Corporate Capital Structure Theories and Modern Research Work Finance Essay

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Methodology: Regression model is used to analyze the data taken from Pakistani firms in sugar sector, listed on Karachi Stock Exchange, during the period 2001-2008. Keywords: Static trade-off theory, Pecking order theory, Agency cost theory, leverage ratio, listed firms, corporate capital structure.

1. Introduction

In the opening chapter, the background, problem discussion and purpose of the study are presented. The chapter ends with targeted group and limitation of study.

1.1 Background and problem discussion

Capital structure is one of the most prolific domains of research in corporate finance. Research is spinning around a few theoretical models of capital structure since over than forty years but could not be able to provide the conclusive assistance to managers and practitioners for choosing between debt and equity in financial decisions.

An important question that companies face in need of new finance is whether to raise debt or equity. A number of theories have been proposed to explain the variation in debt ratios across firms. The theories suggest that firms select capital structures depending on attributes that determine the various costs and benefits associated with debt and equity financing. In spite of the continuing theoretical debate on capital structure, there is relatively little empirical evidence on how companies actually select between financing instruments at a given point in time. The problem of capital structure choice has been heavily discussed by international researchers for the last few decades that:

What are the determinants of capital structure choice?

How do firms choose their capital structures?

"Given the level of total capital necessary to support a company's activities, is there a way of dividing up that capital into debt and equity that maximizes current firm's value? And, if so, what are the critical factors in setting the leverage ratios for a given company?"

Modigliani and Miller's (M&M) theory (1958) is considered as fundamental corporate structure model in the modern corporate finance. The theory ascertained the irrelevance of capital structure to firm's value in perfect markets, without taxes and transaction costs. Following on the this perfect classification of market, most subsequent research focused to demonstrate that a firm's capital structure decision does consider corporate and personal taxes, agency costs, bankruptcy cost, and other frictions. These aspects of corporate environment are referred as "determinants of capital structure". Main research in corporate structure is focused on following two competitive theories:

The first one is the traditional "static trade-off" theory, which derives form the Modigliani and Miller's (1963) hypothesis of capital structure irrelevance and suggests that firms choose their optimal capital structures by trading off the benefits and costs of debt and equity. The main benefit of debt is tax deductibility of interest, which is balanced against bankruptcy costs (Kim 1978) and agency costs (Jensen and Meckling 1976; Myers 1977). It suggests the existence of a target optimal capital structure, which companies try to reach.


Contrary to the above is the "pecking order" theory, developed by Myers and Majluf (1984) which emphasis that there is no target level of leverage and companies use debt only when their internal funds are insufficient, firms instead of aiming towards a target-specific capital structure, choose a type of capital according to the following preference order: internal finance, debt, equity.

Myers (1984) and Myers and Majluf (1984) by referring to the existence of information asymmetry between managers (insiders) and investors (outsiders), Insiders knowing more about the value of the firm than outsiders, avoid issuing equity when the shares of the company are undervalued. Being aware of the above fact, outsiders tend to interpret a share issue as conveying unfavourable information as to the value of the firm. As a result, managers are reluctant to raise equity capital because it is typically followed by a decrease in valuation of the company's assets. Therefore, retained earnings are the most preferred sources of funds and, if external financing is needed, a firm first seeks low risk debt. According to the pecking order theory, external equity financing is used as a last resort.

Titman and Wessels (1988), as well as Rajan and Zingales (1996), whose works are referred to as the most important empirical studies in the field, find strong negative relationships between debt ratios and profitability. This evidence is consistent with the pecking order behaviour and inconsistent with the trade-off theory. One of the latest papers in support of the pecking order theory is by Shyam Sunder and Myers (1999), who explicitly compare it with the static trade-off theory using a panel of US firms. They conclude that, compared to the static trade-off model, the pecking order theory explains more of the variation in actual debt ratios. Even if companies in their sample had well-defined optimal debt ratios, their managers were not trying to obtain them.

Many empirical studies have tried to explain the factors that affect on capital structure's choice. One of the most renowned initial empirical studies is made by Rajan and Zingales (1996) and they explain the various institutional factors of firm's capital structure in the leading industrial countries. Predominantly ongoing debate in corporate finance research sustains the significance of above discussed theories.

