International Research Journal of Finance and Economics ISSN 1450-2887 Issue 101 November, 2012 EuroJournals Publishing, Inc.

. 2012 http://www.internationalresearchjournaloffinanceandeconomics.com

Determinants of Capital Structure: Evidence from Iranian Listed Companies

Masoud Nadem Department of Accounting, Shahreza Branch Payame Noor University, Shahreza, Isfahan, Iran E-mail: masoud_nadem@yahoo.com Tel: 00989132205767 Hosein Nabiei Department of Accounting, Farsan Branch Islamic Azad University, Farsan, Iran Mohamad Noroozi Department of Accounting, Mobarakeh Branch Islamic Azad University, Mobarakeh, Isfahan, Iran Seyed Mohsen Madine Department of Accounting, Mobarakeh Branch Islamic Azad University, Mobarakeh, Isfahan, Iran Arezoo Aghaei Chadegani Young Researcher Club, Mobarakeh Branch Islamic Azad University, Isfahan, Iran Abstract The main objective of this research is to investigate the determinant factors of capital structure of companies listed on Tehran Stock Exchange. Based on pecking order theory (Static and Dynamic Version) and using data of companies listed on Tehran Stock Exchange during 2002 till 2010, we investigated the effect of return on investment, tangible fixed assets, net working assets, firm size and profitability index on debt ratio. The results show that in static version of pecking order, all variables have significant relationship with capital structure. But, in dynamic version of pecking order, fixed assets have positive relationship and net working assets have negative relationship with capital structure.

Keywords: Capital Structure, Accounting Variables, Pecking Order Theory, Tehran Stock Exchange

1. Introduction
One of the main concerns of companies financial managers is making decisions about the appropriate combination of financial resources and determining the composition of capital structure (Aghaei Chadegani et al, 2011). Based on literature, capital structure is a combination of equity and debts
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(Kohher and Raul, 2007). However, it is important for the firm to find the particular combination of debt and equity that maximizes its overall market value. Regarding this fact that capital structure have a direct effect on firm value, researchers try to determine the optimal capital structure which maximize the firm value with lowest cost of financing. One of the most important theories about optimal capital structure is pecking order theory. This theory based on this fact that financing must reduce information asymmetries and agency problems (Abor, 2007). Thus, it could increase owners assurance and it is in accordance with stewardship approach and accountability of managers to owners and investors. On the other hand, determining optimal capital structure is a basic and important issue which will be affected by different variables. For example, controllable variable by firms and accounting variables which arose from the main activities in organizations have an important effect on investors and creditors decisions about firms financing. These factors also have an effective impact on capital structure which maximize the firm value and minimize cost of financing (Raul, 2009). In this research, the determinant factors of capital structure of companies listed on Tehran Stock Exchange is investigated. For this purpose using pecking order theory, we examine the effect of accounting variables on capital structure of companies listed on Tehran Stock Exchange. The main research question is whether based on pecking order theory accounting variables have effect on capital structure or not? Choosing variables is based on the significance of these variables in investors and creditors decision making process. Research variables are return on investment, tangible fixed assets, net working assets, firm size and profitability index. This study contributes to the literature through extending use of pecking order theory in determining effective factors of capital structure in Tehran Stock Exchange. The results of this research provide useful guidelines for managers decision making of financing to reduce agency problems. The discussion in this paper is organized as follows. In next section (2) the relevant literature to develop research hypotheses is discussed, in section (3) the sample selection, research method and variable measurement are explained, in section (4) the research result is analyzed and in section (5) the conclusions of study and suggestions for future researches are discussed.

