Determinants of capital structure. A study on the cement sector of Pakistan

Table of Contents

Introduction

Problem statement

Research question

Research Objective

Significance of the study

Literature review

Delimitation

Hypothesis

Research Methodology

Population

Sample

Data Collection

Data Analysis

Descriptive statistics

Inferential statistics

Variables

Model Specification

Data Analysis and Discussion

Conclusion

Bibliography

Abstract

The decisions relating to the capital structure have been one of the most important decisions that have to be taken by the financial managers in any organization. The cement sector of Pakistan plays a vital role in economic development. Hence the importance of decisions pertaining to its capital structure can’t be denied.

This study investigates the effect of profitability, tangibility, size and liquidity on capital structure decisions of the listed companies in Karachi stock exchange of cement sector in Pakistan. This research study provides the information that would help the management of cement industry to make better decisions related to the capital structure. Its provides a deep insight of an optimal capital structure for the cement industry. Which will then support in maximization of the share value of firms on the one side and the minimization of cost of capital on the other side, and overall it would have a significant effect on the firm’s profitability which is the main objective of any organization. The variables include leverage, profitability, liquidity, Size, and tangibility.

Introduction

The main purpose of this research study is to examine the determinants of the capital structure of the five selected cement companies listed in Karachi stock exchange (K.S.E), For the period of 10 years, from 2004 to 2013.

The capital structure is one of the most important part of any organization. It’s the financial engine of the company. It has a direct impact on the company as a whole Capital structure is basically a combination of a company’s long term debt, specific short-term debt, and equity. The capital structure in other words is how well a firm finances its overall operations and growth by using different sources of funds.

According to most of the theories the capital structure is affected by many external and internal factors, such as tax, political, social, management, and macro economical indicators.

The study carried on, will help the cement sector of Pakistan, to better utilize its capital structure by making better decisions, hence directly have a positive effect on the profitability. Although many theories have been written on capital structure, but there is no theory specific update theory on cement sector of Pakistan. Hence our study work carries on a further research.

The variables in this study are leverage, profitability, liquidity, size, tangibility and liquidity.

Problem statement

When it comes to effective decision making, the capital structure has to be considered. In present, lot of financial representative’s in the cement industry are lacking in some of the basic knowledge of capital structure. Although in past decades the cement sector of Pakistan has had positive net cash flows, but in present as compared with other nation’s cement sector , the Pakistani cement sector has lost a significant share of exports in the international market.

The cost of manufacturing cement is also high in the country. One of the factors of high cost is the high transport cost and fuel problems.

The cement industry in Pakistan has been importing coal as fuel for manufacturing of cement, which is of very high cost. In order to reduce cost cement industry is looking for different alternatives to reduce its fuel cost.

According to sources the fiscal year 2010-11 proved to be a nightmare for the cement sector as 80 per cent of the cement manufacturers suffered huge losses. Mainly because the government failed for payment of inland freight subsidy that could have boosted exports (All Pakistan Cement Manufacturers Association).

These are problems, but of the main is that there isn’t financial expertise when making the right decision while considering the capital structure. Though macroeconomic indicators cannot be controlled, but the management can be controlled to make the best from the organization.

For example many cement companies in Pakistan are not following up an optimal capital structure. Their leverage is not optimal. So is the tangibility and size of the firm. The leverage of any firm has a direct impact on its profitability. Many cement companies listed in KSE are having net loss, the reason is simple, they are not using their capital structure effectively.

Research question

To what extent Leverage, profitability, tangibility, size and liquidity affect the capital structure decisions of the listed companies in cement sector of Pakistan?

Research Objective

The study analyzes the effect of profitability, tangibility, size and liquidity on capital structure decisions of the listed companies in Karachi stock exchange (K.S.E) of cement sector of Pakistan.

Significance of the study

The study has its significant for the financial experts mainly related to the cement sector. By studying this research study, they can make better decisions related to the capital structure. Furthermore the study is also important for investors, who can get deep understanding of the financial engineering of the organization. The students will find this study helpful for carrying on this study in their own studies.

Literature review

There have been many theories related to the capital structure decisions, depending upon the sector and time scale. Most of the studies find that the capital structure does have a significant effect on the organization as a whole.

One of the most famous study has been of Modigliani and Miller, according to their study Tax benefits on debt financing has been the most important determinant of capital structure, while ignoring the dividend. (Modigliani and Miller, 1963).

