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The Determinants Of Capital Structure 1
Proceedings of 2nd
International Conference on Business Management (ISBN: 978-969-9368-06-6)
THE DETERMINANTS OF CAPITAL STRUCTURE
The Determinants of Capital Structure: A Case from Pakistan Textile Sector (Spinning Units)
Pervaiz Akhtar
National University Of Modern Languages, Islamabad
Muhammad Husnain
University Of Agriculture Faisalabad
Muhammad Ahsan Mukhtar
Muhammad Ali Jinnah University, Islamabad

Proceedings of 2nd
Abstract
Capital structure decisions are among the most important and crucial decisions for any business
because of their effect on value and cost of the company. In this paper we have discussed the
determinants of capital structure of Pakistani firms. The sample comprised 30 Pakistani textile
sector companies. Size, growth, financial cost, profitability, and tangibility are used as
independent variables, while leverage is the dependent variable. For analysis purpose descriptive
statistics, correlation and regression analysis are used. The results imply that the spinning sector
companies are small in size and capitalization so these companies prefer internal financing as
compare to external financing.
Keywords: Capital Structure, Leverage, Pakistan Textile Sector, Spinning Sector.

Proceedings of 2nd
Introduction
The Capital Structure Of A Company Is A Particular Combination Of Debt, Equity And
Other Sources Of Finance That It Uses To Fund Its Long-Term Asset. The Key Division
In Capital Structure Is Between Debt And Equity. The Proportion Of Debt Funding Is
Measured By Gearing Or Leverages. There Are Different Factors That Affect A Firm's Capital
Structure, And A Firm Should Attempt To Determine What Its Optimal, Or Best, Mix Of
Financing.
In Corporate World Discussion Of The Determinants Of Capital Structure Is As Old As The
Economic Revolution Of The World. The Capital Structure Is Decided On The Basis Of Some
Forces Which Are Tangible As Well As Intangible In Nature.
In Recent Years, At International Level, Several Authors On Capital Structure Have Proposed
To Identify And Explain Many Great Potential Attributes That Influence The Financial Decision
In Selecting The Right Debt To Equity Variations Across A Firm‟s Capital Structure.
The Link Between A Firm‟s Capital Structure And The Factors That Influence A Firm‟s Debt
Equity Mix Took On Added Importance As A Result Of The Path Breaking Debate Pioneered
By Modigliani And Miller (1958).
Capital Structure Remains To Be A Conventional Issue In Modern Finance. The Path Breaking
Work Of Modigliani And Miller (1958) On The Irrelevance Theorem Served As A Great
Foundation For Many Work To Be Carried Out On The Subject And Pointed Direction That
Such Theories Would Show Under Different Conditions From The Duo Is Capital Structure
Irrelevant.

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These Changes Adapted From The Original Assumptions Took Precedence After Modigliani
And Miller (1963) Theory Demonstrates The Benefits Of Debt By Introducing Taxes. Miller‟s
(1977) Discovery Of The Effect Of The Inclusion Of Personal And Corporate Tax On Firm
Value And Two Theories On Pecking Order Which Consist Of Bankruptcy Costs (Titman,
1984), Agency Cost Theory, Jensen And Meckling, (1976); Myers, (1977) And The Trade Off
Theory Dominate The Literature Of Capital Structure.
Theories Have Been Developed To Explain The Right Debt And Equity Combination For A
Firm To Adapt In Order To Achieve The Optimum Level Of Capital Mix. Traditional Theory Is
In Favour Of Borrowing More For Financing. This Is Mainly Because Of The Tax Advantage
That Is Enjoyed By Debt Whilst Equity Is Not. This Makes Equity More Expensive To Consider.
According To Myers And Majluf (1984), Managers Are Reluctant In The Issuing Of Equity
Because Of The Unwillingness Of Investors As Equity Yields A Return That Is Counted To The
Investors Of Scarce Resource As Their Opportunity Cost, Thus The Issuing Of Equity Should
Only Occur If Equity Is Moderately Priced Or Overpriced.
In Pakistan The Firm‟s Capital Structure Is Generally Decided By The Funds Available In The
Financial Sector Of The Country. The Domestic Savings Are Not So Much Huge Which Can Be
Used To Fulfill The Financial Needs Of The Different Sectors Of The Economy. So Ultimately
The Economy Is Dependent On The Foreign Debts And Aids Related Funds Available In The
Financial Market. The Determinants Of The Capital Structure Gets Change Over The Time On
The Condition Of Available Funds In The Economy.
In General, This Study Covers Each And Every Aspect Of The Subject But Specifically It Is
Related To Capital Structure Of Textile Sector Companies (Spinning Firms) Listed In Karachi