Majority of research work is based on the facts taken from western and American's non-financial firms, For example, Rajan and Zingale's (1996) study is made on G-7 countries, Titman and Wessels (1988) studied U.S firms, Bevan and Danbolt (1999) studied U.K firms. There are few studies that cover non-financial firms from emerging economies.

Although Booth et al (2001) have included Pakistan, in his empirical study of developing countries but Hijazi and Shah (2005) were the first to study determinants of firm-level capital structure in Pakistan. They discuss the all listed non-financial firms from period 1997 to 2001. But so far sugar sector of Pakistan has not been analyzed independently. This report presents an empirical analysis of capital structure of sugar sector in Pakistan with most recent available data.

This report attempts to extend the knowledge of capital structure and its determinants in Pakistani companies. The aim of this research is to analyze the determinants of capital structure of sugar sector of the Karachi stock exchange. A variety of variables that are potentially responsible for determining capital structure decisions in companies can be found in the literature. However in this study, the profitability and tangibility are tested as determinants of capital structure in sugar sector of Karachi stock exchange.

2. Literature Review

The first paper on capital structure was written by Miller and Modigliani in (1958). They conceptually proved that the value of firm in not dependent upon the capital structure decision given that certain conditions are met. Because of the unrealistic assumptions in MM irrelevance theory, research on capital structure gave birth to other theories.

2.1 Theory of irrelevancy of capital structure

Corporate finance theory bases on the Modigliani and Miller (1958) propositions that specify certain conditions under which various corporate financing decisions are irrelevant. The MM propositions provide a base for analysing how financing decisions can create and destroy the value for a corporation. Theory of irrelevancy was presented in an era when research was dominated by assumption that there is no interaction between the firm's investment and financial decisions of the firm.

Modigliani and Miller states that in a perfect competitive market the value of a firm depends on its operating income and level of business risk. Simply, value of firm does not relate to its capital structure. Financing and risk management choices will not affect firm's value if the capital market is perfect. A perfect market has following traits:

A¢â‚¬A¢ All investors are price takers.

A¢â‚¬A¢ All market participants can borrow and lend at the risk free rate.

A¢â‚¬A¢ There are no costs of bankruptcy.

A¢â‚¬A¢ Homogenous risk free classification of firms.

A¢â‚¬A¢ Neutral taxes

A¢â‚¬A¢ Managers always maximize shareholders wealth.

A¢â‚¬A¢ Information symmetry

In their paper, Miller and Modigliani (1958) showed that the value of the firm is independent of the capital structure it takes on (MM irrelevance). They argue that there would be arbitrage opportunities in the perfect capital market if the value of the firm depends on its capital structure. Furthermore, investor can neutralize any capital structure decision of the firms if both investor and firms can borrow at the same rate of interest. Though this theory is based on many unrealistic assumptions, yet it presents the basics theoretical background for advance research (Shah and Hijazi, 2005)

The main result of Modigliani and Miller (1958) irrelevance theorem stated that, under certain conditions, the value of the firm is independent of its capital structure. They argued that a firm's investment policy has an important effect on firm's value, whereas the financing decision is secondary. The theorem was based on the following (explicit and implicit) assumptions; the firm's manager is selfless, always acting in investors' interests (no agency costs); information about the firm is symmetrically distributed between managers and investors; debt is risk-free. Modigliani and Miller also ignored the effects of corporate taxes.

2.2 The Trade-off Theory

Myers (1984) segregated the contemporary opinion on capital structure into two theoretical currents. One of them is the Static Tradeoff Theory (STT), which enlightens that a firm go after a target debt-equity ratio and then behaves in accordance to that. The benefits and expenditures linked with the debt alternative sets this target ratio. These comprises of taxes, cost of bankruptcy as well as agency cost.

Like interest expenses are tax-deductible payments, which reduce the tax liability therefore providing cash savings. As a result firms will use a greater level of debt to take the advantage of tax benefits if the tax rates are greater. If the firms incur losses, the tax benefit will weaken away. Thus if the operating earnings are sufficient to meet up the interest payments after that firms will get the benefit of tax deductibility of interest payments. Therefore tax rate and leverage have positive affiliation.

