Description
It published in impact factor journal.
Science Series Data Report
Vol 4, No. 9;Sep 2012
Determinants of Capital Structure: Empirical Analysis of Fuel and Energy sector of Pakistan Syed Qasim Shah 1 Syed Imtasal Shah 2 Uzma Mehmood Raja 3 Dr. Imran Naseem 4
1. Syed Qasim Shah, Lecturer, Department of Management Sciences, COMSATS Institute of Information Technology, Abbottabad, Pakistan. [email protected] +92-334-8971880
2. Syed Imtasal Shah Student of MBA (1.5), COMSATS Institute of Information Technology, Abbottabad, Pakistan. Uzma Mehmood Raja 3. Lecturer, Department of Management Sciences, COMSATS Institute of Information Technology, Abbottabad, Pakistan. 4. Dr. Imran Naseem Asst. Professor, Department of Management Sciences, COMSATS Institute of Information Technology, Abbottabad, Pakistan.
95
[email protected]
Electronic copy available at:http://ssrn.com/abstract=2154095
Science Series Data Report
Vol 4, No. 9;Sep 2012
5. Determinants of Capital Structure: Empirical Analysis of Fuel and Energy sector of Pakistan Syed Qasim Shah And Syed Imtasal Shah Abstract: The main purpose of this study was to identify the factors that influence the portion of debt financing. We have selected the whole fuel and energy firms for the purpose of analysis which comprises of 18 listed firms. The analyses are for the period 2006-2010. Regression results showed that profitability and Tangibility has a negative association with the debt financing and support Pecking Order Theory. The result of size shows positive relationship with leverage of the firm and supports trade off theory. The result of growth shows positive association and support Pecking order theory.
1. Introduction: Capital Structure is said to be one of the controversial topics in the field of corporate finance and financial management. It is generally defined as “way firm assets are financed through debt, hybrid securities or equity” (Shah and Hijazi 2004). Value of firm’s Capital Structure has always been burning issue. From management perspective capital structure is a very healthy mean to control the cost of capital. Different ways of financing assets can be adopted by a company and the key objective is to attain the optimal capital structure where cost of capital is low. Modigliani and Miller (1958) did the pioneering work in the field of capital structure by presenting Irrelevance theory in 1958. They described that value of the firm is independent of its capital structure. Their theory is founded on efficient market where there are no taxes, bankruptcy cost, agency cost and asymmetric information. Trade-off theory says that the firm controls the optimal capital structure as a trade-off between interest tax shield and cost of financial distress. According to trade-off theory, firm optimal capital structure is the point where
96
[email protected]
Electronic copy available at:http://ssrn.com/abstract=2154095
Science Series Data Report
Vol 4, No. 9;Sep 2012
the tax advantages availed by debt financing balances and the related cost such as bankruptcy. Static trade-off theory more assumes that a firm cannot constantly engage in reducing the cost of capital by employing more debt. There is an optimal point where the cost of capital is at minimum and if the firm goes above that optimal point the debt financing becomes riskier. This study mainly addresses core research question, i.e. what are the determinants of capital structure in Fuel and energy sector of Pakistan? There are various worldwide studies showing various results about companies financing behavior. Shah and Hijazi (2004) did the founding work in Pakistan with regard to the capital structure. We are specifically focusing on the fuel and energy sector because it is considered as a largest sector in Pakistan which is largest with regard to consumption and this sector’s performance can make a solid and substantial impact on the economic development of Pakistan. 2. Overview of Fuel and Energy Sector of Pakistan The importance of fuel energy has been much known with respect to the old-style factors of production, specifically land, labor, entrepreneurship and capital. There is a strong relationship of this sector with economy of the country. Supply and Demand of this sector has a massive impact on economic development of country. Since the start of this century fuel and energy sector has seen lot of changes and volatility and its consumption has been increased by 9 million barrels a day. The fuel and energy sector in Pakistan includes gas, oil, and power. Country’s GDP growth rate is 6.6 % and energy sector’s growth rate is 8.6%. Pakistan has indigenous reserves of natural gas, oil and coal, which offer 61.0 percent (24.7 million Tons of Oils equivalent) of the total net primary energy supplies. The essential energy supply consists of natural gas (51 percent), oil (28 percent), hydroelectricity (13.0 percent), coal (7 percent) and other sources (1 percent), (Economic Survey 2010-11). In Pakistan, due to mixture of increased oil utilization and stable oil production, the oil import has increased. Demand of gas increased
97
[email protected]
Science Series Data Report
Vol 4, No. 9;Sep 2012
with 7 percent, electricity demand has also increased rapidly. From the following figure we have observed that energy sector is the largest sector by size in Pakistan’s economy.
