Last Updated 13 Mar 2020

How Firm Characteristics Affect Capital Structure

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Table of contents

Chapter 1
Introduction

Financing decisions are integral to the value creation of the firm. According to financial theories a variety of financing decisions impact the welfare of the firm. Capital structure composition plays a vital role as one false decision can lead to long term financial distress and even to bankruptcy. The capital structure decision is at the center of many other decisions in the area of corporate finance. These include dividend policy, project financing, issue of long term securities, financing of mergers, buyouts and so on. One of the many objectives of a corporate financial manager is to ensure the lower cost of capital and thus maximize the wealth of shareholders.Capital structure is one of the effective tools of management to manage the cost of capital. When analyzing capital structure we take into account the long term and short term debt employed by the firm. Capital structure can be defined as the debt-to-equity ratio of the firm which provides insights into how risky a firm is. Capital structure of the firm is the mixture of debt and equity a firm deploys to finance its assets. The goal of financial managers is to enhance value of the firm which is positively related to the management of its capital structure, the more effectively managed the capital structure of the firm the greater its value.

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An optimal capital structure is one that balances the costs and benefits of both type of financing. Although optimal capital structure exists in theories but these theories are developed keeping in view strict assumptions of the sort that do not apply to real world. The earlier theories have been modified but the search for optimal capital structure goes on. It has thus been concluded that leverage matters more than ever in the real world and the growth of bond market firms have aggressively moved towards debt financing instead of maintaining a balance[1]

Background

The modern theory of capital structure began with the distinguished paper of Modigliani and Miller (1958). The Modigliani-Miller theorem which is the foundation of modern corporate finance pointed out direction these theories should take by telling us the conditions under which capital structure becomes irrelevant. The theorem at its heart is an irrelevant proposition: There are conditions provided by Miller and Modigliani theorem under which a firm’s financial decisions do not affect its value. The proposition is based on the assumptions like neutral taxes, no capital market friction, symmetric access to credit markets and that the firm’s financial policy reveals no information which makes it irrelevant because these perfect conditions do not exist in the real world. Also, if the firm’s financial decisions did not affect its value there would have been no need for different modes of financing. Taking the case of Miller and Modigliani theorem, if the capital structure is not relevant in a perfect market, then actual world’s imperfections become the prime cause of its irrelevance. There are various theories that account against the assumptions of Miller and Modigliani theorem. According to these theories, a perfect market becomes a hypothetical concept and capital structure finds relevant meaning in the real world. These theories which include trade-off theory, pecking order theory, agency costs etc, are the basis of numerous capital structure researches because they present the Miller and Modigliani Theorem to suit the real world without changing its crux.

The trade-off theory of capital structure states that a firm chooses equity and debt financing to the extent that the costs and benefits of the both are balanced. It states that alongside the costs of employing debt there is a tax advantage to it but the benefit will decline comparative to cost as the debt increases so when deciding the optimal capital structure for the firm managers need to consider the trade-off when deciding how much debt or equity to deploy.

Pecking order theory captures the costs related to asymmetric information. It provides that the firm will rely more on internal sources of financing rather than letting outsiders take ownership. Meaning, when in need of financing the primary preference will be financing from internal sources, then debt financing and equity financing will be given the least preference. Myers (1984) states that equity financing is least favorable because it brings in external ownership and also because when shares are issued investors believe that managers think the firm is overvalued and managers are taking advantage of overvaluation. Due to which investors place a lower value on the firm’s stock.

According to agency costs models capital structure is determined by costs arising due to conflict of interest. Jensen and Meckling (1976) identified two types of conflicts namely, between managers and shareholders, and between debt holders and shareholders. The model concludes that leverage is positively associated with the firm value, default probability, extent of regulation, free cash flow, liquidation value, extent to which firm is a takeover target and the importance of managerial reputation. Also that leverage is negatively related to extent of growth opportunities, interest coverage, cost of investigating firm prospects and probability of recognition following default.

Considerable amount of research on subjects relating firm characteristics and capital structure decisions have provided proof that there exists a relationship between the two. The firm characteristics that we are interested in our research are size, liquidity, interest coverage, growth, tangibility of assets and age of the firm for measures of firm characteristics and long term debt ratio, short term debt ratio and total debt ratio as measures of capital structure. The detail of how data relevant to the variables will be collected is as follows:

Size

Size of the firm has a great theoretical implication on the capital structure decision. The larger the firm the more advantage it can take by leveraging long term debt and more advantage it has under trade-off theory as it is more diversified and suffers from bankruptcy less. Theoretically the impact of size on debt level is positive.

Empirically, the total assets, the total sales or the total number of employees of a firm can be used as a proxy for size of the firm. However, in this research the natural logarithm of total sales of the company will be used to measure size.