2. Literature Review
2.1. Prior Studies Frank and Goyal (2003) examine the pecking order theory of corporate leverage on a broad crosssection of publicly traded American companies during 1971 to 1998. They investigate whether companies consider pecking order theory on their financing choices using 157 companies financial information during 28 years. The results show that the wide range of sample companies do not comply pecking order theory in their financing process and for needed resources they prefer publishing shares. Chen and Roger (2007) investigate the relationship between firm size, commercial risk, sales growth rate, tax, profitability index and intangible assets with capital structure. They use debt ratio for measuring capital structure. The results show that there is a meaningful relationship between these variables and capital structure. The results also show profitability index, intangible assets, tax and sales growth rate have positive relationship and firm size and commercial risk have negative relationship with capital structure. Raul (2009) tries to find the relationship between financial factors and combination of financial resources with considering pecking order theory. They developed two models to investigate the effect of earning before interest and taxes, return on investment, fixed assets, net current assets and firm size on capital structure based on static and dynamic versions of pecking order theory. The sample consists of 200 firms during 2002 until 2004 which divided into three groups. The results of this study show that big firms comparing small firms could achieve better combination of capital structure due to their reputation and low risk. Dimitris and Maria (2010) examine the effect of ownership structure and capital structure on the performance of French companies. They measure capital structure using debt to asset ratio,
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ownership structure using firm size, tangible fix assets and intangible assets and also they measure performance using companys profitability and efficiency. The results show that the amount of power and influence of major shareholders can significantly influence the companys efficiency. They mention that this effect could reduce agency costs between managers and owners. Clark (2010) study financial flexibility on capital structure decisions and composition of financial recourses of U.S companies. The sample consists of companies listed on New York stock exchange during 1971 until 2006. In this research, debt ratio is a dependent variable as a measurement for capital structure. The results show that companies with more flexibility on financial decisions have greater access to different and inexpensive financial resources and they are more successful in acquiring needed funds. 2.2. Conceptual Framework and Research Hypotheses Capital structure is a combination of long-term debt, preferred stock and common stock which are used in corporate financing (Dimitris and Maria 2010). Deciding about the perfect combination of capital structure is one of the main managers duties. The most important issue in determining capital structure is deciding about an appropriate and desirable portion of liabilities and equity because of their direct effect on value of stock market. After determining the amount of capital needed by company, managers decide about which sources of funding and what method should be used (Aghaei chadegani et al, 2011). There are different factors that have effect on making decisions about combination of debt and equity. One of these factors is corporate internal factors which are used to increase the firm value. Maximizing firm value is also an important concern of managers which requires optimum utilization of financial resources and achieving high returns for the company. In this regard, managers can maximize the value of the company in two ways: 1) increasing company efficiency and 2) reducing cost of capital and firm risk (Dimitris and Maria, 2010). Accordingly, an appropriate combination of financial resources can lead to achieve desired level of firm value which called optimal capital structure. The pecking order theory of capital structure predicts that information asymmetry between managers and investors create a preference ranking over financing sources. Pecking order theory formulized by Myers and Majluf (1984) is based on asymmetric information between the firms investors and its managers. This theory suggests that companies have a preferred hierarchy for financing decisions. According to this theory, companies prefer to use resources for financing which create lowest information asymmetry. In cases where information asymmetry is exist between managers and outside investors, managers use retained earnings and reserves for financing. If internal resources are not sufficient, external resources will be used. For this purpose, companies use loans or they publish shares (Matthias and Lawrenz, 2005). Ross (1977) was the first one to address the function of debts as a signaling mechanism when there are information asymmetries between the firms management and its investors. He mention that managers have better knowledge of the firm than investors and they will try to avoid debt when the company is performing poorly for fear that any debt default due to poor cash flow will result in their job loss. Myers and Majluf (1984) later develop more complex model of financing. Based on this model, capital structure will be driven by firms desire to finance new investments preferably through the use of internal funds, then with low-risk debt, and with new equity only as a last resort. They state that financial managers issue debt or equity according to the costs of capital (Chen and Roger, 2007). There are two kind of financial resources based on pecking order theory; internal financing and external financing with static and dynamic versions. In static version of pecking order managers use internal financing but if they use external financing, equity is more costly than debts. It is mentioned that in static version, rating the use of various financial resources applicable in any situations. But in dynamic version, if the firm has different investment projects and also have enough profit for financing, it never use debt financing. Because increasing in financial leverage decrease debt capacity and this lead to disregard the projects with net present value. Thus, according to this version of pecking order, deciding about using different financial resources could be vary regarding assessment of current conditions and forecast future conditions. In this situation, companies may maintain their debt capacity

