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Determinants of capital structure

Determinants
of capital
structure

An empirical study of firms in manufacturing


industry of Pakistan
Nadeem Ahmed Sheikh

117

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 firms and to investigate whether the capital structure models derived from Western
settings provide convincing explanations for capital structure decisions of the Pakistani firms.
Design/methodology/approach Different conditional theories of capital structure are reviewed (the
trade-off theory, pecking order theory, agency theory, and theory of free cash flow) in order to
formulate testable propositions concerning the determinants of capital structure of the manufacturing
firms. The investigation is performed using panel data procedures for a sample of 160 firms listed on
the Karachi Stock Exchange during 2003-2007.
Findings The results suggest that profitability, liquidity, earnings volatility, and tangibility (asset
structure) are related negatively to the debt ratio, whereas firm size is positively linked to the debt
ratio. Non-debt tax shields and growth opportunities do not appear to be significantly related to the
debt ratio. The findings of this study are consistent with the predictions of the trade-off theory,
pecking order theory, and agency theory which shows that capital structure models derived from
Western settings does provide some help in understanding the financing behavior of firms in
Pakistan.
Practical implications This study has laid some groundwork to explore the determinants of capital
structure of Pakistani firms upon which a more detailed evaluation could be based. Furthermore,
empirical findings should help corporate managers to make optimal capital structure decisions.
Originality/value To the authors knowledge, this is the first study that explores the determinants of
capital structure of manufacturing firms in Pakistan by employing the most recent data. Moreover,
this study somehow goes to confirm that same factors affect the capital structure decisions of firms in
developing countries as identified for firms in developed economies.
Keywords Capital structure, Stock exchanges, Manufacturing industries, Pakistan
Paper type Research paper

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.

Managerial Finance
Vol. 37 No. 2, 2011

pp. 117-133
q Emerald Group Publishing Limited
0307-4358
DOI 10.1108/03074351111103668

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37,2

118

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 firm value is maximized. However,
maximization of firm value is not an easy job because it involves the selection of debt and
equity securities in a balanced proportion keeping in view of different costs and benefits
coupled with these securities. A wrong decision in the selection process of securities may
lead the firm to financial distress and eventually to bankruptcy. The relationship
between capital structure decisions and firm 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 specific 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 flow theory emphasizes agency costs. However, these
theories provide some help in understanding the financing behavior of firms 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 few developing countries (Booth et al., 2001). However,
findings of these empirical studies do not lead to a consensus with regard to the
significant 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 influence the
capital structure decisions and diminutive research to describe the financing behavior
of Pakistani firms are few reasons that have evoked the need for this research. We
hope that findings of this empirical study will not only fill 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 findings 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 finally 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 financing has no material effects on
the firm value, therefore, management of a firm 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 firms should use as much debt

as possible due to tax-deductible interest payments. Moreover, the value of a levered


firm exceeds that of an unlevered firm by 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 from corporate 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 when it comes in the form of 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 financing. 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 benefits on the use of debt finance 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 benefit of tax
shields on interest payments encourages firms to take on more debt, but also increases the
probability that earnings in some years may not be sufficient to offset all tax deductions.
Therefore, some of them may be redundant including the tax deductibility of interest
payments. So firms with large non-debt tax shields relative to their expected cash flow
include less debt in their capital structure. This view suggests that non-debt tax shields are
the substitute of the tax shields on debt finance, and therefore, the relationship between
non-debt tax shields and leverage should be negative.
Although the benefit of tax shields may encourage the firms to employ more debt than
other external sources available to them, this mode of finance is not free from costs. Two
potential costs, namely, the bankruptcy costs and the agency costs are associated with this
source of finance. Bankruptcy is merely a legal mechanism allowing 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 profits, and possibly the inability of a
firm 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 firm appeared to fall as the value of the firm increased. The cost of bankruptcy is on
the average about 1 percent of the market value of the firm prior to bankruptcy.
Furthermore, direct costs of bankruptcy, such as legal fees, seem to decrease as a function
of the size of the bankrupt firm. Thus, these findings suggest that direct bankruptcy costs
are less important for capital structure decisions of large firms. In order to investigate the
impact of both direct and indirect bankruptcy costs, Altman (1984) collected the data
related to retail and industrial firms failure in the USA. Altman observed that bankruptcy
costs are not trivial. In many cases, bankruptcy costs exceeded 20 percent of the value of
the firm measured just before the bankruptcy and even in some cases measured several
years before. On average, bankruptcy costs ranged