Liquidity

Theoretically liquidity can have both positive and negative effect on capital structure. Firms that have high liquidity ratio can meet their short term demand more effectively and can deploy more debt signifying a positive relationship. A high liquidity ratio can also be seen as company having trouble securing long term financing by the investors, hence, signifying a negative relationship (pecking order theory).

Liquidity can be measured using quick ratio which is computed by using the following formula: current assets minus inventories divided by current liabilities.

Interest coverage

Interest coverage can be measured by dividing earnings before tax by interest payments. It is theoretically proven to be a determinant of capital structure and there exists a negative relationship between the two. When a firm employs greater debt its interest payments increase and the interest coverage ratio decreases and we are considering interest coverage ratio to be a measurement of default probability, a higher interest coverage ratio implies a lower debt ratio. The pecking order theory also states that if the company has high interest coverage ratio it will have high earnings which can be substituted for external financing.

However, if the company has increased earnings it gives a positive signal to the investors and reduces the cost of financing, hence, signifying a positive relationship between interest coverage and debt ratio.

Growth

Growing firms are in dire need for financing and therefore, they are faced with greater agency problems because they are more flexible in their choice of future investments which increases the cost of debt. Thus, greater the expected growth of the firm lower will be its long-term leverage depicting a negative relationship between the two. Under the pecking order theory firms that are growing will have to take advantage of external financing because their internally generated funds will not suffice their growth needs.

It is measured by calculating percentage increase in the total assets of the firm.

Tangibility

Tangibility refers to the asset structure of the firm including the nature of assets. Theoretically, the more tangible assets a firm has the more easily it can use debt financing by keeping the tangible assets collateral. This suggests a positive relationship between tangibility and debt. However, consistent with pecking-order theory and evidence from developing countries there exist a strong negative relationship between tangibility and debt.

A measure of tangibility is the ratio of fixed assets to total assets of the firm which can be measured by subtracting current assets from total assets and dividing by total assets.

Age of the firm

Age of the firm is used as a standard to measure of reputation in capital structure models. For firms that have been in business for longer time period it is easier to acquire long term debt because of their reputable credit worthiness. It has been proven that older firms tend to have higher debt ratios since they should be higher quality firms. Hence, predicting a positive relationship between age and long term debt.

The age will be proxy by the number of years the firm has been in business.

Justification of research

The problem that we wish to study is how firm characteristics can help in determining an optimal capital structure for the firm. The difference in long-term versus short-term debt is much pronounced in Pakistan; this might limit the explanatory power of the capital structure models derived from Western settings. However, the results of this empirical study suggest that some of the insights from modern finance theory are portable to Pakistan because certain firm-specific factors that are relevant for explaining capital structures in developed countries are also relevant in Pakistan (Sheikh & Wang, 2011).

Capital structure decisions have an important affect of the profitability of the firms with in turn affects not only the wealth of individuals but also the health of the overall economy. If firms are able to effectively apply the western theorems relating to capital structure decisions with respect to the characteristics of their firm they can help in contributing to the overall economy.

Research problem

Problem situation

Research done in developing countries and specifically Pakistan reveal that there are several firm characteristics that affect the capital structure decisions. In Pakistan the market for debt financing is not as developed as the market for equity financing and also the main source of debt financing is through banks. Literature has revealed that an optimal capital structure that balances the benefits and costs of debt and equity financing can help is enhanced value of the firm.

Applying simple statistical tools on data collected about firm characteristics and capital structure decisions can help in identifying relationships that can benefit managers is capital structure decision making.

Research Question

How do firm characteristics (including size, liquidity, interest coverage, growth, tangibility and age of the firm) affect capital structure decisions?

Objectives of the study

The objective of the study will be:

To determine the effect of firm level characteristics on capital structure choice
To allow financial managers to deploy conclusions from this research to optimally chose the capital structure composition which will enhance their firm’s value
To provide real world application of capital structure theories

Plan

The thesis is arranged in the following manner. Chapter 1 of the thesis deals with the introduction of the topic, background information about the source from where the variables are determined and also how these variables will be measure in this research, justification of research which tells about whether this problem is a current one and how does it affects the overall health of the economy, research problem which includes problem situation and problem question, and the objectives of the overall study. Chapter 2 is the literature review which gives details about the works of other authors in related field. It provides details about how the relationship of the variables we are interested in is determined by previous work. Chapter 3 will cover data and methodology which will include details of the sample data, explanation of variables and statistical tools applied. Chapter 4 provides a detailed results and analysis of the findings followed by the final chapter, chapter 5 which concludes the research providing recommendations on our behalf.