Demand of Fuel and energy in Pakistan had grown-up at an annual consumption growth rate of 4.8% in previous five years. On the other side there is chance that it can grow at 8 to 10% per annum. For that reason, demand is also very high for a very extraordinary and constant growth in supply of fuel and energy. The consumption of Fuel and energy is 43.8 %, including Natural Gas 39 %, Oil 11 %, Hydroelectricity 5.2 % ,Coal 1 % .The Sectorial Share of Energy Consumption in Pakistan includes 34.4% Transportation, 34.2 %, Industrial 23 %, Residential 3.1 %, Commercial 2.6 %, Agriculture 2.7 %,. Current predictions of Government of Pakistan about the energy sector are that the deficit in energy will increase from 29 percent to 46 percent by 2015 (Economic Survey 2010-11). 3. Literature review: Shah and Hijazi (2004) argued that if the firm is large in size, the administrative cost of bankruptcy is not considered- as it is very low. But the case is reverse for the smaller firms as direct cost will work as an important and dynamic variable in determining the level of debt. The indirect cost of bankruptcy is linked to the change in investment policies. Due to likely future
98
[email protected]
Science Series Data Report
Vol 4, No. 9;Sep 2012
financial distress firm do not favor investing in research and development and advertisement therefore the level of trust between the firm ability to keep quality and customers decreases. Deficit in trust results in hefty drop of sales share price of the firm is also decreased. Jensen and Meckling (1976) stated that the firm optimal capital structure is a point where there is minimum cost of capital which is strongly determined by the agency cost. All of this started with the philosophy of Principal –agent problem and the conflict of interest. Agency theory certainly has some implications on the firm capital structure. Jensen (1986) Postulated one of the key problems that is availability of free cash flow to the managers. Free cash flow can be defined as the cash flow accessible to the firm after funding all the projects. As discussed earlier managers work as agent to the shareholders who have less than 100 percent stake in business, they try to use the free cash flow sub optimally and objective is to use for their personal benefits and advantages instead increasing the firm’s value. The sub optimal usage of free cash flow is an attempt for increasing the firm size so managers can have greater compensation. One resolution for this problem is suggested by Jensen (1986) that this problem can be controlled by increasing the interest of managers in the business and also adjusting their interests with the firm. One other way is to control the availability of free cash flow to the managers is by increasing the debt financing in firms capital structure. Shah and khan (2007) stated that decrease in availability of free cash flow to the managers due to inviting more debt is an advantage of debt financing. Myers and Majluf (1984) presented Pecking order theory (POT). It is considered as a seriously significant theory of corporate finance. Pecking order theory is based on an exact pattern of financing. It states that the firm will use a specific pattern while forming its capital structure. Initially a firm will finance its projects through internally generated funds i.e. retained earnings.
99
[email protected]
Science Series Data Report
Vol 4, No. 9;Sep 2012
If they are not enough firm will go for debt financing and at the end it will issue equity to finance its projects. POT is also considered as an alternate against the conventional trade-off theory. POT is considered as a good estimate of reality but testing of pecking order theory and the empirical evidences are not strongly sufficient to show that this theory should be considered as of first order importance in determining firms’ capital structure. Frank and Goyal (2000) tested the pecking order theory on extensive cross section of U.S firms over the period 1980-1998. They overruled all of the empirical predictions of the pecking order theory. They basically found that firms financing deficit cannot necessarily determine the corporate debt level. Correa et al (2005) studied the hypothesized prediction of the Pecking Order theory and trade off theory. They studied the Brazilian companies. Large sample of five hundred listed Brazilian companies was taken without the financial sector firms. In their study Pecking Order Theory had more support regarding its empirical hypothesis. Mutalib (2011) worked on the relationship of firm characteristics on its debt financing. He studied on Nigerian companies to test the two formal theories by cross sectional analysis. He mainly studied the firms from the Cement sector of Nigeria. In their finding, Agency cost theory hypothesis is rejected because of the observed positive sign with growth. Profitability unexpectedly came out to be insignificant which is in strong contradiction with the earlier researches along with ENVL (volatility in earnings). Size maintained the asymmetric information philosophy. Datta and Agarwal (2009) did analysis on the Indian financial sector. Their key objective was to study the corporate determinants of the Indian firms when the growth was massive in the boom of the economy. Their results support for Pecking order theory. Results of size showed support to Trade off theory. 4. Research Methodology: Sample
100
[email protected]
Science Series Data Report
Vol 4, No. 9;Sep 2012
This study is focusing on Fuel and Energy Sector of Pakistan. 20 companies have been selected on the basis of purposive sampling for study but after adjustments we left with 17 companies due to non availibity of data. The data has been taken from “Balance Sheet Analysis of Joint Stock Listed companies “issued by State Bank of Pakistan (SBP) from the period 2005-2010”. Variables of the study Dependent Variable Leverage Leverage is defined as “Ratio of assets financed by debt” (Rafique et al. 2008). Earlier different researchers used different measures of leverage. Frank and Goyal (2003) argued that the differences in debt ratios established when it is measured on the base of book value and market value. Independent variables Profitability Profitability makes a substantial impact over the short run and long run on the business performance of a firm. Shah (2007) stated the importance of profitability from the long run side that if a business is to run uninterruptedly then firm must earn a suitable return. In the short run, enough profit earning is required to pay for variable cost and also for some short term reply to minimize losses. In this research we are expecting a negative relationship of profitability with leverage consistent with the pecking order hypothesis. H1: There is negative relationship between profitability and leverage. Size: According pecking order theory Rajan and Zingales (1995) argued that the relationship between size and leverage will be negative because of a reason that large firms having less asymmetric
101
[email protected]
Science Series Data Report
Vol 4, No. 9;Sep 2012
information certainly leads to more equity issuance as they can issue the equity at fair prices. On the other hand according to trade-off theory relationship between size and leverage will be positive as Shah and Hijazi (2004) stated that larger firms are more diversified they have less chances of bankruptcy backing them to use more debt financing. H 2: Size of the firm is positively related to firms leverage Tangibility Static trade-off theory is of the opinion that firms with more fixed assets will go for more debt financing as it will work as surety against the loan as for the firms having large amount of fixed assets have low agency. Rafique et al.(2008) find positive relationship of ratio of fixed assets with leverage. Therefore our third hypothesis will be consistent with the empirical predictions of the trade-off theory. H 3: Firms with higher ratio of fixed assets will borrow more. Growth Myers and Majluf,1984;Shah and Hijazi,2004 support pecking order theory and find positive relation of growth and leverage. Growth is expected to be consistent with empirical predictions of pecking order. Thus a positive relationship between growth and leverage is expected. H 4: There is positive relationship between growth and leverage. Table-1: Detail of variables Independent variables Dependent variable Total Leverage assets debt/total Proxy Expected Empirical relationship leverage with theory prediction of
102
[email protected]
Science Series Data Report
Vol 4, No. 9;Sep 2012
Profitability
EBIT/total assets
Negative
Consistent order theory Consistent
with
pecking
with
trade-off
Size
N(log) sales
Positive theory
Total Tangibility
fixed Positive
Consistent theory
with
trade-off
assets/total assets %age Growth total assets change in Positive
Consistent order theory
with
pecking
5. Data Analysis Technique and Model. This research uses panel data regression model using pooled regression type of data analysis, correlation and descriptive statistics. E-views package is used for analysis. We used following model for analysis.