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for potential future needs and use publishing shares for current needs. It is notable that the amount of maintaining debt capacity depends on the changes in the companys investment opportunities and the changes in asymmetries of information between managers and investors. Pecking order financing choices have important results as follows: There is no optimal or target debt ratio for firms. Companies have a tendency to preserve and accumulate cash. Procedures and corporate dividend policy is a function of investment opportunities so that if the companys investment opportunities have changed, the percentage of dividends increases with the lower slop. If the cash flows produced from firm normal operation are more than investment opportunities, they pay their debts or invest in bonds. If companies need external financing, first they issue preferred stock then issue common stock (Baker and Wurgler, 2000). Since based on pecking order theory, priority use of financial resources is determined in terms of cost and risk of each source thus, firm value and return of companies have an important role in this theory. Among the factors that can determine a companys capital structure and financial choices, controllable internal factors are most important ones. Accounting variables as an internal factors have a significant role on determining firm value and financing cost. Because accounting variables are related to main operation and financial situations of companies. Moreover, accounting variables have an important effect on investors and creditors decision making process (Raul, 2009). For this purpose, some accounting variables which have effect on investors and creditors decisions are used and their effect on capital structure of companies listed on Tehran Stock Exchange is examined. These variables are return on investment, tangible fixed assets, net working assets, firm size and profitability index. Return on investment: return on investment shows the desirability of firms investment. Also, it is a criterion for assessing firms ability in making income and profit. In this study, net profit to average shareholders equity ratio is a measurement for return on investment. Based on conceptual framework, return on investment has an important effect on investors and creditors decision making about assessing financial activities. Therefore, increasing in this ratio could help companies in achieving financial resources with low costs. But, based on pecking order financial choices, companies prefer use bonds. Thus, there is a positive relationship between return on investment and capital structure. Tangible fixed assets: tangible fixed assets which largely help in obtaining long-term facilities are those assets which have physical existence. Companies use these assets during business operations. In this research, total book value of fixed assets to total assets ratio is used for measuring tangible fixed assets. Based on literature, tangible fixed assets represent the companys borrowing capacity and also having more tangible fixed assets reduce agency costs. Thus, there is a positive relationship between tangible fixed assets and capital structure. Net working assets: Net working assets are those assets which are used in firm operations. Net working asset is measured by book value of net working assets on total assets ratio. BVWA = (Inventories + receivable accounts) payable accounts Regarding this fact that short-term debt could be used as a source of external financing for deficit capital of companies, this variable has a negative relationship with capital structure. Since net working capital is calculated as current assets minus current liabilities, thus changes in firms debts adversely affected net working capital. Firm size: Firm size represents companys share in competitive market of products comparing other competitors. For measuring this variable natural logarithm of companys sale is used. Based on conceptual framework, there is a positive relationship between firm size and capital structure. Regarding credit, capacity and diversity of large companys activities, they easily reach out external financial resources. Risk is also low in large companies which reduce expected rate of investors and creditors. Thus, there is a positive relationship between firm size and capital structure.

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Profitability index: profitability index is measured through dividing earnings before interest and tax to book value of total assets. Based on literature profitable companies less relies on borrowing and they prefer internal resources financing (Green et al, 2006). But, regarding dynamic version of pecking order financing, it is expected they will use borrowing in future. For testing static version of pecking order, multivariable regression model is used. According to studies on capital structure and this fact that accounting variables have effect on capital structure decisions, it is expected that there is a meaningful relationship between controllable accounting variables on financing decisions. Based on pecking order theory and two static and dynamic versions main research hypotheses are as follows: H1: Based on static version of pecking order, main accounting variables have meaningful effect on capital structure of companies listed on Tehran Stock Exchange. 5 subsidiary hypotheses are as follows: H1a: Return on investment has a positive relationship with capital structure. H1b: The amount of fixed assets has a positive relationship with capital structure. H1c: Net working assets have a negative relationship with capital structure. H1d: Firm size has a positive relationship with capital structure. H1e: Profitability index has a negative relationship with capital structure. H2: Based on dynamic version of pecking order, main accounting variables have meaningful effect on capital structure of companies listed on Tehran Stock Exchange. 5 subsidiary hypotheses are as follows: H2a: Changes in return on investment have a positive effect on capital structure changes. H2b: Changes in amount of fixed assets have a positive effect on capital structure changes. H2c: Changes in net working assets have a negative effect on capital structure changes. H2d: Changes in firm size have a positive effect on capital structure changes. H2e: Changes in profitability index have a negative effect on capital structure changes.

