Profitability and Corporate Leverage Policy of Firms

gainfulness and Corporate Leverage indemnity of FirmsAbstractThis theatre attempts to determine the kindred amid(prenominal)st the favorableness and supplement policy of familys of dismiss and free energy orbit of Pakistan. The analysis was implemented on 27 loyals in the raise and energy sphere of influence listed at the Karachi blood line transfigure for the period 2003-2008. Regression was used to reveal give away the kinship between the freelance divergeing (Profitability) and aquiline variable (Leverage). We expect the ostracize kind between the Profitability and the Leverage Policy of stanchs in the Fuel and Energy sector of Pakistan, con squiffying the pecking order scheme of metropolis anatomical social organization. The results tack in our mull were non as expected. The results verbalizeed that thither is inverse kindred between positivity and supplement but our results were not that much crucial to accept our hypothesis. So we rejected our pecking order theory hypothesis. at that rearfore we answer that because of certain factors such as economical situation of the Pakistan, rising prices of fossil oil all(prenominal) around the world, interests rates and reliance of loadeds financing deficiencys in the of import on confide financing, pecking order theory pretence becomes in world-shaking in the Energy and Fuel sector of Pakistan.Chapter-1IntroductionCapital construction involves distinct decisions conducen by a firm in financing its pluss. Generally, a firm can solve this issue done contrasting mixes of debts, lawfulness, or diverse financial arrangements. It can in addition combine hampers, TFCs, lease financing, bank loans or much a(prenominal) early(a) options with equity in order to march on the grocery store look upon of the firm.1.1 Importance of the topicOptimal bang-up twist dramas a vital role in the overall value maximisation of a firm. The strategic management of nifty social system ensures access to the corking needed to fund future ontogenesis and enhance financial per ingest upance. Our concentrate on in this ruminate is to jibe the profit of the firm with its supplement. Importance of the rent is to find show up that which beginning of funds either retained earnings, debt or equity, a firm in the Fuel and Energy sector should elect in order to optimize the profit and the value of the firm. In Pakistan, firms unremarkably select short-term borrowing, because commercial banks argon the major lenders and they do not encourage long-term loans. Up to 1994 firms did not rely on market place base debt in mid 1994 the government amended the Company integrity to help companies to raise debt directly from the market in the represent of TFCs (Term pay Certificates).1.2 Background of the get wordVarious full-grown(p) social system theories had been discussed by numerous authors to justify the variation of smashing structu re of different firms. So many questiones had also been taken place in order to solve the brain-teaser of optimal seat of government structure in Pakistani firms. A innate question shine relating to the capital structure was carried by two Pakistani profs Shah and Tahir (2004) which move to answer the question of what determines the capital structure of Pakistani Listed firms former(a) than those in financial sector. Booth, et. Al (2001) had also worked on the determinants of capital structures of 10 developing countries including Pakistan, but their information analyzed the firms that were included in the KSE-100 index from 1980 to 1987. Shah and Tahir (2004) analyzed the data of non-financial firms for the period of 1997-2001 bandage our study differs from theirs on campaign of different sector, variables and period.1.3 Objective of the studyThe physical object of this study is to find surface the affinity between the advantageousness and the corporate supplement policy of firms in the Fuel and Energy sector of Pakistan.We argon trying to figure out that the firms that halt to a greater extent than profits in the Fuel and Energy sector pee-pee patheticer supplement. Our of import focus in this study is to correlate the profit of the firm with its leverage in the context of pecking order theory. accord to pecking order hypothesis firms escape to use internally generated funds get-go and than resort to external financing. This implies that gainful firms leave involve little get along of leverage. Therefore we expect a ostracize relationship between profitability and debt of a firm i.e. higher the profits of a firm, the littleer lead be its debt.1.4 Scope of the studyThis study is limited on the Fuel and Energy sector of Pakistan. There are 27 firms of that sector which are listed on the Karachi blood Exchange. precisely subsequently screening the firms with in discern data, we receive selected 22 firms having complete data for six-spot years from 2003-2008 as the study covers the period from 2003 to 2008.1.5 Disposition of the studyThis study is organized into phoebe bird points. In premier stage we realize described the background of our topic. In secondly stage