Where LG = Leverage TAN = Tangibility SZ = Size PROF = Profitability GR = Growth € = Error term
103
[email protected]
Science Series Data Report
Vol 4, No. 9;Sep 2012
6. Analysis and Discussion: Descriptive statistics Tabel-2: Results of Descriptive Analysis Leverage Mean Median Maximum Minimum Standard deviation No of obs. 102 102 102 102 102 0.434237 0.490221 0.868451 0.006774 0.250397 Profitability 0.059862 0.042168 0.534481 -0.139316 0.127277 Tangibility 15.27866 15.48065 18.94502 8.883086 2.774338 Size 0.703180 0.730378 0.983174 0.289375 0.146895 Growth 0.425549 0.066721 33.47415 -0.409959 3.309091
Table 2 provides a result of the descriptive statistics for our dependent and independent variables. Descriptive statistics shows that the fuel sector and energy use average debt financing in its capital structure. The mean value of 0.43 shows average debt ratio of this industry or 43 percent of the total assets are financed through debt. The value of standard deviation is 25 percent which indicates average change in debt financing and we can easily say that in numerous cases the firms have more debt to their assets. But here average equity financing is 57 percent which is quite high. Mean of the profitability shows that condition of the industry is not appreciable as the average profitability ratio is 5 percent with the standard deviation of 12 percent for fuel and energy sector which is considered to be the biggest sector of Pakistan in terms of its consumption. Mean of tangibility for the whole industry is very high as the mean
104
[email protected]
Science Series Data Report
Vol 4, No. 9;Sep 2012
value is 15.27. Theoretically and ideally value should be less than 1. Shah and Hijazi (2004) described that the ratio of more than 1 for tangibility indicates the greater gross value of the assets that are depreciated but not yet disposed off and the firm has enough number of these assets that’s why the gross value is greater than the total depreciated value. The average of a size is very high and 0.70 percent while mean of growth for fuel and energy sector is 42 percent. Correlation Analysis:
Table-3: Results of Correlation Analysis Profitability Profitability Size Tangibility Growth 1 0.5097 -0.5109 -0.0482 Size 0.5097 1 -0.3401 0.0476 Tangibility -0.5109 -0.3401 1 0.0793 Growth -0.0482 0.0476 0.0793 1
Table 3 shows the result of correlations between the independent variables. Table shows that there is no evidence of multi co linearity among the four independent variables. The highest positive correlation between two variables is 0.5097 and this correlation is between profitability and size. Now we shall argue each and every relationship of our independent variables. There is a negative correlation between tangibility of a firm and its profitability. One exciting correlation is between the size and tangibility of the firm which shows firms which are smaller in size have higher percentage of fixed assets to total assets while that firms that are large in size keep less amount of fixed asset. Tangibility is positively linked to growth of the firm signifying that growing firms have more amounts of fixed assets. Profitability is positively linked to size of the firm which shows that firms with the large size are profitable. Profitability is negatively
105
[email protected]
Science Series Data Report
Vol 4, No. 9;Sep 2012
correlated with growth which shows that growing firms are less profitable. The last observation is that firm’s size is positively correlated to the growth of the firm. Positive relationship is because large firms have enough capacity to invest and are generally considered to be financially strong and invest more in research and development which increases the growth opportunities for generating high profits. Regression Analysis: Table-4: Results of Regression Variable CONSTANT Coefficient 0.177924 Std. Error 0.252426 0.236570 0.012592 0.198717 0.005744 t-Statistic 0.704856 -2.406159 3.434403 -2.765616 0.513744 Prob. 0.4826 0.0181 0.0009 0.0068 0.6086
PROFITABILITY -0.569224 SIZE TANGIBILITY GROWTH Profitability 0.043246 -0.549576 0.002951
First independent variable of our study is profitability. This result indicates that firm’s profitability is negatively related to the dependent variable (Leverage). Profitability has a negative coefficient -0.569224 which shows the strong relationship of profitability with leverage. This relationship shows that when there is 1 percent increase in firm’s profitability there is a negative impact (decrease) on leverage by -0.569224 percent. Our initial hypothesis for this variable was in the support of POT and suggested the relationship between dependent variable (leverage) and profitability of a firm is negative. The results favor empirical prediction of the pecking order theory and also the view of Myers and Majluf (1984) that profitable firms prefer the internally generated funds first before using any debt financing. Results are also consistent with shah and
106
[email protected]
Science Series Data Report
Vol 4, No. 9;Sep 2012
Hijazi (2004). Profitability has a t- statistic -2.406159 and probability value of 0.0181. The pvalue of 0.0181 also shows that the relationship between profitability and leverage is statistically significant at 2 percent. As a result we accept our first hypothesis regarding profitability and leverage and we can confirm that pecking order Theory has support in Fuel and Energy Sector of Pakistan regarding Independent variable (profitability) and leverage of the firm. Size The result of size shows positive relationship of size and leverage of the firm. Size observed a positive coefficient of 0.043246 which suggests that leverage of the firm increases when the firm size is large. Our initial hypothesis about size of the firm was consistent with trade-off theory that suggested the positive relationship of size with leverage of firm; the reason is that direct bankruptcy cost is well spread in large firms. The results confirm the empirical prediction of the static trade-off. Therefore we accept our earlier hypothesis about the size of the firm. The results are also consistent with the result of shah and Hijazi (2004) who also observed the positive link of size and leverage. The t-statistic of size is 3.434403 and p-value is 0.0009 which shows the statistically significant relationship. We can confirm the empirical prediction of static trade off theory has more backing regarding relationship between firm’s size and leverage in its capital structure. Tangibility The results show that tangibility has negative relationship with leverage. Tangibility found a negative coefficient of -0.549576 which shows that tangibility is negatively correlated with debt financing therefore the negative coefficient reject our earlier hypothesis of positive relationship between tangibility and leverage. The results are contradictory with the findings of shah and Hijazi (2004). Negative relationship of tangibility also rejects the static trade-off version of
