Determinants of capital Structure

BY:

Abdul Qadoos Syed AliJaan Waqas Ahmed MBA-DAY(1)

TO

Mr. AHMED ARIF

Determinants of capital Structure | ii

Determinants of capital Structure | i

Abstract:-

This study investigates capital structure of firms registered on Karachi stock exchange and Islamabad stock exchange (Pakistan). This study is to find which independent variables determine the capital structure of Pakistani firms. We find statistically significant coefficients for profitability, size, tangibility and dividend. The negative relationship between profitability and leverage; positive relationships between growth and dividend and confirm the presence of pecking order theory in determining the financing behaviour of Pakistani firms. The strong positive relationship between tangibility and leverage and size and leverage support the theoretical predictions of trade-off theory. The research finds significant change in financing behaviour of firms across industries. There are find partially different results from other studies in Pakistan and as well as for other countries.

Key words: Profitability, Firms Size, Tangibility, dividend, leverage

Determinants of capital Structure | ii

Table of contents
1.1.Background of Study.................................................................................... 1 1.2.Problem Statement ...................................................................................... 3 1.3.Research Questions...................................................................................... 3 1.4.Research Objectives..................................................................................... 3 1.6.Delimitations of the Study............................................................................3

Chapter 2: Literature Review:..............................................................................4

2.1. The trade-off theory (TOT) ..........................................................................7 2.2. Institutional setting in Pakistan....................................................................8 2.3. Literature Gap............................................................................................. 9

Chapter 3: Conceptual model.............................................................................10

3.1. Leverage.................................................................................................... 10 3.2. Profitability ............................................................................................... 11 3.3. Size............................................................................................................ 12 3.4. Tangibility.................................................................................................. 13 3.5. Dividend.................................................................................................... 14 3.6. Theoretical Framework ............................................................................. 15 3.7. Hypothesis................................................................................................. 15

Chapter 4: Research methodology......................................................................16

4.1. Type of Study............................................................................................ 16 4.2. Sample....................................................................................................... 16 4.2.1. Sample Population...............................................................................16 4.2.2. Sample Size......................................................................................... 16 4.2.3. Sample Elements.................................................................................16 4.2.4. Sampling Strategy...............................................................................17 4.3. Procedure of Analysis................................................................................ 17

Chapter 5: Results and Discussion.....................................................................17

Determinants of capital Structure | iii

References...........................................................................................................31

Determinants of capital Structure | 1

Chapter 1: Introduction
A clear understanding of the determinants of capital structure of any given firm is still not clear, it is still mind boggling that how different factors affect capital structure of a firm. This study will be focusing on different determinants of capital structure and will try to find out evidence in the different companies listed in Pakistan. Before we go into the detailed background of the subject we need to understand what is capital structure? Basically capital structure refers to approach that how a firm finances its business or total assets, in which ratio a company uses different sources of finance.

1.1.

Background of Study
According to the trade-off theory while selecting an optimal capital structure a firm

trades off certain advantages of financing through debt against its cost. When firms decide their capital structure they try to achieve a specific ratio which is consistent with different theories which tell us about the trade-off between advantages and disadvantages of debt (Carpentier, 2006). When the amount of financing through short term debt is high it affects the overall leverage of the firm and it is negatively related to the firms operating assets. When the debt is categorized in long term and short term, it is noticed that capital structure based on long term debts financing is positively related to operating assets unlike short term debt financing. Previous findings also show that short term financing is negatively related to the profitability of firms and positively related to the size of company, it is true particularly for the banking sector (Amidu, 2007). Growth is one the factors that causes variations in firms value and this is why firms having greater growth opportunities are considered to be at greater risk, so such firms employ comparatively less debt in their capital structure. The interest which is charged to debtor usually depends on the fact that how much risk is involved in lending money to a certain firm and it totally depends on lenders (Eriotis, 2007). Debt is amount borrowed by a firm to finance its business by issuing debt instruments. Firms usually pay interest on their debt at the end of each period e.g. annually, semi-annually, quarterly etc. Interest is cost of debt for firm and fixed income for creditors.

