The Determinants Of Capital Structure: A Case From Pakistan ...

The Determinants Of Capital Structure 1

Proceedings of 2nd

International Conference on Business Management (ISBN: 978-969-9368-06-6)

THE DETERMINANTS OF CAPITAL STRUCTURE

The Determinants of Capital Structure: A Case from Pakistan Textile Sector (Spinning Units)

Pervaiz Akhtar

National University Of Modern Languages, Islamabad

Muhammad Husnain

University Of Agriculture Faisalabad

Muhammad Ahsan Mukhtar

Muhammad Ali Jinnah University, Islamabad


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Abstract

Capital structure decisions are among the most important and crucial decisions for any business

because of their effect on value and cost of the company. In this paper we have discussed the

determinants of capital structure of Pakistani firms. The sample comprised 30 Pakistani textile

sector companies. Size, growth, financial cost, profitability, and tangibility are used as

independent variables, while leverage is the dependent variable. For analysis purpose descriptive

statistics, correlation and regression analysis are used. The results imply that the spinning sector

companies are small in size and capitalization so these companies prefer internal financing as

compare to external financing.

Keywords: Capital Structure, Leverage, Pakistan Textile Sector, Spinning Sector.


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Introduction

The Capital Structure Of A Company Is A Particular Combination Of Debt, Equity And

Other Sources Of Finance That It Uses To Fund Its Long-Term Asset. The Key Division

In Capital Structure Is Between Debt And Equity. The Proportion Of Debt Funding Is

Measured By Gearing Or Leverages. There Are Different Factors That Affect A Firm's Capital

Structure, And A Firm Should Attempt To Determine What Its Optimal, Or Best, Mix Of

Financing.

In Corporate World Discussion Of The Determinants Of Capital Structure Is As Old As The

Economic Revolution Of The World. The Capital Structure Is Decided On The Basis Of Some

Forces Which Are Tangible As Well As Intangible In Nature.

In Recent Years, At International Level, Several Authors On Capital Structure Have Proposed

To Identify And Explain Many Great Potential Attributes That Influence The Financial Decision

In Selecting The Right Debt To Equity Variations Across A Firm‟s Capital Structure.

The Link Between A Firm‟s Capital Structure And The Factors That Influence A Firm‟s Debt

Equity Mix Took On Added Importance As A Result Of The Path Breaking Debate Pioneered

By Modigliani And Miller (1958).

Capital Structure Remains To Be A Conventional Issue In Modern Finance. The Path Breaking

Work Of Modigliani And Miller (1958) On The Irrelevance Theorem Served As A Great

Foundation For Many Work To Be Carried Out On The Subject And Pointed Direction That

Such Theories Would Show Under Different Conditions From The Duo Is Capital Structure

Irrelevant.


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These Changes Adapted From The Original Assumptions Took Precedence After Modigliani

And Miller (1963) Theory Demonstrates The Benefits Of Debt By Introducing Taxes. Miller‟s

(1977) Discovery Of The Effect Of The Inclusion Of Personal And Corporate Tax On Firm

Value And Two Theories On Pecking Order Which Consist Of Bankruptcy Costs (Titman,

1984), Agency Cost Theory, Jensen And Meckling, (1976); Myers, (1977) And The Trade Off

Theory Dominate The Literature Of Capital Structure.

Theories Have Been Developed To Explain The Right Debt And Equity Combination For A

Firm To Adapt In Order To Achieve The Optimum Level Of Capital Mix. Traditional Theory Is

In Favour Of Borrowing More For Financing. This Is Mainly Because Of The Tax Advantage

That Is Enjoyed By Debt Whilst Equity Is Not. This Makes Equity More Expensive To Consider.

According To Myers And Majluf (1984), Managers Are Reluctant In The Issuing Of Equity

Because Of The Unwillingness Of Investors As Equity Yields A Return That Is Counted To The

Investors Of Scarce Resource As Their Opportunity Cost, Thus The Issuing Of Equity Should

Only Occur If Equity Is Moderately Priced Or Overpriced.