Proceedings of 2nd
Stock Exchange And Their Financing Decision Making. It Explores A Variety Of Factors That
Influence The Determinants Of Capital Structure And Manipulate The Financial Decision Taken
By The Manager As Well The Success Or The Failure To These Decisions.
This Research Study Is Based On The Data Taken From The State Bank Of Pakistan Publication
“Balance Sheet Analysis Of Textile Sector Companies Listed On The Karachi Stock Exchange
Volume-II 2004-2009.”The Research Initially Includes 32 Spinning Units Out Of 101 Textile
Companies Listed On KSE. Time Period Of The Data Is From 2004 To 2009
Size, Growth Rate, Financial Cost, Profitability And Tangibility Are Used As Independent
Variables, While Leverage Is The Dependent Variable. For Analysis Purpose Panel Data
Analysis, Correlation And Regression Analysis Are Used.
1.2 Objectives Of The Study
 To Identify The Determinants Of Capital Structure In The Different Sectors Of
Pakistan Economy.
 To Analyze Which Are The Main Determinants That Influence The Financing
Decision In The Choice Of Capital Structure In Pakistan Economy?
 To Explain The Relationship Between Leverage And The Determinants Of Capital
Structure In Pakistan Economy.
 To Suggest Some Determinants Which Are Of Considerable Attention For Capital
Structure Decision Pakistan Economy?

Proceedings of 2nd
1.3 Significance Of The Study
This Study Will Try To Identify And Analyze The Determinants Of Capital Structure In A
Systematic Way. Study Will Provide The Applicable And Practical Teaching To Anyone Who
Wishes To Understand The Topic. In General This Study Will Cover Many Aspects Of The
Topic But Specifically It Will Try To Determine The Capital Structure Of The Spinning Sector
Firms Listed On Karachi Stock Exchange. This Study Will Help The Managers To Take The
Financing Decision For Their Firms. The Creditors Can Also Take The Benefit To Minimize
Their Risk, In Funding A Specific Sector Firms.
2.0 Literature Review
The Objective Of This Chapter Is To Examine Existing Research On Capital Structure And Its
Determinants With Relative Emphasis On The Different Sectors Of The Pakistan Economy. This
Is So As To Discover And Provide An Insight On The Theoretical Models Used To Explain
Capital Structure And Its Determinants.
The Literature Review Seeks To Offer Clear Understanding On The Theories Of Capital
Structure And To Look At Its Determinants, How They Can Be Influenced By These Theories
And How They Are Related To Gearing.
The Theoretical Foundation For This Research Will Be Established Through Literature Review
Of Relevant Research. Priority Will Be Given To The Most Recent Work, Building Upon Earlier
Works.