Chapter 2
Literature Review

Alfred Marshal defined capital as the part of wealth which is devoted to obtaining further wealth. Capital is the raw material for a firm which is deploys for further gains. How capital plays the role of raw material of the firm is best described by (Groth & Anderson, 1997) who state that a company takes financial capital and converts the capital into assets. It operates those assets to earn economic returns by fulfilling customer needs. This emphasizes the importance of capital and its rightful allocation for the firms, the reason for which we need capital structure decisions. The capital structure decision centers on the allocation between debt and equity in financing the company. An efficient mixture of capital reduces the price of capital. Lowering the cost of capital increases net economic returns which, ultimately, increases firm value (Groth & Anderson, 1997).

The Modigliani-Miller Theorem is a cornerstone of modern corporate finance. At its heart, the theorem is an irrelevance proposition: The Modigliani-Miller Theorem provides conditions under which a firm’s financial decisions do not affect its value. The pioneering work in capital structure argues that under very restrictive assumptions of perfect capital markets, investors’ homogenous expectations, tax-free economy, and no transaction costs, capital structure is irrelevant in determining firm value (Modigliani & Miller, The cost of capital, corporate finance and the theory of investment, 1958). However, these perfect conditions do not prevail in real world which has led to further investigation on the matter on how capital structure composition can enhance firm’s value. This relationship of capital structure with firm’s value has led to the question of the optimal capital structure decision in accordance with firm level characteristics. Later however it was proposed that when taking taxation into consideration firms should employ as much debt capital as possible to achieve an optimal capital structure (Modigliani & Miller, 1963).

As researchers moved on this matter a deeper examination revealed various theories regarding optimal capital structure that balanced benefits and costs related to debt financing[2]. The main benefit that was derived from the utilization of debt financing was that of the “tax shield”. The “tax shield” advantage means that a firm can deploy debt at the cost of interest payments and these payments can help lower the net income of the company for taxation, hence, reducing the amount of tax payable or paid. However, cost of debt includes two types of costs: one involving the inability of the firm to make periodic interest payments (bankruptcy costs) and the other relating to agency cost of monitoring and controlling of the firm’s actions by lenders.

Moving further from taxation, the determination of capital structure is also viewed from the perspective of agency costs and asymmetric information. Theory based on agency cost was initiated by Jensen and Meckling (1976) which was built upon the earlier works of Fama and Miller (1972). They identified two main types of conflicts: between managers and shareholders, and between debt holders and shareholders.

Firms seek value maximization which is achieved through managers appointed as agents by the owners. However, discrepancies may arise between the individual and firm objectives which might lead to managers working for their own personal interests, demanding more salaries and perquisites hence, and tapping into the free cash flow available to the firm. Making use of debt financing not only adds value to the firm but also reducing the conflict. Deploying cash would mean regular interest payments and more efficiency on behalf of the managers to improve cash outflow, thus, adding value to the firm. Interest payments also reduce the amount of free cash flow available, hence, limiting the managers’ demands.

Examining agency theory conflicts between debt holders and shareholders reveal that when lenders provide funds they charge interest according to their own assessment the firm’s risk. Diamond (1989) and Hirshleifer and Thakor (1989) show how managers pursue relatively safe projects out of reputational considerations. Agency costs of debt only arise when there is a risk of default. If debt is totally free of default risk, debt holders are not concerned about the income, value or the risk of the firm. Debt holders typically protect themselves by including provisions that prohibit the management of the firm to significantly alter its business or financial risk. The optimal capital structure is achieved when the benefits reaped by the shareholders equal the costs demanded by the debt holders.

The concept of asymmetric information with respect to capital structure was presented by (Myers, The Capital Structure Puzzle, 1984) and (Myers & Majluf, 1984). They assumed that managers make decisions such as to increase the wealth of existing shareholders. As a consequence, they refuse to issue undervalued shares unless the value transfer from “old” to new shareholders is more than offset by the net present value (NPV) of the growth opportunity. This leads to the conclusion that new shares will only be issued at a higher price than that imposed by the real market value of the firm. Therefore, investors interpret the issuance of equity by a firm as signal of overpricing. Thus, firms will only issue equity as a last resort hence provided by the pecking order theory.

The trade-off theory of capital structure has dominated the capital structure literature. This theory explains the trade-off between tax benefits and bankruptcy cost predicting that firms will maintain an optimal capital structure which will balance the benefits and costs of debt (DeAngelo & Masulis, 1980). The benefits include the tax shield on interest payments and the costs include financial distress costs. The implication of these trade-off models is that firms have target leverage and they adjust their leverage toward the target over time.

