# Capital Structure of Non-financial Listed Firms

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Capital structure shows the ratio of debt to equity financing of a firm to finance its assets. Capital structure of financial firma and non-financial firms differ drastically. A firm can go for different ways of financing like debt and equity. It is very rare to find a firm that completely finances its assets either by using debt or either by equity. Usually there is a mixture of both debt financing and equity financing in a ratio that maximizes the overall value of firms. This has originated different capital structure theories that explain the variation in capital structures of firms over time, across regions and industries. Conversely, empirical evidence shows that it is not possible to have particular capital structure theory for all types of firms.

Pakistan is a developing country with three stock exchanges, of which the Karachi Stock Exchange (KSE) being is the largest. By July'2010, 865 companies were listed on KSE and this number is likely to be changed over time. There are a total of 36 industries. Like other developing economies, the area of capital structure is relatively unexplored in Pakistan. A few Studies on the capital structure of Pakistan's firms have been held before. Shah and Hijazi (2004) study was based on what determines the capital structure of Pakistani listed firms other than those in financial sector. Waliullah and Nishat (2008) empirically examined the determinants of capital structure choice of listed firms in Pakistan. Shah and Khan (2007) extended the work of Shah and Hijazi (2004) by including more years, using relevant models of panel data and including more explanatory variables.

This paper is different because it not only shows what factors determine the capital structure of Pakistan's non-financial listed firms but it also divides the entire period of twenty two years into different sub-periods (economic downturn, upturn, and stability ). It further contributes to the existing literature because it shows the effects of these factors on both short-term and long-term debt during different economic conditions.

Miller and Modigliani were the first ones to write a paper on capital structure in 1958. They both showed in their research that the value of firm is not dependent upon the capital structure. Due to the unrealistic assumptions in MM irrelevant theory, research on capital structure gave room to other theories. The other theories include the trade-off theory, the pecking order theory and the agency theory. These and many other theories have gone through to comprehensive experimental study of developed countries, like USA (Harris and Reviv, 1991). There has been work on other studies that report international comparison of the determinants of capital structure such as, Wald (1999). There are studies that provide evidence from the emerging markets of South-east Asia (Pandey et. al., 2000). This study aims to investigate the firm specific factors of capital structure of a developing country, Pakistan.

## Literature Review

In 1958 Modigliani and Miller presented their paper in a seminar where they explained, that value of firm cannot be increased by using debt (leverage) as part of its capital structure. The crux of their research was based on the worth of a firm should not change if its capital structure changes under the perfect capital markets assumption. But in the real world, no perfect market prevails which implies that capital structure is relevant.

As imperfection exists in the real world, few more theories were proposed by various financial researchers. The classical version of static trade off theory (STT) was proposed by Kraus and Litzenberger (1973), who emphasized on the equilibrium between benefit of tax saving via leverage and cost of insolvency. According to STT theory, there is a benefit to the firm of using leverage for financing in the form of tax saving, also called tax shield. At the same time, there is a certain cost attached to it, which is the bankruptcy cost. One of the assumptions of MM irrelevance theorem is that there is no bankruptcy cost but static trade off theory violates the MM irrelevance proposition by eliminating no bankruptcy cost assumption.

In response to static trade off theory, the pecking order theory was put by Myers and Majluf in 1984. Companies list down their sources of finance according to their priority levels. Internal funds are preferred first and after their depletion, leverage is issued as a second option whereas equity is considered a third option. The pecking order theory (POT) explains that internal financing is preferred over external financing and if external financing is needed then in that scenario debt has precedence over equity.

Jensen and Meckling (1976) proposed that optimal capital structure is obtained by trading off agency costs of debt for the benefits of debt. Managers are acting as agents for shareholders and their stake in the business is not hundred percent. Jensen and Meckling (1976) identified the conflict between managers and shareholders' interests and highlighted the point that a manager's given role in a business has certain implications for capital structure of a firm. First implication is about free cash flow (FCF), which a company generates after laying out funds needed to maintain or expand its asset base. Managers may try to utilize FCF for their own benefit (they may opt for projects which have a lower net present value as compared with other projects) rather than increasing the firm's value.

Jensen (1986) proposed that agency cost can be resolved by increasing a manager's stake in the firm or taking more debt in the capital structure, thus decreasing the amount of free cash flow available to managers. Therefore, reduction in cash flow due to debt financing is considered to be an advantage of debt financing. Second implication is regarding over-investment and under-investment problems. Being agents to shareholders, managers may invest in projects of less viability. This procedure is known as over-investment problem. The reasoning may cause management to refute positive NPV projects, although such projects would increase the worth of firm.

