Academic journal article The Lahore Journal of Economics

A Decomposition Analysis of Capital Structure: Evidence from Pakistan's Manufacturing Sector

Academic journal article The Lahore Journal of Economics

A Decomposition Analysis of Capital Structure: Evidence from Pakistan's Manufacturing Sector

Article excerpt


This study investigates the determinants of the various components of debt-short- and long-term debt and their categories-in the case of nonfinancial listed firms in Pakistan for the period 2008-10. We make a significant distinction between these determinants depending on the components of debt issued: long-term or short-term forms of debt. Our results show that large firms are more likely to have access to long-term debt borrowing than small firms and that, due to supply constraints, small firms resort to short-term forms of debt. Firms with higher potential for growth prefer using less long-term debt as well as debt with fewer restrictive arrangements in order to become more financially flexible. Firms with sufficient fixed assets can generate external finance more easily and at lower cost by using these assets as collateral, which supports the tradeofftheory. Firms generating high levels of profit, however, may choose to finance their investments using internal resources rather than by raising debt finance, which conforms to the pecking order theory. Our results also confirm the presence of the inertia effect and industry-specific effects, and are robust to alternative estimation techniques.

Keywords: Long-term debt, short-term debt, growth, firm size, profitability, Pakistan.

JEL Classification: G32, G15, F23.

(ProQuest: ... denotes formulae omitted.)

1. Introduction

The behavior of corporations in making capital structure decisions is of considerable interest to financial economists. A firm's capital structure comprises different components of debt and equity-a mix of financing that maximizes returns and minimizes risk is known as an optimal capital structure. Capital structure policy, therefore, involves identifying the different factors that determine an optimal capital structure, and entails making tradeoffs between risk and returns. High levels of debt financing may increase expected returns but they also carry a high risk of default on the repayment of debt.

Of the two schools of thought on capital structure, the first argues that there can be an optimal capital structure while the second, led by Modigliani and Miller (1958), argues the opposite. The first school holds that a firm can mix its debt and equity in a proportion that minimizes risk and maximizes the firm's returns and value. It proposes that firms should consider various factors when deciding on a specific capital structure, i.e., the relevance theory of capital structure. The second school supports the idea that different levels of capital structure offer the same level of risk and return, i.e., that capital structure does not matter and should not be considered as the firm's value is determined by its underlying investment decisions (Brealey & Myers, 1996). The theory of the irrelevance of capital structure holds on the basis of certain assumptions, e.g., no transaction costs, no taxes, symmetric information, and no bankruptcy cost. When these assumptions do not hold, capital structure decisions become relevant in financing decisions.

Since Modigliani and Miller's (1958) influential study on the irrelevance of capital structure in investment decisions, a large body of theoretical literature has developed capital structure models under different assumptions. Some theories are based on traditional determinants such as tax advantage and the bankruptcy cost of debt, e.g., the tradeofftheory, while others apply modern financial economics and use an asymmetric information or game theory framework in which debt or equity is used as a signaling tool or strategy choice.

Theories that have been widely tested empirically include the tradeofftheory, pecking order theory, agency cost theory, and signaling information (for an excellent review of the literature on capital structure, see Frank & Goyal, 2003; Harris & Raviv, 1990). In addition, firms may find that the availability of external financing is restrictive and that the cost of different types of external finance may vary. …

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