The Capital Structure Enigma: Perspective of an Emerging Market

Abstract

The broader theme of this research was to understand the determinants of Capital Structure of firms and analyze their importance for an emerging market like Pakistan. There were three cornerstones of this research. Firstly, it analyzed the existing debt structures of Pakistani firms and the associated reasoning behind their borrowing decisions. The results of this research supported the trade-off theory in general. We observed that firms in Pakistan were trying to maintain a targeted debt ratio, leading to the existence of Trade-off Theory, while signs of Pecking Order Theory, to explain the borrowing pattern of sampled firms, were almost non-existent. The results were found to be consistent not only across different industries, but also in firms of different sizes. The second paper of this research investigated the relationship between the determinants, of debt financing, and debt ratios, treating the life-cycle stage as a moderating variable. Debt ratios of firms were found to vary across different life-cycle stages. The life-cycle stage of a firm was found to moderate the relationships of two main determinants of debt financing with the debt ratios of a firm, which were: Tangibility of Assets, and Non-Debt Tax Shields; but the life-cycle stage was not found moderating the relationship of Profitability with Debt Ratios. Size and growth came out to be insignificant determinants of Debt ratios. In the third paper the survey approach was used to collect primary data. Finance managers of sampled firms (i.e. the decision makers) were directly asked the reasons that they considered important in their borrowing decision. Results suggested that the managers in Pakistan preferred to use internally generated equity funds for financing, followed by taking bank loans, as their second option. The decision makers considered ensuring long term sustainability of firms, and a constant flow of funds, as the two most important determinant for their decision to borrow. Exploratory Factor analysis was done to reduce the number of these indicators, related to manager’s decision to borrow, into six factors. These include Market Interactions, Cash Management, Costs, Share Price, Agency Costs, and Asymmetric Information. The measurement model of six latent factors was tested using a Confirmatory Factor Analysis; and then Path analysis was conducted that helped in finding out that Market Interactions, Costs and Agency Costs had a significant impact on a manager’s preference to borrow.