Determinants of Capital Structure

Size

Regardless of the reasons there is agreement between theories about the positive impact of size on firm’s capital structure. Size is closely related to risk and bankruptcy cost. From the point view of the trade-off theory, firms trade-off between the benefits of leverage such as tax savings or mitigation of agency problems against the costs of leverage such as the costs of bankruptcy. It is argued by (Rajan & Zingales, 1995) that larger firms are better diversified thus they suffer less from bankruptcy. Furthermore, larger firms will more easily attract a debt analyst to provide information to the public about the debt issue. Banks are more willing to lend their funds to larger firms partly because they are more diversified and partly because larger firms usually request larger amounts of debt capital than smaller firms. Larger firms also have lower agency cost of debt. Larger firms also have low bankruptcy costs because they are believed to have the required resources and ability to minimize the risk of their stock investment. Henceforth, they are less subject to financial distress (Tong & Ning, 2004). From the view point of asymmetric information it is evident that smaller firms face a higher cost of obtaining external funds. Moreover, (Bevan & Danbolt, 2002) argue that due to credit rating, large companies are more likely to have access to non-bank debt financing. In turn, this too would suggest a positive relationship between size and debt.

Evident from the above mentioned work is that there exists a positive relationship between size and the level of debt employed by the firm.

Many studies suggest there is a positive relation between leverage and size. It is concluded by (Marsh, 1982) that large firms more often choose long-term debt (LTD), while small firms choose short-term debt (STD). Large firms may be able to take advantage of economies of scale in issuing LTD, and may even have bargaining power over creditors.

There is also however, a conflicting view suggesting that that cost of issuing debt and equity is negatively related to firm size. On the other hand, size may also be a proxy for the information that outside investors have. It is argued by (Fama & Jensen, 1983) (Rajan & Zingales, 1995) that larger firms provide more information to their lenders as compared to smaller firms. So by the order of pecking-order theory larger firms which disclose more information to lenders should have more equity financing than debt, hence, lower levels of leverage.

Liquidity

For the purpose of this research we will be considering both short term and long term debt when taking into account capital structure decisions. Therefore, the firms’ ability to cover its short term debt has a strong influence on debt ratio. The short term coverage of leverage is an indication of liquidity of the firm (Eriotis, Vasiliou, & Ventoura-Neokosmidi, 2007). Liquidity (LQ) ratios have both a positive and a negative effect on the capital structure decision, and so the net effect is unknown. First, firms with high LQ ratios may have relatively higher debt ratios due to their greater ability to meet short-term obligations. This argument suggests a positive relationship between a firms’ LQ and its debt ratio. Alternatively, firms with more liquid assets may use such assets as sources of finance to fund future investment opportunities. Thus, a firm’s LQ position would have a negative impact on its leverage ratio (Abu Mouamer, 2011).

The positive and negative effect of liquidity can be explained in the light of capital structure theories. The trade-off theory suggests that companies with higher liquidity ratios should borrow more because they have a greater ability to meet contractual obligations on time. Thus, the theory predicts a positive linkage between liquidity and leverage. On the other hand, the pecking order theory predicts a negative relationship between liquidity and leverage, because a firm with greater liquidities prefers to use internally generated funds while financing new investments.

From the view point of investors highly liquid assets may be considered a negative sign. The investors may think of the firm not having enough opportunities for long-term investment. Hence, high liquidity ratio may be considered as a negative signal from the view point of institutional investors. It may however, be considered a positive sign at the same time because firms that have a high liquidity ratio are more likely to be able to pay their investors when faced with default risk because highly liquid assets are easily convertible to cash.

Interest Coverage

Interest coverage is a measure of a firm’s ability to pay the claim against its debt. When talking about leverage and debt financing, interest coverage should not be ignored. According to (Harris & Raviv, 1990) interest coverage is considered a determinant of capital structure. An increase in debt without similar increase in net earnings can result in higher default probability for the firm because it will be unable to make increased interest payments and will ultimately have to liquidate.

The element of earnings volatility can also be captured in interest coverage ratio. We assume interest coverage ratio to be as a measure of default probability which is either an inherent business risk or inefficient management practices. Similarly, earning volatility is considered to be either the inherent business risk in the operations of a firm or a result of inefficient management practices (Shah & Khan, 2007). The study conducted by (Harris & Raviv, 1990) revealed a negative relationship between interest coverage and leverage, meaning that a higher interest coverage ratio will result in lower debt. According to pecking order theory firms that have a high interest coverage ratio are likely to have lower debt and ability to generate relatively high level of earnings which can be a substitute of financing.

According to the trade-off theory firms that have high interest coverage ratio have higher earnings which mean that they can easily meet their obligation requirements and should deploy more debt.

Growth

Theories based on agency problems state conflict of interest between the three major stakeholders of the company namely, management, shareholders and debt holders. These agency problems are more likely to be seen in firms that are growing, reason being that these firms are more flexible in their choice of future investments.

The relationship between growth and capital structure is subject to much controversy. We consider two theories of capital structure[3] in the real world. According to the pecking order theory a firm uses internal financing as the primary source of generating funds, therefore, firms that are growing will increasingly generate internal financing and as its operations increase will move towards debt because internally generated funds will not be sufficient to fulfill its financing needs. It signifies that growing firms are more likely to take advantage of leverage, henceforth; there exists a positive relationship between the two.

