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Profitability And The Corporate Leverage Policy Of Firms

Abstract

This study attempts to determine the relationship between the profitability and leverage policy of firms of Fuel and Energy sector of Pakistan. The analysis was implemented on 27 firms in the Fuel and energy sector listed at the Karachi Stock Exchange for the period 2003-2008. Regression was used to find out the relationship between the independent variable (Profitability) and dependent variable (Leverage). We expect the negative relationship between the Profitability and the Leverage Policy of firms in the Fuel and Energy sector of Pakistan, confirming the pecking order theory of capital structure. The results found in our study were not as expected. The results showed that there is inverse relationship between profitability and leverage but our results were not that much significant to accept our hypothesis. So we rejected our pecking order theory hypothesis. Therefore we conclude that because of certain factors such as economic situation of the Pakistan, rising prices of oil all around the world, interests rates and reliance of firm’s financing needs mostly on bank financing, pecking order theory model becomes insignificant in the Energy and Fuel sector of Pakistan.

Chapter-1

Introduction

Capital structure involves different decisions taken by a firm in financing its assets. Generally, a firm can solve this issue through different mixes of debts, equity, or other financial arrangements. It can also combine bonds, TFCs, lease financing, bank loans or many other options with equity in order to boost the market value of the firm.

1.1 Importance of the topic:

Optimal capital structure plays a vital role in the overall value maximization of a firm. The strategic management of capital structure ensures access to the capital needed to fund future growth and enhance financial performance. Our focus in this study is to correlate the profit of the firm with its leverage. Importance of the study is to find out that which source of funds either retained earnings, debt or equity, a firm in the Fuel and Energy sector should prefer in order to optimize the profit and the value of the firm. In Pakistan, firms usually prefer short-term borrowing, because commercial banks are the major lenders and they do not encourage long-term loans. Up to 1994 firms did not rely on market based debt; in mid 1994 the government amended the Company Law to help companies to raise debt directly from the market in the form of TFCs (Term Finance Certificates).

1.2 Background of the study:

Various capital structure theories had been discussed by many authors to explain the variation of capital structure of different firms. So many researches had also been taken place in order to solve the mystery of optimal capital structure in Pakistani firms. A thorough research study relating to the capital structure was carried by two Pakistani professors Shah and Tahir (2004) which attempted to answer the question of what determines the capital structure of Pakistani Listed firms other than those in financial sector. Booth, et. Al (2001) had also worked on the determinants of capital structures of 10 developing countries including Pakistan, but their data analyzed the firms that were included in the KSE-100 Index from 1980 to 1987. Shah and Tahir (2004) analyzed the data of non-financial firms for the period of 1997-2001 while our study differs from theirs on grounds of different sector, variables and period.

1.3 Objective of the study:

The objective of this study is to find out the relationship between the profitability and the corporate leverage policy of firms in the Fuel and Energy sector of Pakistan.

We are trying to figure out that the firms that have more profits in the Fuel and Energy sector have lower leverage. Our main focus in this study is to correlate the profit of the firm with its leverage in the context of pecking order theory.

According to pecking order hypothesis firms tend to use internally generated funds first and than resort to external financing. This implies that profitable firms will have less amount of leverage. Therefore we expect a negative relationship between profitability and debt of a firm i.e. higher the profits of a firm, the lesser will be its debt.

1.4 Scope of the study:

This study is limited on the Fuel and Energy sector of Pakistan. There are 27 firms of that sector which are listed on the Karachi Stock Exchange. But after screening the firms with incomplete data, we have selected 22 firms having complete data for six years from 2003-2008 as the study covers the period from 2003 to 2008.

1.5 Disposition of the study:

This study is organized into five stages. In first stage we have described the background of our topic. In second stage review of literature has been done. In next stage we have explained our data and variables used in our analysis. At fourth stage we have discussed the model and the statistical test to be used. While the last stage concludes the results of the test.

Chapter 2

Literature Review

In this chapter we have gone through the various research studies regarding the leverage and well known capital structure theories.

