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 Managers 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

Exchanges 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 Pakistans 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 firms expected growth,
tax shields, volatility or tangibility of assets. However, they found
profitability to be negatively associated with firms 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 Joint 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 = 1 (T) + 2 (S) + 3 (G) + 4 (P) +

Where
L = Leverage
T = Tangibility of assets
S = Size of the firm
G = Growth
P = Profitability
= 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

supports 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

supporting 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

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