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from 11 to 17 percent of the firm value up to three years before the bankruptcy. Moreover,
bankruptcy gobbles up a larger fraction of the assets value for small companies than for
large ones. These findings suggest that the financial distress costs differ with respect to the
size of the firm and are relevant in determining the capital structure of the firm.
The use of debt in the capital structure of a firm also leads to agency costs. The agency
costs refer to the costs generated as the result of conflicts of interest. Therefore, agency
costs stem as a result of the relationships between managers and shareholders, and those
between debt holders and shareholders ( Jensen and Meckling, 1976). Conflicts 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 firms
resources and may be able to transfer the firms resources for their own personal benefits.
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 firms value. This inefficiency is reduced when a large fraction of
the firms equity is owned by the managers.

According to Myers (2001), conflicts 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 firm. However, if the
chance of default is significant and managers also act in the interest of shareholders,
then shareholders can attain benefits 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 equityfinanced capital investments. Finally, the managers may postpone immediate
bankruptcy or reorganization by obscuring financial problems from the creditors.
However, debt holders might also be aware of these temptations and strive to confine
the opportunistic behavior of managers by writing the debt contracts accordingly.
Bankruptcy and financial distress costs and agency costs constitute the basics of the
trade-off theory. The trade-off theory states that firms borrow up to 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 financial distress. Under the trade-off theory framework, a firm is
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 firm
value. The trade-off theory has strong practical appeal. It rationalizes moderate debt ratios.
It is also consistent with certain obvious facts, for instance, companies with relatively 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 firms prospects
than are outside investors. Second, managers act in the best interests of existing
shareholders. Under these conditions, a firm will sometimes forgo positive net present
value projects if accepting them forces the firm to issue undervalued equity to new
investors. This in turn provides a rationale for firms to value financial slack, such as
large cash and unused debt capacity. Financial slack permits the firms to undertake
projects that might be declined if they had to issue new equity to investors. More
specifically, pecking order theory predicts that firms prefer to use internal financing
when available and choose debt over equity when external financing is required.

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 flow
which states that high leverage leads to a rise in the value of a firm despite the threat of
financial distress, when a firms operating cash flow exceeds its profitable investment
opportunities (Myers, 2001). Conflicts between shareholders and managers over payout
policies are especially severe when a firm generates free cash flow. 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 inefficiencies.
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 profitably reinvested
inside the firm. 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 benefits of control and
reputation. These findings suggest that a high debt ratio may be dangerous for a firm, but
it can also add value by putting the firm 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 flow theory
emphasizes agency costs. Thus, there is no universal theory of debt-equity choice and
no reason to expect one (Myers, 2001). However, there are several useful conditional
theories that can provide support in understanding the financing behavior of firms.
3. Determinants of capital structure
This section briefly explains the attributes, suggested by the different conditional theories
of capital structure (as explained above), which may affect the firms capital structure
decisions. These attributes are denoted as profitability, size, non-debt tax shields,
tangibility (asset structure), growth opportunities, earnings volatility, and liquidity. The
attributes and their relationship to the optimal capital structure choice are discussed below.

Profitability
The trade-off theory suggests a positive relationship between profitability and leverage because
high profitability promotes the use of debt and provides an incentive to firms to avail the
benefit of tax shields on interest payments. The pecking order theory postulates that firms
prefer to use internally generated funds when available and choose debt over equity when
external financing is required. Thus, this theory suggests a negative relationship between
profitability (a source of internal funds) and leverage. Several empirical studies have also
reported a negative relationship between profitability 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 firm size as an important
determinant of capital structure. For instance, Rajan and Zingales (1995) in their study