More leverage means where the debt financing is in excess.

The liquidity of a company and its effect on optimal capital structure has been showing various trends. It has been found that liquidity of assets has both positive and negative effect on the leverage.(Williamson 1988), In other study capital structure of a firm is usually achieved when the financial benefits of debt financing exceed the financial costs of debt charged by debt providers such as banks etc (Myers & Majluf, 1984).

There are strong evidences of sizeable and costs of distress in relation to changes in leverage and the associated cost and the benefits of the leverage of the firm (Sibilkov2009).

There are results that debt financing has been changing as per the market trends of debt issues (Doukas, Guo & Zhou 2011).

The differences of capital structure also varies from country to country basis, every country has its own macro economical indicators. (Muzir, 2011).

Krauseova (1995) described the capital structure of Czech firms in the period from 1990 to 1993. Bauer and Bubak (2003) also test for the existence of optimal capital structure and for relevance of signaling theory in the case of Czech listed firms.

Myers and Majluf (1984) discussed that firms prefer to finance with internal funds rather than debt if internal equity is sufficient due to the asymmetric information. Hence, profitability is expected to have negative relation with leverage.

Delimitation

We delimit this study to cement sector of Pakistan.

Hypothesis

The relationship between the Leverage of cement industry and its independent variables have been explained, this study make’s a set of hypothesis.

H1: There is a significant positive relation between leverage and firm size of cement industry of Pakistan.

H2: There is a significant negative relationship between leverage and firm size of cement industry of Pakistan.

H3: There is a significant positive relationship between leverage and profitability of cement industry of Pakistan.

H4: There is a significant negative relationship between leverage and profitability of cement industry of Pakistan.

H5: There is a significant positive relation relationship between leverage and tangibility of cement industry of Pakistan.

H6: There is a significant negative relationship between leverage and tangibility of cement industry of Pakistan.

H7: There is a significant positive relationship between leverage and liquidity of cement industry of Pakistan.

H8: There is a significant negative relationship between leverage and liquidity of cement industry of Pakistan.

Research Methodology

The purpose of this research is to contribute towards the very important aspects of the financial management, known as the Capital structure and its effect on firm’s performance. Here the investigation of relationship between the different variables of capital structure, such as profitability, tangibility, size and liquidity are studied of the cement sector made for a period of 10 years, from 2004 to 2013, of 5 cement companies listed in KSE.

The variables and firms included in this research study will also be discussed; the distribution patterns of data and the other statistical techniques in investigating the relationship between these variables will be studied.

Population

In Karachi stock exchange there are total 17 cement companies listed. Our population size is 17.

Sample

Out of 17 listed companies of cement sector, we selected a sample of 5 companies due to date availability. In the study our sample size is 5.

Instrumentation

The research will carry the SPSS software to conduct research. The statistical tools which will be used are Pearson correlation and linear regression.

Data Collection

The data collected for this research was taken from annual reports of the selected cement companies. The data has been taken from year 2005 to 2013.

Data Analysis

Regression is used to estimate the association between the studied variables. The following model is thus developed for testing.

Descriptive statistics

The quantitative data is taken from the different financial statements of the listed cement companies.

Inferential statistics

The financial ratios are used to make the predications of the data.

Theoretical Framework

In this research study we will see relationship between Leverage and firm size, tangibility, liquidity and profitability. Following is the table showing the dependent and independent variables,

Abbildung in dieser eseprobe nicht enthalten

Variables

The variables have been chosen, on the recommendations from previous research indications.

Dependent Variable

Leverage (Debt/equity ratio):

A measure of a company's financial leverage, calculated by dividing its total liabilities by stockholders' equity. It indicates what proportion of equity and debt the company is using to finance its assets.

Independent Variables

Firm size (log of sales):

Firm size represents the overall size of the firm. There are various methods to calculate the size of firm. We have chosen Net sales, as a medium of firm size, by according to the previous research study by Patrick Bauer Empirical Evidence from the Czech Republic (2004). Here Log of net sales has been taken.

Profitability (ROTA):

The independent variable profitability is calculated using the financial ratio, Return of total assets (ROTA). Its calculated by EBIT divided by Net assets. The ratio is used as an indicator of how effectively a company is using its assets to generate earnings.

Liquidity (current ratio ):

A liquidity ratio that measures a company's ability to pay short-term obligations. It is calculated by current assets divided by current liabilities.