Capital structure refers to specific mixture of debt and equity a firm needs to finance its operations and optimal capital structure plays a vital role in the overall value maximization of a firm. This has given birth to different capital structure theories that attempt to explain the variation in capital structures of firms.

The Miller & Modigliani theorem showed that the market value of a firm is determined by the risk of its underlying assets and its earning power and is independent of the choices to finance its investments i.e the value of the firm is independent of the capital structure it takes on. But Myers suggested the contemporary thinking on capital structure in form of Static Tradeoff Theory. This explained that a firm initially following a target debt-equity ratio behaves accordingly. The costs and benefits related to the debt option make this target ratio. The costs and benefits are cost of financial distress, tax shields and agency cost.

There are different theories that are used to explain the capital structure decisions which are based n the asymmetric information, tax benefits associated with the debt, bankruptcy cost and agency cost. The asymmetric information is related with pecking order framework and the other three are rooted in static trade-off choice.

Under the trade off theory firms tried to equate the marginal benefits of an additional unit of debt with the related marginal cost, while holding the firm’s assets and investments plans. Under this model the key benefits are debt tax deductibility and the mitigation of agency cost while the main cost of additional debt is bankruptcy.

Green, Murinde and Suppakitjarak (2002) observed that the tax policy also effect the capital structure decision of firms. Firm are allowed to deduct interest on debt in computing taxable profit under tax ordinance while the payments associated with the equity such as dividends are not tax deductible. Therefore, the tax effect encourages the debt usage by the firm if the rates are higher and more debt increases cash savings in form of after tax proceeds to the owner.

Usage of debt in the capital structure of the firm also leads to agency cost which arises as a result of relationship between the share holder and manager while the firm’s management is the agent and the share holder being the principal. Agent may not choose to maximize their principal’s wealth. The conflict arises as the managers have less than 100% of the residual claim. Thus, managers may invest in projects that reduce the value of the firm while enhancing their control over its resources. Additional cash flow is the prime source of the agency cost. Debt helps to mitigate this agency cost as the firm is committed to pay out excess cash in the form of interest payments.

The probability of bankruptcy increases with the increase in the level of the debt. If the firm goes beyond the optimum level of debt, then it is more likely that the firm will default on the repayment of the loan. As a result of that, the control of the firm will be shifted from share holders to the bond holders or the creditors who will liquidate the firm in order to recover their investment. There are also direct and indirect costs associated with the bankruptcy. Direct cost includes administrative costs of bankruptcy and costs of reorganization in the event of insolvency. While the indirect cost arises when the firm gets into financial distress. It may arise because of the change in the investment policies of the firm if firm foresees possible bankruptcy. In order to avoid the possible financial distress it will cut down the expenditure on certain departments like research and development, training of employees and advertisements etc. Therefore, if a firm is perceived to be closed to bankruptcy customers may be less willing to buy its goods because of low perceived quality of goods and the risk that the firm will not be able to meet its warranty obligation. Employees may also be less interested to work for the firm and creditors are less inclined to extend trade credit.

Hence under the static trade off theory the optimal capital structure represents a level of leverage that balances the bankruptcy and the benefits of tax deductibility and mitigation of the agency costs.

While The Pecking Order Theory of Myers (1984) and Myers and Majluf (1984), stated that firm while establishing its capital structure follow a hierarchy of financial decisions. First of all firm uses its internal financing i.e. retained earnings in order to finances its projects. In case of need of external financing, they prefer a bank loan first then go for the public debt. Thus in accordance with the Pecking Order Theory, profitable firms while having the available internal funds prefers not to incur debt for new projects.

A study was carried by Benito, (2002) which considered the two most influential approaches, the trade off and packing order theories, in understanding capital structure decisions of firms of Spain and United Kingdom. This study made a valuable contribution to our study because of the same objective of testing Pecking Order Theory with reference to capital structure of firms. The resulting data included 6417 Spanish companies over period of 1985-2000 and 1784 British quoted non-financial companies over period of 1973-2000. The results provided significance in favor of pecking order theory, concluding debt ratios found to be significantly inversely related to cash flow and profitability of the firm and vary positively with its investment.