brush up of literary works has been done. In next stage we realise explained our data and variables used in our analysis. At fourth stage we hurl discussed the fashion model and the statistical mental analyze to be used. period the last stage concludes the results of the test.Chapter 2Literature ReviewIn this chapter we have gone by dint of the various research studies regarding the leverage and well known capital structure theories.Capital structure refers to specific mixture of debt and equity a firm needs to finance its trading ope rations and optimal capital structure plays a vital role in the overall value maximization of a firm. This has given birth to different capital structure theories that attempt to explain the vari ation in capital structures of firms.The Miller Modigliani theorem showed that the market value of a firm is determined by the risk of exposure of its netherlying assets and its earning power and is independent of the choices to finance its investments i.e the value of the firm is independent of the capital structure it takes on. But Myers suggested the contemporary thinking on capital structure in form of Static Tradeoff possible action. This explained that a firm initially following a design debt-equity ratio behaves accordingly. The courts and pull ins related to the debt option make this target ratio. The be and benefits are be of financial distress, tax shields and representation cost.There are different theories that are used to explain the capital structure decisions which are based n the asymmetric information, tax benefits associated with the debt, unsuccessful person cost and agency cost. The asymmetric information is related with pecking order framework and the different three are rooted in static mass-off choice. to a lower place the trade off theory firms tried to equate the marginal benefits of an additional unit of debt with the related marginal cost, sequence holding the firms assets and investments plans. Under this model the key benefits are debt tax set forthibility and the mitigation of agency cost while the main cost of additional debt is bankruptcy.Green, Murinde and Suppakitjarak (2002) observed that the tax policy also effect the capital structure decision of firms. Firm are allowed to deduct interest on debt in computing taxable profit infra tax ordinance while the payments associated with the equity such as dividends are not tax deductible. Therefore, the tax effect encourages the debt usage by the firm if the rates are higher and more debt increases cash savings in form of later tax proceeds to the owner.Usage of debt in the capital structure of the firm also leads to agency cost which arises as a result of relation ship between the share holder and manager while the firms management is the agent and the share holder being the principal. Agent may not choose to maximize their principals wealth. The conflict arises as the managers have less than 100% of the residual claim. Thus, managers may invest in projects that reduce the value of the firm while enhancing their control over its mental imagerys. Additional cash die hard is the prime source of the agency cost. Debt helps to mitigate this agency cost as the firm is committed to pay out excess cash in the form of interest payments.The probability of bankruptcy increases with the increase in the aim of the debt. If the firm goes beyond the optimum level of debt, indeedce it is more probably that the firm will default on the repayment of the loan. As a result of that, the control of the firm will be shifted from share holders to the bond holders or the creditors who will liquidate the firm in order to receive their investment. There are al so direct and indirect costs associated with the bankruptcy. contribute cost includes administrative costs of bankruptcy and costs of reorganization in the event of insolvency. While the indirect cost arises when the firm gets into financial distress. It may arise because of the change in the investment policies of the firm if firm foresees contingent bankruptcy. In order to avoid the possible financial distress it will cut down the expenditure on certain departments like research and development, training of utiliseees and advertisements etc. Therefore, if a firm is perceived to be unappealing to bankruptcy customers may be less willing to buy its goods because of low perceived quality of goods and the risk that the firm will not be able to meet its warranty obligation. Employees may also be less interested to work for the firm and creditors are less inclined to go away trade credit.Hence under the static trade off theory the optimal capital structure represents a level of lev erage that balances the bankruptcy and the benefits of tax deductibility and mitigation of the agency costs.While The Pecking commit conjecture of Myers (1984) and Myers and Majluf (1984), declared that firm while establishing its capital structure follow a hierarchy of financial decisions. First of all firm uses its internal financing i.e. retained earnings in order to finances its projects. In fortune of need of external financing, they