107
[email protected]
Science Series Data Report
Vol 4, No. 9;Sep 2012
Jensen and Meckling (1976) which includes agency cost of leverage. The negative coefficient shows that firms that have higher share of fixed assets will use less debt financing in their capital structure. T-statistic of tangibility is -2.765616 and p-value is 0.0068 which show the statistically significant relation. The results reject our earlier hypothesis about the empirical prediction of trade off theory. Therefore we can definitely confirm that pecking order theory has more empirical support in the fuel and energy sector of Pakistan regarding its relationship with leverage. Growth The result of growth is found to be positive which suggests firms that are growing will use more debt financing in their capital structure. Growth observed a positive coefficient of 0.002951 which confirms our earlier hypothesis to the empirical prediction of pecking order theory. Our initial hypothesis about growth was also based on the empirical prediction of extended version of POT. However this result is also constant with the findings of Rafique et al. (2008) who also observed a positive relation of growth with leverage. On the other hand statistically this relationship is not found to be significant as growth has t-statistic of 0.513744 and p value of 0.6086 which indicates that the results are not reliable. Thus we reject the empirical prediction of both formal conventional theories i-e pecking order and trade-off and also rejects our hypothesis. Table 6. Overall results and relationship with theories Dependent independent variables Leverage Profitability Total debt/total assets EBIT/total assets Negative Consistent with Proxy Observed relationship Empirical prediction of theory
pecking order theory
108
[email protected]
Science Series Data Report
Vol 4, No. 9;Sep 2012
Size
N log sales
Positive
Consistent
with
trade-off order theory Tangibility Total fixed Negative Consistent with
assets/total assets Growth %age change in total assets Positive
pecking order theory Consistent pecking order with
7. Conclusion This research basically analyzed the determinants of corporate financing structure to measure the formal theories presented by well-known finance scholars. Focus has been on the fuel and energy sector of Pakistan particularly as it is the biggest sector and which contributes greatly in the development of the economy. The main purpose of this study was to identify the factors that influence the portion of debt financing. Four hypotheses were constructed based on the hypothesized prediction of the (TOT) and (POT) to test these theories. Two of the hypothesis regarding size and tangibility were consistent with the (TOT) representing their positive association with debt financing whiles the other two hypotheses were consistent with the (POT) regarding the profitability and Growth of the company indicating their negative association with debt financing. For the purpose of analysis we have applied pooled regression, as a sample, consists of only companies from the fuel and energy sector with no heterogeneity across the cross sections.
109
[email protected]
Science Series Data Report
Vol 4, No. 9;Sep 2012
References Correa, C.A., Basso, L.F.C.B., Nakamura, W.T. (2005), “What determines the capital structure of the largest brazilian firms”? An Empirical analysis using panel data. Datta, D. & Agarwal, B. (2009), “Determinants of Capital Structure of Indian Corporate Sector in the Period of Bull Run 2003-2007 - An Econometric Study. Frank, M.Z, and Goyal, V.K. (2003), “Testing the Pecking Order Theory of Capital Structure,” Journal of Financial Economics, 67(2): 217-248. Jensen, M. (1986), “Agency Costs of Free Cash Flow, Corporate Finance and Takeovers. American Economic Review” 76:2, 323–329. Jensen, M. C. & Meckling, W. H. (1976), “Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure. Journal of Financial Economics” 3, 305–360. Modigliani, F. & Miller, M.H. (1958), “The Cost of Capital, Corporation Finance and the Theory of Investment” ‘The American Economic Review, 48(3): 261-297. Mutalib, M. (2011), “Determinants of capital structure in cement industry: a case of Nigerian listed cement firms”. Myers, S. & Majluf, N. (1984), “Corporate Financing and Investment Decisions When Firms Have Information Investors Do Not Have,” Journal of Financial Economics, 13: 187-222. Rafiq, M., Iqbal, A. & Atiq, M. (2008), “the Determinants of Capital Structure of the Chemical Industry in Pakistan’. The Lahore Journal of Economics, pp. 139-158. Rajan, R. & Zingales, L. (1995), “What Do We Know about Capital Structure? Some Evidence from International Data,” Journal of Finance, 50: 1421-1460.
110
[email protected]
Science Series Data Report
Vol 4, No. 9;Sep 2012
Shah, A. & Hijazi S. (2004), “The Determinants of Capital Structure in Pakistani Listed Non-Financial Firms,’ the Pakistan Development Review, 43. Shah, A. & Khan, S. (2007), “Determinants of Capital Structure: Evidence from Pakistani Panel Data, International Review of Business Research Papers Vol. 3, No.4, 265-282. Shah, S. M. A. (2007), “The Determinants of Corporate of Debt Policy –Pre and Post Financial Market Reforms (A Case from Textile Industry of Pakistan)’.
Pakistan Economic Survey 2010-11
111
[email protected]
doc_597220718.pdf
It published in impact factor journal.
