An Empirical Investigation On Capital Structure Of Non-financial Listed Firms In Pakistan

Capital structure management involves the selection of debt and equity securities in a way that will maximize the value of the firm. In a seminal study, Modigliani and Miller (1958) proved that in perfect capital markets the choice between debt and equity has no material effects on the value of the firm. Their irrelevance proposition is based on restrictive assumptions which do not hold in the real world, when these assumptions are removed then choice of capital structure becomes an important value determining factor. Majority of empirical research on capital structure has been derived from data from developed countries that have many institutional similarities. Alternatively, research to understand the financing behavior of firms in developing countries has received much less attention. In particular, little is empirically known about the financing behavior of firms in Pakistan. Therefore, this dissertation attempts to fill a gap in the literature by exploring three key issues relevant to capital structure using the data of Pakistani firms. Firstly, this study investigates the most significant firm-specific factors that affect the capital structure. Secondly, this study explores the effect of internal attributes of corporate governance on capital structure. Finally, this study analyzes the effect of capital structure on firm performance.Investigation relevant to most significant firm-specific factors that affect the capital structure is performed using the data of 260 non-financial firms listed on the Karachi Stock Exchange (KSE) Pakistan during 2000-2009. Empirical results indicate that profitability and non-debt tax shields are negatively, whereas firm size is positively related to the total debt ratio and the long-term debt ratio. Notably, asset tangibility and liquidity are negatively related to the total debt ratio, and positively related to the long-term debt ratio. Although growth is negatively related to the total debt ratio and the long-term debt ratio but the relationship is found significant only with the total debt ratio. Earnings volatility is negatively related to the total debt ratio but the relationship is insignificant. Alternatively, earnings volatility is significantly and positively related to the long-term debt ratio. As far as the impact of industry classification on capital structure is concerned, energy & fuel, paper & board, sugar & allied, and textile industries have a significant positive affect on the total debt ratio. On the other hand, cement, chemical, engineering, and textile industries have a significant positive influence on the long-term debt ratio. These findings indicate that capital structure models do have predictive power. Moreover, debt ratios in Pakistani firms seem to be affected in the same way and by the same types of variables that are significant in developed countries. However, the signs on some of the coefficients, particularly liquidity, asset tangibility, and earnings volatility are sometimes the opposite of what we would expect. This might be due to profound dependence of firms in Pakistan on short-term debt which have different determinants than long-term debt.Investigation concerning the effect of internal attributes of corporate governance on capital structure is performed using the data of 155 non-financial firms listed on KSE during 2004-2008. The results indicate that board size, outside directors, and ownership concentration are positively; whereas, director remuneration is negatively related to the total debt ratio and the long-term debt ratio. Managerial ownership is negatively related to the long-term debt ratio. CEO duality is negatively related to the total debt ratio and the long-term debt ratio but relationship is found insignificant in all regressions. The control variables such as profitability and liquidity are negatively, whereas firm size is positively related to the total debt ratio and the long-term debt ratio. Notably, asset tangibility is positively related to the long-term debt ratio and negatively related to the total debt ratio. In sum, empirical findings indicate that internal measures of corporate governance have material effects on capital structure.Investigation concerning the impact of capital structure on firm performance is made using the data of 240 non-financial firms listed on KSE during 2004-2009. The empirical results indicate that all measures of capital structure (i.e., the total debt ratio, the long-term debt ratio, and the short-term debt ratio) are negatively related to the firm performance (i.e., the return on assets and the market-to-book ratio). The negative relationship between capital structure and performance indicates that the agency issues may lead the firms to use higher than appropriate levels of debt in their capital structure. This overleveraging may increase the lenders'influence which in turn limits the strategic choice of managers, thus affecting their ability to carry out critical strategic decisions. As far as control variables are concerned, firm size and growth are positively, whereas tangibility is negatively related to the return on assets and the market-to-book ratio. This finding indicates that variables other than capital structure also influence the firm performance.Finally, empirical results of this dissertation have some policy implications for professional managers, lenders, investors, and market analysts. For instance, empirical results indicate that financial managers should consider various costs and benefits combined with debt and equity capital before establishing an optimal capital structure. Lenders should tenderly inflict debt covenants considering their affect on firm performance because in the event of poor performance they will have to bear the consequences due to limited liability of the shareholders. Investors and market analysts should consider the debt levels before investing their resources in the firms.