In order to find the best empirical explanation for the capital structure of Brazilian firms Medeiros and Cecilio (2004) tested a model to represent the Static Trade-off Theory and Peking Order theory. This theory is helpful for our study because of the same independent variables that is profitability.

“Profitability - all the STT streams sustain that a positive relationship must exist between profitability and debt. The stream based on bankruptcy costs states that these costs increase when earnings fall so that leverage tends to be lower for less profitable firms or those with higher earnings volatility. For the stream focusing on tax benefits, the more profitable the firm the more it benefits from the tax shield provided by interest payments. The agency stream believes that large amounts of free cash flows build up the dispute between shareholders and managers, which make those firms to issue more debt in order to diminish the problem (Fama and French, 2003). According to the POT, retained earnings are the firm’s best financing option. This type of resource does not produce information asymmetries and can be used promptly for new projects. The information asymmetry caused by equity issues or by more complex securities that require a higher degree of communication with the market is the basis of the POT. It is exactly to dodge the adverse selection premium brought by the information asymmetry that firms opt for internal financing as their major source of resources (Myers, 1984). The relationship between these two variables must be therefore negative?. Medeiros and Cecilio (2004)

The sample of their study included 371 non-financial firms with shares listed in the Brazilian stock exchanges from 1995 to 2002. The analysis of results of the study led to the conclusion that the pecking order theory provides the best explanation for the capital structure of those firms

Another study on the capital structure was carried by Abor, (2008) comparing the capital structure of large un-quoted firms, small and medium enterprises (SMEs) and publicly quoted firms in Ghana using a panel regression model. On the grounds of the similar independent variable this study made a useful contribution to our review literature. The results showed insignificant difference between the capital structures of large unquoted firms and publicly quoted firms. The results of all sample groups showed that the total debt has relatively a high proportion of short-term debt. The results of the regression test indicated that age and size of the firm, profitability, risk, asset structure and managerial ownership are significant influencers in decisions regarding the capital structure of Ghanaian firms.

Chiarella et.al (1991) conducted a study in Australia on the determinants of corporate capital structure by seeking to provide evidence on the significance of capital structure determinants in Australian context. This study provided a great support for writing review literature of our study. The analysis was carried on a sample of 226 Australian firms from 1977-1985. The results showed that company non-debt tax shields display a negative relationship with debt ratios. The results also supported the pecking order hypothesis of Myers and Majluf (1984) showing significant negative relationship of profitability with debt ratios and indicating that firms prefer to finance investments with internally retained earnings before issuing debts. The results provided some evidence of size effect indicating that the larger firms tend to employ more debts in their capital structure. Results showed positive but insignificant relationship between cash holdings and debt ratios while confirming the free cash flow hypothesis of Jensen (1986). Simultaneously results did not provide any support for growth opportunity and collateral value attributes as determinants of debt ratios.

A study on the Malaysian companies regarding the capital structure and the firm characteristics was carried by an Indian professor Pandey (2000). This study is useful for our study because of one of the same independent variable i.e. profitability. The study was carried on Malaysian companies in order to examine their determinants of capital structure using data from 1984 to 1999 while classifying the data into four periods that relates to different stages of capital market of Malaysia. Results of the regression clarified that profitability, size; growth, risk tangible variables have significant impact on all debt types. Results showed persistent and consistent negative relationship of profitability with all debt ratios in all periods, thus accepting the prediction capital structure according to the pecking order theory.

A research relating to the capital structure was carried by two Pakistani professors Shah and Tahir (2004) which attempted to answer the question of what determines the capital structure of Pakistani Listed firms other than those in financial sector. Because this study was also carried in Pakistan so it provided a support to a great extent in order to understand the capital structure according to Pakistan’s environment. A sample of 445 listed firms on KSE were taken and their five year data from 1997-2001 were taken into consideration. Pooled regression results indicated that assets tangibility is positively correlated with debt, concluding that asset structure does not matter in determination of capital structure of Pakistani firms. Size was positively correlated with leverage suggesting that large firms would employ more debt. Growth was found to be negatively correlated with leverage that supports the simple version of pecking order theory that growing firms finance their investment opportunities first by their internally generated funds. There was strong relationship between profitability and leverage. Profitability was negatively correlated with leverage that supports the pecking order theory.