Tangibility ( Fixed assets to total net assets)

The variable tangibility is measured by the financial ration, fixed asset to total asset ratio. A measure of the extent to which fixed assets are financed with respect to total assets. A higher return indicates that the fixed assets are used efficiently with respect to total assets.

Model Specification

The econometric model is defined as follows:

The regression model explains the relationship between the dependent variable and independent variable.

LVRG it= β0 + β1 (Fms it) + β2 ( PBT it) + β3 (TNG it ) + β4 (LQTY it) + e

LGi,t = the leverage of the firm i at time t

PBTi,t = profitability of the firm i at time t

CRi,t = current ratio of firm I at time t

FMSi,t = the size of the firm i at time t

TNGi,t = tangibility of the firm i at time t

Data Analysis and Discussion

Descriptive Analysis

Abbildung in dieser eseprobe nicht enthalten

The correlation shows relationship between the variables. We can see that the firm size is positive correlated with leverage, 1 % increase in leverage will tend to increase .626% of firm size.

On the other hand, there is a significant negative correlation between leverage and profitability. If there is 1 % increase in leverage it will decrease -1.56 % of profitability.

Moreover tangibility is also negatively correlated with leverage. An increase of 1 in leverage affects the tangibility to move at a significant negative direction at 1.76.Similarly liquidity is also negative correlated with leverage, as an increase of 1 % in leverage will tend to decline liquidity negatively at .290.

It’s clear that only firm size is positively correlated with leverage.

As for the previous research studies on capital structure decision, this phenomenon of capital structure is the same for mainly the countries belonging to the developing world.

Abbildung in dieser eseprobe nicht enthalten

The value of F-statistic is significant thus it shows reliability ofthe model. Adjusted R2 shows that the independent variables explain the 0.489 of the leverage. R2 shows

Overall model perfectness, it explains that almost .53% of the variation in the leverage is due to changes in the explanatory variables. The remaining 47% variation is owing to the unknown variables.

Durbin-Watson stat is .722, that shows the positive correlation and predicts that there is no multi collinearly and auto correlation in the model due to errors.

Abbildung in dieser eseprobe nicht enthalten

The results are based upon the regression model. The information to pay attention to here is the probability shown as “Sig.” in the table. If this probability is below 0.05, we conclude that the F-statistic is large enough so that we can reject the hypothesis that none of the explanatory variables help explain variation in Y.

As for the firm size, its unstandardized co efficient B is 1.46, which indicates that if there is an increase of 1 unit of dependent variable the firm size will move to the positive direction at 1.146.

Moroever its level of significance is less than 0.05 alpha level, so its significant to the dependent variable.

Similarly the liquidity’s coeffient is negative -1.084, this means that 1 unit increase in dependent variable will cause liquidity to decline by -1.084. While its level of significance is less than the alpha level .001 < 0.05, it indicates its significant.

On the other hand, Profitability is positive at 0.35 while tangibility is negative at -0.16, but both of these variables have significance level greater than alpha level , .678 > 0.05 and .950 > .05. This shows that both of the variables are not significane.

Conclusion

The research study taken had significant results, and it is thereby concluded that the way in which capital structure is managed it has significant impact on the overall organization, specifically the cement sector.

There is a significant positive relation between leverage and firm size, we accept H1. On the other hand, liquidity has a significant negative relation with the leverage. Moreover tangibility and profitability are insigficant.

Bibliography

Amarjit Gill, Nahum Bigger, Neil Mathur (2011), The Effect of Capital Structure on Profitability: Evidence from the United States, International Journal of Management Vol. 28 No. 4 Part 1Approach, Journal of Finance, 47, 1343-1366

Mahvish Sabir, Qaisar Ali (2012) Determinants of capital structure: A study of oil and gas sector of Pakistan

Modigliani, Merton H. Miller (1963), Corporate Income Taxes and the Cost of Capital: A Correction, The American Economic Review, Vol. 53, No. 3, pp. 433-443

Myers & majluf (1984) Corporate Financing and investment decision when firms have information that investors do not have

Williamson (1988), Asset liquidity and capital structure Douksas, Gua, Zhou (2010)Hot Debt Markets and Capital Structure , European Financial Management, Vol. 17, No. 1, pp. 46-99, 2010.

Czech Journal of Economics and Finance, 54, 2004, ã. 1-2

Determinants of Capital Structure Empirical Evidence from the Czech Republic Patrik BAUER (2004).