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Determinants of Capital Structure: A Case of Listed Energy Sector Companies in Pakistan
Introduction
Two financing options available to all firms: Debt and Equity
The Manager’s Objective: to achieve ‘optimal’ capital structure
Academic research has focused on why firms choose to use more/ less amount of debt; which companies/ industries are more leverage and why?
Why energy sector
Important for the whole economy / business sector
Significant portion of Karachi Stock Exchange’s total market capitalization
Research Objectives
To ascertain whether the determinants used by Rajan and Zingales (1995) and others apply to capital structure decisions made by listed firms in Pakistan’s energy sector
To find out which of the capital structure theories better explains the capital structure of these firms
Literature Review Important Studies
Titman and Wessels (1988)
Found no evidence that debt ratios are related with a firm’s expected growth, tax shields, volatility or tangibility of assets. However, they found profitability to be negatively associated with firm’s debt.
Harris and Raviv (1990)
Argued that managers do not always act in the best interests of the shareholders and debt provides a mechanism that helps keep things in order
Rajan and Zingales (1995)
Studied companies in the G-7. Found differences across different countries while some variables were found to be having same relationship with leverage across all countries (e.g. tangibility)
Literature Review (continued)
Drobetz and Fix (2003)
used Swiss data to study the predictions of Static Tradeoff and Pecking order theories. Found that Swiss firms tended to use comparatively less leverage (compared with Anglo-American countries) and more profitable firms also exhibited less reliance on debt
Tahir and Hijazi (2006)
Studied the capital structure of listed cement companies in Pakistan Their aim was to study the unique attributes of this sector and how its capital structure decisions differ from other listed firms. They found that growth, tangibility and profitability had significant impact on leverage, whereas size did not seem to impact leverage considerably
Theories of capital structure
Static Trade-off Theory
Firms target an optimal debt ratio believing that such ratio will maximize the value of the firm. The optimal point is achieved when the marginal benefit of issuing debt equals the increase in the costs associated with issuing more debt
Pecking Order Theory firms prefer to finance their investments with internally generated funds as opposed to external financing. When external financing is required, managers tend to prefer debt financing over equity
Agency Theory
This theory states that an optimum capital structure results from minimization of the costs arising from conflicts between shareholders and debt-holders
Data and Variables
Data mainly obtained from ‘Balance Sheet Analysis of t Stock Companies’ compiled by State Bank of Pakistan for the period 2004-2008 (five years)
Data and Variables (continued)
Leverage: total debt to total assets
Tangibility: Fixed Assets (net)/ Total Assets
Size: Log of total sales
Profitability: Earnings before taxes/ total assets
Growth: Percentage change in total assets over the previous year
Sectors Sectors in the energy sector: Oil & Gas Marketing Companies Oil & Gas Exploration Companies Refineries Power Generation Companies
Research Methodology Regression
analysis using the following model:
L = β1 (T) + β2 (S) + β3 (G) + β4 (P) + ε Where L = Leverage T = Tangibility of assets S = Size of the firm G = Growth P = Profitability ε = the error term
Results Variable
Observed Relationship
Expected Relationship in Static Trade-off Theory
Expected Relationship in Pecking Order Theory
Tangibility
Positive
Positive
Negative
Size
Positive
Positive
Negative
Growth
Positive
Negative
Positive/ Negative*
Profitability
Negative
Positive
Negative
Conclusion
Predictive capability of these capital structure theories is rather mixed, as no single theory completely explains the behavior of financial decision makers in the listed firms in Pakistani energy sector.
In Pakistan, power sector firms with more tangible assets use greater debt which may be due to the collateral value of their assets and ease of obtaining financing
For Pakistani energy sector firms, size was found to be positively associated with leverage suggesting that larger firms tend to use higher leverage. The reasons could be lower bankruptcy risks in larger firms, more diversified portfolio and ease of obtaining financing
Growth, was found to be positively associated with leverage which s the simple version of pecking order theory (which states that growth firms would finance the expanding operations by incurring more debt)
Conclusion
Profitability - was found to be negatively associated with leverage ing the view of Pecking Order Theory that profitable firms tend to have less leverage due to availability of internally generated funds
As no single model completely explains the behavior of managers in the Pakistani energy sector companies with regard to capital choice decisions, it could be deduced that capital choice decisions are more complex than predicted by these theories and there is a need for further research to come up with a model that better explains these decisions.