Science Series Data Report
Vol 4, No. 9;Sep 2012
Determinants of Capital Structure: Empirical Analysis of Fuel and Energy sector of Pakistan Syed Qasim Shah 1 Syed Imtasal Shah 2 Uzma Mehmood Raja 3 Dr. Imran Naseem 4
1. Syed Qasim Shah, Lecturer, Department of Management Sciences, COMSATS Institute of Information Technology, Abbottabad, Pakistan. [email protected] +92-334-8971880
2. Syed Imtasal Shah Student of MBA (1.5), COMSATS Institute of Information Technology, Abbottabad, Pakistan. Uzma Mehmood Raja 3. Lecturer, Department of Management Sciences, COMSATS Institute of Information Technology, Abbottabad, Pakistan. 4. Dr. Imran Naseem Asst. Professor, Department of Management Sciences, COMSATS Institute of Information Technology, Abbottabad, Pakistan.
95
[email protected]
Electronic copy available at:http://ssrn.com/abstract=2154095
Science Series Data Report
Vol 4, No. 9;Sep 2012
5. Determinants of Capital Structure: Empirical Analysis of Fuel and Energy sector of Pakistan Syed Qasim Shah And Syed Imtasal Shah Abstract: The main purpose of this study was to identify the factors that influence the portion of debt financing. We have selected the whole fuel and energy firms for the purpose of analysis which comprises of 18 listed firms. The analyses are for the period 2006-2010. Regression results showed that profitability and Tangibility has a negative association with the debt financing and support Pecking Order Theory. The result of size shows positive relationship with leverage of the firm and supports trade off theory. The result of growth shows positive association and support Pecking order theory.
1. Introduction: Capital Structure is said to be one of the controversial topics in the field of corporate finance and financial management. It is generally defined as “way firm assets are financed through debt, hybrid securities or equity” (Shah and Hijazi 2004). Value of firm’s Capital Structure has always been burning issue. From management perspective capital structure is a very healthy mean to control the cost of capital. Different ways of financing assets can be adopted by a company and the key objective is to attain the optimal capital structure where cost of capital is low. Modigliani and Miller (1958) did the pioneering work in the field of capital structure by presenting Irrelevance theory in 1958. They described that value of the firm is independent of its capital structure. Their theory is founded on efficient market where there are no taxes, bankruptcy cost, agency cost and asymmetric information. Trade-off theory says that the firm controls the optimal capital structure as a trade-off between interest tax shield and cost of financial distress. According to trade-off theory, firm optimal capital structure is the point where
96
[email protected]
Electronic copy available at:http://ssrn.com/abstract=2154095
Science Series Data Report
Vol 4, No. 9;Sep 2012
the tax advantages availed by debt financing balances and the related cost such as bankruptcy. Static trade-off theory more assumes that a firm cannot constantly engage in reducing the cost of capital by employing more debt. There is an optimal point where the cost of capital is at minimum and if the firm goes above that optimal point the debt financing becomes riskier. This study mainly addresses core research question, i.e. what are the determinants of capital structure in Fuel and energy sector of Pakistan? There are various worldwide studies showing various results about companies financing behavior. Shah and Hijazi (2004) did the founding work in Pakistan with regard to the capital structure. We are specifically focusing on the fuel and energy sector because it is considered as a largest sector in Pakistan which is largest with regard to consumption and this sector’s performance can make a solid and substantial impact on the economic development of Pakistan. 2. Overview of Fuel and Energy Sector of Pakistan The importance of fuel energy has been much known with respect to the old-style factors of production, specifically land, labor, entrepreneurship and capital. There is a strong relationship of this sector with economy of the country. Supply and Demand of this sector has a massive impact on economic development of country. Since the start of this century fuel and energy sector has seen lot of changes and volatility and its consumption has been increased by 9 million barrels a day. The fuel and energy sector in Pakistan includes gas, oil, and power. Country’s GDP growth rate is 6.6 % and energy sector’s growth rate is 8.6%. Pakistan has indigenous reserves of natural gas, oil and coal, which offer 61.0 percent (24.7 million Tons of Oils equivalent) of the total net primary energy supplies. The essential energy supply consists of natural gas (51 percent), oil (28 percent), hydroelectricity (13.0 percent), coal (7 percent) and other sources (1 percent), (Economic Survey 2010-11). In Pakistan, due to mixture of increased oil utilization and stable oil production, the oil import has increased. Demand of gas increased
97
[email protected]
Science Series Data Report
Vol 4, No. 9;Sep 2012
with 7 percent, electricity demand has also increased rapidly. From the following figure we have observed that energy sector is the largest sector by size in Pakistan’s economy.