In Pakistan The Firm‟s Capital Structure Is Generally Decided By The Funds Available In The

Financial Sector Of The Country. The Domestic Savings Are Not So Much Huge Which Can Be

Used To Fulfill The Financial Needs Of The Different Sectors Of The Economy. So Ultimately

The Economy Is Dependent On The Foreign Debts And Aids Related Funds Available In The

Financial Market. The Determinants Of The Capital Structure Gets Change Over The Time On

The Condition Of Available Funds In The Economy.

In General, This Study Covers Each And Every Aspect Of The Subject But Specifically It Is

Related To Capital Structure Of Textile Sector Companies (Spinning Firms) Listed In Karachi


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Stock Exchange And Their Financing Decision Making. It Explores A Variety Of Factors That

Influence The Determinants Of Capital Structure And Manipulate The Financial Decision Taken

By The Manager As Well The Success Or The Failure To These Decisions.

This Research Study Is Based On The Data Taken From The State Bank Of Pakistan Publication

“Balance Sheet Analysis Of Textile Sector Companies Listed On The Karachi Stock Exchange

Volume-II 2004-2009.”The Research Initially Includes 32 Spinning Units Out Of 101 Textile

Companies Listed On KSE. Time Period Of The Data Is From 2004 To 2009

Size, Growth Rate, Financial Cost, Profitability And Tangibility Are Used As Independent

Variables, While Leverage Is The Dependent Variable. For Analysis Purpose Panel Data

Analysis, Correlation And Regression Analysis Are Used.

1.2 Objectives Of The Study

To Identify The Determinants Of Capital Structure In The Different Sectors Of

Pakistan Economy.

To Analyze Which Are The Main Determinants That Influence The Financing

Decision In The Choice Of Capital Structure In Pakistan Economy?

To Explain The Relationship Between Leverage And The Determinants Of Capital

Structure In Pakistan Economy.

To Suggest Some Determinants Which Are Of Considerable Attention For Capital

Structure Decision Pakistan Economy?


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1.3 Significance Of The Study

This Study Will Try To Identify And Analyze The Determinants Of Capital Structure In A

Systematic Way. Study Will Provide The Applicable And Practical Teaching To Anyone Who

Wishes To Understand The Topic. In General This Study Will Cover Many Aspects Of The

Topic But Specifically It Will Try To Determine The Capital Structure Of The Spinning Sector

Firms Listed On Karachi Stock Exchange. This Study Will Help The Managers To Take The

Financing Decision For Their Firms. The Creditors Can Also Take The Benefit To Minimize

Their Risk, In Funding A Specific Sector Firms.

2.0 Literature Review

The Objective Of This Chapter Is To Examine Existing Research On Capital Structure And Its

Determinants With Relative Emphasis On The Different Sectors Of The Pakistan Economy. This

Is So As To Discover And Provide An Insight On The Theoretical Models Used To Explain

Capital Structure And Its Determinants.

The Literature Review Seeks To Offer Clear Understanding On The Theories Of Capital

Structure And To Look At Its Determinants, How They Can Be Influenced By These Theories

And How They Are Related To Gearing.

The Theoretical Foundation For This Research Will Be Established Through Literature Review

Of Relevant Research. Priority Will Be Given To The Most Recent Work, Building Upon Earlier

Works.


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The Equity And Debt Value Used By The Company In Its Operation Will Constitute Its Capital

Structure. The Capital Structure Decision Is Therefore A Very Important One Because Of The

Impact Such A Decision Has On The Firm‟s Ability To Deal With Its Competitive Environment.

It Is Often Debated Whether Commonly Perceived "Good Industry” Is Defined By Its

Determinants That Can Point Towards The Right Mixture To Be Used To Achieve Optimum

Capital Structure. Leverage Ratios Of Specific Industries Have Been Documented And Their

Results Are In Broad Agreement And Show That Highly Geared Industries Have Consistently

High Leverage.