Determinants of capital Structure | 2

Debt has maturity refers to time period until particular debt remains outstanding such as a 10-year bond, 20-year bond etc. Debt can be categorized as short term debt and long term debt. Short term debt is borrowing of firm that have maturity of one year or less such as short term bank loan, T-bill etc, while long term debt represents the debt that remains outstanding for more than one year for example, note, debenture, bond etc. Debt can also be classified as secured and unsecured debt. Secured debt is borrowing that pledge certain asset of firms as a security in condition of financial distress such as collateral. Unsecured debt is borrowing that does not pledge any asset of firm such as note and debenture (Ross, 2008). Leverage refers to debt ratio in total financing of firm. Capital structure varies from firm to firm based on set of characteristics a firm has. Some firms issue only equity are called unlevered firms while other issue equity along with debt and are branded as levered firms. Some firms use 20 percent debt and 80 percent equity while other firms use 80 percent debt and 20 percent equity. The different behavior of financing by firms gives birth to a question that why do some firms use more leverage while other use less or no leverage in their capital structure? What does exactly motivate the managers to use leverage? Does holding the debt in the capital structure maximize the value of the firms or wealth of stockholders? To answer these critical questions lets discuss the two popular propositions of Modigliani and Millers (also called M&M). M&Ms proposition-I assumes a condition in which there is no taxation, perfect capital market, no transaction costs, no financial distress cost, there will be no effect of leverage on firms value. But M&Ms proposition-II embraces the importance of leverage decision on value of firm. According to M&Ms Proposition-II, using debt can maximize the value of firm because in real world corporate taxation exists and firms are bound to pay the tax on the each unit of currency earned in operating income/ earnings before tax. When a firm borrows it must pay interest and according to generally accepted accounting principles the interest is paid before paying any tax, it means interest payment is tax deductible therefore interest payment decreases tax obligation and protect firm from some tax burden. Firm can save the tax rate for example 35 or 40 percent on each unit paid in interest (Arnold, 2008) (Modigliani, 1958).

Determinants of capital Structure | 3

1.2.

Problem Statement
Taking decision about the capital structure of the business have always been a

difficult task, because capital structure directly affects the performance and profitability of the business, there are several determinants of capital structure and each one of them have direct affect on financial leverage which needs to be vindicated.

1.3.

Research Questions
What are the factors involved in determining firms capital structure? How firms choose their capital structure? What are the different variables that affect capital structure? Do theories of capital structure stand true in context of Pakistani companies?

1.4.

Research Objectives
To figure out different factors which affect capital structure decision To identify the affect of different factors on capital structure To learn how different factors affect the performance of the firm To find the evidence of capital structure theories in companies listed in Pakistan

1.5. Significance of Study

Though these topic determinants of capital structure have been studied over the time again and again, but if we look into this topic with reference to the Pakistani companies still there is a lot of work needed to be done. This study will be a step ahead to look into the evidence from Pakistani companies and will try to vindicate theories of capital structure.

1.6.

Delimitations of the Study

There are many determinants and factors that affect the capital structure of the

company, so we have ignored many variables like inflation, growth and size of the firm.

Determinants of capital Structure | 4

Chapter 2: Literature Review:

Capital structure are play vital role to maximize the company value. How company maximizes the firms return and increases its values. What is the effect and how they found to increase wealth. The company struggle the cost and benefit of the leverage. The firm manager they decide leverage to use in the capital structure or they avail market opportunity either to decide issue debt or equity. That can change to utilize the debt either go to equity. Manager adjusts debt to equity ratio. And they maintain our target and also maintain leverage period of time. Find exact capital structure to maximize firms values and boost up wealth. Many of the studies have been conducted and to collect the empirical evidence (Ooi, 1999). Basically capital structure is to explain the firm way which they can be financing partly with debt and equity. If the firms use the debt they protect the tax. According to the principle of accounting debt is not paid tax deducting the interest before tax. That company benefit for using the debt. When making decision about how much debt and equity to use for financing its business. Firms are optimizing its value where marginal cost of debt. Firm determined by balancing the cost and target leverage first we identified by single period between cost and benefit of debt. Secondly we identified the target debt and may be adjusting over time with change in mitigate the risk and magnitude of cost and its benefits of debt (Rogao, 2009). US firms moving to word target leverage and also leverage target required to take 3.7 years average period to achieve the debt time and their targeted capital structure and to adjust debt ratio maintain and adjusting their leverage. First target may be static which might be identified period cost and debt benefits. And second dynamic trade off policy. Many of the firm moving to debt Where economic condition are good as compared to country where economic condition are stable or may be bad report show that 80% percent of chief financial officer agree to having target leverage. Experiencing higher market to book value ratio tend to have low target debt ratio (Amidu, 2007).