prefer a bank loan first then go for the public debt. Thus in accordance with the Pecking Order Theory, profitable firms while having the available internal funds prefers not to incur debt for refreshed projects.A study was carried by Benito, (2002) which considered the two most influential approaches, the trade off and packing order theories, in understanding capital structure decisions of firms of Spain and United Kingdom. This study made a valuable contribution to our study because of the same objective of testing Pecking Order Theory with reference to capital structure of firms. The resulting data included 6417 Spanish companies over period of 1985-2000 and 1784 British quoted non-financial companies over period of 1973-2000. The results provided significance in favor of pecking order theory, reason debt ratios found to be significantly inversely related to cash return and profitability of the firm and vary positively with its investment.In order to find the vanquish empirical explanation for the capital structure of Brazilian firms Medeiros and Cecilio (2004) well-tried a model to represent the Static Trade-off Theory and capital of Red China Order theory. This theory is helpful for our study because of the same independent variables that is profitability.Profitability all the STT bleeds sustain that a positive relationship must endure between profitability and debt. The stream based on bankruptcy costs states that these costs increase when earnings fall so that leverage tends to be lower for less profitable firms or those with higher earnings volatility. For the stream focusing on tax benefits, the more profitable the firm the more it benefits from the tax shield provided by interest payments. The agency stream believes that tumid amounts of free cash flows build up the dispute between shareholders and managers, which make those firms to issue more debt in order to diminish the problem (Fama and French, 2003). fit in to the POT, retained earnings are the firms best financing option. This type of resource does not produce information asymmetries and can be used like a shot for new projects. The information asymmetry caused by equity issues or by more complex securities that require a higher degree of chat with the market is the basis of the POT. It is exactly to dodge the perverse selection subsidy brought by the information asymmetry that firms opt for internal financing as their major source of resources (Myers, 1984). The relationship between these two variables must be hence invalidating. Medeiros and Cecilio (2004)The hear of their study included 371 non-financial firms with shares listed in the Brazilian production line exchanges from 1995 to 2002. The analysis of results of the study led to the conclusion that the pecking order theory provides the best explanation for the capital structure of those firmsAnother study on the capital structure was carried by Abor, (2008) comparing the capital structure of great(p) un-quoted firms, baseborn and medium enterprises (SMEs) and publicly quoted firms in Ghana using a control panel reversion model. On the grounds of the similar independent variable this study made a useful contribution to our check into literature. The results showed insignificant deflection between the capital structures of large unquoted firms and publicly quoted firms. The results of all sample groups showed that the hit debt has relatively a high proportion of short-term debt. The results of the regression test indicated that a ge and size of the firm, profitability, risk, asset structure and managerial ownership are significant influencers in decisions regarding the capital structure of Ghanaian firms.Chiarella et.al (1991) conducted a study in Australia on the determinants of corporate capital structure by pursuance to provide evidence on the significance of capital structure determinants in Australian context. This study provided a heavy(p) champion for writing review literature of our study. The analysis was carried on a sample of 226 Australian firms from 1977-1985. The results showed that company non-debt tax shields display a negative relationship with debt ratios. The results also support the pecking order hypothesis of Myers and Majluf (1984) showing significant negative relationship of profitability with debt ratios and indicating that firms prefer to finance investments with internally retained earnings before issuance debts. The results provided some evidence of size effect indicating tha t the larger firms tend to employ more debts in their capital structure. Results showed positive but insignificant relationship between cash holdings and debt ratios while confirming the free cash flow hypothesis of Jensen (1986). Simultaneously results did not provide any support for growth opportunity and collateral value attributes as determinants of debt ratios.A study on the Malaysian companies regarding the capital structure and the firm characteristics was carried by an Indian professor Pandey (2000). This study is useful for our study because of one of the same independent variable i.e. profitability. The study was carried