Proceedings of 2nd
The Equity And Debt Value Used By The Company In Its Operation Will Constitute Its Capital
Structure. The Capital Structure Decision Is Therefore A Very Important One Because Of The
Impact Such A Decision Has On The Firm‟s Ability To Deal With Its Competitive Environment.
It Is Often Debated Whether Commonly Perceived "Good Industry” Is Defined By Its
Determinants That Can Point Towards The Right Mixture To Be Used To Achieve Optimum
Capital Structure. Leverage Ratios Of Specific Industries Have Been Documented And Their
Results Are In Broad Agreement And Show That Highly Geared Industries Have Consistently
High Leverage.
In 50 Years Since The Pioneering Work Of Modigliani And Miller (1958), Vast Amount Of
Academic Effort Of Research Has Been Devoted To Models Explaining Capital Structure. The
Extensive Literature On The Subject Matter Is Of High Interest And Has Shown Its Popularity In
The Corporate Finance Circles.
The Genesis Of The Theory Of Capital Structure Received Maximum Attention After The
Seminal Work Of Modigliani And Miller (1958) On „Capital Structure Irrelevance Theory‟
Often Referred To As MMI. This Paper Served As A Great Foundation For Many Of The Recent
Work Carried On The Subject. The Enormous Criticism Received After The Publication Of
MMI Gave Rise To MMII In (1963) Which Included Tax, A Component Absent In The Former.
Debt Is Borrowed Money That A Fixed Payment In The Future (Interest Payments And
Repaying Principal) Is Made. Equity On The Other Hand Is The Leftover After Debt Payments
Have Been Made. Combining Debt With Equity Gives The Gearing Or Leverage Position Of
The Company. Debt Can Be Short Term Or Long Term. Equity Financing Entails Issuing

Proceedings of 2nd
Common Stocks Or Preferred Shares To Investors. In Return For The Money Paid, Shareholders
Receive Ownership Interest In The Corporation. This Is Referred To Share Capital.
In An Attempt To Avoid Bankruptcy, Robicheck And Myers (1966) Propose That The Addition
Of Debt May Force A Firm To Have Its Future Strategy In Order To Finance Promised
Payments On Outstanding Debt. However, The Firm Is Likely To Incur Costs Which Are
Associated With This Sort Of Action.
The Implications Of This Analysis Generated Enormous Criticism. Stiglitz, (1962); Baumol And
Malkiel, (1967); Rubinstein (1973) And Scott (1976), Share A General Consensus That This
Traditional Theory Fails To Consider The Damaging Effects Of Increased Debt On Firm.
Stiglitz (1962) Demonstrated That If Debt Is Traded In A Separate Market In Which Investors
Are More Pessimistic About The Firm Than Its Equity Holders, Then A Sufficiently Large
Increase In Debt Can Lower The Total Value Of A Firm. More Reasonably, Robichecks And
Meyers (1966) And Baxter (1967), Have Argued That Debt Policy Is Not Relevant And That An
Internal Optimal Capital Structure Can Exist.
Baumol And Malkiel (1967) Have Argued That Capital Structure Will Not Be Irrelevant If
Investors Incur Transaction Costs When Engaging In Arbitrage Activities. Rubinstein (1973)
Shows That If Security Markets Are Partially Segmented, Where Traders Are More Risk Averse
Than Investors, Then A Sufficiently Large Increase In Debt Can Lower The Total Value Of The
Firm.
According To Scott (1976), The Use Of The Traditional Theory In Such A Manner Can Have
Negative Implications On A Firm Value Because It Fails To Consider The Effects Of Increased

Proceedings of 2nd
Debt On A Firm. Same Are The Findings Of Hatfield Al Et (1994) Who Suggest That Firms
Prefer An Optimum Level Of Debt And They Increase Or Decrease That Level To Enhance
Their Value In The Market. The Firms Want That Level Of Debt Where They Can Beat Other
Industry In Battle Of Market Value.
There Are Many Variables Which Can Influence The Firms Leverage Ratio And Can Have A
Positive Or Negative Impact On The Value Of The Firm. Harris And Raviv (1995) Identify
Variables That Are Considered To Influence The Firm‟s Leverage Ratio Such As: Size,
Tangibility, Tax Shields, Growth Opportunities, Bankruptcy Probability And Assets.
According To Stewart (2000), Equity Financing Is Better Option When Cash Flows And Assets
Are Not Predictable. This Means That Investors Have Enforceable Rights To The Firm‟s Assets,
But Cannot Prevent Insiders (Managers Or Entrepreneurs) From Capturing Cash Flow. Insiders
Must Co Invest And Pay In Each Period A Dividend Sufficient To Ensure Outside Investors
Participation For At Least One More Period. Shah And Hijazi (2004) Found That The Larger
Firms Employ More Debt Because They Have More Strength To Absorb The Risk Of
Bankruptcy. If Larger Firm Defaults In Any Case The Bankruptcy Costs For Such Firm Will Be
Low As Proportion Of Their Total Worth, Which Is The Prime Reason Of Taking More Debt By
Larger Firms. The Smaller Firms Take Less Debt Because Of Their Fear To Become Bankrupt If
They Are Unable To Repay Their Debt On Time.
Song (2005) Initiates That Capital Structure Determinants Are Dependent On The Nature Of
Debt Taken By The Firms. The Different Determinants Have Different Impact On Short Term
And Long Term Debt. This Study Finds Positive Relation Of Tangibility Of Assets Value With
Long Term Debt While It Is Negatively Related With Short Term Debt. Size Is Positively