In 50 Years Since The Pioneering Work Of Modigliani And Miller (1958), Vast Amount Of

Academic Effort Of Research Has Been Devoted To Models Explaining Capital Structure. The

Extensive Literature On The Subject Matter Is Of High Interest And Has Shown Its Popularity In

The Corporate Finance Circles.

The Genesis Of The Theory Of Capital Structure Received Maximum Attention After The

Seminal Work Of Modigliani And Miller (1958) On „Capital Structure Irrelevance Theory‟

Often Referred To As MMI. This Paper Served As A Great Foundation For Many Of The Recent

Work Carried On The Subject. The Enormous Criticism Received After The Publication Of

MMI Gave Rise To MMII In (1963) Which Included Tax, A Component Absent In The Former.

Debt Is Borrowed Money That A Fixed Payment In The Future (Interest Payments And

Repaying Principal) Is Made. Equity On The Other Hand Is The Leftover After Debt Payments

Have Been Made. Combining Debt With Equity Gives The Gearing Or Leverage Position Of

The Company. Debt Can Be Short Term Or Long Term. Equity Financing Entails Issuing


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Common Stocks Or Preferred Shares To Investors. In Return For The Money Paid, Shareholders

Receive Ownership Interest In The Corporation. This Is Referred To Share Capital.

In An Attempt To Avoid Bankruptcy, Robicheck And Myers (1966) Propose That The Addition

Of Debt May Force A Firm To Have Its Future Strategy In Order To Finance Promised

Payments On Outstanding Debt. However, The Firm Is Likely To Incur Costs Which Are

Associated With This Sort Of Action.

The Implications Of This Analysis Generated Enormous Criticism. Stiglitz, (1962); Baumol And

Malkiel, (1967); Rubinstein (1973) And Scott (1976), Share A General Consensus That This

Traditional Theory Fails To Consider The Damaging Effects Of Increased Debt On Firm.

Stiglitz (1962) Demonstrated That If Debt Is Traded In A Separate Market In Which Investors

Are More Pessimistic About The Firm Than Its Equity Holders, Then A Sufficiently Large

Increase In Debt Can Lower The Total Value Of A Firm. More Reasonably, Robichecks And

Meyers (1966) And Baxter (1967), Have Argued That Debt Policy Is Not Relevant And That An

Internal Optimal Capital Structure Can Exist.

Baumol And Malkiel (1967) Have Argued That Capital Structure Will Not Be Irrelevant If

Investors Incur Transaction Costs When Engaging In Arbitrage Activities. Rubinstein (1973)

Shows That If Security Markets Are Partially Segmented, Where Traders Are More Risk Averse

Than Investors, Then A Sufficiently Large Increase In Debt Can Lower The Total Value Of The

Firm.

According To Scott (1976), The Use Of The Traditional Theory In Such A Manner Can Have

Negative Implications On A Firm Value Because It Fails To Consider The Effects Of Increased


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Debt On A Firm. Same Are The Findings Of Hatfield Al Et (1994) Who Suggest That Firms

Prefer An Optimum Level Of Debt And They Increase Or Decrease That Level To Enhance

Their Value In The Market. The Firms Want That Level Of Debt Where They Can Beat Other

Industry In Battle Of Market Value.

There Are Many Variables Which Can Influence The Firms Leverage Ratio And Can Have A

Positive Or Negative Impact On The Value Of The Firm. Harris And Raviv (1995) Identify

Variables That Are Considered To Influence The Firm‟s Leverage Ratio Such As: Size,

Tangibility, Tax Shields, Growth Opportunities, Bankruptcy Probability And Assets.