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

Empirical findings on this issue are still mixed. Wald (1999) has shown a
significant positive relationship between size and leverage for firms in the USA, the
UK, and Japan and an insignificant negative relationship for firms in Germany and a
positive relationship for firms in France. Chen (2004) has shown a significant
negative relationship between size and long-term leverage for firms in China. Several
empirical studies have reported a significant positive relationship between leverage
and firm size (Marsh, 1982; Bauer, 2004; Deesomsak et al., 2004; Zou and Xiao,
2006; Eriotis et al., 2007; Jong et al., 2008; Serrasqueiro and Rogao, 2009).
Non-debt tax shields
Tax shields benefit on the use of debt finance may either be reduced or even eliminated
when a firm is reporting an income that is consistently low or negative. Consequently, the
burden of interest payments would be felt by the firm. DeAngelo and Masulis (1980)
proposed that non-debt tax shields are the substitute of the tax shields on debt financing.
So firms with larger non-debt tax shields, ceteris paribus, are expected to use less debt in
their capital structure. Empirical findings are mixed on this issue. Bradley et al. (1984)
have shown a strong direct relationship between leverage and the relative amount of nondebt tax shields. Titman and Wessels (1988) have found no support for an effect on debt
ratios arising from non-debt tax shields. Wald (1999) and Deesomsak et al. (2004)
reported a significant negative relationship between leverage and non-debt tax shields.
Viviani (2008) has shown a significant negative relationship only between short-term debt
ratio and non-debt tax shields. Bauer (2004) has shown a negative but less significant
relationship between non-debt tax shields and the measures of leverage.

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

projects that cannot be collateralized. This incentive may also induce a positive
relationship between leverage and the capacity of a firm to 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 firms 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
between tangibility and leverage. Booth et al. (2001) have reported a negative relationship
between tangibility and leverage for firms 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, firms holding future growth opportunities, which are a form of
intangible assets, tend to borrow less than firms holding more tangible assets because growth
opportunities cannot be collateralized. This finding suggests a negative relationship between
leverage and growth opportunities. Agency theory also predicts a negative relationship because
firms with greater growth opportunities have more flexibility to invest suboptimally, thus,
expropriate wealth from debt holders to shareholders. In order to restrain these agency
conflicts, firms with high growth opportunities should borrow less. Several empirical studies
have confirmed this relationship, i.e. Deesomsak et al. (2004), Zou and Xiao (2006) and Eriotis
et al. (2007). Wald (1999) has shown that the USA is the only country where high growth is
associated with lower debt/equity ratio. This finding confirms the predictions of Myerss (1977)
model that ongoing growth opportunities imply a conflict between debt and equity interests.
This conflict also causes the firms to refrain from undertaking net positive value projects.

Earnings volatility
Several empirical studies have shown that a firms 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 firm being unable to meet its contractual claims as they
come due. A firms debt capacity may also decrease with an increase in its earnings
volatility which suggests a negative association between earnings volatility and
leverage. Various empirical studies have shown a significant 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 firm with
greater liquidities prefers to use internally generated funds while

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financing new investments. A few empirical studies have shown their results 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 firms,
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 financial statements of all non-financial firms
listed on KSE[1]. Moreover, it allows for the calculation of many variables that are known
to be relevant from studies of firms in developed countries. The final sample, after
considering any missing data, consists of a balanced panel of 160 firms over a period of
five 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 findings with prior empirical studies in developed and developing
countries. The dependent variable is the debt ratio; the explanatory variables include
profitability, size, non-debt tax shields, tangibility, growth opportunities, earnings
volatility, and liquidity. Their definitions are listed in Table I. All the variables are
measured using book values because the data employed in this study come from
financial statements only.
This study used the debt ratio as a measure of leverage, defined as book value of total
debt divided by the book value of total assets. The total debt is the sum of short-term and
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 significant
proportion in the make up of total debt. On average short-term debt represents 76 percent
of the total debt employed by the companies included in our sample[2]. The profound
dependence of Pakistani firms on short-term debt confirms the findings of Demirguc-Kunt
and Maksimovic (1999) that a major difference between developing and developed
countries is that developing countries have substantially lower amounts of long-term debt.

