Is Negative Profitability-Leverage Relation the only Support for the Pecking Order Theory in Case of Pakistani Firms?

Abstract

Previous studies on capital structure in Pakistan have reported evidence in support of the pecking order theory. However, this evidence is largely based on testing one dimensional relationship between leverage ratios and firms’ profitability. The objective of this paper is to extensively test the pecking order theory in Pakistan with well-known pecking order testing models. Specifically, we use a sample of 321 firms listed on the Karachi Stock Exchange from 2000 to 2009 and test pecking order theory with models suggested by Shyam-Sunder and Myers, Frank and Goyal, Watson and Wilson, and Rajan and Zingales. Results of these models indicate that there exits only weak evidence in support of pecking order theory in Pakistan. However, strong support is found for pecking order theory when leverage ratios are regressed on profitability ratio, along with a set of control variables. This discrepancy in the results of the two sets of models needs further investigation, as well as care in interpreting the results of existing studies on capital structure in Pakistan. Our results show robustness even after controlling for possible profits understatements or weak corporate governance practices. JEL Classification: G10, G21, G32 Keywords: Pecking Order Theory, Profitability-Leverage Relation, KSE