Proceedings of 2nd
Related With Short Term Debt And It Is Negatively Related With The Long Term Debt Of The
Firm.
Lima (2008) Conducted A Research In Bangladesh On Pharmaceutical Companies And The
Findings Of The Research Are Almost Same And Are Aligned With Research Results In Rest Of
The Developed Countries Of The World. The Size, Value Of Assets, And Financial Cost Do
Effect The Financial Decision Of The Companies In This Sector. The Larger Companies Have
More Access To Funds And Less Chances Of Default That‟s Why They Enjoy More Borrowings
As Compare To Smaller Firms.
The Firm‟s Size Has Been The Critical Point Of Capital Structure Decision. According To
Muradoglu (2009) As The Small Firms Have Restricted Access To The Funding That‟s Why,
They Face Higher Interest Rate As Compare To Larger Firms And Their Growth Is Ultimately
Influenced. In Developing Countries The Larger Firms Can Easily Access The Debt Financing
Whereas The Availability Of Funds For Smaller Firms Is Dependent On The Economic
Conditions Of The Country.
There Is Also Difference In The Capital Structure Of Private And Public Owned Firms.
Dewaelheyns & Hulle (2009) Argue That In Private Sector Companies The Capital Structure Of
The Firms Is Not Driven Only By The Internal Financing But The External Financing Do Have
An Impact On The Decision. Although The Private Firms Have Limited Access To Debt
Financing But Still They Continue To Expand In Many Parts Of The World Because They
Follow Pecking Order Theory (Mayers 1984), Which Suggests That Firms Prefer Internal
Financing Until They Funds Are Sufficient To Meet Their Needs.

Proceedings of 2nd
3.0 Conceptual Framework And Methodology
3.1 Dependent Variable
1. Leverage (Debt/Equity)
3.2 Independent Variables
1. Size
2. Growth
3. Financing Cost
4. Profitability
5. Tangibility
3.3 Hypotheses
Total Five Variables Have Been Used In This Study. The Only Dependent Variable Of The
Study Is Leverage And Independent Variables Were Hypothesized As Follow:
H1: Profitability Is Negatively Related With Leverage.
H2: Size Is Negatively Related With Leverage.
H3: Growth Is Negatively Related With Leverage.
H4: Financing Cost Is Negatively Related With Leverage.
H5: Assets Tangibility Is Negatively Related With Leverage.

Proceedings of 2nd
3.4 Sample And Methodology
This Research Study Is Based On The Data Taken From The State Bank Of Pakistan Publication
“Balance Sheet Analysis Of Textile Sector Companies Listed On The Karachi Stock Exchange
Volume-II 2004-2009.”The Research Initially Includes 32 Spinning Units Listed On KSE. Time
Period Of The Data Is From 2004 To 2009.
We Present In Our Design Both Theoretical And Quantitative Analyses. For Quantitative
Analysis We Use Two Methods: First: Correlations Is Used To Find Out The Association
Between The Variables Under Consideration. Second: Regression Analysis Is Used To Further
Measure The Relationship Of The Dependent And Independent Variable Accurately.
3.5 Statistical Tools
 Descriptive Data Analysis
 Correlation
 Regression
Following Model Will Be Used For The Purpose Of Analysis.
D/E = Α + Β1 (PFT) + Β2 (SZ) + Β3 (G) + Β4 (F.C) + Β5 (TG) +Εi
 Where As
 D/E = Measure Of Leverage
 PFT = Profitability
 SZ = Size
 G = Growth Opportunities