According To Stewart (2000), Equity Financing Is Better Option When Cash Flows And Assets

Are Not Predictable. This Means That Investors Have Enforceable Rights To The Firm‟s Assets,

But Cannot Prevent Insiders (Managers Or Entrepreneurs) From Capturing Cash Flow. Insiders

Must Co Invest And Pay In Each Period A Dividend Sufficient To Ensure Outside Investors

Participation For At Least One More Period. Shah And Hijazi (2004) Found That The Larger

Firms Employ More Debt Because They Have More Strength To Absorb The Risk Of

Bankruptcy. If Larger Firm Defaults In Any Case The Bankruptcy Costs For Such Firm Will Be

Low As Proportion Of Their Total Worth, Which Is The Prime Reason Of Taking More Debt By

Larger Firms. The Smaller Firms Take Less Debt Because Of Their Fear To Become Bankrupt If

They Are Unable To Repay Their Debt On Time.

Song (2005) Initiates That Capital Structure Determinants Are Dependent On The Nature Of

Debt Taken By The Firms. The Different Determinants Have Different Impact On Short Term

And Long Term Debt. This Study Finds Positive Relation Of Tangibility Of Assets Value With

Long Term Debt While It Is Negatively Related With Short Term Debt. Size Is Positively


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Related With Short Term Debt And It Is Negatively Related With The Long Term Debt Of The

Firm.

Lima (2008) Conducted A Research In Bangladesh On Pharmaceutical Companies And The

Findings Of The Research Are Almost Same And Are Aligned With Research Results In Rest Of

The Developed Countries Of The World. The Size, Value Of Assets, And Financial Cost Do

Effect The Financial Decision Of The Companies In This Sector. The Larger Companies Have

More Access To Funds And Less Chances Of Default That‟s Why They Enjoy More Borrowings

As Compare To Smaller Firms.

The Firm‟s Size Has Been The Critical Point Of Capital Structure Decision. According To

Muradoglu (2009) As The Small Firms Have Restricted Access To The Funding That‟s Why,

They Face Higher Interest Rate As Compare To Larger Firms And Their Growth Is Ultimately

Influenced. In Developing Countries The Larger Firms Can Easily Access The Debt Financing

Whereas The Availability Of Funds For Smaller Firms Is Dependent On The Economic

Conditions Of The Country.

There Is Also Difference In The Capital Structure Of Private And Public Owned Firms.

Dewaelheyns & Hulle (2009) Argue That In Private Sector Companies The Capital Structure Of

The Firms Is Not Driven Only By The Internal Financing But The External Financing Do Have

An Impact On The Decision. Although The Private Firms Have Limited Access To Debt

Financing But Still They Continue To Expand In Many Parts Of The World Because They

Follow Pecking Order Theory (Mayers 1984), Which Suggests That Firms Prefer Internal

Financing Until They Funds Are Sufficient To Meet Their Needs.


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3.0 Conceptual Framework And Methodology

3.1 Dependent Variable

1. Leverage (Debt/Equity)

3.2 Independent Variables

1. Size

2. Growth

3. Financing Cost

4. Profitability

5. Tangibility

3.3 Hypotheses

Total Five Variables Have Been Used In This Study. The Only Dependent Variable Of The

Study Is Leverage And Independent Variables Were Hypothesized As Follow:

H1: Profitability Is Negatively Related With Leverage.

H2: Size Is Negatively Related With Leverage.

H3: Growth Is Negatively Related With Leverage.

H4: Financing Cost Is Negatively Related With Leverage.

H5: Assets Tangibility Is Negatively Related With Leverage.


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3.4 Sample And Methodology

This Research Study Is Based On The Data Taken From The State Bank Of Pakistan Publication

“Balance Sheet Analysis Of Textile Sector Companies Listed On The Karachi Stock Exchange

Volume-II 2004-2009.”The Research Initially Includes 32 Spinning Units Listed On KSE. Time

Period Of The Data Is From 2004 To 2009.

We Present In Our Design Both Theoretical And Quantitative Analyses. For Quantitative

Analysis We Use Two Methods: First: Correlations Is Used To Find Out The Association

Between The Variables Under Consideration. Second: Regression Analysis Is Used To Further

Measure The Relationship Of The Dependent And Independent Variable Accurately.

