing their activities out of their profits. However, there may be a rare chance of following target payout policy. The negative coefficient of size may mean that the larger firms find it cheap to issue new equity and obtain funds. It may also indicate lower asymmetric information due to better corporate governance and transparency, thus reducing leverage. 6. Further Research Suggestion It is noticed in many studies that profitability is negatively related with leverage. The firms with higher profits tend to retain more to finance their activities. It can be interpreted as the companies follow either residual dividend policy or stable dividend payout policy. Further, research can confirm the dividend policies adopted by companies and its effect on their capital structure.

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