Proceedings of 2nd
 FC = Financial Cost
 TG = Tangibility Of Assets
 Ε = The Error Term
4.0 Data Anaylsis
4.1 Descriptive Data Analysis
Table.01
20 Pakistani Firms, 2004 – 2009, 5 Years 120 Observations
Leverage
Size Growth
Financial
Cost
Profitability Tangibility
Mean 560.7 1388.66 1386.3 113.885 17.687 1190
Median 291.4 1094 1110.95 58.8 16.6 997.4
Standard
Deviation 2122 977.167135 998.353 163.478 104.76 787.2
Sample Variance 4503936 954855.61 996708 26725 10975 6E+05
Range 23246 4264.8 4337.5 856.9 1088.9 3583
Count 120 120 120 120 120 120
4.2 Pearson’s Correlations Coefficients

Proceedings of 2nd
Table.02
Leverage Size Growth Financial Cost Profitability Tangib
Leverage 1
Size -0.08 1
Growth -0.08 0.85434047 1
Financial Cost 0.276 0.41992973 0.32594 1
Profitability -0.03 0.00757611 0.0331 -0.0087 1
Tangibility 0.05 0.91191437 0.85641 0.43823 0.0369 1
4.3 Regression Statistics
Table.03
Multiple R 0.348447854
R Square 0.121415907
Adjusted R
Square 0.082881517
Standard
Error 2032.398447
Observations 120
4.4 Anova
Df SS MS F Significance F
Regression 5 65075095.05 13015019 3.150845 0.010588304
Residual 114 470893352.8 4130643
Total 119 535968447.8

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Coefficients Standard Error T Stat P-Value Lower 95%
Upper
95%
Lower
95.0%
Upper
95.0%
Intercept 723.1610393 339.9231641 2.127425 0.03554 49.77589121 1396.5 49.776 1396.55
Size -0.488615758 0.498764338 -0.97965 0.329332 -1.476664038 0.4994 -1.477 0.49943
Growth -0.039483809 0.388897454 -0.10153 0.91931 -0.809886644 0.7309 -0.81 0.73092
Financial
Cost 4.829305568 1.281641817 3.768062 0.000262 2.290383083 7.3682 2.2904 7.36823
Profitability -0.430654912 1.78430111 -0.24136 0.809711 -3.965341553 3.104 -3.965 3.10403
Tangibility 0.023919891 0.631077504 0.037903 0.969831 -1.226239744 1.2741 -1.226 1.27408
5. Results Description And Conclusion
5.1 Overall Overview of the Findings
Analysis Of All Firms Shows That Total 12% Variation In Dependent Variable I.E. Leverage Or
Debt To Equity Is Related To The Values Of All Five Independent Variables Of The Study As
Evidenced In R-Square Value In Other Words 12 % Variation In Leverage Decision Of The
Firm Is Explained By Profitability, Size, Tangibility, Growth, And Cost Of Financing. Rest Of
The 88% Is Due To Extraneous Variables. Overall Significance And Goodness Of The Model Is
Relatively Low Just Because Of The Unavailability Of Data Or Incomplete Data Available
Through Different Sources Which Is Unable To Use In This Study.
5.1.1 Size
From The Theoretical Point Of View, The Effect Of Size On Leverage Is Unclear. As Rajan And
Zingales (1995,) Claim: “Larger Firms Tend To Be More Diversified And Fail Less Often, So
Size (Computed As The Logarithm Of Net Sales) May Be An Inverse Proxy For The Probability
Of Bankruptcy. If So, Size Should Have A Positive Impact On The Supply Debt. Some Authors

