Impact of Capital Market Expansion on Company s Capital Structure

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1 Impact of Capital Market Expansion on Company s Capital Structure Saqib Muneer 1, Muhammad Shahid Tufail 1, Khalid Jamil 2, Ahsan Zubair 3 1 Government College University Faisalabad, Pakistan 2 National University of Modern Languages, Faisalabad, Pakistan 3 Lecturer Government College University Faisalabad, Pakistan A R T I C L E I N F O *Corresponding Author: khalidjamil29@yahoo.com DOI: /nijesr Keywords: Pakistan, Capital Market Development, Debt Ratios, Financing Policies, Debt and Equity Market I. INTRODUCTION A B S T R A C T The main function of the capital market is to generate long-term funds for state, banking institutions and for companies. In addition capital market provides a place for trading short-term and long-term securities. The channelizing and raising the funds is matched by the existence of the stock, bond and banking markets within the capital market. The capital market builds a link between savers and investors. It plays an important role in mobilizing the savings and diverting them in productive investment. In this way the capital market plays an important role in promoting the productivity and success of the country and boost up economic growth in the country. The literature on capital structure reveals that there are five basic sources of financing available to companies. These resources are classified by literature as; Bank credit, Bonds and debentures, issuance of equity, lease finance and retained earnings. Various studies on corporate finance [7], [12] showed that firms operating in developing countries have a constraint of higher information asymmetry due to which they employed less external financing. In addition, the capital markets are not fully developed in these countries. That s why the debt ratio of companies is likely to increase as the capital market in The aim of the current study is to examine the impact of capital market development on debt ratios of 150 manufacturing firms in Pakistan from 2006 to To measure the capital market development, two equally weighted indices are constructed over the 10-year period. This study uses dynamic panel data models. The results show a significant impact of capital market development on debt ratios of manufacturing firms. The results also reveal that manufacturing firms in Pakistan use stock market as a substitute for longterm financing. This study has not found a huge decrease in debt ratios in years with lower score of debt market index. The results of this study have implications for various policy issues. Manufacturing firms in Pakistan have confined themselves mainly to loans from banks. The regulatory authorities should take critical steps to promote all segments of financial markets so that firms have more choices to raise funds from financial markets. these economies develops over time. Pakistan s economy is mainly bank based economy, therefore major source of financing for manufacturing firms is bank loan. [4] stated that while predicting the debt ratio of firms, their country s origin can help more as compare to firm specific variables. Therefore, it is an interesting issue to examine whether the firms change their financing policies with the evolving capital markets in a country. This study adds to the literature in three ways. First, most of the earlier studies conducted in Pakistan on capital structure [ 1 7 ], [ 2 0], [ 1 6 ], [12], [15], [2], [1], [5], [18] have focused on determinants of capital structure and tested agency theory, pecking order theory and trade off models etc. The question that, how non-financial firms listed at the Karachi Stock Exchange respond to the development of capital market is still unanswered in Pakistan. Therefore, the current study hypothesize that the financing decisions of manufacturing firms are significantly explained by the state of development of capital markets (stock market and banking system) in Pakistan. Second, to our knowledge, first time in Pakistan this study formed two equally weighted indices for debt and equity markets, namely Debt Market Index (DMI) and Equity Market Index (EMI). This methodology for constructing capital market development indices was used by [13]. Third, this 1