Determinants of capital Structure | 5

Leverage play vital role in diminishing the agency cost in operating diversifying and mitigating business risk. When a firm issuing debt it means allowing outside investor to finance firms operation for interest. It borne by shareholder to creditor and it decrease the agency cost on the other interest payment on debt leverage and less stake holder in business. And also less amount interest paid. If the debt is increasing the tax amount is reduced. Companies not 100 percent finance their capital with debt. Company increase the leverage ratio increases the profitability of financial distress. Distress means a firm cant pay off its debt obligation. For example decline in sale. It also decrease market share it also decline in share price and loss of human resources etc. financial distress firms changes the investment policy. Firm may looking short-range cut back in research and development expenses? That would be happened which ultimately decrease the firm value. Distress also creates loses in the mind and trust (Taylor, 2008). Agency costs are also important role to play in capital structure. Firms uses on techniques to align management goal is maximizing the wealth of share holder. Two main sources of agency costs first is Separation of stakeholder and second are management creates agency problem. It means conflict of interest firm manage to use the organization resource for maximizing the wealth of shares holder. Another source of finance is retained earning refers net income that company reinvest into business is called retained earnings. It is very easy source of financing to acquire it. If your issuing debt or equity and they control their price from fluctuation (Marcia Cristi, 2005). Debt is also important source of money to increasing the firms wealth. Borrowing of firm is denoted by debt. Debt offer tax shield benefit to deductible in the tax. If firm issuing more debt it considered as good news and price of share increase in the market. But debt makes a firm bound to pay interest which at maturity of the time to be paid. It is not easy to acquire. This article showed that the importance relationship between capital structure cost of capital and among capital budgeting decisions and firm value. And it also effect bankruptcy cost on capital structure and firm value. Debt usage positively relates to risk and firm size. Study investigate that variables are one which effect and measured them. Like capital structure and debt effect the decisions of the companies (Serkan Yilmaz Kandir, 2008). The theoretical principles underlying the capital structure, financing and lending choices of firms can be described either in terms of a static trade-off choice or pecking order

Determinants of capital Structure | 6

framework. The static trade-off choice encompasses several aspects, including the exposure of the firm to bankruptcy and agency cost against tax benefits associated with debt use. Bankruptcy cost is a cost directly incurred when the perceived probability that the firm will default on financing is greater than zero. One of the bankruptcy costs is liquidation costs, which represents the loss of value as a result of liquidating the net assets of the firm. This liquidation cost reduces the proceeds to the lender, should the firm default on finance payments and become insolvent. Given the reduced proceeds, financiers will adjust their cost of finance to firms in order to incorporate this potential loss of value. Firms will, therefore, incur higher finance costs due to the potential liquidation costs (Cassar, 2003). Another cost that is associated with the bankruptcy cost is distress cost. This is the cost a firm incurs if non-lending stakeholders believe that the firm will discontinue. If a business is perceived to be close to bankruptcy, customers may be less willing to buy goods and services due to the risk of a firm not being able to meet its warranty obligations. In addition, employees might be less inclined to work for the business and suppliers less likely to extend trade credit. These stakeholders behaviour effectively reduces the value of the firm. Therefore, firms which have high distress cost would have incentives to decrease debt financing so as to lower these costs. Given these bankruptcy costs, the operating risk of the firm would also influence the capital structure choice of the firm because firms which have higher operating risk would be exposed to higher bankruptcy costs, making cost of debt financing greater for higher risk firms. Research has found that high growth firms often display similar financial and operating profiles (Hutchinson, 1989). Debt financing may also lead to agency costs. Agency costs are the costs that arise as a result of a principal-stakeholder relationship, such as the relationship between equityholders or managers of the firm and debt holders. (Myers, 1984) showed that, given the incentive for the firm to benefit equity-holders at the expense of debt holders, debt-holders need to restrict and monitor the firms behaviour. These contracting behaviours increase the cost of capital offered to the firm. Thus, firms with relatively higher agency costs due to the inherent conflict between the firm and the debt-holders should have lower levels of outside debt financing and leverage. Firms also consider within the static trade-off framework, the tax benefits associated with the use of debt. This benefit is created as the interest payments associated with debt are tax deductible while payments associated with equity such as dividends are appropriated from profit. This tax effect encourages the use of debt by firms as more debt increases the after-tax proceeds to the owner. The theory among other things predicts a positive relationship

Determinants of capital Structure | 7

between tax and leverage. The pecking order theory suggests that firms have a particular preference order for capital used to finance their businesses (Myers, 1984).