3.5 Statistical Tools

Descriptive Data Analysis

Correlation

Regression

Following Model Will Be Used For The Purpose Of Analysis.

D/E = Α + Β1 (PFT) + Β2 (SZ) + Β3 (G) + Β4 (F.C) + Β5 (TG) +Εi

Where As

D/E = Measure Of Leverage

PFT = Profitability

SZ = Size

G = Growth Opportunities


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FC = Financial Cost

TG = Tangibility Of Assets

Ε = The Error Term

4.0 Data Anaylsis

4.1 Descriptive Data Analysis

Table.01

20 Pakistani Firms, 2004 – 2009, 5 Years 120 Observations

Leverage

Size Growth

Financial

Cost

Profitability Tangibility

Mean 560.7 1388.66 1386.3 113.885 17.687 1190

Median 291.4 1094 1110.95 58.8 16.6 997.4

Standard

Deviation 2122 977.167135 998.353 163.478 104.76 787.2

Sample Variance 4503936 954855.61 996708 26725 10975 6E+05

Range 23246 4264.8 4337.5 856.9 1088.9 3583

Count 120 120 120 120 120 120

4.2 Pearson’s Correlations Coefficients


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Table.02


Leverage Size Growth Financial Cost Profitability Tangibility

Leverage 1

Size -0.08 1

Growth -0.08 0.85434047 1

Financial Cost 0.276 0.41992973 0.32594 1

Profitability -0.03 0.00757611 0.0331 -0.0087 1

Tangibility 0.05 0.91191437 0.85641 0.43823 0.0369 1

4.3 Regression Statistics

Table.03


Multiple R 0.348447854

R Square 0.121415907

Adjusted R

Square 0.082881517

Standard

Error 2032.398447

Observations 120

4.4 Anova

Df SS MS F Significance F

Regression 5 65075095.05 13015019 3.150845 0.010588304

Residual 114 470893352.8 4130643

Total 119 535968447.8


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Coefficients Standard Error T Stat P-Value Lower 95%

Upper

95%

Lower

95.0%

Upper

95.0%

Intercept 723.1610393 339.9231641 2.127425 0.03554 49.77589121 1396.5 49.776 1396.55

Size -0.488615758 0.498764338 -0.97965 0.329332 -1.476664038 0.4994 -1.477 0.49943

Growth -0.039483809 0.388897454 -0.10153 0.91931 -0.809886644 0.7309 -0.81 0.73092

Financial

Cost 4.829305568 1.281641817 3.768062 0.000262 2.290383083 7.3682 2.2904 7.36823

Profitability -0.430654912 1.78430111 -0.24136 0.809711 -3.965341553 3.104 -3.965 3.10403

Tangibility 0.023919891 0.631077504 0.037903 0.969831 -1.226239744 1.2741 -1.226 1.27408

5. Results Description And Conclusion

5.1 Overall Overview of the Findings

Analysis Of All Firms Shows That Total 12% Variation In Dependent Variable I.E. Leverage Or

Debt To Equity Is Related To The Values Of All Five Independent Variables Of The Study As

Evidenced In R-Square Value In Other Words 12 % Variation In Leverage Decision Of The

Firm Is Explained By Profitability, Size, Tangibility, Growth, And Cost Of Financing. Rest Of

The 88% Is Due To Extraneous Variables. Overall Significance And Goodness Of The Model Is

Relatively Low Just Because Of The Unavailability Of Data Or Incomplete Data Available

Through Different Sources Which Is Unable To Use In This Study.

5.1.1 Size

From The Theoretical Point Of View, The Effect Of Size On Leverage Is Unclear. As Rajan And

Zingales (1995,) Claim: “Larger Firms Tend To Be More Diversified And Fail Less Often, So

Size (Computed As The Logarithm Of Net Sales) May Be An Inverse Proxy For The Probability

Of Bankruptcy. If So, Size Should Have A Positive Impact On The Supply Debt. Some Authors


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Find A Positive Relation Between Size And Leverage, For Example Huang And Song (2002),

Rajan And Zingales (1995).