Information asymmetry is the difference in the level of information between insiders and outsiders of a company regarding investment opportunities and income distribution of a firm. The first impact on capital structure due to information is called signaling. Ross (1977) suggested that managers have better information of the income distribution of a firm than shareholders. That is why when firms issue debt, they generate positive signals to the outside world about the firm's income distribution, implying that the firm has stable income and is in a position of paying regular interest installments.

Castanias (1983) empirically tested for the validity of MM irrelevance theory of capital structure. He was in favor of the Tax Shelter and Bankruptcy Cost [1] (TS-BC) Theory of an optimal capital structure. The TS-BC theory states that a firm's optimal leverage is the function of distribution of future earnings, business risk, default costs and taxes. Castanias examined the relationship between leverage and the probability of success and failure of a company. The ratios used signify that as leverage increases, failure rate decreases, showing inverse relationship and proving this hypothesis. In relation to the irrelevance hypothesis, correlation was showing positive association only in cases of the first four ratios which is totally against Modigilani irrelevance hypothesis. Therefore, these empirical results were only consistent with the TS-BC hypothesis.

The rationale behind Rajan and Zingales (1995) research was to analyze whether capital structure in other countries is related to factors like tangible assets, market to book ratios, log sales and profitability, which influences capital structure of U.S. firms. Later they compared the results with public firms operating in major industrialized G-7 [2] countries. They found that in G-7 countries, regression results were parallel to the U.S. market. Results showed that firm's leverage had negative relationship with tangibility in all countries except Japan since Japanese firms with fixed assets could borrow.

Market to book value and profitability showed a negative association with leverage. Positive sign between leverage and profitability had been observed in the case of UK since the dominant source of external financing in UK is equity. Positive correlation existed between leverage and size in all countries except Germany. The best explanation for association between leverage and size is that the larger firms are better diversified and have lower probable bankruptcy costs, which enable them to take on more leverage. From these empirical results, it can be deduced that market to book ratio, profitability and asset size support the pecking order theory and only size of sales favors static trade off theory.

Burgman (1996) examined differences in the factors identifying capital structure between multinational companies (MNCs) and domestic companies. His study supports debt in their capital structures as they have lower earnings volatility and lower chance of bankruptcy as compared with domestic companies. However, they still have less leverage in their capital structure as there are various other factors which need to be considered like political risk, exchange rate risk, uncertain tax systems, agency costs and many more before deciding on the capital structure of a corporation.

Two models had been identified by Shyam-Sunder and Myers (1999) to examine debt financing patterns over time. First model was pecking order and the second was the simple target adjustment model which states that changes in debt ratio are explained by deviations of current ratio from the target. Based on the two models, the research paper of Shyam-Sunder and Myers (1999) evaluated target debt ratios under the assumption of maximization of shareholder wealth as a major goal of corporation and found a strong support for pecking order framework under the state of financial deficit.

Kayhan and Titman (2005) have examined the effect of cash flows, investment expenditures and stock price histories on capital structure proportions mainly on debt. The results indicate that the capital structures of firms do move back towards their targets but the speed of moving back is sluggish. Particularly, it has been observed that debt ratios get affected by financial deficit. Then, it has been found that stock price change affects capital structure significantly less than financial deficit. The reason is that stock prices changes are related with changes in the target debt ratios. This literature has completely supported static trade off theory as the results have proved that firms' histories strongly influence the capital structures and they tend to move capital structures towards debt ratios.

Kumar (2007) has critically analyzed factors affecting financial leverage of firms from a theoretical perspective. His article concluded by saying that different researchers have tried to signify the factors affecting financial leverage and capital structure theories evolved. The effectiveness of these theories were restricted to their respective relevance. Moreover, two challenges have been highlighted for further research in this field. Firstly, integration of determinants of financial leverage into a common framework and secondly, explanation of independent determinants of financial leverage network phenomena.

Cole (2008) was the first researcher, who analyzed capital structure decision of small and privately held firms. Two main conclusions were deduced from this research. Firstly, the results were more favorable for pecking order theory instead of static trade off theory. Secondly, when the data sets of both small and large firms were compared, it was found that degree of leverage was totally different for each firm. As a concluding remark of this article, it can be said that all results are more favorable or supportive towards pecking order theory as compared to static trade off theory.

