Abstract
Why the financial structure is still believed to be relevant within business firms? A number of competing theories have been developed for explaining this question. The three theories that stand out are Pecking order, Trade off and Agency cost. However, the first two are frequently referred to and contradictory to each other. The ‘trade-off’ theory suggests that corporate taxes in combination with bankruptcy costs imply that there exists an optimal combination of debt and equity capital that management should search for in order to maximize shareholder value. The challenging ‘pecking order’ theory recognizes no such optimum, but instead states that there is a ranking order in the firms between different types of capital where the issuance of equity capital is seen only as a last resort. This paper examines the role and importance of different firm characteristics that explain financial structure as well as the theories that best fit in Pakistani context and considers concepts like optimal capital structure, risk, financial hierarchy and asymmetric information. The sample of the study consists of firms extracted from financial (70 firms) and non-financial (120 firms) sectors listed on the KSE for a period of 2000-2013. Secondary data is extracted from firm’s annual reports. The sources like SBP publications; Bloom burgee business week and KSE were used to collect data. The results indicate that firms in the two sectors prefer funds generated internally for financing their assets. Moreover debt will be preferred to equity once external funds are required. The pecking order appears to be a good description of financing behavior for a large sample of firms over a long time period after accounting for debt capacity. We have also studied agency theory of the firm however there was little evidence to support the Agency cost theory.
Highlights
IntroductionTheories targeting these decisions have in common that they depart from more or less reasonable—albeit divergent—assumptions about market efficiency in terms of the objectives, expectations and information accessibility of different stakeholders like shareholders, creditors and managers
What is the rationale behind financing structure decisions in business firms in practice? Theories targeting these decisions have in common that they depart from more or less reasonable—albeit divergent—assumptions about market efficiency in terms of the objectives, expectations and information accessibility of different stakeholders like shareholders, creditors and managers
The results that we found in our study are compared with the results of some previous studies; we have used the related work on firm’s characteristics that affect capital structure just to prove the validity of the study
Summary
Theories targeting these decisions have in common that they depart from more or less reasonable—albeit divergent—assumptions about market efficiency in terms of the objectives, expectations and information accessibility of different stakeholders like shareholders, creditors and managers. What is the rationale behind financing structure decisions in business firms in practice? In that respect these theories can alone provide only a partial analysis for understanding why a firm is displaying a certain financial structure. Capital structure is basically a mix of company's leverage and equity that a firm uses to finance its assets. Opler, Saron and Titman (1997) argues that there exist some difficulties in identifying optimal capital structure that will maximize shareholder value, so due to the difficulties these opportunities’ are often passed over without giving due attention
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