The probability of default enhances as the level of debt increases from most favorable level of debt. If the firm leaves beyond this most favorable point, it is more possible that the firm will fail to pay on the repayment of the loan; as a result the control of the firm will be shift as of shareholders to bondholders, they will strive to get back their investments by liquidating the firm. As of this risk a firm may face two kinds of bankruptcy costs; including direct and indirect costs. Direct costs comprises of the administrative and legal expense of the bankruptcy system. Incase firm is large in size; these costs comprise only a small percentage to the firm. Though, for a small firm, fixed costs comprise a higher percentage and are measured as an active variable in choosing the level of debt. Indirect costs arise due to change in investment policies of the firm, if the firm forecast possible financial distress. To stay away from probable bankruptcy, the firm will decreases expenditures on training and advertisements, research and development etc. Resulting, the customer starts to doubt the firm's capability to sustain the similar level of quality in services and goods. This uncertainty appears in the form of a fall in sales and ultimately results in a fall of the firm's price of the market share.

Modigliani and Miller (1963) states that, firm can have 100% debt in its capital structure for receiving utmost benefit of tax shield, but in reality capital structure compose of entirely with debt is not possible. Consequently, Static Trade Off Theory suggests the limited amount of debt and proposes that the optimal leverage ratio of the firm is determined by the trade-off between tax shields with debt financing against higher bankruptcy cost.

According to Static Trade Off Theory, optimal debt ratio varies from firm to firm. Firm having safe and tangible assets and plenty of taxable income have high debt ratio. Such firms will be in a position to provide collateral for debts and in case of default, tangible assets will be apprehended but still firm may be in a place to avoid bankruptcy. According to theory profitable firms take more benefit of the tax shield by debt financing because there is fewer chance for them to go bankrupt therefore profitable firms are capable to raise its debt ratio more than a less profitable firm.

2.3 Signaling Theory

There is significant branch of literature centering on the firm's financial behavior. This domain of research focuses information distribution as a determinant of corporate capital structure. Their research work can be split in to two distinct categories: one who claims that firm uses capital structure to signal private information to the uninformed agents in capital markets and second who asserts that capital structure that minimizes the problems of information asymmetry can lead the firm to invest sub optimally.

Ross (1977), suggested that debt is taken as a means to highlight investors' confidence in the company, that is if a company issues the debt it gives a indication to the markets that the firm is expecting positive cash flows in the upcoming time, as the principal and interest expenses on debt are a fixed contractual compulsion that a firm has to pay from its cash flows. Therefore the higher level of debt reveals the manager's confidence in future cash flows. Accordingly firms in their efforts to enhance the worth of equity will use high debt in the capital formation.

Another impact of the signaling factor is the dilemma of the under pricing of equity. Incase firm issues equity in spite of debt for financing its fresh projects; investors will take the signal negatively: while managers have better information about the firm as compare to investors, they may issue equity once it is overpriced.

The effect of information upon the capital structure of a firm can be reflected by its past cumulative requirement for external finance. Myer and Majluf (1984) say that since the investors can't separate the information about the new projects from that of under or over valuation of the current stocks, the capital structure of the firm may help to prevent mis-pricing the equity. Following this argument, firm don't issue equity for financing new project rather they will first fulfill their needs of financing from internally generated funds then issue debt if further financing is required and finally issue equity as a last

resort. This has been termed as "Pecking Order Theory".

In the Rose model, managers know the true distribution of firm's returns, but investors do not, mangers benefit if firm's securities are more highly valued by the market but are penalized if the firm goes bankrupt. Firms with higher value are predicted to issue more debt as a signal to investors in order to differentiate them from lower value firms. Further model shows positive relation between profitability, debt level, and bankruptcy probability.

2.4 Pecking order theory (POT)

Pecking Order Theory (POT) explained by Myers and Majluf (1984) and Myers (1984) states that firms pursue a hierarchy of financial decisions while setting up its capital structure. At first, firms favor to finance their projects with the help of internal financing i.e. retained earnings. If they require external financing, first they go for a bank loan and then for public debt. As a last alternative, the firm will issue equity to finance its project. Therefore as per POT the profitable firms are opt to incur debt for new projects as they have the available internal funds for this project. Myers and Majluf (1984) explained firms are reluctant to issue equity as of asymmetric information between the management and the new stockholders. Myers and Majluf (1984) explain that investors generally perceive that managers use private information to issue risky securities when they are overpriced. This perception of investors leads to the underpricing of new equity issue. Sometimes this underpricing is very severe and cause substantial loss to the existing shareholders. Because of this, firms will avoid issuing equity for financing new project; rather they will first fulfil their needs of financing from internally generated funds then issue debt if further financing is required and finally issue equity as a last resort. Myers (1977) proposed that firms acting to make best use of the interest of equity holders will be reluctant to issue equity as of the wealth transfer to debt holders, Myers and Majluf (1984) proposed firms are unwilling to issue equity because of an unfavorable selection problem.