Proceedings of 2nd
Find A Positive Relation Between Size And Leverage, For Example Huang And Song (2002),
Rajan And Zingales (1995).
In Our Study Size Of The Firms Also Suggests Accepting The Negative Hypothesis And
Rejecting The Hypothesis That With Increase In Size Of The Firm, The Leverage Of The Firm
Also Increases As This Test Is Statistically Insignificant.
5.1.2 Growth
According To Myers (1977), Firms With High Future Growth Opportunities Would Use More
Equity Financing, Because A Higher Leveraged Company Is More Likely To Pass Up Profitable
Investment Opportunities. As Huang And Song (2002) Claim: “Such An Investment Effectively
Transfers Wealth From Stockholders To Debt Holders.” Therefore A Negative Relation Between
Growth Opportunities And Leverage Is Predicted. As Market-To-Book Ratio Is Used In Order
To Proxy For Growth Opportunities, There Is One More Reason
Growth Of The Firm Is Negatively Related To Debt/Equity Ratio In Our Study As The
Regression Analysis Shows Negative Relationship With Debt To Equity Ratio So We Accept
The Hypothesis Generated In Our Study That Is Growth Is Negatively Related With Our
Dependent Variable.
5.1.3 Financial Cost
Financial Cost Is Positively Related With Debt To Equity Ratio Which Simply Means That
When The Debt Ratio Of Any Company Will Increase There Will Also Be Sure Increase In The

Proceedings of 2nd
Financing Cost Of The Company. The Positive Hypothesis Is Accepted Which Was Suggested In
The Start Of Our Study In Theoretical Framework And Hypotheses Generation Section.
5.1.4 Profitability
There Are No Reliable Theoretical Predictions On The Effects Of Profitability On Leverage. The
Trade Off Theory Suggests That The Firms With More Profit Should Take More Debt. The Free
Cash-Flow Theory Propose That More Profitable Firms Should Employ More Liability In Order
To Control Managers, To Tempt Them To Pay Out Cash As A Substitute Of Spending Money
On Incompetent Projects. However, Pecking-Order Theory Claims, Firms Prefer Internal
Financing Over External.
Profitability Is Negatively Related With Leverage As It Is Hypothesized In This Study The
Results Of Regression Analysis Shows That The Profitability Is Negatively Related With
Leverage So It Suggests That We Should Accept The Null Hypothesis.
5.1.5 Tangibility
It Is Assumed, From The Hypothetical Point Of View, That Tangible Assets Are Used As
Guarantee. Therefore It Lowers The Risk Of Creditors In Case Of Bankruptcy. As Booth Et Al.
(2001,) State: “The More Tangible The Firm‟s Assets, The Greater Its Ability To Issue Secured
Debt And The Less Information Revealed About Future Profits.” Thus A Positive Relation
Between Tangibility And Leverage Is Assumed.
Several Empirical Studies Confirm This Suggestion, Such As (Rajan – Zingales,1995), (Friend –
Lang, 1988) And (Titman – Wessels, 1988) Find. On The Other Hand, For Example Booth Et

Proceedings of 2nd
Al. (2001) And Huang And Song (2002) Experience A Negative Relation Between Tangibility
And Leverage.
There Is A Positive Relationship Between Tangibility And Firms Leverage. In Both Regression
Techniques This Test Is Significant.
Conclusion
This finds that capital structure determination is not a science so the firms analyze a number of
factors to choose a best mix of debt and equity. In Pakistan as well there are different factors that
affect a firm's capital structure decision. The results suggest that in Pakistan most of the firms
prefer internal funds over the external financing. In Pakistan the main source of funding is
banking sector which generally prefers the larger firms while funding. So the larger firms can
take loan very easily because of the banking sector preferences. As most of the Pakistani firms
are of medium size, therefore these firms are unable to take loans for their future projects. One
more possible reason of taking less loans can be the legal procedures and obligations involved in
the process of debt financing. The last reason which is not proved yet could be the religious
teaching about the interest, which is forbidden in Islam.

Proceedings of 2nd
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