2.1. The trade-off theory (TOT)

An important motive of trade-off theory of capital structure is to explain the way in which firms can typically be financed partly with debt and partly with equity. Trade-off theory states that there are benefits of financing with debt i.e. tax shield benefit, agency benefit and there are also costs of funding with debt e.g. costs of financial distress, agency costs. Therefore the firm that is maximizing its value will focus on offsetting costs against benefits of debt when making decision about how much debt and equity to use for financing its business. (Ross, 2008) argue that firm can optimize its value at a point where marginal costs of debt and marginal benefits of debt are balanced. According to (Myers, 1984) each firm that follows trade-off theory has target debt and it gradually moves toward its target debt. Target leverage is determined by balancing the cost and benefits of leverage but structure of target leverage is not clear. (Frank, 2009) argue that this target debt can be classified into two ways. First the target debt may be static which might be identified by single period trade-off between costs and benefits of debt and is called static trade-off theory. Second the target debt may be adjusting over time with change in magnitude of costs or benefits of debt. While examining the US firms, (Huang R. &., 2009) say that US firms moving toward their target leverage with moderate speed. US firms take 3.7 years average period to achieve their targeted capital structure in the condition of any deviation from the target debt. The UK firms adjust to their target debt ratio relatively quickly. (Leary, 2005) showed the behaviour of US firms, in time of market friction, adjusting their leverage as if they follow dynamic trade-off policy. Consistent with trade-off model, (Cook, 2010) argue that firms moving faster toward target debt rate in the county where economic condition are good as compared to country where economic conditions are bad. (Graham, 2001) indicate that about 80 percent of chief financial officers confirms having target leverage. (Antoniou, 2008) report that firms have target leverage ratio. Firms that are experiencing higher market to book value ratio, tend to have low target debt ratio (Hovakimian, 2004).

Determinants of capital Structure | 8

2.2. Institutional setting in Pakistan

Every country of world such as Pakistan is special with regard to distinct set of features for example religion, governing rules, regulations, laws, policies, language, culture, tax rate, health facilities, literacy rate, GDP, inflation, vision, strategies, geographic location etc. These distinct country features certainly restrict and guide production and consumption behaviour of individuals and institutions within certain situations. Especially corporations need large amount for production of goods and services for selling and consumption. Pakistan is developing country with distinct institutional setting affecting financing decision of firms. Specifically from financing decision perspective, institutional setting in Pakistan includes bond market/fixed income market, tax laws, inflation, bankruptcy cost recovery rate and economic conditions. Islamic republic of Pakistan got independence in 1947 on the name of Islam and more than 95% of population in Pakistan is Muslim. According to Islamic Laws (Shariah), interest is strictly prohibited. Fixed income market is considered as paying interest on investment. So Muslims in Pakistan may avoid investing in any financial instrument that offers interest. This may be cause of avoiding to invest with corporate bond. Extraordinary spread of banks in Pakistan has been observed because of monopoly of banks in financing corporate debt. The cost of insolvency in Pakistan is lowest in South Asian region. According to copublications of World Bank, International Finance Corporation and Oxford University Press (Doing Business) from 2004 to 2009, bankruptcy cost in Pakistan is 4% of assets that is equivalent to those of Japan and Korea from 2003 to 2008 except 2005 and equal (only in 2003 in USA)/ lower than those in UK and USA. As table 1 shows the bankruptcy cost in South Asian countries is much higher as compare to that in Pakistan. The bankruptcy cost in India is floating from 9% to 18% that is much higher as compare to 4% in Pakistan in mentioned period. Insolvency cost remains stagnant at 8% in Bangladesh and Nepal. Liquidation cost decreases in Sri Lanka from 18% in 2003 to 5% in 2008 and increases in China from 18% in 2003 to 22% in 2008. According to trade off theory, the cost of bankruptcy helps manager to choose appropriate leverage target. Economic conditions in Pakistan have been remaining exceptional since 2003. These economic conditions include rapid change in GDP growth, energy crisis, inflation, unemployment, fiscal deficit, war on terror, balance of trade deficit, foreign direct investment, earthquake of 08 October, 2005 etc.

Determinants of capital Structure | 9

GDP growth rate rapidly increased from 2.0 percent in 2001 to 9.0 percent 2005. Pakistans economy has grown at 7.5 percent per annum during three years from FY 2003/04 to FY 2005/06 therefore it became one of fastest growing economy in the Asian region (Economic survey of Pakistan, 2005-06). Pakistan sustained this growth rate momentum because of dynamism in industry, agriculture, service with emergence of new investment attained new height at 20.0 percent of GDP (Shah, 2004) (Shah A. &., 2007).

2.3. Literature Gap

Empirical literature suggests a variety of proxies to analyze leverage that uses debt to equity ratio, debt ratio. The role of leverage in the explanation of capital structure has been under examination in diverse world markets. In Pakistan this type of work has been done in Karachi stock exchange, there is lack of such empirical in Islamabad Stock Exchange It has been seen that from the last 4 to 5 years the local and global stock markets are under immense pressure of recession. Our study focuses on Islamabad stock exchange and capturing the determinants of capital structure and this study conducted can give new insights.