A study in Hong Kong was carried by Hung, et.al (2002) examing the inter-relationship between profitability, cost of capital and capital structure among property developers and contractors in Hong Kong. The results showed that capital gearing is positively related with assets but negatively with profit margins.

Bartholdy and Cesario (2006) analysed the decisions regarding the capital structure of Portuguese non-listed bank financed firms. Primary purpose of the research was to find out the impact of debt tax shield on the decisions regarding capital structure of small non-listed firms. The secondary purpose was to find out that whether the determinants of capital structure of larger listed firms were also same as in case of smaller non-listed firms. The research explained that the solution of two big problems (agency and asymmetric information) for large firms are apparent on the balance sheet as restriction on debt. On the other hand it is less apparent on the balance sheet of smaller firms. This provided the smaller firms with the benefit of tax shield due to more debt. This research has provided a great support in writing our review literature and understanding the relationship between profitability and debt to a great extent. The sample of their research consisted 998 firms with 7765 firm years’ observations. The results concluded that the tax provisions regarding the carry forward of tax losses and debt tax shield play a vital role in determining the capital structure of small non-listed firms. It was also concluded that in order to solve agency problem traditional balance sheet variables were significant in large listed firms but were insignificant for the small non-listed firms with the exception of variables required to solve bankruptcy risk.

A research study was conducted in Greece by Eriotis, et.al (2007) aiming to isolate the firm characteristics that effect capital structure. The investigation was performed using panel data for a sample of 129 Greek companies listed on Athens Stock Exchange during 1997-2001. The findings justified a negative relationship between the debt ratio of the firms and their growth, and size appeared to have a positive relation.

Gropp and Florian (2008) conducted research study regarding the determinants of the capital structure of banks by examining the capital structure of banks from the prospective of empirical capital structure literature for non-financial firms. The sample of the study includes 200 largest listed banks (100 from US and 100 from EU) from the sixteen different countries (US and 15 EU members) from 1991 to 2004. The results suggest that the capital requirements may only be of second importance for bank’s capital structures and confirm the robustness of corporate finance findings in a holdout sample of banks.

In order to examine the capital structure across countries a study was carried by Rajan and Luigi (1994). The primary objective of the study was to establish whether the choice of capital structure in other countries is based on the factors similar to those influencing capital structure of US firms. Study was on the 8000 non-financial corporations of G-7 countries (USA, Germany, Japan, France, UK, Italy and Canada) for the period of 1987-1991. After correcting the differences ranging from accounting practices to legal and institutional environments between the countries. results of the study showed extent to which firms are levered is fairly similar across the G-7 countries except UK and Germany being relatively less levered.

Sakuragawa (2001) conducted another study regarding the capital structure of banks under non-diversifiable risk. The purpose of the research was to study the design of optimal capital structure of a large financial corporation when it faces a non-diversifiable risk. When there is a non-diversifiable risk the intermediary finds it profitable to issue equity because by issuing equity it can reduce the cost and the probability of bank’s failure. The intermediary designs the optimal capital structure by balancing the marginal benefit of reducing probability of bank’s failure against the marginal cost of debt-equity swap. Results showed that a large corporation under weaker conditions realizes more efficient allocation by issuing both debt and equity than by issuing only debt.

An African study was conducted by cole-man (2007) whose aim was to examine the impact of capital structure on the performance of microfinance institutions. Panel data covering the ten-year period 1995-2004 were analyzed within the framework of fixed- and random-effects techniques. Results showed that the most of the microfinance institutions employ high leverage and finance their operations with long-term as against short-term debt. Results also revealed that the highly leveraged microfinance institutions perform better by reaching out to more clientele, enjoy scale economies, and therefore are better able to deal with moral hazard and adverse selection, enhancing their ability to deal with risk.