Ramlall (2009) explored debt to equity ratio for non-financial firms of Mauritius. Regression results showed that profitability was statistically significant only in case of short term loans, showing that more lucrative firms resorted to less usage of debt by relying more on internal funds. Non debt tax shield was found to be solely statistically significant in case of long term liabilities. For rest of the dependent variables, growth, profitability, and non-debt tax shield variables were all found not to statistically affect leverage and they all exhibited signs consistent with the pecking order theory.

## Research Question and Hypothesis

This study is different because it does not only shows what factors determine the capital structure of Pakistan's non-financial listed firms but it also divides the entire period of twenty two years into different sub-periods (economic downturn, upturn, and stability ). It further contributes to the existing literature because it shows the effects of these factors on both short-term and long-term debt during different economic conditions.

## Dependent and Independent Variables

After discussing the various theories of capital structure in the literature, now the potential dependent and independent variables for the study are discussed. The definition of leverage depends on the purpose of the analysis (Rajan and Zingales, 1995). Leverage is defined as debt-to-firm value ratio for agency problem related studies of capital structure. Interest coverage ratio is used in a study of leverage and financial distress. Other definitions of leverage include total liabilities-to-total assets, debt-total assets, debt-to-net assets, and debt-to-capitalization. Book value and market value can also be used to study debt.

One of the most used measures of leverage is to take total debt or only long term debt as a percentage of total assets. From the previous studies of capital structure, leverage is used as a proxy for debt. Due to the compact size and cost constraints of Pakistani firms, short-term debt is effectively used for financing.

Commercial banks do not promote long term financing and at the same time they are the crucial source of lending. Term Finance Certificates and corporate bond market is a recent phenomena in the history of Pakistan's market.. This explains why firms on average in Pakistan have more short term financing than long term financing. Booth, et al. (2001) paper on “determinants of capital structure in developing countries” mentioned, Pakistan's firms prefer the use of short term financing than long term financing.

This is study is contributes to previous studies in Pakistan, because independent variables have different effect on the types of debt, therefore, I have used three types of measures for debt: long-term (long-term debt to total assets), short-term (short-term debt to total assets) and total (total debt to total assets ratios). Some previous research studies (Titman and Wessels, 1988; Pandey et. al., 2000; Chung, 1993) have used different measures of leverage. Each debt ratio is measured in book value and market value terms. Therefore, this paper has used six measures of debt ratio as dependent variable. In the market value debt ratio, the market value of debt is treated same as the book value and the current market capitalization of equity is used as the market value of equity.

In a comparative cross country study, Rajan and Zingles (1995) found the following four important variables: growth, tangibility, profitability and size. Many other studies (Titman and Wessels, 1988; Pandey et. al. 2000; Barclay and Smith, 1996; Castanias, 1983; Bradley, Janell and Kim, 1984) also showed risk (earnings volatility) and investment opportunity (market-to-book value) as important determinants of debt policy. Therefore, this paper uses these six variables in this study as independent variables and discusses below each variable in detail.

Debt ratio (D) is taken as a dependent variable in this study. This study has used six measures of debt ratio. The six measures of debt ratio are divided into three book value measures and three market value measures. These book value and market value ratios of debt are further divided into long-term debt, short-term debt and total debt is divided by total assets.

Tangibility (T): Tangible assets act as buffer and provide security to lenders in the event of financial crisis according to trade-off hypothesis. Jensen and Mekling (1976) mentioned in their research that assets protect lenders from agency problem caused by the shareholders-lenders conflict. There are few studies that report a significant direct relationship between tangibility and total debt (Titman and Wessels, 1988). Chittenden (1996) and Stohs and Mauer (1996) found a proportional relationship between tangibility and long-term debt, but at the same time they found an inverse relationship between tangibility and short-term debt.

Firms that have surplus amounts of fixed assets have a benefit of being able to borrow at a lower interest. Therefore, these firms can borrow more than other firms that cannot enjoy such lower interest rate. This clearly means that firms have a direct relationship between tangibility of assets and debt.

Growth (G): Literature shows that firms need to invest in their fixed assets as encounter growth in sales. This shows that firms that grow need funds for investment in fixed assets. Both trade-off theory and pecking order theory support the fact that there is an increase in the retained earnings of high growth firms and these firms issue debt to sustain the debt ratio. Therefore, is expected to have a positive relationship between debt ratio and growth. According to this, growth causes firms to shift financing from new equity to debt, as they need more funds to reduce the moral hazard problem. Baskin (1989) reports a significant positive relation between growth and debt. On the contrary, Titman and Wessels (1988) do no find any relationship.