Determinants of capital Structure | 10

Chapter 3: Conceptual model

3.1. Leverage
Leverage ratio is taken as dependent variable while searching for the determinant of the capital structure. We are taking into account the book value of the total assets for calculating leverage ratio instead of market value of total assets because it is book value of assets that is considered when company either giving the collateral for loan or facing the bankruptcy. Book leverage is preferred because financial market is fluctuating over time at a great level, therefore manager are said to rely on book value while considering the financing policy of the firm. This view is consistent with argument of (Graham, 2001) that large number of managers does not rebalance with fluctuation in financial market. Leverage is figure that is more reliable and free from the effect of those factors which are beyond the control of firm (Frank, 2009). Four definitions of Lev which are 1) long term debt (LTD) over market value of assets, 2) LTD over book value of assets, 3) total debt (TD) over market value of assets and 4) TD over book value of asset. Although capital structure theories use long term debt as proxy of Leverage of firm (Jong, 2008) but we use here two proxies: long term debt ratio (Lev1) and total debt ratio (Lev2) because the main source of firms in Pakistan to borrow was commercial bank until mid of 1994, when government of Pakistan removed most of constraints and amended company law to permit corporation to borrow directly from market by issuing term finance certificate (Shah A. &., 2007). With limited history in corporate bond and commercial banks do not motivate long term debt; most of firms rely on short term debt. (Shah A. H., 2004) found that average size of firm in Pakistan is small which make it difficult for the firm to access capital market in term of technical difficulties and cost (Booth, 2001). It investigate the capital structure of firms in developing countries including Pakistan and find that firms in developing countries more rely on short term debt than long term debt

Determinants of capital Structure | 11

Proxy of leverage: Leverage = total debt Total equity

3.2. Profitability
Profitability can be main independent variable that determines capital structure and represent pecking order and trade-off theories quite clearly. As trade-off theory says firms identify the target debt ratio by comparing benefit from and cost of leverage. Any decrease (increase) in cost (benefit) allows the firm to readjust target leverage by enhancing debt. Profitable firm are less risky with frequent cash flow from business decreasing the cost of financial distress such as bankruptcy cost. It is unanimously recognized that more profitability in world of tax with more leverage can save more tax for shareholder showing benefit from leverage. More benefit from leverage will disturb cost benefit relationship thus allows the firm to borrow more (Frank, 2009) argue that expected cost of financial distress is low for profitable firms thus finding tax shield more valuable. This reflects the positive relationship between Leverage and profitability. Agency cost perspective also regarded debt as a disciplinary measure and more valuable for firms with high profit producing the more free cash flow (Jensen, 1986). It means trade-off theory suggests positive relationship between profitability and leverage (Margaritis, 2007) argue that profitability has positive effect on Lev of firm. Contrary to trade-off theory, pecking order theory suggests that profitable firm prefer to use retained earnings to finance their current or potential projects. (Myers, 1984) argues that firms with no profit or insufficient profit prefer to borrow debt and then issue equity securities if requirement for the funds is not fulfilled by debt borrowing. It means pecking order theory predicts negative relationship between profitability and leverage. Some empirical evidences also validate negative correlation between profitability and leverage (Tong, 2005). Proxy of profitability: Profitability = Net income

Determinants of capital Structure | 12

Sales

3.3. Size
Size can be another important determinant of capital structure because literature show contradicting views about the relationship between size and debt. Larger firms are 27 more diversified, have less default risk, and lower cost of financial distress. Larger firm diversification advantage reduces bankruptcy (Titman, 1998). Therefore according to tradeoff theory any decrease in cost of leverage allows the firms to increase leverage thus predicts positive relationship between size and leverage because size of firm diminishes the cost of leverage Pecking order theory is interpreted as it predicts negative relationship between size and leverage because larger firms are well known and have longer/older history of adding retained earnings in their capital structure (Frank, 2009). Therefore firm with more retained earnings additions should have less leverage. (Margaritis, 2007) find non-monotonic relationship between Size and Lev. They find size is negatively related to low debt ratio and positively related to mid and high debt ratios. Larger firm generates more profit as compared to small firm therefore according to pecking order theory profitable firm prefers internal financing than external one. This suggests that Size is negatively related with debt. We expect positive relationship between size and debt because of three main reasons. First, despite the fact that main source of leverage in Pakistan is short term bank loan yet larger firms are well known by investors; therefore it becomes easy for large firms to issue long term debt in financial markets in Pakistan. Secondly larger firm are diversified so law and order situation such as in NWFP may not hurt its overall sales. Finally, suppose if leverage of larger firm is mainly financed by short term bank loan yet larger firm generate larger cash flow and change in cost of debt capital may not affect cash flow of firms. Proxy of Size:

Determinants of capital Structure | 13

Size= Log (sales)