2 study examines the individual as well as aggregative response of debt ratios to capital market development. For this purpose manufacturing firms belong to chemical, fuel & energy and textile industry are put into analysis. The reason to select these three industries is that these industries are among top clients of banking credit over a decade. These three industries also represent a major portion of total market capitalization of manufacturing companies listed at Karachi stock exchange. The remaining part of the paper is divided into three sections. The second section lists literature review which is followed by methodology and analysis. The fourth section briefly explains research findings. The last section concludes the research. The continuing debate about the factors that affect firm s financing decision initiated with the notable work of [14]. The [14] argued that firm s value is independent of financial leverage. This argument was heavily criticized, but provided a new researchable issues for researchers. A number of theories such as pecking order, trade off theory, and free cash flow models tried to resolve these issues while searching for optimal capital structure for firms. II. COMPANY SPECIFIC VARIABLES AND FINANCING DECISION IN PAKISTAN INTRODUCTION One study [5] examined the impact of various corporate governance measures on capital structures of listed companies in Pakistan. The findings of this study showed the size of the board and managerial shareholding have significant negative relation with debt to equity ratio. The results also reveal that ownership structure plays very important role in determining financial structure of firms. Further the results revealed the larger and less profitable firms use less debt in their capital structure. [2] concluded in his study that firm size, risk, profitability, liquidity and age of the firm are key determinants of capital structure of companies belonging to life insurance sector. [10] conducted a study for Pakistani cement industry to analyze the determinants of capital structure of firms and checked the applicability of pecking order and trade off theories. The results indicated that larger and profitable firms tend to be levered while firms with more tangible assets and high growth use more debt in their financial structure. [15] found the determinants of capital structure in chemical industry, their findings suggested that income variation, non-debt tax shields, firm size, tangibility of assets and firm profitability are major determinants of financial structure of firms. [20] tested the pecking order and trade off theories in Pakistan and found determinants of capital structure for non- financial firms by using panel data from The results indicated that larger firms use more debt because they have less chances of bankruptcy. Further the results highlighted that high growth and more profitable firms tend to use less external financing. A study [11] conducted a study to examine the determinants of capital structure of non-financial firms in Pakistan. This study provides empirical evidence that majority of firms in Pakistan prefer internal financing over external financing. One of the possible reasons to justify this behavior of firms is the absence of bond market. The second reason may be that majority of firms are of medium sized due to which they avoid to get long term loans from banks. [16], [21] examined panel data of Pakistani firms from for exploring the determinants of financing policies and testing the agency theory, pecking order theory and trade-off theory. The findings elaborated that trade off theory is applicable in Pakistan in case of asset tangibility. while the firm s growth support the agency theory because agency costs are normally high for growing firms therefore these firms use less external borrowed funds. The results also showed that highly profitable firms follow the pecking order hierarchy of available funds. A group of researcher [1] examined the applicability of pecking order theory and trade off theory. Their study concluded that as firms become more profitable and highly liquid they tend to rely more on retained earnings rather than external debt. [2] worked on the determinants of financing patterns of non-financial firms listed at Karachi Stock Exchange; they also tested the pecking order and trade off theories. Their study explored that firms with high profitability and growth prefer internal financing over external financing. Their study extended the local literature by incorporating three new variables (dividend payout, liquidity and tax), their study reveals that capital structure of firms vary across industries. Their study provides evidence that firm size, dividend payout and liquidity have significant negative impact on capital structure while asset tangibility and non-debt tax shields have significant positive influence. A. Capital Markets and Financing Decision A study [4] analyzed the capital structure decisions of firms in developing countries; they found that the financing patterns of firms in developing countries are affected by the same set of variables as in developed countries. They also provide evidence that country differences could not be ignored; there are county specific factors which influence the financing decisions of firms. The results highlighted that firm s profitability and asset tangibility play a significant role in financing decisions, in each country debt ratios 2