Fernandez (2003) analyzed the driving forces of capital structure in Chile for the period

1990-2002. The purpose of the research was to study aggregate leverage and interest-bearing liabilities in isolation for all firms, and firms segmented by economic sector. Their sample of the study consisted of 64 firms having the complete information for the whole sample period of 1990-2002. Results while supporting the trade-off theory revealed that the firms favored equity over debt issues to cover their financing deficit because of the Chile’s tax and monetary policies.

In order to find out the determinants of very small firm’s financial leverage Barbosa and Cristiana (2003) carried a research. They

described the relationship between profitability and financial leverage as:

As far as profitability is concerned, the most common expectation in the financial structure literature is for a negative relationship with financial leverage. Toy and others (1974 p.877), Marsh (1982 p.126 footnote 22), Friend and Lang (1988 p.277), Titman and Wessels (1988 p.6) and Barton and others (1989 p.40) all say that in different words. According to them, a firm with a high profit rate, ceteris paribus, would maintain a relatively lower debt ratio because of its ability to finance itself from internally generated funds. The preference for raising capital first from retained earnings may be due, according to Titman and Wessels (1988 p.6), to the costs of issuing new equity or debt that arise because of asymmetric information or transaction costs. Marsh (1982 p.126 footnote 22) raises the possibility that the impact may be due to the tendency of firms to issue new equity immediately after periods of abnormally good performance. Hall and Weiss (1967 p.328) assert that relatively profitable firms take some of their exceptional returns in the form of reduced risk, through retaining earnings, and, therefore, show lower debt to assets ratios. Rajan and Zingales (1995 p.1451) cite Jensen (1986) who predicts that, if the market for corporate control is ineffective, managers of profitable firms prefer to avoid the disciplinary role of debt. This preference would lead to a negative correlation between profitability and debt. Gupta (1969 p.522) speaks of a theory that extends the first belief above mentioned from the firm level to the industry level. Accordingly, profitable industries, because of the greater availability of internally generated funds related to their high profitability; tend to have lower debt in their financial structure. Last, Gale (1972 p.417-8) interprets leverage as representing the degree of risk or otherwise in the industries in which the firm competes and hypothesizes that leverage should then be negatively related to profitability. This author himself acknowledges that his reasoning is somewhat at odds with previous discussions and theory, though. According to him, low debt to total capital ratios would reflect high industry risk because of two aspects. First, the corresponding capital structures would be the result of higher investment on the part of entrepreneurs, who, differently from lenders, place a lower value on security relative to rewards. Second, high-risk industries are, at least theoretically, associated with higher profitability. Barbosa and Cristiana (2003)

Results of their research concluded that the growth, entrepreneur’s risk tolerance, size and operational cycle were positively correlated with the financial leverage whereas asset composition, inflation, profitability and business risk are negatively correlated with financial leverage of very small firms.

Chapter-3

Methodology

In this section, we have explained the source of data, sample size, explanation and measurement of the variables, and the regression model.

3.1 Source of Data

In this study financial data of firms listed on the Karachi Stock Exchange under Fuel and Energy sector of Pakistan is taken from the State Bank of Pakistan Publications “Balance Sheet Analysis of Joint Stock Companies Listed on the Karachi Stock Exchange 2003-2008?.

3.2 Sample size

This study is carried on the Fuel and Energy sector of Pakistan. There are 27 firms of that sector which are listed on the Karachi Stock Exchange. But after screening the firms with incomplete data, we have selected 22 firms having complete data for six years from 2003-2008 as our study covers the period from 2003-2008. So we have 132 firm years for the panel data analysis.

3.3 Explanation and Measurement of the variables

Basically our study follows the framework of Shah and Tahir (2005). We include only two variables in our study. First variable is leverage (dependent variable) and another is profitability (Independent variable). In this section we describe these two variables and explain how they are measured.

3.3.1 Leverage (Dependent variable)

Leverage is explained as percentage of assets financed by debts. Different researchers have measured leverage differently. Frank and Goyal (2003) differentiated between two debt ratios, one based on market value while the other on book value. Debt ratio based on market value relates with the firm’s future situation whereas on the other hand debt ratio based on book value tends to reflect the past situation.