Rajan and Zingales (1995) explained the determinants of capital structure in their cross-sectional study and examined that at the level of the individual firm, gearing may be enlightened by four key determinants i.e., market-to-book, size, profitability and tangibility. Rajan and Zingales (1995) performed their analysis on the G-7 countries upon a firm-level sample as the results of their regression analysis somewhat vary across the countries; that appear to expose some reasonably strong conclusion.

Rajan and Zingales (1995), as well as Titman and Wessels (1988), whose works are referred to as the most important empirical studies in the field, find strong negative relationships between debt ratios and profitability, this is also evidenced by Bevan and Danbolt (2002). This evidence is consistent with the pecking order behavior and inconsistent with the trade-off theory. Given, however, that the analysis is effectively performed as an estimation of a reduced form, such a result masks the underlying demand and supply interaction which is likely to be taking place. Although on the supply-side one would expect that more profitable firms would have better access to debt, the demand for debt may be negatively related to profits. The inability of lenders to distinguish between good and bad risks prevents them from charging variable interest rates dependent on the actual risk. In this event lenders are forced to increase the general cost of borrowing, which will tend to induce a problem of adverse selection as good risks are driven from the market by the high costs of borrowing. Due to this information asymmetry, companies will tend to prefer internal to external financing, where available.

2.5. Agency Theory

Jensen and Meckling (1976) are most prominent figures in research of agency cost domain. Jensen and Meckling (1976) discover the probable conflict between managers and shareholders interests as of the manager's share of less than 100 percent in the firm. In addition, acting as agents to shareholders, managers try to appropriate wealth away from bondholders to shareholders by taking more debt and investing in risky projects. The managers' given role has many implications for the capital structure of a firm.

They suggest that as manager possess less then 100% residual claims and it causes conflicts between shareholder and managers. Subsequent type of conflict between debtholder and shareholder can arise when issuance of debt gives more incentive to shareholder. More explicitly, debt investment is inclined towards shareholders, if an investment yields large return, well above the face value of debt, shareholders captures most of the gain. But if investment goes fail and firm approaches to bankruptcy,

equityholder just skip away and debtholders bear the whole consequences.

According to Jensen and Meckling, agency relationship is an agreement between two parties. One of them (agent) performs certain services on the behalf of other (principal). The problem of stirring an agent to behave as if he were maximizing the principal's welfare is rather common. In this relationship both parties are utility maximizer, therefore there is always a chance that agent will not always performs its responsibilities to maximize the benefits of principal. Principal have to restrain this problem by fixing an appropriate level of incentives for agent and to monitor the agent's actions (by incurring

monitoring cost). In this relation principal incur certain cost, called "agency cost", which can explain as the sum of following activities:

A¢â‚¬A¢ The monitoring expenditures by the principal

A¢â‚¬A¢ The bonding expenditures by the agent

A¢â‚¬A¢ The residual loss.

Principal incurs monitoring cost to limit the unexpected activities of agent. Bonding expense can be describe as "in some conditions it will pay the agent to expend resources (bonding costs) to guarantee that he will not take certain actions which would harm the principal or to ensure that the principal will be compensated if he does take such actions." In some cases, even both parties incur the agency cost but still agent's certain decision for profit maximization would not increase the welfare of agent. This loss is termed as "residual lost" and it can be defined as "the dollar equivalent of the reduction in welfare experienced by the principal as a result of agent's divergence from principal's expectation is also a cost of the agency relationship and that is referred as the residual loss".

To mitigate the agency problems, various methods have been suggested. Jensen and Meckling (1976) suggest either to increase the ownership of the managers in the firm in order to align the interest of mangers with that of the owners or increase the use of debt which will reduce the equity base and thus increase the percentage of equity owned by mangers. The use of debt increases the chances of bankruptcy and job loss that further motivate managers to use the organizational resources efficiently and reduce their consumption on perks. Jensen (1986) present free-cash flow hypothesis, Free cash flow refers to cash flow available after funding all projects with positive cash flows. Managers having less than 100% stake in business and their compensation tied to firm's expansion may try to use the free cash flows sub-optimally and increase firm size resulting in greater compensation. Jensen (1986) propose that this problem can be somehow restricted by increasing the stake of managers in the company or by rising debt in the capital structure, thus dropping the amount of "free" cash accessible to managers.