3 are differently affected by level of capital market development, GDP growth and inflation. Another work [13] examined the impact of development in debt and equity market on firm s debt ratios in five developed economies and eight transition economies. They found a significant and positive impact of debt market development on debt ratios of property companies. The results also depicted a significant negative influence of equity market development on debt ratios. In addition their study concluded that larger companies have more tangible assets and more growth opportunities have a tendency to utilize more debt in their capital structure. [3] found the impact of macroeconomic factors on financing decisions of firms. The results depicted that bank credit plays significant role while firms decide about their capital structure. GDP found to have significant negative effect on corporate financing decision as well as return on assets, return on equity, tangibility and Tobin s Q also have significant predictive ability for firms financing patterns. Stock market development has no significant impact on corporate financing. [21] found that capital structure decisions are significantly predicted by industry and firm specific factors, income level and growth rate of the economy in which firm operate, in addition legal and financial institutions also have significant impact of financing decisions of firms. He also explored the impact of firm specific variables, development of financial markets and macroeconomic factors on short term and long term debt. The results highlighted that as the maturity of debt vary the direction and magnitude of impact of financial market development also vary. [8] examined the relationship between development of financial markets (Banking system and stock market) and financing choices of listed firms in Ghana. The findings show that development in stock market positively affects the firm s financing decision. This study explored that development of equity market plays an important role in capital structure for developing countries like Ghana. III. DATA ANALYSIS This study used annual data collected from financial statements of firms (for firm-specific variables) and World Bank Financial Structure (WBFS) database (for indicators of DMI and EMI) over ten years from The sample of this study consists of 150 non-financial firms listed at Karachi stock exchange. These Manufacturing firms belong to chemical, fuel & energy, and textile sector. By employing dynamic panel models (fixed effect and random effect) this study examines the financing patterns of manufacturing firms individually as well as jointly. [9] test is used to select fixed effect versus random effect model. Panel data deals to groups, firms and countries etc. over time series, there is hurdle to be heterogeneity in these groups. The panel data techniques take into account this problem of heterogeneity. By joining time series of crosssectional observations, panel data provides more informative data, variability, less co-linearity between independent variables, more degrees of freedom and more effectiveness. IV. RESULTS AND DISCUSSION The figure 4.1 and 4.2 shows the debt market index and equity market index in Pakistan from 2001 to After 2003, debt market index remains stable up to 2007 and then shows a continuous decline. On the other hand, Equity Market Index is showing fluctuations from 2003 to 2006 and after that equity market index shows a continuous downward trend. Pakistani equity market faced six major crashes from ; these crashes were one of the major factors of continuous downward trend. Another possible reason of decline in EMI score may be delisting of large number of firms from stock market. Table 1 presents the descriptive statistics for all variables. The standard deviation of equity market index is very large as compare to debt market index due to high volatility in stock market. Debt ratios of firms related to textile industry are higher than other two industries. Average debt ratio of all firms is 67 percent. Chemical industry has highest future investment opportunities while textile (0.951) and energy sector (0.978) have equal investment opportunities to some extent. In order to check whether the manufacturing firms use more (less) debt in years with higher (Lower) debt market index and similarly for equity market index. We clustered the firms into two portfolios based on the median values of DMI and EMI. It can be seen in Table 2 that total debt ratios are not showing significant difference in both sets of years with lower and higher Debt Market Index. This difference of debt ratios for individual industries as well as for over all sample is inconclusive. Table 3 indicates that total debt ratios of firms are slightly high during years with lower Equity Market Index as compared to years with higher Equity Market Index score. This suggests that during the years when stock market shows a decline, the manufacturing firms in Pakistan employ more debt in their capital structure. Based on these results it can be argued that manufacturing firms in Pakistan use stock market as a substitute source of financing. This finding is consistent with [8] who explored the impact of financial market development on capital structure of listed firms in Ghana. But our finding is contrary 3