While in our study measuring leverage through book value, we have mainly two reasons in our mind. First, one of the main benefits of debt is tax shield that is the interest payments are tax deductible expense, resulting in cash savings. Once the debt is issued these tax shield advantages do not vary by the market value of the debt. Second point in our mind while measuring leverage through book value is the relationship of debt with bankruptcy risk. The probability of bankruptcy increases with the increase in the debt. Moreover, in case of bankruptcy of a firm, the value of the debt through the book value of the debt is more relevant than the market value of debt.

While measuring the financial leverage we faced a problem of choosing either total debt or only long term debt as percentage of total assets. Interestingly many capital structure theories favor long term debt but we have used total debt because the average firm size in Pakistan is small which limits their access to capital market because of technical difficulties and cost involved. So the firms in Pakistan prefer short term borrowing because of the fact that the major lenders in Pakistan are commercial banks and they discourage long term borrowing. Firms in Pakistan did not rely on the market based debt upto 1994, but in the mid of 1994 Government while amending Company Law, allowed firms to raise debt directly in the form of TFC’s (Term Finance Certificates) from the market.

Thus in our study we have measured the leverage through total debt to total asset ratio.

3.3.2 Profitability (Independent Variable)

Profitability has been the main point of distinction between the Static Trade-off Theory and the Pecking Order Theory. Static Trade-off Theory explains that the firm with higher profitability has more reasons to issue more debt while taking tax shield benefit. While on the other hand, Pecking Order Theory presupposes that firms with larger earnings tend to use its internally generated funds i.e. retained earnings initially to fulfill their financial needs then they go for debt. Thus, Static Trade-off Theory expects a positive and direct relationship between profitability and leverage of a firm while Pecking Order Theory suggests negative relationship between the two above said variables.

We have measured the profitability as the ratio of Net Income before Tax divided by the total assets.

3.4 Research hypothesis

This research study supports the Pecking Order Theory hypothesis and our proposed research hypothesis is “There is significant negative relationship between profitability and leverage of a firm?.

Ho: There is significant negative relationship between profitability and leverage of a firm

3.5 Regression Model

Linear Regression analysis has been used in this study. Basically we have used pooled regression type of panel data analysis. By saying this we mean that the company’s financial data and time series data are pooled together in a column.

The equation for our regression model will be

LG= β0 + β1 (PF) + ε.

Where

LG= Leverage

β0= Constant

PF= Profitability

ε= Error term

Chapter 4

Results of the test and interpretation.

This chapter contains the results of the descriptive statistics and linear regression test. There are 27 firms in Energy and fuel sector which are listed on the Karachi Stock Exchange. But after screening the firms with incomplete data, we have selected 22 firms having complete data for the six years from 2003-2008 as our study covers that specified period. So we have 132 firm years for the panel data analysis.

4.1 Data Consideration:

For data consideration to be suitable for linear regression we graph the P-P plot of dependent and independent variable in order to check that the data is normally distributed. The P-P plots of profitability and leverage are as follows.

Above Normal P-P Plot of Independent variable (Profitability) shows that the variable follows a normal distribution. On the other hand dependent variable (leverage) is also said to be fairly normally distributed.

In order to show the linear regression model is appropriate for the data or not we graph a scatter plot between profitability and leverage which is as follows:

Scatter plot shows that whether linear regression model is appropriate for the data or not.

However above scatter plot appears to be suitable for linear regression.

4.2 Results of the test:

After running the linear regression test on SPSS we have the following results.

Table-1

Descriptive Statistics

Total No:

Minimum

Maximum

Mean

Standard Deviation

Profitability (PF)

132

-0.22

0.43

0.0515

0.12441

Leverage (LV)

132

.00

1.27

0.5588

0.27425

Valid No: (list wise)

132

Table-1 contains the descriptive statistics of the variables of our study i.e. profitability and leverage. This table indicates that the maximum loss on the total assets of a Pakistani energy and fuel sector firm listed on KSE is 0.22 or 22% while the maximum a firm has earned return on total assets is 0.43 or 43% and the average profitability in form of return on total assets o of a firm of the above sector is 0.0515 or 5.15% with the standard deviation of 12.44% during that period of 2003-208. While on the other hand, the minimum leverage (total liabilities to total assets) of a Pakistani energy and Fuel firm listed on KSE is 0% and the maximum is 1.27 or 127%, while the average leverage of firms is 0.5588 or 55.88% with the standard deviation of 27.42%.