Harris and Reviv (1990) gave one more reason of using debt in capital structure. They say that management will hide information from shareholders about the liquidation of the firm even if the liquidation will be in the best interest of shareholders because managers want the perpetuation of their service. They suggest that mangers have incentives to pursue strategies that reduce their employment risk. This conflict can be solved by increasing the use of debt financing since bondholders will take control of the firm in case of default as they are powered to do so by the debt indentures. Stulz (1990) said when shareholders cannot observe either the investing decisions of management or the cash flow position in the firm, they will use debt financing. Managers, to maintain credibility, will over-invest if it has extra cash and under-invest if it has limited cash. Stulz (1990) argued that to reduce the cost of underinvestment and overinvestment, the amount of free cash flow should be reduced to management by increasing debt financing.

The bondholder expropriation hypothesis says that shareholders try to gain advantage at the cost of bondholders. If investment yields high returns, the extra or additional benefits go to shareholders and if the firm fails, the bondholders also sustain the loss. So bondholders share extra risks for no reward. Being agents to shareholders, management tries to invest even in projects that may not have good chances of viability. This phenomenon is termed as "overinvestment problem". The losses sustained by shareholders because of this incentive are termed as "asset substitution effect". On the other hand, the underinvestment problem refers to the tendency of

managers to avoid safe net present value projects in which value of equity may decrease a little, however, increase in value of debt maybe high. This happens because management, being primarily responsible to shareholders, does not concern itself with the overall increase in value of the firm rather it tries to increase the value of equity only [Myers and Majluf (1984)].

Jenson and Meckling (1976) propose that optimal capital structure is reached by trading off the agency costs of debt against the benefits of debt.

Dependent and Independent Variables

This part is devoted to factors that company ought to take in consideration while deciding capital structure. In general, companies have three sources to raise funds for new investment: use retained earning, issue debt and issue equity. These three sources make the capital and ownership structure. There are certain restraints for utilization of these components of capital structure. Firms do not invest completely by retained earning, for maintaining current assets. Debt is considered as cheaper source, compared to equity issue and it provides tax shelter but access of debt plus with high interest rate leads to bankruptcy. Issue of equity direct changes the ownership structure and give no tax shelter. A firm is said to be unrevealed if it has no debt, while firm with debt liability is leveraged.

Objective of this study is to determine factors that have impact on leverage of sugar sector of KSE listed companies. Leverage is dependent variable and this paper is taking two independent variables i.e. tangibility and profitability.


Leverage indicates the proportion of assets financed by debt. The choice of the measure of corporate capital structure may be controversial, as lack of a univocal definition of capital structure led to emergence of a variety of factors used to measure it (kinga mazur 2007). Usually, different forms of debt ratio are used, the differences between the measures concern mainly two things. The first one relates to the nature of debt included, Some authors adopt a more inclusive measure of debt that is total debt, Others work only with long-term debt, Short-term measures are applied rarely (kinga mazur 2007). Additionally, many authors have reported that results achieved with the narrow and the broad concepts are either very similar or better with the use of the broader concept. According to Bevan and Danbolt (2002), focusing on longterm debt when analyzing firms which incorporate a larger percentage of short-term debt into their structure, will yield limited explanatory power. They argue that inclusion of trade credit has a substantial impact on explanatory variables.

Fama and French (2002) raised some contradictions arising due to the use of two different debt shares. (Pecking Order and Static Tradeoff) theories, both apply to the debt book value, and there are uncertainties if the predictions may be comprehensive to the debt market value. Following a previous study on non-financial Pakistani listed firms by Shah & Hijazi (2005) study uses the book value measure of leverage. The key benefit of debt is that the interest payments are tax-deductible and therefore provides cash savings. The tax shield benefits are not changed by the market value of the debt once it is issued, so the market value of the debt is inappropriate for this study.

On the other side, the prime cost of borrowing is the increased probability of bankruptcy. If a firm go down in financial distress and face bankruptcy, at that time the relevant value of the debt is the book value of the debt not the market value of the debt (Shah & Hijazi, 2005).