Areas for further research
Using different measures of leverage e.g. Short term and Long term debt
Incorporating both book value and Market value of debt
Including a larger sample of companies and doing intra-sector comparisons
Differentiating between different ownership structures
References
Bancel, F. and Mitto, U. (2002), ‘The Determinants of Capital Structure Choice: A Survey of European Firms’, AFA 2003 Washington, DC Meetings; EFMA 2002 London Meetings, Available at SSRN: papers.ssrn.com/sol3/papers.cfm?abstract_id=299172 (Accessed: June 05, 2009) Booth, L., Aivazian, V., Demirguc-Kunt, A. and V. Maksmivoc (2001), ‘Capital structures in developing countries’, Journal of Finance 56, pp.87-130. Brealy, R., Myers, S. and Marcus, A. (1995), Fundamentals of Corporate Finance, International Edition, McGraw Hill, Inc. Buferna, F., Bangassa, K. and Hodgkinson, L. (2005), ‘Determinants of Capital Structure – Evidence from Libya’, University of Liverpool Research Paper Series No.2005/08, ISSN 1744-0718 Chen, L., Lensink, R. and Sterken, E. (1998), ‘The Determinants of Capital Structure: Evidence from Dutch Data’, European Economic Association Annual Congress, Berlin, September 2-5, 1998 Chiarella, C., Pham, T., Sim, A.B, and Tan, M. (1991), ‘Determinants of Corporate Capital Structure: Australian Evidence’ “University of Technology, Sydney – School of Finance and Economics Working Paper” Daskalakis, N. and Psillaki, M. (2003), ‘The Determinants of Capital Structure of the SMEs: Evidence from the Greek and the French firms’, Available at: http://www.univorleans.fr/DEG/GDRecomofi/Activ/psillaki_strasbg05.pdf (Accessed: June 10, 2009) Devic, A. and Krstic, B. (2001) Comparatible Analysis of The Capital Structure Determinants in Polish and Hungarian Enterprises – Empirical Study, part of the project "Economic Efficiency of Development Strategies of Enterprise in Market Economy - Possibilities and ways for improvement" (No. 1406) - Ministry of Science, Technology and Development - Republic of Serbia. Drobetz, W. and Fix, R. (2003), ‘What are the determinants of capital structure? Some evidence for Switzerland’; University of Basel, WWZ/ Department of Finance, Working Paper No. 4/03 Harris, M. and A. Raviv, (1990) Capital structure and the informational role of debt, Journal of Finance 45, pp. 321-349
References (continued)
Jensen, M., and W. Meckling, (1976), ‘Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure’, Journal of Financial Economics 3, pp. 305-360. Modigliani, F. and Miller, M., (1958), ‘The Cost of Capital, Corporation Finance and the Theory of Investment’, The American Economic Review, Vol. 48, pp. 433-443 Myers, S., and N. Majluf, (1984), ‘Corporate Financing and Investment Decisions When Firms Have Information Investors Do Not Have’, Journal of Financial Economics, 13, pp. 187-222. Myers, S.C., (1977), ‘Determinants of Corporate Borrowing’, Journal of Financial Economics, Vol. 5., pp. 147-175 Rajan, R. and Zingales, L., (1995), ‘What Do We Know about Capital Structure? Some Evidence from International Data’, The Journal of Finance, Vol. 50. pp.1421-1460 Sevil, G., Sayılır, O. and Yıldırım, S. (2005), ‘Determinants of Capital Structure: Evidence from Turkish Manufacturing Firms’, Available at: http://home.anadolu.edu.tr/~gsevil/capital.pdf (Accessed May 26, 2009) Hijazi, T. and Tariq, Y. (2006), ‘Determinants of Capital Structure: A Case for the Pakistani Cement Industry’, The Lahore Journal of Economics, 11:1, (Summer 2006), pp. 63-80 Shah, A. and Hijazi, T. (2004), ‘The Determinants of Capital Structure of Stock Exchange-listed Non-financial Firms in Pakistan’, The Pakistan Development Review, 43:4, Part II, pp. 605-618 State Bank of Bank of Pakistan, ‘Balance Sheet Analysis of t Stock Companies Listed on The Karachi Stock Exchange’ - 2008 Titman, S. and Wessels, R., (1988), ‘The Determinants of Capital Structure Choice’, The Journal of Finance, Vol. 43, No.1, pp. 1-19
Introduction
Two financing options available to all firms: Debt and Equity
The Manager’s Objective: to achieve ‘optimal’ capital structure
Academic research has focused on why firms choose to use more/ less amount of debt; which companies/ industries are more leverage and why?