Table-2

Correlation

Leverage (LV)

Profitability(PF)

Pearson Correlation LV

PF

1.00

-0.112

-0.112

1.00

Total No:

132

132

The above correlation table shows the relationship between independent variable (Profitability) and dependent variable (Leverage). The value of Pearson correlation which is -0.112 or -11.2%, indicates negative but weak relationship between profitability and leverage.

Table-3

ANOVA

Model

Sum of squares

df

Mean Square

F

Significance value

Regression

0.124

1

0.124

1.654

0.201

Residual

9.729

130

0.075

Total

9.853

131

Predictors: (Constant), Profitability.

Dependent Variable: Leverage

The above ANOVA table tests the acceptability of the model from a statistical perspective. The regression row displays information about the variation accounted for by the model while the residual row shows information about the variation that is not accounted for by the model. As the residual sum of squares i.e. 9.729 is far higher than regression sum of squares i.e. 0.124, which indicates that very less variation in leverage is explained by the model. It is also evident from the significance value of F statistics which is higher than 0.05.

While the ANOVA table is a useful test of the model’s ability to explain any variation in the dependent variable, it does not directly address the strength of that relationship. So, in order to check the strength of the relationship between the model and dependent variable, we have another table of model summary which is as follows.

Table-4

Model Summary

Model

R

R Square

Adjusted R Square

Standard error of the estimate

1

0.112

0.013

0.005

0.27357

Predictors: (Constant), Profitability.

Dependent Variable: Leverage

The above model summary table reports the strength of the relationship between the model and the dependent variable i.e. leverage in our study. The value of R (the multiple correlation coefficient) is 0.112 or 11.2% which indicates weak relationship. The value of R square (the coefficient of determination) shows that about 1.3% variation in the leverage is explained by the model. Unfortunately our model becomes insignificant in the Pakistan’s energy and fuel sector’s environment. But in an earlier study conducted by Shah and Hijazi regarding the Determinants of capital structure of stock exchange-listed non-financial firms in Pakistan in 2004 such sort of model proved significant. Moreover, another study conducted by Benito in UK’s environment regarding capital structure decisions of firm also favored the pecking order model.

Table-5

Coefficient

Model

Unstandardized Coefficients

Standardized Coefficients

t-value

Significance value

Beta

Std. Error

Beta

Constant

0.571

0.026

22.162

0.000

-0.247

0.192

-0.112

-1.286

0.201

In above table in order to determine the importance of the predictor (profitability) we look at the value of standardized coefficients of profitability that is -0.112 indicating that it does not contribute more to the model which is also shown by the significance value of the F statistics which is higher than 0.05. While our results are not consistent with the earlier studies regarding determinants of capital structure carried in Pakistan by Hijazi and Yasir (2006) and Shah and Hijazi (2005).

Therefore on the basis of Pearson correlation and R square (the coefficient of determination) we reject our null hypothesis that there is significant negative relationship between profitability and leverage of a firm. Our results are not in contrast with the pecking order theory as we expected.

Our results are consistent with Frank and Goyal (2003) who found out that the pecking order hypothesis proved significant for larger US firms rather then for smaller firms. Rajan and Zingles (1995) also showed mixed results. In their research Pecking Order hypothesis proved significant for USA, Canada and Japan while insignificant for other countries. On the other hand an earlier study conducted by Shah and Tahir (2004) regarding the determinants of capital structure of stock exchange-listed non-financial firms in Pakistan, such sort of model proved significant. Moreover, another study conducted by Benito (2002) in UK’s environment regarding capital structure decisions of firm also favored the pecking order model.

Chapter-5

Conclusion

In this study we analyzed a sample of 22 firms of Fuel and Energy sector which are listed on the Karachi Stock Exchange and having complete data for six years from 2003-2008. So we analyzed 132 firm years’ data to test pecking order theory hypothesis that there is significant negative relationship between profitability and leverage of a firm. But unfortunately our model becomes insignificant in the Pakistan’s Energy and fuel sector’s environment.