3. Research Method
For investigating the effect of main accounting variables on capital structure, financial statement data of companies listed on Tehran stock exchange during 2002 until 2010 are used. In this research for choosing samples, Purposeful Sampling is used. This means that companies considering the following features are selected: During the research period their stock trading has not stopped. Companies are not financial intermediation and investment firms. They listed on Tehran Stock Exchange until the end of 2010. In terms of increase comparability, their fiscal year ends to march. Debt to equity ratio that represents the capital structure of these companies should be positive. Considering the mentioned conditions total numbers of 101 companies are selected from all industries except investment and financial intermediation. Thus, secondary data of these companies are gathered and Eviews software is used for analyzing data. To estimate the research models, time series data are combined with cross-sectional data. Also, the combined data divided into two groups; panel data and pooled data. For determining data type, F leamer test is used. If based on F leamer test, data are panel data Hausman test will be used. Also, for determining significance of overall regression equation, F-fisher test and for coefficient of independent variables t-test are used. 3.1. Static Version of Pecking Order In static version of pecking order, due to information asymmetry between managers and owners, companies should use resources with lowest information asymmetry for financing. Thus, if internal resources are not sufficient, external resources will be used based on their lowest information

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asymmetry. For this purpose, they use debt issuance or equity issuance. First model which is used to test static version of pecking order hypothesis is as follows: DEBTit 1 ROI it 2TANGit 3 NWAit 4 SIZEit 4 PROFit t Where: DEBT: Debt to total equity ratio ROI: Return on investment TANG: Total tangible fixed assets NWA: Net working assets SIZE: Firm size PROF: Profitability index 3.2. Dynamic Version of Pecking Order Based on this version of pecking order, companies could maintain their borrowing capacity for acquiring more validity and they could use other financial resources like publishing shares for future needs. Generally, in every period, obtaining needed financial resources has done considering companys conditions. Thus, in developing dynamic model, changes in every variable during different period are used. Second model which is used to test dynamic version of pecking order hypotheses is as follows: DEBTit 1ROI it 2 TANGit 3 NWAit 4 SIZEit 4 PROFit t Where: DEBT = changes in debt ratio DEBTit DEBTit DEBTi (t 1) ROI = changes in return on investment ROI it ROI it ROI i (t 1) TANG = changes in amount of net fixed assets TANGt TANGt TANG(t 1) NWA = changes in net working capital NWAit NWAit NWAi ( t 1) SIZE = changes in companys sales SIZEit SIZEit SIZEi (t 1) PROF = changes in amount of profitability PROFit PROFit PROFi (t 1) In model 1 and model 2, i and t respectively show different companies and different time. To estimate coefficient of variables in these models, multivariable regression and OLS are used.

4. Data Analysis and Testing Hypotheses

For data analysis and testing hypotheses initial data and needed information are extracted from audited financial statement of companies listed on Tehran Stock Exchange during research period. Then, using Microsoft office excel data of dependent and independent variables are classified and using Eviews software relationship between variables are examined. 4.1. Testing Static Version of Pecking Order Hypotheses For analysing static version of pecking order model, first F-Limer test is used. For distinguishing panel data from pooled data, if error is less than 5% data are panel and if it is more than 5% data are pooled. The results of cross-section F-test is 0, thus, data are panel. Afterwards, fixed effects and random effects of data are examined using Hausman test.

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Regarding the results of Hausman test in static model, error is 0.0004. Thus, fixed effects of panel data are accepted. Table 1 shows the results of testing static version of pecking orders hypotheses. For every hypothesis, error is 5% and confidence level is 95%.
Table 1: The results of testing static version of pecking order using OLS
Coefficient 2/1109 0/6136 1/9843 -0/4267 1/4714 -0/8741 Std. Error 0/4539 1/5773 1/6525 3/2853 1/5346 1/1542 t-Statistic 4/6501 1/8471 3/6319 -2/66604 2/8969 -2/5847 Error 0/0000 0/0035 0/0003 0/0000 0/0000 0/0000