Firms that have a high growth also send a positive signal to the investors about the firm’s future financial performance, hence attracting investments. High growth firms are also seen as providing more capital gains to the investors. Thus, a firm’s growth rate is considered to be a positive signal for investors.

On the contrary, models based on agency theory suggest increase in agency costs resulting in discouragement of leverage. Firms that are growing are more likely to be face with the choice of numerous investment opportunities which may give rise to conflict of interest among the stakeholders as to which investment to pursue. Lenders of debt fear that the firm might choose to go for risky projects which will result in an increase in the cost of debt with respect to its benefits, hence reducing its use. Therefore, as proven by (Rajan & Zingales, 1995) there is a negative relationship between growth opportunities and leverage.

Based on (Bas, Muradoglu, & Phylaktis, 2009) results from research in developing countries, we see different responses from small and large firms towards debt financing. As firms become larger, they become more diversified and risk of failure is reduced as a result of that they can have higher leverage. Based on our results, small and large companies have different debt policies. Due to the information asymmetries, small firms have limited access to finance; therefore, they face higher interest rate costs. Also, they are financially more risky compared to large firms. As a result of that, small companies have restricted access to debt financing which may influence their growth.

It is empirically proven by (Deesomsak, Paudyal, & Pescetto, 2004) from their study of firms from Asia Pacific region that growth tends to have a negative impact on leverage.

Tangibility

From the view point of agency theory, the shareholders of a leveraged firm have an incentive to invest sub-optimally (Titman & Wessels, 1988). Theoretically it is argued by (Jensen & Meckling, 1976) that issuing debt increases the shareholders motivation to invest sub-optimally in high-risk projects, taking advantage of the possibility of increasing their benefits at the expense of increasing the risk, which is passed on to the debt-holders, who are the ones that would suffer the possible losses. However, if debt is secured against assets, the borrower is restricted to using loaned funds for a specific project, and creditors have an improved guarantee of repayment. They also point out that the agency cost of debt exists as the firm may shift to riskier investment after issuing debt, and transfer wealth from creditors to shareholders to exploit the option nature of equity. If a firm’s tangible assets are high, then these assets can be used as collateral, diminishing the lender’s risk of suffering such agency costs of debt.

It is argued by (Myers & Majluf, 1984) firms find it advantageous to issue secured debt because issuing debt that the investors know is supported by tangible assets helps reduce costs of debt. This finding suggests a positive relationship between tangibility and leverage along with results from (Al-Najjar & Taylor, 2008). These results are consistent with that of the agency theory.

In contrast pecking-order theory which suggests that firm’s prioritize internal financing proving that there should be a negative relationship between tangibility and leverage. Firms that have a greater proportion of tangible assets can use them for financing instead of securing long-term debt. Based on the study of (Sheikh & Wang, 2011) in Pakistan, there exists a strong negative relationship between tangibility and leverage. Studies from developing countries have shown existence of strong negative relationship between tangibility and leverage (Mazur, 2007). However, research from developed countries has shown a positive relationship between the two (Rajan & Zingales, 1995) (Titman & Wessels, 1988). These results are consistent with the pecking-order theory of capital structure.

Age of the firm

Age of the firm is an important determinant of capital structure as it is a standard signal of reputation which is integral when acquiring financing. Investors are more likely to invest in firms with a good reputation and stability which is attributed to firms that have been in the business for long. Similarly, when granting a loan banks will evaluate creditworthiness of the firm by looking at how long it has been in business.

From the life cycle perspective, over time, the firm establishes itself as a continuing business and it therefore increases its capacity to take on more debt.

The use of age as a determinant of capital structure was suggested by (Diamond, 1989). He considers reputation as the good name a firm has built up over the years. Directors concerned with a firm’s reputation tend to act more prudently and avoid riskier projects in favor of safer projects, even when the latter have not been approved by shareholders, thus reducing debt agency costs. Consistent with agency theory, he suggests that firms who have been in the business longer send out a positive signal to the investors, thus, making it easy to secure debt.

Study conducted by (Petersen & Rajan, 1994) depicts that since older firms are higher quality firms they can secure debt easily and will have higher debt ratios. It is suggested by (Hall, Hutchinson, & Michaelas, 2004) however, that age of the firm has dual effect. According to the study it is confirmed that age is positively related to long-term debt but negatively related to short-term debt.

Theoretical Framework

The dependant variable which is the variable of primary interest is the total debt ratio which includes both short-term and long-term debt. Although capital structure decisions are mainly concerned with long-term debt but because of an increased use of short-term debt in Pakistani companies we consider it to important in our calculations. The variance in the dependant variable, debt-ratio will be explained with the help of six independent variables namely; size, liquidity, interest coverage, growth, tangibility of assets and age of the firm.