3.4. Tangibility
A firm with more physical asset can borrow at cheaper cost of debt capital as compare to company with less physical assets. The tangibility of assets offers the bargaining power to company. (Jensen, 1976) point out that agency cost between the creditors and shareholders exists because firm may invest in riskier projects after borrowing and may transfer the wealth from creditors to shareholder. Companies having more fixed asset can borrow more by pledging their fixed asset as collateral and mitigating lenders risk of bearing such agency cost of debt (Ross, 2008). Therefore firm with low agency cost can increase the debt it means trade-off theory predicts positive relationship between tangibility of assets and debt. (Margaritis, 2007) argue that TNG of firm is positively related to Lev. Studies conducted by (Huang, 2006) also suggest the positive correlation between fixed asset and leverage. (Frank, 2009) found positive relationship between TNG and Lev level. However results from developing world are mixed. (Shah A. &., 2007) found significant positive relationship between TNG and Lev for Pakistani firms. Booth et al (2001) find negative relationship between TNG and Lev in ten developing countries (including Pakistan). (Huang, 2006) says experience significant positive relationship between TNG and Lev in China. The negative relationship between TNG and Lev, may infer the results consistent with predictions of market timing theory because if firm has more tangibility and issues equity may indicate mispricing of financial instruments for example overvaluation of shares, undervaluation of bond etc. Other reasons may include cheap cost of equity risk premium, expensive cost of debt. Market timing theory suggests when the stock price in the market is overvalued then based on asymmetric information, the companies issue the equity. Firms buy their own stock when price of stock is perceived undervalued. The limited history of financial market for debt in Pakistan left creditors less aware and more cautious to debt market. So creditors may avoid to invest with firms have less tangibility because bankruptcy may leave less amount of money to recover their investment. If we consider the short term bank loan as a main source of leverage yet bank may feel relax to forward loan to firm with more tangibility than that of low tangibility. Beside this more corporate tax rate, more average recovery rate, and least average cost of bankruptcy in Pakistan as compared to that in other south Asian countries also permit the firm to increase the leverage.

Determinants of capital Structure | 14

Proxy of Tangibility: Tangibility= Net fixed assets Total assets

3.5. Dividend
According to pecking order, firms with higher profitability are experiencing the lower debt in their capital structure. But it is solely depending upon the policy of firm. If the company has low retention ratio (high payout ratio) then company must issue more debt that will increase the Leverage ratio. POT suggests that firm with higher payout history has fewer amounts to reinvest in business thus indicating positive relationship between payout ratio and Leverage. In the condition of high GTH opportunity, POT suggests the low payout. (Tong, 2005) find the past Dividend and Lev has significantly positive relationship. As mentioned above, (Adedeji, 1998) suggests that because of reluctance to cut the Dividend in the condition of earning shortage, firms borrow to pay the Dividend thus indicating the positive relationship between Dividend and debt ratio. The empirically confirms the positive relationship between the Dividend and Leverage ratio (Baskin, 1989). Payment and debt financing can serve as alternatives to address the agency cost of free cash flow problem. Paying cant offer firm any tax benefit while borrowing more not only reduces the agency cost of free cash flow problem but also offers tax shield benefit. Therefore decreasing agency cost and increasing tax benefit may let the firm to borrow more and more leverage may leave fewer amounts with firm to pay. (Allen, 1989) find that firm might not wish to pay high Dividend in the presence of high fixed charges of financing. Therefore trade-off theory would suggest negative relationship between payout and Leverage. (Frank, 2009) point out that the firms that pay Dividends have less Lev as compare to firms those do not paying . We expect positive relationship between and leverage because major portion of population in Pakistan belongs to middle and lower class and shareholder of public corporation from these classes will prefer to get immediate return in form of payment will decrease the retention ration of firm thus firm may not have sufficient amount to reinvest in the business so firm may borrow more for fulfilling need for funds.

Proxy of dividend: Dividend= dividend

Determinants of capital Structure | 15

Total equity

3.6. Theoretical Framework

Figure: Theoretical Framework

Profitability

Size

Financial leverage

Tangibility

Dividend

3.7. Hypothesis

Determinants of capital Structure | 16

Hypothesis 1: There is a positive relationship between profitability and leverage. Hypothesis 2: There is a positive relation between size and leverage.

Hypothesis 3: There is a negative relationship between tangibility and leverage. .

Hypothesis 4: There is a negative relationship between dividend and leverage

Chapter 4: Research methodology

4.1. Type of Study
This study is related to finance. We are testing the relationship among different variables so it is hypothesis testing.

4.2. Sample
4.2.1. Sample Population
The research is conducted for non-financial sector of Pakistan and among the nonfinancial sector textile industry will be our population.