In Our Study Size Of The Firms Also Suggests Accepting The Negative Hypothesis And

Rejecting The Hypothesis That With Increase In Size Of The Firm, The Leverage Of The Firm

Also Increases As This Test Is Statistically Insignificant.

5.1.2 Growth

According To Myers (1977), Firms With High Future Growth Opportunities Would Use More

Equity Financing, Because A Higher Leveraged Company Is More Likely To Pass Up Profitable

Investment Opportunities. As Huang And Song (2002) Claim: “Such An Investment Effectively

Transfers Wealth From Stockholders To Debt Holders.” Therefore A Negative Relation Between

Growth Opportunities And Leverage Is Predicted. As Market-To-Book Ratio Is Used In Order

To Proxy For Growth Opportunities, There Is One More Reason

Growth Of The Firm Is Negatively Related To Debt/Equity Ratio In Our Study As The

Regression Analysis Shows Negative Relationship With Debt To Equity Ratio So We Accept

The Hypothesis Generated In Our Study That Is Growth Is Negatively Related With Our

Dependent Variable.

5.1.3 Financial Cost

Financial Cost Is Positively Related With Debt To Equity Ratio Which Simply Means That

When The Debt Ratio Of Any Company Will Increase There Will Also Be Sure Increase In The


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Financing Cost Of The Company. The Positive Hypothesis Is Accepted Which Was Suggested In

The Start Of Our Study In Theoretical Framework And Hypotheses Generation Section.

5.1.4 Profitability

There Are No Reliable Theoretical Predictions On The Effects Of Profitability On Leverage. The

Trade Off Theory Suggests That The Firms With More Profit Should Take More Debt. The Free

Cash-Flow Theory Propose That More Profitable Firms Should Employ More Liability In Order

To Control Managers, To Tempt Them To Pay Out Cash As A Substitute Of Spending Money

On Incompetent Projects. However, Pecking-Order Theory Claims, Firms Prefer Internal

Financing Over External.

Profitability Is Negatively Related With Leverage As It Is Hypothesized In This Study The

Results Of Regression Analysis Shows That The Profitability Is Negatively Related With

Leverage So It Suggests That We Should Accept The Null Hypothesis.

5.1.5 Tangibility

It Is Assumed, From The Hypothetical Point Of View, That Tangible Assets Are Used As

Guarantee. Therefore It Lowers The Risk Of Creditors In Case Of Bankruptcy. As Booth Et Al.

(2001,) State: “The More Tangible The Firm‟s Assets, The Greater Its Ability To Issue Secured

Debt And The Less Information Revealed About Future Profits.” Thus A Positive Relation

Between Tangibility And Leverage Is Assumed.

Several Empirical Studies Confirm This Suggestion, Such As (Rajan – Zingales,1995), (Friend –

Lang, 1988) And (Titman – Wessels, 1988) Find. On The Other Hand, For Example Booth Et


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Al. (2001) And Huang And Song (2002) Experience A Negative Relation Between Tangibility

And Leverage.

There Is A Positive Relationship Between Tangibility And Firms Leverage. In Both Regression

Techniques This Test Is Significant.

Conclusion

This finds that capital structure determination is not a science so the firms analyze a number of

factors to choose a best mix of debt and equity. In Pakistan as well there are different factors that

affect a firm's capital structure decision. The results suggest that in Pakistan most of the firms

prefer internal funds over the external financing. In Pakistan the main source of funding is

banking sector which generally prefers the larger firms while funding. So the larger firms can

take loan very easily because of the banking sector preferences. As most of the Pakistani firms

are of medium size, therefore these firms are unable to take loans for their future projects. One

more possible reason of taking less loans can be the legal procedures and obligations involved in

the process of debt financing. The last reason which is not proved yet could be the religious

teaching about the interest, which is forbidden in Islam.


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