Further consideration in choosing the suitable measure of leverage is to take sum debt or just long term debt as a percentage of total assets. despite the fact that capital structure theories believe long term debt as a proxy for financial leverage, shah and Hijazi (2004) employed the measure of total debt as in Pakistan firms have typically short-term financing as the average firm size is small which makes access to capital market hard in terms of cost and technical complexity (Shah and Hijazi 2004). The major resource of debt in Pakistan have been commercial banks, which do not promote long term loans, with approximately no reliance on market based debt until mid 1994 when government stimulated to eliminate the majority of the constraints amongst which one act was to revise company law to allow corporate entities to raise debt straight from the market in form of Term Finance Certificates. So corporate bond market has inadequate record and is in the process of development. This gives explanation why firms on standard in Pakistan have more short term financing than long term financing. Booth et al (1999) also determined in study on determinants of capital structure in developing countries together with Pakistan that the use of short term financing is privileged than long term financing in developing countries.

Following Booth et al (2001), Rajan & Zingales(1995) and Beven & Danbolt (2002),this study calculate leverage (LEV) of firm as the ratio of total liabilities to total assets. Rationale behind using total debt rather than long term or short term debt is to avoid their contradictory

relations with leverage. These inconsistent relations are shown by Myer's (1984) investigation, positive association of short term debt with financial leverage and negative with long term debt.

Independent Variables

1. Tangibility (TG)

Assets structure is commonly suggested as a variable since fixed assets can serve as collateral. Greater collateral may alleviate the agency costs of debt (Jensen and

Meckling 1976; Myers 1977). That is why, according to the static trade-off theory, there should be a positive relationship between fixed assets and debt. On the other hand, the pecking order theory predicts that firms holding more tangible assets will be less prone to asymmetric information problems and thus less likely to issue debt. This argument suggests a negative relationship. Results obtained for developed countries (Rajan and Zingales 1995; Titman and Wessels 1988) found positive relation between assets structure and debt ratios. According to Bevan and Danbolt (2002), the relationship between assets structure and debt depends on the measure of debt applied. They found assets structure to be positively correlated with long-term debt and negatively correlated with short-term debt elements.

According to the static tradeoff approach (jensen and Meckling, 1976), firms with higher fixed assets ratios provide collateral for new loans, supporting debt. On the other hand, according to Pecking Order Theory as argued by Harris and Raviv (1991), firms with low levels of fixed assets would have more troubles of asymmetric information, making them issue more debt, as equity problems would only be probable by under pricing them. Alternatively, firms with higher levels of asset tangibility are normally larger firms that can issue equity at fair prices, so they do not require issuing debt to finance fresh investment. According to them, the anticipated relationship between asset tangibility and debt should then be negative.

A firm with a huge sum of fixed assets can simply raise debt at cheaper charges because of the collateral worth of fixed assets. Companies with a higher tangible assets ratio have an advantage to have more loan because loans are presented to them at a comparatively cheaper rate. Therefore this study look forward to have a positive association between tangibility of assets and leverage.

In this study tangibility of assets is calculated as the ratio of fixed assets to total assets.


Profitability is a major point of differ among the Pecking Order and Static Tradeoff Theory. According to STT, the higher profitability of the firm provides more explanation to issue debt, as it reduces tax obligation. According to the trade-off hypothesis, firms would choose to have high levels of debt in order to obtain attractive tax shields. This would imply a positive relationship between profitability and debt. Jensen (1986) argues that cash-rich firms should acquire new debt to prevent managers from wasting free cash flows, which implies positive relationship for liquidity.

On the other hand, the POT presupposes that larger earnings guide to the enhancement of the major resource firms select to cover their financial shortfall. Given the 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 [Myers and Majluf (1984)]. The majority of empirical evidence favours the view that profitability and liquidity are negatively correlated with debt ratios (Titman and Wesssels 1988; Rajan and Zingales 1995). This study expect a negative relationship between profitability and leverage.

In previous studies, the measure of profitability used was operating earnings before interest payments and income tax (EBIT). But following Shah and Hijazi (2005) this study measure profitability (PF) as the ratio of net income before taxes divided by total assets.

Empirical Results

Data is selected from Sugar Sector of Karachi Stock Exchange as given by State Bank of Pakistan in the publication "Balance Sheet Analysis of Joint Stock Companies Listed on The Karachi Stock Exchange 2001-2006 and 2003-2008". The period of study covers eight years, from 2001 to 2008. However several companies are not included in data because complete information is not available and over all 16 companies data is collected.