4 to the evidence provided by [14]. To check the robustness of this finding we will control the firm specific factors in the subsequent section of this paper. Table 1 Descriptive Table 2 Total Debt Ratios of Firms Partitioned By Years with Higher and Lower DMI Table 3 Total Debt Ratios of Firms Partitioned By Years with Higher and Lower EMI We can see in Table 4 that Chi-Sq. Statistic is significant for model 1 (p < 0.05), the null hypothesis of Hausman Test that random effect model is not appropriate is rejected. For model 2, 3 and 4 alternative hypothesis, that fixed effect model is appropriate is accepted. Another method F-Stat is also used by researchers for model selection between common effect and fixed effect. Table 4 Hausman Test As discussed in literature review the firm s financing decisions are affected by firm characteristics therefore, by using firm level data this study conducted a robust analysis. Table 5 shows the results of the panel data models. The results of Model 1 present the combined response of debt ratios of 150 manufacturing firms to the capital market indices. The coefficients for DMI and EMI have expected signs and are statistically significant; this suggests that as the debt market becomes mature, financing policies of manufacturing firms in Pakistan are becoming more debt oriented. This finding supports the results of [14]. The Debt Market Index remains insignificant throughout the individual cross sections in model 2, 3 and 4. On the other hand, the coefficient of Equity Market Index (-0.001) shows significant impact in case of chemical sector. For textile sector Equity Market Index shows a complementary role with respect to debt market because it has significant positive coefficient. Among firm specific variables only profitability and size shows a significant negative impact on debt ratios which supports the pecking order model. The results also indicated that firms related to textile sector use debt to finance investment opportunities and asset tangibility helps them to access bank credit. Our results are consistent with [1], [2], [16], [17], [15]. For getting more insight about the impact of capital market indices on debt ratios for individual cross sections we run three additional panel models. Table 5 Dynamic Panel Data models All Models in this table are Dynamic Panel Models. Model 1 is Random Effect Model dealing with overall cross sections. While Model 2, 3 and 4 are Fixed Effect Models for Industry wise Sub Samples of chemical, fuel & energy and textile respectively. V. CONCLUSION AND FUTURE RESEARCH The current study is aimed to analyze the impact of capital market development on debt ratios of 150 manufacturing firms in Pakistan from 2006 to To measure capital market development, two indices Debt Market Development Index and Equity Market Development Index are constructed from The findings of the study suggest that manufacturing firms in Pakistan use stock market as a substitute for long term financing, but the preferable source of finance for firms is debt market. The results have not depicted a large decrease in debt ratios in years with lower DMI score. Although the impact of capital market indices is significant on debt ratios but it is very small in magnitude. In Pakistan, profitable and large manufacturing firms try to use less debt and rely more on their internal funds. The results highlighted the capital market of Pakistan is young, smaller and more volatile with poor accounting standards and ineffective legal setup. Due to these conditions of capital market, credit providing institutions require higher risk spread which leads to higher borrowing costs. This led firms to prefer internal financing. The Equity market Index has not consistent signs in all regressions. The findings of this study suggest the level of development of debt market slightly and positively affect the financing patterns of firms in Pakistan. On the other hand, maturity of stock market has an inverse impact on debt ratios of manufacturing firms. The results of this study have implications for various policy issues. Manufacturing firms in Pakistan have confined themselves mainly to loans from banks. The regulatory authorities should take critical steps to promote all segments of financial markets so that firms have more choices to raise funds from financial markets. Future studies may increase the sample by considering other major industries. REFERENCES [1] Afza, T., & Hussain, A. (2011). Determinants of capital structure across selected manufacturing sectors of Pakistan. International Journal of Humanities and Social Science, 1(12), [2] Ahmad, Z., Abdullah, N. M. H., & Roslan, S. (2012). Capital structure effect on firms performance: Focusing on consumers and industrials sectors on Malaysian firms. International review of business research papers, 8(5),