Table I.
Definition of variables

Variables
Dependent variable
Debt ratio (DRit)
Explanatory variables
Profitability (PROFit)
Size (SIZEit)
Non-debt tax shields (NDTS
Tangibility (TANGit)
Growth opportunities (GROW

Earnings volatility (EVOL


Liquidity (LIQit)

DRit
PROFit
SIZEit
NDTSit
TANGit

EVOLit
LIQit
b0
b1-b7
1

it

Methodology
This
study
employed panel
data procedures
because sample
contained
data
across firms 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 fixed
effects.
Under
the
hypothesis
that there are no
groups
or
individual effects
among the firms
included in our
sample,
we
estimated
the
pooled
OLS
model.
Since
panel
data
contained
observations on
the same crosssectional
units
over several time
periods
there
might be crosssectional effects
on each firm or

on a set of group of firms. Several techniques are available to deal with such type of
problem but two panel econometric techniques, the fixed and the random effects
models, are very important. The fixed effects model takes into account the
individuality of each firm or cross-sectional unit included in the sample by letting the
intercept vary for each firm but still assumes that the slope coefficients are constant
across firms. The random effects model estimates the coefficients 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) specification test to determine which estimation model, either fixed or random
effects, best explains our estimation.
The description of three estimation models pooled OLS, the fixed effects, and the
random effects is given below:
DRit b0 b1PROFit b2SIZEit b3NDTSit b4TANGit b5GROW it
b6EVOLit b 7LIQit 1it
DRit b0i b1PROFit b2SIZEit b3NDTSit b4TANGit b5GROW it
b6EVOLit b7LIQit mit
DRit b0 b1PROFit b2SIZEit b3NDTSit b4TANGit b5GROW it
b6EVOLit b7LIQit 1it mit
where:
debt ratio of firm i at time t.
profitability of firm i at time t.
size of firm i at time t.
non-debt tax shields of firm i at time t.
tangibility of firm i at time t.
GROWit growth opportunities of firm i at time t.
earnings volatility of firm i at time t.
current ratio of firm i at time t.
common y-intercept.
coefficients of the concerned explanatory variables.
stochastic error term of firm i at time t.

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b0i

y-intercept of firm I.

mit

error term of firm i at time t.

1i

cross-sectional error component.

5. Empirical results and discussions


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

Table II.
Summary statistics

Variables

Observations

DRit
PROFit

800
800
800
800
800
800
800
800

SIZEit
NDTSit
TANGit
GROWit
EVOLit

LIQit

Country
Developing countries data
Brazil
India
Jordan
Malaysia
Mexico
South Korea
Thailand
Turkey
Zimbabwe
G-7 countries data
Canada
France
Germany
Italy
Japan
UK
USA
Table III.

Mean
0.607852
0.055274
7.376455
0.038546
0.518880
20.165196
0.547126
1.148879

No. of firms
49
99
38
96
99
93
64
45
48
318
225
191
118
514
608
2580

SD
0.156759
0.110648
1.178565
0.032315
0.190491
72.85970
1.006701
0.665056

Minimum

Maximum

0.115851
21.001851
1.435085
0.000699
0.020310
21705.662
0.008834
0.157232

0.891286
1.240773
11.01449
0.201533
0.926522
1,008.796
9.821189
6.666245

Time period

Total debt ratio (%)

1985-1991
1980-1990
1983-1990
1983-1990
1984-1990
1980-1990
1983-1990
1983-1990
1980-1988

30.3
67.1
47.0
41.8
34.7
73.4
49.4
59.1
41.5

1991
1991
1991
1991
1991
1991
1991

56.0
71.0
73.0
70.0
69.0
54.0
58.0

Source: Data of debt ratios of firms in developing countries are adopted from Booth et al. (2001),

Debt ratios

whereas data of debt ratios of firms in G-7 countries are taken from Rajan and Zingales (1995)

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 firms show similar financing behavior as observed for firms in
developing and G-7 countries.
Prior to estimating the coefficients of the model, the sample data were also tested
for multicollinearity. Results are presented in Table IV, which show that most crosscorrelation terms for the explanatory variables are fairly small, thus giving no cause
for concern about the problem of multicollinearity among the explanatory variables.
Under the hypothesis that there are no groups or individual effects among the firms
included in our sample, we estimated the pooled OLS model. The estimation results
are presented in Table V, which indicates that profitability, size, non-debt tax shields,
tangibility, and liquidity proved to be significant in confidence level of 5 percent.
Earnings volatility found less significant while the variable growth opportunities
2
found highly insignificant. The OLS regression has high adjusted R and appears to
be able to explain variations in the debt ratio. Furthermore, the F-statistic confirms the
significance of the OLS regression model.
Since our sample contained data across firms and overtime there might be crosssectional effects on each firm or on a set of group of firms. In order to deal with those
effects, two panel econometric techniques, namely, the fixed effects and random
effects estimation models, are employed. Results of these estimation models are
presented in Tables VI and VII. Under both estimations models profitability, size,
DRit