Profitability (P): According to the literature of pecking order theory, firms first makes use of all internally available funds and then goes for external financing. Due to this it implies that profitable firms will have less amount of leverage according to Myers and Majluf (1984). It is expected to have a negative relationship between profitability and leverage.

Size (S): Firms that are large in size have a large portfolio in which they invest to minimize risk, therefore they are less chances of bankruptcy (Rajan and Zingales, 1995). These firms have an advantage of issuing debt and equity at a lower cost because of their large size which small firms do not have. Titman and Wessels (1988) research show that larger firms raise funds from long-term debt and small firms do it from short-term debt because of agency conflict. Barclay and Smith (1996) find significant positive relation between size and debt ratio. Remmers et. al. (1974) in their study of capital structure argued that there is no significant effect of size. Stohs and Mauer (1996) also disclosed a positive relation between size and debt maturities.

Risk (R): according to the trade-off theory, higher risk increases the probability of financial suffering. Thus, it predicts a negative relationship between leverage and risk. Castanias (1983) in his study showed an inverse relationship between risk and leverage, bankruptcy costs should be quite large. Bradley, Janell and Kim (1984) find an inverse relationship between earnings variability and leverage. However, Titman and Wessels (1984), find no connection between earnings variability and leverage.

Investment opportunities (IO): is a firm's intangible asset that does not have value like that of a fixed asset. The intangible value is vanishes during times of if financial distress takes place. Myers (1977) study shows that there is a threat of devaluation of assets for firms that have substantial intangible value. This view suggests an inverse relationship between debt ratio and investment opportunities.

Balance sheet does not capture the future investment opportunities rather share price reflects them. Therefore, a proxy (market-to-book value ratio) is used for calculation investment opportunities. Empirical evidence on the relationship between investment opportunities (reflected through market-to-book value ratio) and capital structure is not conclusive.

Titman and Wessels (1988) and Lasfer (1995) confirm a negative relation between investment opportunities and long-term debt or total debt ratios include. Michaelas et.al. (1999), report positive relation between debt and investment opportunities. Their study not only show a positive relation of investment opportunities with long-term, but also for total debt and short-term debt ratio. Stohs and Mauer (1996) and Barclay and Smith (1996) find negative relationship between growth opportunities and all types of debt.

## Regression Equation and Variable Calculation

Di,t = βo + β1Ti,t-I + β2Gi.t-1 + β3Pi,t-1 + β4Si,t-1 + β5Ri,t-1 + β6IOi,t-i + ei,t

T: in the regression equation stands for tangibility. Tangibility in the equation is explained as fixed assets of a firm divided by its total assets. As mentions earlier in the proposal, according to the trade-off theory, this study is expected to have a directly proportional relationship between tangibility and long-term debt ratio. As this study also looks at the short-term debt and according to the matching principle, a negative relationship between tangibility and short-term debt ratio is expected.

H1: There is a positive relationship between tangibility of an asset and long-term debt

H2: There is a negative relationship between tangibility of an asset and short-term debt

G: in the regression equation stands for growth of the firms. In the study Titman and Wessels (1988), growth is measure in various ways, such as, expenditure on research to totals sales, market to book value of equity and annual percentage increase in total assets of a firm. According to the current study, growth is measured as a percentage increase in total assets. This data is taken from the financial reports of all the listed companies on the KSE-100. Same data is also available on State Bank of Pakistan publication.

H3: High growth firms are expected to a positive relation with high debt ratio

P: in the regression equation stands for profitability of firms. Available literature measures profitability as earnings before interest and taxes, divided by total assets. My study has obtained the data from the Financial Annual Reports of the listed companied for measuring profitability in the same way as previous studies. As per the pecking order hypothesis, it is hypothesized that profitability has a negative relation with debt ratios. The trade-off theory would be validated if a positive relation is found between profitability and debt ratio.

H4: There is a indirect relationship between profitability and leverage

S: In the current study natural log in taken to smooth the measure for sales for calculating size of a firm. As recommended by the trade-off theory, it is hypothesized that size has a positive association with debt ratios.

H5: There is a negative relationship between size and leverage of the firm.

R: in the regression equation risk is computed as coefficient of variation in EBIT over four years. In accordance with the trade-off theory, it is expected to have a positive association between risk (earnings volatility) and debt ratio

H6: There is a direct relationship between risk and debt ratio

IO: variable is approximated by market-to-book value ratio since market value of shares is expected to reflect future potential of investment opportunities. In accordance with the pecking order theory, it is expected that investment opportunities have negative association with long-term debt and positive association with short-term debt ratio.