Why energy sector
Important for the whole economy / business sector
Significant portion of Karachi Stock Exchange’s total market capitalization
Research Objectives
To ascertain whether the determinants used by Rajan and Zingales (1995) and others apply to capital structure decisions made by listed firms in Pakistan’s energy sector
To find out which of the capital structure theories better explains the capital structure of these firms
Literature Review Important Studies
Titman and Wessels (1988)
Found no evidence that debt ratios are related with a firm’s expected growth, tax shields, volatility or tangibility of assets. However, they found profitability to be negatively associated with firm’s debt.
Harris and Raviv (1990)
Argued that managers do not always act in the best interests of the shareholders and debt provides a mechanism that helps keep things in order
Rajan and Zingales (1995)
Studied companies in the G-7. Found differences across different countries while some variables were found to be having same relationship with leverage across all countries (e.g. tangibility)
Literature Review (continued)
Drobetz and Fix (2003)
used Swiss data to study the predictions of Static Tradeoff and Pecking order theories. Found that Swiss firms tended to use comparatively less leverage (compared with Anglo-American countries) and more profitable firms also exhibited less reliance on debt
Tahir and Hijazi (2006)
Studied the capital structure of listed cement companies in Pakistan Their aim was to study the unique attributes of this sector and how its capital structure decisions differ from other listed firms. They found that growth, tangibility and profitability had significant impact on leverage, whereas size did not seem to impact leverage considerably
Theories of capital structure
Static Trade-off Theory
Firms target an optimal debt ratio believing that such ratio will maximize the value of the firm. The optimal point is achieved when the marginal benefit of issuing debt equals the increase in the costs associated with issuing more debt
Pecking Order Theory firms prefer to finance their investments with internally generated funds as opposed to external financing. When external financing is required, managers tend to prefer debt financing over equity
Agency Theory
This theory states that an optimum capital structure results from minimization of the costs arising from conflicts between shareholders and debt-holders
Data and Variables
Data mainly obtained from ‘Balance Sheet Analysis of t Stock Companies’ compiled by State Bank of Pakistan for the period 2004-2008 (five years)
Data and Variables (continued)
Leverage: total debt to total assets
Tangibility: Fixed Assets (net)/ Total Assets
Size: Log of total sales
Profitability: Earnings before taxes/ total assets
Growth: Percentage change in total assets over the previous year
Sectors Sectors in the energy sector: Oil & Gas Marketing Companies Oil & Gas Exploration Companies Refineries Power Generation Companies
Research Methodology Regression
analysis using the following model:
L = β1 (T) + β2 (S) + β3 (G) + β4 (P) + ε Where L = Leverage T = Tangibility of assets S = Size of the firm G = Growth P = Profitability ε = the error term
Results Variable
Observed Relationship
Expected Relationship in Static Trade-off Theory
Expected Relationship in Pecking Order Theory
Tangibility
Positive
Positive
Negative
Size
Positive
Positive
Negative
Growth
Positive
Negative
Positive/ Negative*
Profitability
Negative
Positive
Negative
Conclusion
Predictive capability of these capital structure theories is rather mixed, as no single theory completely explains the behavior of financial decision makers in the listed firms in Pakistani energy sector.
In Pakistan, power sector firms with more tangible assets use greater debt which may be due to the collateral value of their assets and ease of obtaining financing
For Pakistani energy sector firms, size was found to be positively associated with leverage suggesting that larger firms tend to use higher leverage. The reasons could be lower bankruptcy risks in larger firms, more diversified portfolio and ease of obtaining financing
Growth, was found to be positively associated with leverage which s the simple version of pecking order theory (which states that growth firms would finance the expanding operations by incurring more debt)
Conclusion
Profitability - was found to be negatively associated with leverage ing the view of Pecking Order Theory that profitable firms tend to have less leverage due to availability of internally generated funds
As no single model completely explains the behavior of managers in the Pakistani energy sector companies with regard to capital choice decisions, it could be deduced that capital choice decisions are more complex than predicted by these theories and there is a need for further research to come up with a model that better explains these decisions.
