The Positive Relationship between Profitability and Leverage Finance Essay

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The prediction of information asymmetry hypothesis by Myers and Majluf (1984) is approved by the negative sign whereas the predictions of bankruptcy theory and free-cash flow hypothesis by Jensen (1984) are not substantiated. It is thus proved that pecking order theory dominates trade-off theory. Frydenberg(2001b) describes retained earnings as the most important source of financing. Good profitability thus reduces the need for external debt. So result is conformity with our findings. Hence, the trade-off theory suggests a positive relationship between profitability and leverage because high profitability promotes the use of debt and provides an incentive to firms toavail the benefit of tax shields on interest payments. The pecking order theory postulatesthat firms prefer to use internally generated funds when available and choose debt overequity when external financing is required. Thus, this theory suggests a negativerelationship between profitability (a source of internal funds) and leverage. Severalempirical studies have also reported a negative relationship between profitability andleverage (Toy et al., 1974; Titman and Wessels, 1988; Rajan and Zingales, 1995; Wald,1999; Booth et al., 2001; Chen, 2004; Bauer, 2004; Tong and Green, 2005; Huang and Song,2006; Zou and Xiao, 2006; Viviani, 2008; Jong et al., 2008; Serrasqueiro and RogaA‹Å“o, 2009).

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Debt to Equity Ratio:

According to our results beta coefficient is -0.326, whereas the value t-statistics is -2.257. Level of significance is 0.033. Debt to Equity Ratio is negatively correlated to leverage at -0.068. Our result shows that money lenders have been risk averse and they try to insure their profitability along with principle amount. If company debt ratio continuously shows increasing trend, this will give bad impression to money lenders so they will not be willing to invest. In this case companies always prefer to use their internal funds or retained. Harry Markowitz(1952) Current Ratio:Current ratio variable is positively correlated at coefficient of 0.362. Value of t-statistics is 2.622 this shows a highly significant result at 0.015. Our correlation table suggests that there is a highly significant positive correlation between current ratio and leverage. The value of Pearson correlation is 0.482**. This would encourage the investor to invest in companies with high current ratio because in this case companies’ Current Assets shows increasing trend. In case of company default these assets will ensure investor’s repayment of principle amount. So companies can easily get leverage.


Using 5 variants of panel data analysis, we attempt to find the determinants of capital structure of KSE listed none-financial firms for the period 2005-2010. The effect of 5 explanatory variables is measured on leverage ratio which is calculated by dividing the total debt by total assets. Tangibility is significantly negatively related to debt. In Pakistan, where court process is slow and accounting profits do not reflect a true picture of firm performance, creditors prefer the security of specific claim on fixed assets. The prediction of trade-off theory is confirmed by our result. Size, measured by natural log of sale, has a negatively coefficient but is insignificant. It means that firms in the sample do not consider their sizes as an active variable in deciding the leverage level. Size gives a comparative advantage of lower asymmetric information when a large firm makes an IPO.


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