Data Analysis

This atudy uses Regression analysis

This paper estimates that

Lvit = Bo + BXit + E

Lvit = The measure of leverage of a firm i at time t

Bo = The intercept of the equation

Bi = The change coefficient for xit variables

Xit = The different independent variables for leverage of a firm i at time t

E = The error term

Table 1


R Square







Table 1 shows that F ratio for the regression model is significant, which indicates that regression model is best fit. Total variation in the independent variable explained by the regression model as indicated by Rsquare is 0.388.

Table 2 reports the results of regression analysis. Analysing the results for the effects of independent variable on dependent variable, this study find that asset tangibility is negatively correlated with leverage, However, this do not find much evidence that this relationship is statistically Significant. Results indicate that tangibility is not explanatory variable of leverage because regression coefficient is not statistically significant. Thus this study rejects the hypothesis 1 that leverage and tangibility have significant positive relationship. The results thus do not confirm the Jensen and Meckling's (1976) and Myers' (1977) version of trade-off theory that debt level should increase with more fixed tangible assets on balance sheet.

Profitability is statistically significant and nagatively correlated with leverage as showmn in table 2 and shows that more profitable firms are using less debt and more dependent on internal financingand later on issuing stocks, Consistent with the findings of Titman and Wessels (1988), Rajan and Zingales (1995) all find gearing to be negatively related to the level of profitability. Of all the independent variables chosen for this study, profitability has turn out to be the most statistically significant determinant of capital structure in the

context of Pakistan. Profitability is negatively correlated with income. This suggests that profitable firms in Pakistan use more of equity and less debt. This supports the pecking order theory and also approves the earlier hypothesis about profitability that laverage and profitability have significant positive relationship.


This finding is in contrast to the earlier finding by Shah and Hijazi (2004). They found that tangibility was not significantly related to leverage ratio.

Financial Situation

According to the pecking order hypothesis, firms have a preference for internal finance over external finance. Availability of internal funds is captured by the variables profitability and liquidity. If the pecking order theory holds, these two should be negatively correlated with capital structure. Alternatively, according to the trade-off hypothesis, firms would choose to have high levels of debt in order to obtain attractive tax shields. This would imply a positive relationship between profitability and debt. Jensen (1986) argues that cash-rich firms should acquire new debt to prevent managers from wasting free cash flows, which implies positive relationship for liquidity.

Capital Structure Definition



Alan A. Bevan (London Business School)

Jo Danbolt (University of Glasgow) Working Paper 2000/9


In their cross-sectional analysis of the determinants of the capital structure for companies in the G-7 economies, Rajan and Zingales (1995) examine the extent to which, at the level of the individual firm, gearing may be explained by four key factors, namely, the level of growth opportunities (proxied for by the ratio of the market value to the book value of total assets), size (measured as the natural logarithm of sales), profitability (earnings before interest, tax and depreciation to total assets), and collateral value ("tangibility", proxied by the ratio of fixed to total assets).


Modigliani and Miller (1963) argue that, due to the tax deductibility of interest payments, companies may prefer debt to equity. This would suggest that highly profitable firms would choose to have high levels of debt in order to obtain attractive tax shields.

Alternatively, Myers (1984) and Myers and Majluf (1984) predict that, as a result of asymmetric information, companies will prefer internal to external capital sources. Thus a pecking-order is established, whereby companies with high levels of profits tend to finance investments with retained earnings rather than by the raising of debt finance. Consistent with this theory, Titman and Wessels (1988), Rajan and Zingales (1995) all find gearing to be negatively related to the level of profitability. Consequently, we hypothesise:

H: The level of gearing is negatively related to the level of profitability.


Titman and Wessels, and Rajan and Zingales find a significant positive relationship between tangibility and gearing.

The Determinants of Capital Structure Choice

Sheridan Titman; Roberto Wessels

IN RECENT YEARS,A number of theories have been proposed to explain the variation in debt ratios across firms. The theories suggest that firms select capital structure depending on attributes that determine the various costs and benefits associated with debt and equity financing.

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Corporate Capital Structure Theories And Modern Research Work Finance Essay. (2017, Jun 26). Retrieved November 30, 2023 , from

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