Variables
DRit
PROFit

1.0000
20.3222
0.1382
20.0739
0.0692
20.0195
20.2316
20.6302

SIZEit
NDTSit
TANGit
GROWit
EVOLit

LIQit

PROFit

SIZEit

NDTSit

1.0000
0.2054
20.0281
20.3182
0.0082
0.0722
0.3929

1.0000
2 0.0391
2 0.2681
2 0.0134
2 0.6007
0.1351

1.0000
0.1841
20.0310
0.0917
20.0703

Variables

Coefficient

C
PROFit

0.825937
2 0.223053
0.020456
2 0.299191
2 0.263211
26
7.17 10
2 0.007898
2 0.177752

SIZEit
NDTSit
TANGit

GROWit
EVOLit

LIQit
2

SE
0.040538
0.038392
0.004402
0.119903
0.024567
25
5.18 10
0.004972
0.000694

TANGit

1.0000
0.0005
20.0154
20.5182

GROWit

1.0000
0.0078
0.0276

127

EVOLit LIQit

1.0000
0.1014 1.0000

t-statistic

Prob.

20.37416
25.809910
4.647338
22.495272
210.71404
20.138361
21.588466
225.58635

0.0000
0.0000
0.0000
0.0128
0.0000
0.8900
0.1126
0.0000

Determinants
of capital
structure

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

Table IV.
Pearson correlation
coefficient matrix

Table V.
The effect of explanatory
variables on the debt
ratio (DRit) using the
OLS estimation model

MF
37,2

128

tangibility, earnings volatility, and liquidity proved to be significant with a confidence


level of 5 percent. Non-debt tax shields proved significant only under the random effects
estimation model. Growth opportunities remained highly insignificant under both
2
estimation models. The adjusted R for the fixed effects estimation model is higher than
for the simple pooling model, indicating the existence of the omitted variables. The results
2
of the Hausman specification test are reported in Table VIII. The test is asymptotically x
distributed with 7 df. Results indicate that the null hypothesis is rejected and we may be
better off using the estimation of the fixed effects model.
Variables

Coefficient

C
PROFit

0.696930
2 0.149226
0.031443
2 0.134187
2 0.302437
26
2 1.10 10
2 0.021170
2 0.121057

SIZEit
NDTSit
TANGit

Table VI.
The effect of explanatory
variables on the debt ratio
(DRit) using the fixed
effects estimation model

GROWit
EVOLit

LIQit
Notes: R

C
PROFit

The effect of explanatory


variables on the debt ratio
(DRit) using the random
effects estimation model

0.067591
0.034256
0.008405
0.098235
0.043316
25
4.00 10
0.009192
0.008192

0.825745; SE of regression 0.073519; adjusted R

t-statistic

Prob.

10.31093
24.356266
3.741148
21.365980
26.982158
20.027499
22.303169
214.77790

0.0000
0.0000
0.0002
0.1724
0.0000
0.9781
0.0216
0.0000

0.780047; sum of squared

residual 3.421363; F-statistic 18.06989; Prob. . F-statistic 0.000000

Variables

Table VII.

SE

Coefficient

SE

t-statistic

Prob.

0.775204
0.049631
15.61935
0.0000
2 0.165676
0.032329
25.124703
0.0000
SIZEit
0.020262
0.005608
3.612828
0.0003
NDTSit
2 0.192198
0.094844
22.026479
0.0431
TANGit
2 0.246056
0.030305
28.119214
0.0000
26
25
GROWit
3.91 10
2 3.14 10
20.080284
0.9360
EVOLit
2 0.013829
0.006345
22.179607
0.0296
LIQit
2 0.143623
0.007102
220.22313
0.0000
2
2
Notes: R 0.392376; SE of regression 0.075322; adjusted
R 0.387006; sum of squared
residual 4.493354; F-statistic 73.06263; Prob. . F-statistic 0.000000

Variables

Fixed effects

Random effects

Var. (Diff.)