H7: There is positive relationship between investment opportunity and ST debt

H8: There is negative relationship between investment opportunity and LT debt.

## Data and Methodology

## Sample

The data set is based on a firm's own financial reports. This data is used for the analysis of the capital structure of all the firms in chosen sample from 1998 to 2009. It has been taken from various volumes of the “Balance Sheet Analysis of Joint Stock Companies Listed on The Karachi Stock Exchange”.

The number of companies included in the statistical analysis varies from year to year. There are a total of eight hundred and sixty five firms and thirty six industries. All financial institutions such as commercial banks, insurance companies, securities firms and mutual funds are not included in the sample because they have a special capital structure. Their capital structure is strongly influenced by investors' insurance schemes and debt like liabilities and hence they are not comparable to the debt issued by corporate (non financial) firms. To generalize this study only non-financial companies are included in the sample. From a total of thirty six industries, twenty eight industries are non-financial. Due to incompatibility of the capital structure of the firms with in the non-financial industries, only fifteen [3] industries were chosen. Moreover, only one hundred and fifty eight firms are finally selected due to unavailability of the financial reports from two hundred and forty three firms from selected fifteen industries for which the data was available.

However eighty five firms are companies were omitted since the available data was less than twelve years. One of the most probable reasons is due to their recent entry in the stock market or delisting from the stock market. Therefore, it is foreseeable that there might be unbalanced data for some firms. The analysis in this paper is thus based on the remaining 158 firms spread across the fifteen industrial categories. Companies that exist throughout the twelve year period with no missing data are included in the study. The study also eliminated outliers. The study adjusted data of those companies, which change their financial year. First the research annualizes the subsequent year data and then substitute missing data by the mean value. There are all together 1,896 observations.

The selected time period from 1998 to 2009 is intended to capture the differences in economic conditions of the Pakistani economy. The entire period from 1998 to 2009 is divided into sub-periods. Given the capital market and general economic conditions in Pakistan, these periods, respectively, correspond with downturn, upturn, and stability.

The division of sub-periods of this paper is considered on the basis of the economic conditions of Pakistan. A simple measure of GDP growth rates has been taken from year 1998 to2009. The down-turn sub-period shows negative percentage growth of the GDP, whereas the stability and upward period shows the positive GDP percentage growth. This information is taken from the Federal Bureau of Statistics of Pakistan and State Bank of Pakistan. Years from 1998 to 2000 are of economic up-turn. Economic stability is from 2001 to 2007. Time period from 2008 to 2009 is of economic down-turn.

## Econometric Models

I have followed the same methodology used by Pandey et. al (2000) in studying the capital structure of Malaysian firms. To minimize the measurement error due to random fluctuations in variables I have calculated two year mean values of variables, except for growth and earnings volatility. The dependent variable (debt ratio) is regressed to the lagged independent variables to avoid the problem of reverse causality.

In my study differences debt ratios are expected to be seen. This could result from variations in a firm's dynamics through different time periods. Therefore, just like Pandey et. al (2000) I have used pool data for sub-periods and examines the influence of the firm characteristics on debt policy with lagged independent variables, this pooled sample consists of 1,896 observations from fifteen industries. This paper pooled OLS regressions to understand the statistical relationship between debt ratios and independent variables. The current paper is expected to report results of cross-sectional regression that uses the mean values of variables of sub-periods. This approach ignores changes through time. Therefore, the third approach is to use the fixed effects model. This approach examines the effect of independent variables on debt policy on the basis of variation across time.

The paper also estimates OLS regressions for each period separately. The average debt ratio of period 2001-2007 is regressed to the averages of independent variables for the previous period of 1998-2000 and so on. The results, with some differences, are generally expected to be robust to the estimation methods and the time periods.

## Conclusion

This research examines the determinants of capital structure of Pakistani companies utilizing data from 1988 to 2009. It classifies data into three various sub-periods that corresponds to different economic conditions of the country. In this study debt is divided into three components, short-term, long-term and total debt combined with book value and market values. From previous studies the results of pooled OLS regressions are expected to show that all but investment opportunity have significant influence on all types of debt. These outcomes are expected to be consistent with the model of fixed effect estimation with one exception that risk variable loses its significance. Investment opportunity is expected to have no significant impact on debt percentage in the emerging stock market of Pakistan. It is further expected that the results will achieve robustness over different sub-periods. It is expected that persistent and consistent negative relationship of profitability with all three types of debt measures in all sub-periods and under all estimation methods confirms the pecking order theory in developing market.

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