5 [3] Bokpin, G. (2013). Determinants and value relevance of corporate disclosure: Evidence from the emerging capital market of Ghana. Journal of Applied Accounting Research, 14(2), [4] Booth, L., Aivazian, V., Demirguc Kunt, A., & Maksimovic, V. (2001). Capital structures in developing countries. The journal of finance, 56(1), [5] Butt, S. A., & Hasan, A. (2009). Impact of ownership structure and corporate governance on capital structure of Pakistani listed companies. [6] Butt, S. A., & Hasan, A. (2009). Impact of ownership structure and corporate governance on capital structure of Pakistani listed companies. [7] De Haas, R. (2004). Law, finance, and growth during transition: a survey. De Economist, 152(3), [8] Doku, J. N., Adjasi, C. K. D., & Sarpong- Kumankuma, E. (2011). Financial market development and capital structure of listed firms: Empirical evidence from Ghana. Serbian journal of management, 6(2), [9] Hausman, J. A. (1978). Specification tests in econometrics. Econometrica: Journal of the Econometric Society, [10] Hijazi, S. T., & Bin Tariq, Y. (2006). Determinants of capital structure: A case for Pakistani cement industry. [11] Ilyas, J. (2008). The determinants of capital structure: Analysis of non-financial firms listed in Karachi stock exchange in Pakistan. [12] Iqbal, S. M. J., Muneer, S., Jahanzeb, A., Rehman, S. U. (2012). A Critical Review of Capital Structure Theories. Information Management and Business Review, 4(11), [13] Kunt, A. D., & Maksimovic, V. (1995). Stock market development and firm financing choices (No. 1461). World Bank Publications. [14] Le, T. T., & Ooi, J. T. (2012). Financial structure of property companies and capital market development. Journal of Property Investment & Finance, 30(6), [15] Modigliani, F., & Miller, M. H. (1958). The cost of capital, corporation finance and the theory of investment. The American economic review, [16] Rafique, M. (2011). Effect of profitability & financial leverage on capital structure: A case of Pakistan s automobile industry. [17] Ramakrishnan, S., Nabi, A. A., Muneer, S., & Anuar, M. A. (2015). An Interaction between Firm Strategy, Capital Structure and Firm s Performance. Journal of Economics and Behavioral Studies, 7(4), [18] Muneer, S., Bajuri, N. H., & Rehman, S. U. (2013). Moderating Effect of Agency Cost on the Relationship Between Capital Structure, Dividend Policy and Organization Performance: a brief Literature Review. Actual Problems of Economics, 11(149), [19] Shah, A., & Khan, S. (2007). Determinants of capital structure: Evidence from Pakistani panel data. [20] Shah, A., Hijazi, T., & Javed, A. Y. (2004). The Determinants of Capital Structure of Stock Exchange-listed Non-financial Firms in Pakistan [with Comments]. The Pakistan Development Review, [21] Taddese Lemma, T., & Negash, M. (2013). Institutional, macroeconomic and firm-specific determinants of capital structure: The African evidence. Management Research Review, 36(11),

6 TABLE 1 DESCRIPTIVE Mean Median Max Min Std. Dev. Skewness N EMDI DMDI Chemical 27 ROA SALES F.A (Net) TQ Fuel & Energy 12 LEVERAGE ROA SALES F.A (Net) TQ Textile 84 LEVERAGE ROA SALES F.A (Net) TQ Overall 123 LEVERAGE ROA SALES F.A (Net) TQ TABLE 2 TOTAL DEBT RATIOS OF FIRMS PARTITIONED BY YEARS WITH HIGHER AND LOWER DMI Years With Higher DMI Years With Lower DMI Industry Chemical Fuel & Energy Textile Overall

7 TABLE 3 TOTAL DEBT RATIOS OF FIRMS PARTITIONED BY YEARS WITH HIGHER AND LOWER EMI Years With Higher EMI Years With Lower EMI Industry Chemical Fuel & Energy Textile Overall TABLE 4 HAUSMAN TEST Test Summary Model 1 Model 2 Model 3 Model 4 Chi- Sq. Statistics Chi-Sq. d.f Prob TABLE 5 DYNAMIC PANEL DATA MODELS Model 1 Model 2 Model 3 Model 4 Coefficient t-stat Coefficient t-stat Coefficient t-stat Coefficient t-stat DMI 0.006*** EMI ** *** *** PROFIT *** *** *** *** SIZE *** *** TANGIB *** TQ *** R Squared Adj. R DW Statistic F-statistic Prob(F-stat) N Notes: *** Significant at the 0.01 level. ** Significant at the 0.05 level. All Models in this table are Dynamic Panel Models. Model 1 is Random Effect Model dealing with overall cross sections. While Model 2, 3 and 4 are Fixed Effect Models for Industry wise Sub Samples of chemical, fuel & energy and textile respective 7

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