Demand of Fuel and energy in Pakistan had grown-up at an annual consumption growth rate of 4.8% in previous five years. On the other side there is chance that it can grow at 8 to 10% per annum. For that reason, demand is also very high for a very extraordinary and constant growth in supply of fuel and energy. The consumption of Fuel and energy is 43.8 %, including Natural Gas 39 %, Oil 11 %, Hydroelectricity 5.2 % ,Coal 1 % .The Sectorial Share of Energy Consumption in Pakistan includes 34.4% Transportation, 34.2 %, Industrial 23 %, Residential 3.1 %, Commercial 2.6 %, Agriculture 2.7 %,. Current predictions of Government of Pakistan about the energy sector are that the deficit in energy will increase from 29 percent to 46 percent by 2015 (Economic Survey 2010-11). 3. Literature review: Shah and Hijazi (2004) argued that if the firm is large in size, the administrative cost of bankruptcy is not considered- as it is very low. But the case is reverse for the smaller firms as direct cost will work as an important and dynamic variable in determining the level of debt. The indirect cost of bankruptcy is linked to the change in investment policies. Due to likely future
98
[email protected]
Science Series Data Report
Vol 4, No. 9;Sep 2012
financial distress firm do not favor investing in research and development and advertisement therefore the level of trust between the firm ability to keep quality and customers decreases. Deficit in trust results in hefty drop of sales share price of the firm is also decreased. Jensen and Meckling (1976) stated that the firm optimal capital structure is a point where there is minimum cost of capital which is strongly determined by the agency cost. All of this started with the philosophy of Principal –agent problem and the conflict of interest. Agency theory certainly has some implications on the firm capital structure. Jensen (1986) Postulated one of the key problems that is availability of free cash flow to the managers. Free cash flow can be defined as the cash flow accessible to the firm after funding all the projects. As discussed earlier managers work as agent to the shareholders who have less than 100 percent stake in business, they try to use the free cash flow sub optimally and objective is to use for their personal benefits and advantages instead increasing the firm’s value. The sub optimal usage of free cash flow is an attempt for increasing the firm size so managers can have greater compensation. One resolution for this problem is suggested by Jensen (1986) that this problem can be controlled by increasing the interest of managers in the business and also adjusting their interests with the firm. One other way is to control the availability of free cash flow to the managers is by increasing the debt financing in firms capital structure. Shah and khan (2007) stated that decrease in availability of free cash flow to the managers due to inviting more debt is an advantage of debt financing. Myers and Majluf (1984) presented Pecking order theory (POT). It is considered as a seriously significant theory of corporate finance. Pecking order theory is based on an exact pattern of financing. It states that the firm will use a specific pattern while forming its capital structure. Initially a firm will finance its projects through internally generated funds i.e. retained earnings.
99
[email protected]
Science Series Data Report
Vol 4, No. 9;Sep 2012
If they are not enough firm will go for debt financing and at the end it will issue equity to finance its projects. POT is also considered as an alternate against the conventional trade-off theory. POT is considered as a good estimate of reality but testing of pecking order theory and the empirical evidences are not strongly sufficient to show that this theory should be considered as of first order importance in determining firms’ capital structure. Frank and Goyal (2000) tested the pecking order theory on extensive cross section of U.S firms over the period 1980-1998. They overruled all of the empirical predictions of the pecking order theory. They basically found that firms financing deficit cannot necessarily determine the corporate debt level. Correa et al (2005) studied the hypothesized prediction of the Pecking Order theory and trade off theory. They studied the Brazilian companies. Large sample of five hundred listed Brazilian companies was taken without the financial sector firms. In their study Pecking Order Theory had more support regarding its empirical hypothesis. Mutalib (2011) worked on the relationship of firm characteristics on its debt financing. He studied on Nigerian companies to test the two formal theories by cross sectional analysis. He mainly studied the firms from the Cement sector of Nigeria. In their finding, Agency cost theory hypothesis is rejected because of the observed positive sign with growth. Profitability unexpectedly came out to be insignificant which is in strong contradiction with the earlier researches along with ENVL (volatility in earnings). Size maintained the asymmetric information philosophy. Datta and Agarwal (2009) did analysis on the Indian financial sector. Their key objective was to study the corporate determinants of the Indian firms when the growth was massive in the boom of the economy. Their results support for Pecking order theory. Results of size showed support to Trade off theory. 4. Research Methodology: Sample
100
[email protected]
Science Series Data Report
Vol 4, No. 9;Sep 2012
This study is focusing on Fuel and Energy Sector of Pakistan. 20 companies have been selected on the basis of purposive sampling for study but after adjustments we left with 17 companies due to non availibity of data. The data has been taken from “Balance Sheet Analysis of Joint Stock Listed companies “issued by State Bank of Pakistan (SBP) from the period 2005-2010”. Variables of the study Dependent Variable Leverage Leverage is defined as “Ratio of assets financed by debt” (Rafique et al. 2008). Earlier different researchers used different measures of leverage. Frank and Goyal (2003) argued that the differences in debt ratios established when it is measured on the base of book value and market value. Independent variables Profitability Profitability makes a substantial impact over the short run and long run on the business performance of a firm. Shah (2007) stated the importance of profitability from the long run side that if a business is to run uninterruptedly then firm must earn a suitable return. In the short run, enough profit earning is required to pay for variable cost and also for some short term reply to minimize losses. In this research we are expecting a negative relationship of profitability with leverage consistent with the pecking order hypothesis. H1: There is negative relationship between profitability and leverage. Size: According pecking order theory Rajan and Zingales (1995) argued that the relationship between size and leverage will be negative because of a reason that large firms having less asymmetric
101
[email protected]
Science Series Data Report
Vol 4, No. 9;Sep 2012
information certainly leads to more equity issuance as they can issue the equity at fair prices. On the other hand according to trade-off theory relationship between size and leverage will be positive as Shah and Hijazi (2004) stated that larger firms are more diversified they have less chances of bankruptcy backing them to use more debt financing. H 2: Size of the firm is positively related to firms leverage Tangibility Static trade-off theory is of the opinion that firms with more fixed assets will go for more debt financing as it will work as surety against the loan as for the firms having large amount of fixed assets have low agency. Rafique et al.(2008) find positive relationship of ratio of fixed assets with leverage. Therefore our third hypothesis will be consistent with the empirical predictions of the trade-off theory. H 3: Firms with higher ratio of fixed assets will borrow more. Growth Myers and Majluf,1984;Shah and Hijazi,2004 support pecking order theory and find positive relation of growth and leverage. Growth is expected to be consistent with empirical predictions of pecking order. Thus a positive relationship between growth and leverage is expected. H 4: There is positive relationship between growth and leverage. Table-1: Detail of variables Independent variables Dependent variable Total Leverage assets debt/total Proxy Expected Empirical relationship leverage with theory prediction of
102
[email protected]
Science Series Data Report
Vol 4, No. 9;Sep 2012
Profitability
EBIT/total assets
Negative
Consistent order theory Consistent
with
pecking
with
trade-off
Size
N(log) sales
Positive theory
Total Tangibility
fixed Positive
Consistent theory
with
trade-off
assets/total assets %age Growth total assets change in Positive
Consistent order theory
with
pecking
5. Data Analysis Technique and Model. This research uses panel data regression model using pooled regression type of data analysis, correlation and descriptive statistics. E-views package is used for analysis. We used following model for analysis.
