MANAGING THE GAP BETWEEN ACTUAL AND TARGET CAPITAL STRUCTURE: AN EVIDENCE FROM PAKISTAN

Abdul Rafay,Farrukh Ijaz,Usman Javed Gilani

doi:10.29145/jmr/12/0102003

Abdul Rafay, Farrukh Ijaz + Show 1 more

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https://doi.org/10.29145/jmr/12/0102003

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Abstract

Investment framework is one of the most significant components that impact the company’s value. Reliable funding choices for a company generally lead to a capital structure that increases the firm’s value (Abor, 2006). Early studies provide contradictory reviews about a company’s capital structure decisions. This paper investigates the partial adjustment model for a company’s target capital structure. The study also explores how companies operating in different sectors of Pakistani market adjust towards the target capital structure levels. The study also recognizes that an unanticipated share price change also have an effect on the target capital structure. The results indicate that companies do have target leverage and that their adjustment speed varies from sector to sector of the Pakistani market. A typical sector closes more than 50% of the gap between its actual and its target debt ratios within one year.

Highlights

Capital Structure, in simple terms, informs the use of debt and equity by a company to raise the required funds over a certain period of time
Textile Sector: The generalized methods of moments (GMM) analysis for the textile sector shows that the MDRit coefficient indicates an adjustment speed of 35.44% (t value = 6.50) annually from the current debt structure
The inclusion of SURP variable increases the annual speed adjustment from 35.44% to 41.39%, indicating an increment of almost 6% in the adjustment speed towards the target capital structure for the textile sector

Summary

Introduction

Capital Structure, in simple terms, informs the use of debt and equity by a company to raise the required funds over a certain period of time. According to Kundakchyan & Zulfakarova (2014), the Optimal Capital Structure for a company is one which offers a balance between the ideal debt-to-equity ratios and minimizes the firm's cost of capital. In other words, it is the mix of debt and equity that maximizes a firm's return on capital, thereby maximizing its value. Many researchers have studied the complex set of factors that are used by the companies to establish their optimal capital structure. Few of these factors include sector’s leverage ratio, firm size, GDP growth, profitability, inflation and financial risk. Despite extensive academic research and empirical literature, identification of factors that are generically relevant to capital structure decisions is still an ongoing task

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