4.2.2. Sample Size

The sample will be extracted from this population. Sample will comprise those firms whose data is conveniently available.

4.2.3. Sample Elements

The companies are the elements which are listed in ISE and KSE.

Determinants of capital Structure | 17

4.2.4. Sampling Strategy

The sampling strategy will be probability sampling and in that it will be restricted and systematic. The data used will be secondary data. The data will be panel/pool data because it will be collected from twenty companies for the period of four years, (2008-12).

4.3. Procedure of Analysis

The analysis of data will be done through different statistical tools like correlation and regression.

Chapter 5: Results and Discussion

5.1. Descriptive Analysis
Table 1: Descriptive Statistics

Std. N Minimum Maximum Statistic 2.6363 Mean Statistic .605025 Deviation Statistic .5740396 .6287766 .3335753 .3507974 2.7040941 Skewness Std. Statistic Statistic Profitability Size Dividend Tangibility Leverage Valid N (listwise) 100 100 100 100 100 100 .0126 6.1856 .0000 .0000 .0104 Statistic .941 .155 2.475 1.862 .533 Error .241 .241 .241 .241 .241 Statistic .315 -.273 5.758 6.973 -.952 Kurtosis Std. Error .478 .478 .478 .478 .478

9.0000 7.639181 1.6695 2.2206 .184249 .472977

9.8890 3.933539

Determinants of capital Structure | 18

Table 1 shows the Minimum and maximum number of data. It shows that which is average distribution, standard deviation which is dispersion from mean and Skewness which shows the normality of data. Here we can see that only values of Size variables and Profitability under Skewness lies in the range of -1 to +1 which shows the normality of data. But others variables are not under the Skewness range that data are abnormal.

Determinants of capital Structure | 19

Table 2: Correlation

Profitability Profitabilit y Size Dividend Tangibility Leverage 1 .233 .302 .645 .017

Size

Dividend

Tangibility

Leverage

1 .115 .000 .024 1 .848 .927 1 .861 1

Determinants of capital Structure | 20

Table 2 depicts the correlation of Independent variables with Dependent variable. This correlation can either be positive or negative it only shows the nature and frequency of relation. Positive correlation means that the variables move in the same direction and vice versa. Here in this case we can see that there is negative correlation of IV,s with DV which clearly shows that if the values of IV,s show increasing trend then the DV will show the decreasing trend and vice versa.

Determinants of capital Structure | 21

5.2. Regression
Table 3: Model Summary

Std. Error of the Model 1 R .318a R Square .101 Adjusted R Square .063 Estimate 2.6169907 Durbin-Watson 1.568

a. Predictors: (Constant), Tangibility, Dividend, Profitability, Size b. Dependent Variable: Leverage

Determinants of capital Structure | 22

Table 3 is showing that the independent variables accounts for 2.9% change in the dependent variable, whereas the value of Durbin Watson indicates that there is absence of auto correlation and serial correlation in our data.

Determinants of capital Structure | 23

Table 4: ANOVA

Model 1 Regression Residual Total

Sum of Squares 73.280 650.621 723.900

df 4 95 99

Mean Square 18.320 6.849

F 2.675

Sig. .037a

a. Predictors: (Constant), Tangibility, Dividend, Profitability, Size b. Dependent Variable: Leverage

Determinants of capital Structure | 24

ANOVA test is used to find the level of relationship among different variables. Table 4 shows that the value of Significance is less than .05 which proves that the model is significant and independent variables have the strong relation with dependent variables, whereas F value checks the model fitness.

Determinants of capital Structure | 25

Table 5: Coefficients

Unstandardized Coefficients Model 1 (Constant) Profitabilit y Size Dividend Tangibility B -4.498 .985 1.000 -.393 .491 Std. Error 3.697 .459 .466 .802 .822

Standardized Coefficients Beta .212 .232 -.048 .064 t -1.217 2.146 2.144 -.489 .597 Sig. .227 .034 .035 .626 .552

Collinearity Statistics Tolerance .968 .805 .966 .832 VIF 1.033 1.243 1.035 1.201

a. Dependent Variable: Leverage

Determinants of capital Structure | 26

Table 5 shows that if we bring 1 unit change in Profitability it will bring -.062 changes in dependent variable which is shown by the unstandardized beta value. T statistics is showing the strength of relationship between the variables for a strong relationship the value of T should be greater than 2. Table is showing that value of T in all the variables is less than 2 which shows a weak relationship among the variables. If VIF value is greater than 4 and Tolerance value is less than .25 then there is problem multicollinearity. Here we can see the same situation that multicollinearity does not exists in our data.