Where LG = Leverage TAN = Tangibility SZ = Size PROF = Profitability GR = Growth € = Error term
103
[email protected]
Science Series Data Report
Vol 4, No. 9;Sep 2012
6. Analysis and Discussion: Descriptive statistics Tabel-2: Results of Descriptive Analysis Leverage Mean Median Maximum Minimum Standard deviation No of obs. 102 102 102 102 102 0.434237 0.490221 0.868451 0.006774 0.250397 Profitability 0.059862 0.042168 0.534481 -0.139316 0.127277 Tangibility 15.27866 15.48065 18.94502 8.883086 2.774338 Size 0.703180 0.730378 0.983174 0.289375 0.146895 Growth 0.425549 0.066721 33.47415 -0.409959 3.309091
Table 2 provides a result of the descriptive statistics for our dependent and independent variables. Descriptive statistics shows that the fuel sector and energy use average debt financing in its capital structure. The mean value of 0.43 shows average debt ratio of this industry or 43 percent of the total assets are financed through debt. The value of standard deviation is 25 percent which indicates average change in debt financing and we can easily say that in numerous cases the firms have more debt to their assets. But here average equity financing is 57 percent which is quite high. Mean of the profitability shows that condition of the industry is not appreciable as the average profitability ratio is 5 percent with the standard deviation of 12 percent for fuel and energy sector which is considered to be the biggest sector of Pakistan in terms of its consumption. Mean of tangibility for the whole industry is very high as the mean
104
[email protected]
Science Series Data Report
Vol 4, No. 9;Sep 2012
value is 15.27. Theoretically and ideally value should be less than 1. Shah and Hijazi (2004) described that the ratio of more than 1 for tangibility indicates the greater gross value of the assets that are depreciated but not yet disposed off and the firm has enough number of these assets that’s why the gross value is greater than the total depreciated value. The average of a size is very high and 0.70 percent while mean of growth for fuel and energy sector is 42 percent. Correlation Analysis:
Table-3: Results of Correlation Analysis Profitability Profitability Size Tangibility Growth 1 0.5097 -0.5109 -0.0482 Size 0.5097 1 -0.3401 0.0476 Tangibility -0.5109 -0.3401 1 0.0793 Growth -0.0482 0.0476 0.0793 1
Table 3 shows the result of correlations between the independent variables. Table shows that there is no evidence of multi co linearity among the four independent variables. The highest positive correlation between two variables is 0.5097 and this correlation is between profitability and size. Now we shall argue each and every relationship of our independent variables. There is a negative correlation between tangibility of a firm and its profitability. One exciting correlation is between the size and tangibility of the firm which shows firms which are smaller in size have higher percentage of fixed assets to total assets while that firms that are large in size keep less amount of fixed asset. Tangibility is positively linked to growth of the firm signifying that growing firms have more amounts of fixed assets. Profitability is positively linked to size of the firm which shows that firms with the large size are profitable. Profitability is negatively
105
[email protected]
Science Series Data Report
Vol 4, No. 9;Sep 2012
correlated with growth which shows that growing firms are less profitable. The last observation is that firm’s size is positively correlated to the growth of the firm. Positive relationship is because large firms have enough capacity to invest and are generally considered to be financially strong and invest more in research and development which increases the growth opportunities for generating high profits. Regression Analysis: Table-4: Results of Regression Variable CONSTANT Coefficient 0.177924 Std. Error 0.252426 0.236570 0.012592 0.198717 0.005744 t-Statistic 0.704856 -2.406159 3.434403 -2.765616 0.513744 Prob. 0.4826 0.0181 0.0009 0.0068 0.6086
PROFITABILITY -0.569224 SIZE TANGIBILITY GROWTH Profitability 0.043246 -0.549576 0.002951
First independent variable of our study is profitability. This result indicates that firm’s profitability is negatively related to the dependent variable (Leverage). Profitability has a negative coefficient -0.569224 which shows the strong relationship of profitability with leverage. This relationship shows that when there is 1 percent increase in firm’s profitability there is a negative impact (decrease) on leverage by -0.569224 percent. Our initial hypothesis for this variable was in the support of POT and suggested the relationship between dependent variable (leverage) and profitability of a firm is negative. The results favor empirical prediction of the pecking order theory and also the view of Myers and Majluf (1984) that profitable firms prefer the internally generated funds first before using any debt financing. Results are also consistent with shah and
106
[email protected]
Science Series Data Report
Vol 4, No. 9;Sep 2012
Hijazi (2004). Profitability has a t- statistic -2.406159 and probability value of 0.0181. The pvalue of 0.0181 also shows that the relationship between profitability and leverage is statistically significant at 2 percent. As a result we accept our first hypothesis regarding profitability and leverage and we can confirm that pecking order Theory has support in Fuel and Energy Sector of Pakistan regarding Independent variable (profitability) and leverage of the firm. Size The result of size shows positive relationship of size and leverage of the firm. Size observed a positive coefficient of 0.043246 which suggests that leverage of the firm increases when the firm size is large. Our initial hypothesis about size of the firm was consistent with trade-off theory that suggested the positive relationship of size with leverage of firm; the reason is that direct bankruptcy cost is well spread in large firms. The results confirm the empirical prediction of the static trade-off. Therefore we accept our earlier hypothesis about the size of the firm. The results are also consistent with the result of shah and Hijazi (2004) who also observed the positive link of size and leverage. The t-statistic of size is 3.434403 and p-value is 0.0009 which shows the statistically significant relationship. We can confirm the empirical prediction of static trade off theory has more backing regarding relationship between firm’s size and leverage in its capital structure. Tangibility The results show that tangibility has negative relationship with leverage. Tangibility found a negative coefficient of -0.549576 which shows that tangibility is negatively correlated with debt financing therefore the negative coefficient reject our earlier hypothesis of positive relationship between tangibility and leverage. The results are contradictory with the findings of shah and Hijazi (2004). Negative relationship of tangibility also rejects the static trade-off version of