Prob.

PROFit
SIZEit

20.149226
0.031443
20.134187

20.165676
0.020262
20.192198

0.000128
0.000039
0.000655

0.1464
0.0741
0.0234

NDTSit

Table VIII.
Fixed and random effects
test comparison

20.302437
20.000001
20.021170
20.121057

TANGit
GROWit
EVOLit

LIQit
2

20.246056
20.000003
20.013829
20.143623
2

Notes: Wald x (7 df) 46.333298; Prob. . x 0.0000000

0.000958
0.000000
0.000044
0.000017

0.0685
0.6038
0.2697
0.0000

Discussion
According to empirical findings, profitability and liquidity have a negative and
significant relationship with the debt ratio, which confirms that firms finance their
activities following the financing pattern implied by the pecking order theory.
Moreover, high cost of raising funds might also restrict the Pakistani firms to rely on
internally generated funds because of relatively limited equity markets combined with
lower levels of trading. This finding also confirms that information asymmetry is
especially relevant in the capital structure decisions of the firms listed on KSE.
The variable size has a positive and significant impact on the debt ratio. This
finding is consistent with the implications of the trade-off theory suggesting that
larger firms should operate at high debt levels due to their ability to diversify the risk
and to take the benefit of tax shields on interest payments. The estimated coefficient
of earnings volatility has the predicted negative sign and is statistically significant.
This finding confirms the predictions of the trade-off theory which suggests that firms
with less volatile earnings should operate at high debt levels due to their ability to
satisfy their contractual claims on due date. Pakistani firms 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 firms
with volatile earnings. For this reason, firms 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 fixed 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 insignificant 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 finding 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 relationship between tangibility
and short-term debt ratio (Karadeniz et al., 2009).

Although manufacturing firms in Pakistan heavily rely on short-term debt either


because of small and undeveloped bond market or due to high-cost long-term bank
debt. However, it is difficult to be certain that this negative relationship is the outcome
of profound dependency of firms 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
firms which encourage managers to consume more than the optimal level of
perquisites. Consequently, firms with less collateralizable assets may choose higher
debt levels to limit their managers consumption of perquisites.

Determinants
of capital
structure
129

MF
37,2

130

The agency explanation seems to be more valid for firms in Pakistan due to the
fact that firms 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 from Western settings. However, the results of this empirical study
suggest that some of the insights from modern finance theory are portable to Pakistan
because certain firm-specific 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
manufacturing firms listed on the KSE Pakistan during 2003-2007. The investigation
is performed using panel econometric techniques, namely, pooled OLS, fixed 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 included short-term debt as well because of its significant proportion in the make
up of total debt of the firms included in our sample.
According to the results of empirical analysis, profitability and liquidity are negatively
correlated with the debt ratio. This finding is consistent with the pecking order hypothesis
rather than with the predictions of the trade-off theory. The firm size is positively
correlated with the debt ratio. This finding supports the view of firm 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
finding 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 firms with less collateralizable
assets may choose higher debt levels to limit the managers consumptions of perquisites.
Moreover, a significant negative impact of liquidity on the debt ratio indicates that firms
maintained excessive liquidity which may encourage managers to consume more than the
optimal level of perquisites. Consequently, firms with less collateralizable assets borrow
more to confine 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 fixed effects model does not. No
significant relationship is found between the debt ratio and growth opportunities.

Finally, the difference in long-term versus short-term debt might limit 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 financing behavior of Pakistani firms.
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 financial statements in accordance with the approved
accounting standards as applicable in Pakistan. Approved accounting standards

comprise of such International Financial Reporting Standards issued by the International


Accounting Standard Board as are notified under the Companies Ordinance 1984.
2. The total debt is the sum of long-term and short-term debt. On average long-term 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
firms 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 first 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 finance specialization and Department of Business Administration awarded him a
Certificate 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 field of system engineering, integrated evaluation
methodology and applications, corporate governance, management, corporate finance, etc.

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Determinants
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