Areas for further research
Using different measures of leverage e.g. Short term and Long term debt
Incorporating both book value and Market value of debt
Including a larger sample of companies and doing intra-sector comparisons
Differentiating between different ownership structures
References
Bancel, F. and Mitto, U. (2002), ‘The Determinants of Capital Structure Choice: A Survey of European Firms’, AFA 2003 Washington, DC Meetings; EFMA 2002 London Meetings, Available at SSRN: papers.ssrn.com/sol3/papers.cfm?abstract_id=299172 (Accessed: June 05, 2009) Booth, L., Aivazian, V., Demirguc-Kunt, A. and V. Maksmivoc (2001), ‘Capital structures in developing countries’, Journal of Finance 56, pp.87-130. Brealy, R., Myers, S. and Marcus, A. (1995), Fundamentals of Corporate Finance, International Edition, McGraw Hill, Inc. Buferna, F., Bangassa, K. and Hodgkinson, L. (2005), ‘Determinants of Capital Structure – Evidence from Libya’, University of Liverpool Research Paper Series No.2005/08, ISSN 1744-0718 Chen, L., Lensink, R. and Sterken, E. (1998), ‘The Determinants of Capital Structure: Evidence from Dutch Data’, European Economic Association Annual Congress, Berlin, September 2-5, 1998 Chiarella, C., Pham, T., Sim, A.B, and Tan, M. (1991), ‘Determinants of Corporate Capital Structure: Australian Evidence’ “University of Technology, Sydney – School of Finance and Economics Working Paper” Daskalakis, N. and Psillaki, M. (2003), ‘The Determinants of Capital Structure of the SMEs: Evidence from the Greek and the French firms’, Available at: http://www.univorleans.fr/DEG/GDRecomofi/Activ/psillaki_strasbg05.pdf (Accessed: June 10, 2009) Devic, A. and Krstic, B. (2001) Comparatible Analysis of The Capital Structure Determinants in Polish and Hungarian Enterprises – Empirical Study, part of the project "Economic Efficiency of Development Strategies of Enterprise in Market Economy - Possibilities and ways for improvement" (No. 1406) - Ministry of Science, Technology and Development - Republic of Serbia. Drobetz, W. and Fix, R. (2003), ‘What are the determinants of capital structure? Some evidence for Switzerland’; University of Basel, WWZ/ Department of Finance, Working Paper No. 4/03 Harris, M. and A. Raviv, (1990) Capital structure and the informational role of debt, Journal of Finance 45, pp. 321-349
References (continued)
Jensen, M., and W. Meckling, (1976), ‘Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure’, Journal of Financial Economics 3, pp. 305-360. Modigliani, F. and Miller, M., (1958), ‘The Cost of Capital, Corporation Finance and the Theory of Investment’, The American Economic Review, Vol. 48, pp. 433-443 Myers, S., and N. Majluf, (1984), ‘Corporate Financing and Investment Decisions When Firms Have Information Investors Do Not Have’, Journal of Financial Economics, 13, pp. 187-222. Myers, S.C., (1977), ‘Determinants of Corporate Borrowing’, Journal of Financial Economics, Vol. 5., pp. 147-175 Rajan, R. and Zingales, L., (1995), ‘What Do We Know about Capital Structure? Some Evidence from International Data’, The Journal of Finance, Vol. 50. pp.1421-1460 Sevil, G., Sayılır, O. and Yıldırım, S. (2005), ‘Determinants of Capital Structure: Evidence from Turkish Manufacturing Firms’, Available at: http://home.anadolu.edu.tr/~gsevil/capital.pdf (Accessed May 26, 2009) Hijazi, T. and Tariq, Y. (2006), ‘Determinants of Capital Structure: A Case for the Pakistani Cement Industry’, The Lahore Journal of Economics, 11:1, (Summer 2006), pp. 63-80 Shah, A. and Hijazi, T. (2004), ‘The Determinants of Capital Structure of Stock Exchange-listed Non-financial Firms in Pakistan’, The Pakistan Development Review, 43:4, Part II, pp. 605-618 State Bank of Bank of Pakistan, ‘Balance Sheet Analysis of t Stock Companies Listed on The Karachi Stock Exchange’ - 2008 Titman, S. and Wessels, R., (1988), ‘The Determinants of Capital Structure Choice’, The Journal of Finance, Vol. 43, No.1, pp. 1-19
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