The larger the size of the firm the more diversified it is and the lesser is the likelihood of bankruptcy which gives a positive signal to the investors and reduces the cost of issuing debt. Hence, it signifies a positive relationship between size and leverage. When a firm is more liquid it means that it has a greater ability to cover its short term obligations. In accordance with capital structure theories there are two conflicting views. Trade-off theory suggests that firms that can meet their short-term obligations effectively should borrow more debt, hence, suggesting a positive relationship. In contrast, the pecking order theory suggests a negative relationship. It states that if a firm has more liquid assets it is better able to meet its financing needs internally, therefore, eliminating the need of external financing of any sort. Interest coverage refers to the ability of the firm to pay its interest obligations. Firms that have a high interest coverage ratio prefer lower debt or have relatively high earnings a portion of which they use for financing purposes. Hence, in accordance with pecking order theory, the relationship between interest coverage and leverage is negative. The relationship between growth and leverage is also subject to contradictions. Pecking order theory suggests a positive relationship between the two. It states that as firms grow its internally generated funds cannot suffice its financing needs, hence it starts employing debt financing. In contrast when a firm faces growth opportunities it also faces high agency costs because of uncertainty about the choice of projects. It gives out a negative signal to the investors, increasing the cost of financing. Thus, agency cost theory suggests a negative relationship. A positive relationship between tangibility and leverage is evident from the theory of agency costs because if a firm has more tangible assets, the cost of issuing debt is reduced. However, a strong negative relationship between tangibility and leverage is apparent from data of developing countries which is consistent with the pecking-order theory. Age of the firm and debt level are positively related because size is an indicator is quality and as firms age investors perceive them to be higher quality firms and the cost of acquiring debt decreases.

Chapter 3
Data and Methodology

Sample Data

For the purpose of this research non-probability sampling, more specifically, convenience sampling was chosen. Twenty firms were chosen from the firms listed in Islamabad Stock Exchange (ISE). The collected data was from the time period 2006-2010. The variables of interest were calculated using published annual reports of the firms available on their website.

All the firms selected in the sample are non-financial firms owing to the differences in capital structure composition across financial and non-financial sectors[1].

Variables

Dependent Variable

The dependent variable in our study will be the total debt ratio (Variable: DR) which will include both long-term and short-term debt.

The capital structure is how a firm finances its operations via various modes of financing including debt and equity. Therefore, when analyzing capital structure of the firm we use both short-term and long-term debt. Although the strict conception of capital structure refers to long-term debt of the firm but we use short-term debt as well because of increased use of short term debt by Pakistani companies.

Independent Variables

The independent variables are:

Size of the firm (Variable: SIZE) which will be determined by taking the natural logarithm of sales. Under the trade-off theory of capital structure the size of the firms is proven to have a positive relationship with debt because older firms due to their diversification face lower chances of bankruptcy.
Liquidity of the firm (Variable: LIQ) which will be measured using the firm’s quick, or acid test, ratio. Liquidity can have a dual effect on capital structure. The pecking order theory states a negative relationship between liquidity and debt ratio.
Interest coverage ratio (Variable: INCOV) which is net income before tax divided by interest payments. Interest coverage has a negative relationship under the trade-off theory. Whereas, a companies’ increased earnings can decrease the cost of employing debt signifying a positive relationship.
Growth of the firm (Variable: GROWTH) which will be measured a percentage change in total assets. Growth is also subject to controversy. Under the pecking order theory it shows a positive relation with debt ratio whereas, the assumptions of agency cost theory signify a negative relationship.
Tangibility of assets (Variable: TANG) which will be measured by dividing fixed assets by total assets. The negative relationship of tangibility and debt ratio is evident under the assumptions of the pecking order theory.
Age of the firm (Variable: AGE) which will be determined by the number of years the firm has been in business. Older firms because of their developed reputation can easily take advantage of debt, hence indicating a positive relationship.

Methodology

The type of data we are using for this research is longitudinal and cross-sectional data, meaning that we will be studying a variable over a period of five years to account for changes. The same firms that are sampled in cross-section are then re-sampled at a different time, hence, providing us with a panel data set.

In order to estimate the effects of our independent variables on debt ratio we use three estimation models, namely, pooled ordinary least square (OLS), the random effects model and the fixed effects model

Panel data analysis

Panel data analysis is a method of studying a particular subject over multiple time periods. With repeated observations of enough cross-sections, panel data allows us to study change within a shorter time series. The two approaches of panel data analysis that we will be employing are pooled ordinary least square (OLS), random effects model, and fixed effects model

Pooled OLS model works under the assumption that there are no unique attributes of individuals within the data set. Since we are observing same cross-sectional units there may be cross-sectional effects. To deal with these problems we use random effects model and fixed effects model.