Determinants of capital Structure | 27

Figure 1: Histogram

Determinants of capital Structure | 28

Figure 1 shows the normality of data. It equally lies on the distribution curve which means that all the data is normal therefore regression is assumption is fulfilled as it is showing the bell shaped curve.

Determinants of capital Structure | 29

Figure 2: P-P Plot

Determinants of capital Structure | 30

Figure 2 shows that there is a maximum level of hetroscedasticity because our minimum data is on the line which means that our data is dispersed and our assumption of homoscedasticity is not fulfilled

Determinants of capital Structure | 31

References
A., A. (1998). Does the pecking order hypothesis explain the dividend payout ratios of firms in the UK. Journal of Business Finance and Accounting , 1127-1155. Allen, D. E. (1989). The determinants of corporate capital structure: Japanese evidence. Applied Economics , 569-585. Amidu, M. (2007). Determinants of capital structure of banks in Ghana: an empirical approach. Baltic Journal of Management , 67-69. Antoniou, A. G. (2008). The determinants of capital structure: Capital market-oriented versus bank- oriented institutions. Journal of Financial Quantitative Analysis , 59-92. Arnold, G. (2008). Corporate financial management. Prentice Hall , 32-45. Baskin, J. B. (1989). An empirical investigation of the pecking orderhypothesis. Financial Management , 26-35. Booth, L. A.-K. (2001). Capital Structures in developing countries. Journal of Finance , 87130. Carpentier, C. (2006). The valuation effects of long-term changes in capital structure. International Journal of Managerial Finance , 2 (1), 4-18. Cassar, G. a. (2003). Capital Structure and financing of SMEs: Australian evidence . Journal of Accounting and Finance , 123-147. Cook, D. &. (2010). Macroeconomic conditions and capital structure adjustment speed. Journal of Corporate Finance , 73-87. Eriotis, N. (2007). How firm characteristics affect capital structure: an empirical study. Managerial Finance , 321-331.

Determinants of capital Structure | 32

Frank, M. Z. (2009). Capital structure decisions: Which factors are reliabily important? . Financial Management , 1-38. Graham, J. &. (2001). The theory and practice of corporate finance: Evidence from the field. Journal of Financial Economics , 187-243. Hovakimian, A. H. (2004). Determinants of target capital structure: ths case of sual debt and equity issues. Journal of Financial Econimics , 517-540. Huang, G. &. (2006). The determinants of capital structure: Evidence from China. China Economic Review , 14-36. Huang, R. &. (2009). Testing theories of capital structure and extimating the speed of adjustment. Journal of Financial and Quantitative Analysis , 237-272. Hutchinson, P. a. (1989). The financial profile of growth firms. University of New England Armidale , 12-23. Jensen, M. &. (1976). Theory of the firm: Managerial behavior, agency costs and ownership structure. Journal of Financial Economics , 305-360. Jong, A. d. (2008). Capital structure around the world: The roles of firm and country specific determinants. Journal of Banking & Finance , 54-69. Leary, M. &. (2005). Do firms rebalance their capital structure. Journal of Finance , 25752619. Marcia Cristi, Z. M. (2005). Capital structure: determinants of debt adjustment. Journal of Management , 1-55. Margaritis, D. &. (2007). Capital structure and firm efficiency. Journal of Business Finance and Accounting , 47-69. Modigliani, F. &. (1958). The cost of capital corporation finance and the theory of investment. American Economic Review , 261-297. Myers, S. a. (1984). Corporate financing and investment decisions . Journal of financial Economics , 187-221. Ooi, J. (1999). The determinants of capital structure: Evidence on UK property companies. Journal of Property Investment & Finance , 464-478. Rogao, Z. M. (2009). Capital structure of listed Portuguese companies: Determinants of debt adjustment. Review of Accounting and Finance , 54-75. Ross, S. A. (2008). Modern financial management. Bell Journal of Economics , 23-40. Serkan Yilmaz Kandir, E. K. (2008). Determinants of Capital Structure: investiage the factors affecting capital structure decisions. Journal of Economices , 1-16.

Determinants of capital Structure | 33

Shah, A. &. (2007). Determinants of capital structure: Evidence from Pakistani panel data. International Review of Business Research Papers , 265-282. Shah, A. H. (2004). The determinants of capital structure of stock exchange-listed non finanxial firms in Pakistan. Pakistan Development Review , 605-617. Taylor, B. A.-N. (2008). The relationship between capital structure and ownership structure. Managerial Finance , 919-933. Titman, S. &. (1998). The determinants of capital structure choice. Journal of Finance , 1-19. Tong, G. &. (2005). Pecking order or trade-off hypothesis? Evidence on the capital structure of Chinese companies. Applied Economics , 79-89.