107
[email protected]
Science Series Data Report
Vol 4, No. 9;Sep 2012
Jensen and Meckling (1976) which includes agency cost of leverage. The negative coefficient shows that firms that have higher share of fixed assets will use less debt financing in their capital structure. T-statistic of tangibility is -2.765616 and p-value is 0.0068 which show the statistically significant relation. The results reject our earlier hypothesis about the empirical prediction of trade off theory. Therefore we can definitely confirm that pecking order theory has more empirical support in the fuel and energy sector of Pakistan regarding its relationship with leverage. Growth The result of growth is found to be positive which suggests firms that are growing will use more debt financing in their capital structure. Growth observed a positive coefficient of 0.002951 which confirms our earlier hypothesis to the empirical prediction of pecking order theory. Our initial hypothesis about growth was also based on the empirical prediction of extended version of POT. However this result is also constant with the findings of Rafique et al. (2008) who also observed a positive relation of growth with leverage. On the other hand statistically this relationship is not found to be significant as growth has t-statistic of 0.513744 and p value of 0.6086 which indicates that the results are not reliable. Thus we reject the empirical prediction of both formal conventional theories i-e pecking order and trade-off and also rejects our hypothesis. Table 6. Overall results and relationship with theories Dependent independent variables Leverage Profitability Total debt/total assets EBIT/total assets Negative Consistent with Proxy Observed relationship Empirical prediction of theory
pecking order theory
108
[email protected]
Science Series Data Report
Vol 4, No. 9;Sep 2012
Size
N log sales
Positive
Consistent
with
trade-off order theory Tangibility Total fixed Negative Consistent with
assets/total assets Growth %age change in total assets Positive
pecking order theory Consistent pecking order with
7. Conclusion This research basically analyzed the determinants of corporate financing structure to measure the formal theories presented by well-known finance scholars. Focus has been on the fuel and energy sector of Pakistan particularly as it is the biggest sector and which contributes greatly in the development of the economy. The main purpose of this study was to identify the factors that influence the portion of debt financing. Four hypotheses were constructed based on the hypothesized prediction of the (TOT) and (POT) to test these theories. Two of the hypothesis regarding size and tangibility were consistent with the (TOT) representing their positive association with debt financing whiles the other two hypotheses were consistent with the (POT) regarding the profitability and Growth of the company indicating their negative association with debt financing. For the purpose of analysis we have applied pooled regression, as a sample, consists of only companies from the fuel and energy sector with no heterogeneity across the cross sections.
109
[email protected]
Science Series Data Report
Vol 4, No. 9;Sep 2012
References Correa, C.A., Basso, L.F.C.B., Nakamura, W.T. (2005), “What determines the capital structure of the largest brazilian firms”? An Empirical analysis using panel data. Datta, D. & Agarwal, B. (2009), “Determinants of Capital Structure of Indian Corporate Sector in the Period of Bull Run 2003-2007 - An Econometric Study. Frank, M.Z, and Goyal, V.K. (2003), “Testing the Pecking Order Theory of Capital Structure,” Journal of Financial Economics, 67(2): 217-248. Jensen, M. (1986), “Agency Costs of Free Cash Flow, Corporate Finance and Takeovers. American Economic Review” 76:2, 323–329. Jensen, M. C. & Meckling, W. H. (1976), “Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure. Journal of Financial Economics” 3, 305–360. Modigliani, F. & Miller, M.H. (1958), “The Cost of Capital, Corporation Finance and the Theory of Investment” ‘The American Economic Review, 48(3): 261-297. Mutalib, M. (2011), “Determinants of capital structure in cement industry: a case of Nigerian listed cement firms”. Myers, S. & Majluf, N. (1984), “Corporate Financing and Investment Decisions When Firms Have Information Investors Do Not Have,” Journal of Financial Economics, 13: 187-222. Rafiq, M., Iqbal, A. & Atiq, M. (2008), “the Determinants of Capital Structure of the Chemical Industry in Pakistan’. The Lahore Journal of Economics, pp. 139-158. Rajan, R. & Zingales, L. (1995), “What Do We Know about Capital Structure? Some Evidence from International Data,” Journal of Finance, 50: 1421-1460.
110
[email protected]
Science Series Data Report
Vol 4, No. 9;Sep 2012
Shah, A. & Hijazi S. (2004), “The Determinants of Capital Structure in Pakistani Listed Non-Financial Firms,’ the Pakistan Development Review, 43. Shah, A. & Khan, S. (2007), “Determinants of Capital Structure: Evidence from Pakistani Panel Data, International Review of Business Research Papers Vol. 3, No.4, 265-282. Shah, S. M. A. (2007), “The Determinants of Corporate of Debt Policy –Pre and Post Financial Market Reforms (A Case from Textile Industry of Pakistan)’.
Pakistan Economic Survey 2010-11
111
[email protected]
doc_597220718.pdf