Random effects model is adequate if we want to draw inferences about the whole population, not only our sample of interest. It assumes that there are unique, time constant attributes of individuals that are a result of random variations.

Fixed effects model is adequate only is we want to draw conclusions about the sampled individuals. It assumes that there are unique attributes of the individuals in the sample that are not a result of random variation and that do not vary across time.

The description of the three models- pooled OLS regression, random effects and fixed effects model is given below:

DRi,t = ?0 + ?1SIZEi,t + ?2LIQi,t + ?3INCOVi,t + ?4GROWTHi,t + ?5TANGi,t + ?6AGEi,t + ?i,t

DRi,t = ?0 + ?1SIZEi,t + ?2LIQi,t + ?3INCOVi,t + ?4GROWTHi,t + ?5TANGi,t + ?6AGEi,t + µi,t

DRi,t = ?0 + ?1SIZEi,t + ?2LIQi,t + ?3INCOVi,t + ?4GROWTHi,t + ?5TANGi,t + ?6AGEi,t + ?i,t + µi,t

Where,

DRi,t= Debt ratio of the firm i at the time t

SIZEi,t = Size of the firm i at the time t

LIQi,t = Liquidity of the firm i at the time t

INCOVi,t = Interest Coverage of the firm i at the time t

GROWTHi,t = Growth of the firm i at the time t

TANGi,t = Tangibility of the firm i at the time t

AGEi,t= Age of the firm i at the time t

?0= Common y-intercept

?1-?6 = Intercepts of the independent variables

?i,t = Stochastic error term of firm i at the time t

µi,t = Error term of firm i at the time t

Chapter 4
Results and Discussion

Working under the assumption that there are no unique attributes of the firms included in the data set, the results of the OLS estimation model are given in Table 1. The results show liquidity, tangibility and age to have a significant relationship with debt ratio at a confidence level of less than 5 percent. However, the relationship of size, interest coverage and growth was found to be highly insignificant. The OLS regression has an adjusted R squared of 0.352774 indicating that the independent variables account for 35.27% of change in the dependent variable. The F- statistic which is highly significant confirms the significance of this model. The Durbin-Watson statistic is a measure of autocorrelation[2]. Small values of the statistic such as the one in this model are indicative of presence of autocorrelation.

Table 1: The effect of independent variables on dependent variable (DR) using OLS estimation model

Variable

Coefficient

Std. Error

t-Statistic

Prob.

C

0.8612

0.078132

11.02233

0.0000

SIZE

2.89E-11

3.71E-11

0.779994

0.4374

LIQ

-0.104432

0.016037

-6.511986

0.0000

INCOV

3.62E-05

2.86E-05

1.268824

0.2077

GROWTH

0.006024

0.050429

0.119462

0.9052

TANG

-0.218241

0.101337

-2.153622

0.0339

AGE

-0.002373

0.001112

-2.133731

0.0355

R-squared

0.391999

Mean dependent var.

0.521482

Adjusted R- squared

0.352774

S.D. dependent var.

0.199906

S.E. of regression

0.160825

Sum squared resid.

2.405413

F-statistic

9.993395

Durbin-Watson stat

0.710832

Prob(F-statistic)

0.00000

Due to the existence of data across firms and overtime, to overcome the cross-sectional effect on the firms we use two additional methods of estimation. The results random effects model in Table 2 however only shows a significant relationship of liquidity and debt ratio at a confidence level of less than 5 percent. The adjusted R square for the random effects model however is far greater than OLS estimation model at 70.66%

Table 2: The effect of independent variables on dependent variable (DR) using random effects estimation model

Variable

Coefficient

Std. Error

t-Statistic

Prob.

C

0.634449

0.105608

6.007581

0.0000

SIZE

3.59E-11

2.74E-11

1.309595

0.1936

LIQ

-0.066583

0.019919

-3.342701

0.0012

INCOV

1.41E-05

2.03E-05

0.694044

0.4894

GROWTH

0.052377

0.037267

1.405443

0.1632

TANG

-0.006486

0.096275

-0.067368

0.9464

AGE

-0.001222

0.002104

-0.58089

0.5627

R-squared

0.724386

Mean dependent var.

0.521482

Adjusted R-squared

0.706604

S.D. dependent var.

0.199906

S.E. of regression

0.108281

Sum squared resid.

1.090403

Durbin-Watson stat

1.109475

Table 3 shows results from the fixed effects estimation model. The fixed effects model shows a significant relationship of growth and age with debt ratio at a confidence level of less that 5 percent. The R squared of the model is higher than the other two at 73.84%. The F-statistic shows that the model has a significant high explanatory power.

Table 3: The effect of independent variables on dependent variable (DR) using fixed effects estimation model

Variable

Coefficient

Std. Error

t-Statistic

Prob.