ROI TANG NWA SIZE

Variables

Durbin Watson stat 1/98475

PROF R squared ( R 2 ) 0/8712 Adjusted R squared 0/7844

F Statistic 9/48002 P rob ( F Statistic ) 0/0000

The results show that in static version of pecking order, independent variables (return on investment, tangible fixed assets, net working assets, firm size and profitability index) have a meaningful relationship with dependent variable (capital structure). Capital structure was measured by debt ratio in this research. According to results of data analysis, with 1% increase in return on investment, debt ratio (capital structure) will increase 0.61. Thus, T-test results show that there is a meaningful and positive relationship between return on investment and capital structure. Moreover, fixed assets and firm size have a positive relationship with debt ratio. The results show with 1% increase in fixed assets, debt ratio will increase 1.98 and with 1% increase in firm size, debt ratio will increase 1.47. But, net working assets and profitability index have negative relationship with capital structure. Because, with 1% increase in net working assets and profitability index, debt ratio will decrease 0.42 and 0.87 respectively. Thus, T-test results show that there is a meaningful and negative relationship between net working assets and profitability index and capital structure. As table 1 represents, R2 of static version of pecking order model is 0.87. It means that 87% of changes in capital structure could explained by first model variables.
4.1. Testing Dynamic Version of Pecking Order Hypotheses For testing dynamic version of pecking order model, first, F-limer test is used for distinguishing panel data from pooled data. The results of F-limer test show that data are panel. Then, fixed effects and random effects of data were examined using Hausman test. Regarding the results of Hausman test in dynamic model, error is 0.00108. Thus, fixed effects of panel data are accepted. Table 2 shows the results of testing dynamic version of pecking orders hypotheses. For every hypothesis, error is 5% and confidence level is 95%.
Table 2: The results of testing dynamic version of pecking order using OLS
Coefficient 2/1531 0/2792 0/9028 -0/3883 0/6695 0/2145 Std. Error 0/4603 0/7176 7/51 2/9896 0/6989 1/2541 t-Statistic 4/743 0/8404 1/8135 -2/2461 1/0905 1/8542 Error 0/0000 0/00159 0/00013 0/00905 0/8745 0/0145

ROI TANG NWA SIZE

Variables

PROF

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Table 2: The results of testing dynamic version of pecking order using OLS - continued

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R squared ( R 2 ) 0/678925 Adjusted R squared 0/5843 Durbin Watson stat 1/1863

F Statistic 6/62179 P rob ( F Statistic) 0/0000

The results of T-test show that in dynamic version of pecking order, only fixed assets and net working assets have a meaningful relationship with capital structure. The results show with 1% increase in tangible fixed assets and net working assets, debt ratio increase 0.90 and -0.38 which is less than first model. Thus, T-test results show that there is not a meaningful relationship between these variables and capital structure.

5. Summary and Concluding Remarks

In this research the effect of accounting variables on capital structure of companies listed on Tehran Stock Exchange based on static and dynamic version of pecking order theory is investigated. The results of testing static version model show that the amount of fixed assets has a positive effect on capital structure. This result emphasis on the use of debt in capital structure when companies fixed assets increased. This positive meaningful relationship between fixed assets and capital structure is also confirmed in Raul (2009) and Demitris and Mariya (2010) studies. Firm size like fixed assets have a positive effect on capital structure of firms listed on Tehran Stock Exchange. The impact of firm size in determining financial options of capital structure is more than other variables. Large companies with more sales have more opportunities to use bank loans. Regarding their reputation, they convince banks and financial institutes that they could repay their debts using these financial resources. Return on investment also has positive meaningful effect on capital structure. But, net working assets and profitability index have negative effect on capital structure. This result is consistent with Raul (2009)s research results. Due to this fact that companies with high profitability could use internal financing and have fewer tendencies to use debt financing, this negative relationship is justified. The results of testing dynamic model show that based on dynamic version pecking order, fixed assets have positive effect and net working assets have negative effect on capital structure. According to the results of testing static and dynamic versions of pecking order models, in static version, optimal capital structure is reachable. Because, in static model firm value, financing costs, flexibility and reliability of funds are considered. But, lake of existence of several decision making options for financial managers in Tehran Stock Exchange make companies eager to use long term debt financing. Further researches are needed to determine factors which have effect on optimal capital structure based on other theory like agency theory among companies listed on Tehran Stock Exchange. Also, further studies are suggested to examine the relationship between ownership structure and capital structure.

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