Effect of capital structure on the performance of firms: Evidence from Pakistan and Indian stock market

Abstract

This purpose of this study is to find the influence of various firm level characteristics such as, leverage, participation of equity and insider ownership on the profitability of the Pakistani and Indian listed corporations in the two major stock exchanges Karachi and Bombay stock exchanges in each country respectively and then comparison of the finding between two countries. Employing the cross-sectional data methodology, i examine the leverage, participation of equity, profitability and insider ownership of 84 companies in Pakistan and 75 companies in India from KSE 100 index and BSE 100 index respectively for the time period of 2000 - 2010 inclusive both year. Different conditional theories of capital structure are reviewed (the trade-off theory, pecking order theory, agency theory, and theory of free cash flow) in order to formulate testable propositions concerning the determinants of firms performance. Four variables multiple regression models are used to estimate the effect of firm level attributes on profitability. The results obtained from three different regression models show that profitability and long term leverage are negatively correlated in both KSE and BSE corporations. Moreover I find that insider ownership is positively related to profitability and it is significant in the KSE and it is insignificant in BSE listed corporations. Furthermore participation of equity is positively related in to profitability of both KSE and BSE listed corporations which are showing significant impact with Karachi stock exchange listed companies that are significance at the 1% significance level and in Bombay stock exchange it is insignificant. This study suggests that companies should implement effective and efficient capital structure policy which improves the performance and profitability. Practical implications - This study has laid some groundwork to explore the determinants of firm's performance of Pakistani and Indian firms upon which a more detailed evaluation could be based. Furthermore, empirical findings should help corporate managers to make optimal capital structure decisions that will enhance the firm value and shareholders wealth.