Our results are consistent with Frank and Goyal (2003) who found out that the pecking order hypothesis proved significant for larger US firms rather then for smaller firms. Rajan and Zingles (1995) also showed mixed results. In their research Pecking Order hypothesis proved significant for USA, Canada and Japan while insignificant for other countries. On the other hand an earlier study conducted by Shah and Tahir (2004) regarding the determinants of capital structure of stock exchange-listed non-financial firms in Pakistan, such sort of model proved significant. Moreover, another study conducted by Benito (2002) in UK’s environment regarding capital structure decisions of firm also favored the pecking order model.

The results found in our study were not as expected. The results showed that there is inverse relationship between profitability and leverage but our results were not that much significant to accept our hypothesis. So we rejected our pecking order theory hypothesis.

Our results while proving insignificant for Pecking order theory, intend to the fact that the firms in our sample have lower probability of bankruptcy and therefore have a higher capacity for debt. It is also consistent with the fact suggested by Jenson (1986) that the managers being the agents can be restricted through the debt from generating large amounts of free cash flows.

Thus, Pecking order hypothesis has proved insignificant in Energy and fuel sector of Pakistan because of some macroeconomic variables as economic growth of the country, rising prices of oil all around the world, interests rates and reliance of firm’s financing needs mostly on bank financing.

As in the earlier years undertaken in our study Pakistan’s economy had been growing at an average rate of over 7.6 percent per annum over the last three years from 2004 to 2007 and the government was making efforts to sustain the momentum going forward.

Knowing well that there exists strong relationship between economic growth and energy demand government is making efforts to address the challenges of rising energy demand. These include, import of piped natural gas from Iran and Turkmenistan, import of LNG; increase in oil and gas exploration in the country; utilizing 175 billion tones of Thar coal reserves; setting up of new nuclear power plants; exploiting the affordable alternate energy resources and overhauling existing power generation plants to enhance their capacity generation.(Economic Survey 2006-2007)

Such economic growth resulted in the increase in total liabilities of Energy and Fuel firms specially because of taking debt to meet their operation’s requirement in order to meet surge in energy demand. According to pecking order theory firms having higher profits will not prefer to take debt at first instance. But our data and results showed no relationship between profitability and leverage.

While in the start of 2008 international oil prices fluctuated widely which results in leaving all vulnerable oil importing countries like Pakistan in stress. The volatile energy picture has not only made dents in major macroeconomic variables namely budget deficit, current account balance, inflation, exchange rate and foreign exchange reserves but also eroded the purchasing power of poor on back of the rising prices of petroleum products.

The world has also been facing the challenge of international financial crises, thus making way for wide spread recession which ultimately impact negatively on such economies which significantly impact on international market for growth efforts.

Pakistan has experienced a slow down in all economic activities as a result of international financial crises and demand contraction policies of government. The major impact has been experienced in the industrial sector. Energy consumption being the integral part of all the economic activities declined as result of economic slow down. Energy in its all forms has declined or at least remained stagnant during the year 2008-09.the most prominent has been the large scale manufacturing sector which due to its negative growth of 7.7 % experienced decline in energy consumption. Interestingly poor and un-interrupted power supply on back of circular debt problem has been singled out as one of the prime reason for dismal performance. (Economic Survey 2008-09)

One more reason why pecking order hypothesis has been rejected in Energy and Fuel sector of Pakistan is that firms in our sample are mostly financed by the banks as compared to the market financing. One of the main differences between market financing and bank financing is that banks while mitigating their risk monitor the firms on continuous periods and charging higher interest rates than the market financing by financial markets. Moreover, Pecking Order Theory has been proved more valid in market financed firms rather than the bank financed firms.

Therefore we conclude that because of certain factors such as economic situation of the Pakistan, rising prices of oil all around the world, interests rates and reliance of firm’s financing needs mostly on bank financing, pecking order theory model becomes insignificant in the Energy and Fuel sector of Pakistan.

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