SIZE

4.07E-11

2.63E-11

1.545093

0.1266

LIQ

-0.026374

0.023938

-1.101763

0.2741

INCOV

9.67E-06

1.96E-05

0.49318

0.6233

GROWTH

0.083721

0.036586

2.288292

0.025

TANG

0.052184

0.100137

0.521122

0.6038

AGE

0.018864

0.007641

2.468839

0.0159

R-squared

0.804487

Mean dependent var.

0.521482

Adjusted R-squared

0.738435

S.D. dependent var.

0.199906

S.E. of regression

0.102239

Sum squared resid.

0.773503

F-statistic

60.8982

Durbin-Watson stat

1.377933

Prob(F-statistic)

0.00000

Discussion of results

The above statistical analysis shows the following relationships between the firm characteristics and capital structure.

Size and capital structure

The results of all the three estimation models indicate that there is a positive but no significant relationship between size and debt ratio. The positive relationship is consistent with the trade-off theory of capital structure under which the cost of debt for larger firms is because of lesser likelihood of bankruptcy as they are more diversified. This makes it easier for them to deploy debt. These findings are also supported by the agency cost theory of capital structure. However, this finding remains in contradiction with pecking-order theory according to which larger firms who disseminate more information to the investors should be more likely to take advantage of equity than debt. The result is consistent with (Shah & Khan, 2007) study of the Pakistani panel data.

Liquidity and capital structure

The results indicate a significant negative relationship between liquidity and capital structure using OLS and random estimation model, making the results applicable to the entire population. The negative relationship means that highly liquid firms a less likely to take advantage from leverage. These findings are consistent with pecking order theory of capital structure according to which when firms have high liquidity they are more likely to use the internally generated funds for financing. From the view point of investors in (Tong & Ning, 2004) highly liquid firms send out a negative signal which increases the cost of debt. This negative relationship is also proven from the studies of (Abu Mouamer, 2011) (Sheikh & Wang, 2011) (Eriotis, Vasiliou, & Ventoura-Neokosmidi, 2007)

Interest coverage and capital structure

The results from all the three estimation models show a positive but no significant relationship between interest coverage and capital structure. This positive relationship is in contradiction with the pecking order theory and the study by (Harris & Raviv, 1990) which indicates a significant negative relationship.

Growth and capital structure

The relationship between growth and capital structure according to our results is only positive and significant in the fixed effects estimation model. This positive relationship is consistent with the pecking order theory according to which as firms grow the internally generated funds become insufficient and they start taking advantage of debt financing. Similarly, growing firms send a positive signal to investors decreasing the cost of debt. Study conducted by (Abor & Biekpe, 2009) shows a significant positive relationship of growth with long-term debt ratio only.

Tangibility and capital structure

The study shows a significant negative relationship between tangibility and capital structure using only OLS estimation model. There is however contradiction in the direction of relationship with regard to the three models. OLS and random effects estimation model show a negative relationship whereas the fixed effects model shows positive relationship. These findings are consistent with the pecking order theory which states firms with more tangible assets can use them for financing as opposed to acquiring external debt. A strong negative relationship is also evident from the studies of (Sheikh & Wang, 2011).

Age and capital structure

The results show contradiction in the relationship of age and capital structure. The OLS estimation model shows a significant negative relationship between age and capital structure whereas the fixed estimation model shows a significant positive result. These finding are consistent with (Hall, Hutchinson, & Michaelas, 2004) study which also indicates a dual relationship of age and capital structure.

Chapter 5
Conclusion and Recommendations

This study attempted to explore the relationship between firm characteristics and capital structure decisions in the firms listed in Islamabad Stock Exchange during the time period 2006-2010. Regression analysis was used as a statistical tool to explain the strength and direction of relationship between the variables. The dependent variable for the study was debt ratio. Although capital structure decisions are mainly concerned with long-term debt, we include short-term debt in our calculations because of increasing trend towards short-term debt in Pakistan. The independent variables used were size, liquidity, interest coverage, growth, tangibility and age.

Our study shows a significant negative relationship between liquidity and capital structure using the OLS and random effects estimation model, a significant positive relationship between growth and capital structure using the fixed effects estimation model, a significant negative relationship between tangibility and capital structure using OLS estimation model, and a dual relationship of age and capital structure.

The study contains a number of firms with variations in their structure which can be a contribution to a number of variables not showing significant results. The sample contained companies like Nishat mills limited and Biafo industries limited which employed as little debt as 12% only and on the contrary other companies like Sui northern gas pipelines that were indebted at above 80%. A further sector wise analysis of the firms would yield more significant relationships between the studied variables and debt ratio.

Although there are differences in the capital structure of Pakistani firms as opposed to western firms due to increased use of short-term debt we see that the capital structure theories are applicable in Pakistan as well. Though increasing research is being done on this topic it is safe to say that capital structure decisions still remain a puzzle and the search for optimal capital structure is ongoing.

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