on Malaysian companies in order to examine their determinants of capital structure using data from 1984 to 1999 while classifying the data into four periods that relates to different stages of capital market of Malaysia. Results of the regression clarified that profitability, size growth, risk sheer variables have significant impact on all debt types. R esults showed persistent and unvarying negative relationship of profitability with all debt ratios in all periods, and so accepting the prediction capital structure according to the pecking order theory.A research relating to the capital structure was carried by two Pakistani professors Shah and Tahir (2004) which attempted to answer the question of what determines the capital structure of Pakistani Listed firms other than those in financial sector. Because this study was also carried in Pakistan so it provided a support to a great extent in order to understand the capital structure according to Pakistans environment. A sample of 445 listed firms on KSE were taken and their five year data from 1997-2001 were taken into circumstance. Pooled regression results indicated that assets tangibility is positively correlative with debt, concluding that asset structure does not matter in intent of capital structure of Pakistani firms. Size was positively correlated with leverage suggesti ng that large firms would employ more debt. Growth was found to be negatively correlated with leverage that supports the simple version of pecking order theory that ontogeny firms finance their investment opportunities first by their internally generated funds. There was lovesome relationship between profitability and leverage. Profitability was negatively correlated with leverage that supports the pecking order theory.A study in Hong Kong was carried by Hung, et.al (2002) examing the inter-relationship between profitability, cost of capital and capital structure among property developers and contractors in Hong Kong. The results showed that capital pitch is positively related with assets but negatively with profit margins.Bartholdy and Cesario (2006) analysed the decisions regarding the capital structure of Portuguese non-listed bank financed firms. Primary purpose of the research was to find out the impact of debt tax shield on the decisions regarding capital structure of tiny non-listed firms. The secondary purpose was to find out that whether the determinants of capital structure of larger listed firms were also same as in case of wasteder non-listed firms. The research explained that the solution of two big problems (agency and asymmetric information) for large firms are apparent on the balance tag end as restriction on debt. On the other hand it is less apparent on the balance sheet of smaller firms. This provided the smaller firms with the benefit of tax shield due to more debt. This research has provided a great support in writing our review literature and understanding the relationship between profitability and debt to a great extent. The sample of their research consisted 998 firms with 7765 firm years observations. The results concluded that the tax viands regarding the carry forward of tax losses and debt tax shield play a vital role in determining the capital structure of small non-listed firms. It was also concluded that in order to solve agency problem traditional balance sheet variables were significant in large listed firms but were insignificant for the small non-listed firms with the keep oution of variables required to solve bankruptcy risk.A research study was conducted in Greece by Eriotis, et.al (2007) aiming to isolate the firm characteristics that effect capital structure. The investigation was performed using panel data for a sample of 129 Greek companies listed on Athens Stock Exchange during 1997-2001. The findings justify a negative relationship between the debt ratio of the firms and their growth, and size appeared to have a positive relation.Gropp and Florian (2008) conducted research study regarding the determinants of the capital structure of banks by examining the capital structure of banks from the prospective of empirical capital structure literature for non-financial firms. The sample of the study includes 200 largest listed banks (100 from US and 100 from EU) from the sixteen different countr ies (US and 15 EU members) from 1991 to 2004. The results suggest that the capital requirements may however be of second importance for banks capital structures and confirm the robustness of corporate finance findings in a holdout sample of banks.In order to examine the capital structure across countries a study was carried by Rajan and Luigi (1994). The primary objective of the study was to establish whether the choice of capital structure in other countries is based on the factors similar to those influencing capital structure of US firms. show was on the 8000 non-financial corporations of G-7 countries (USA, Germany, Japan, France, UK, Italy and Canada) for the period of 1987-1991. After correcting the differences ranging from accounting practices to legal and institutional environments between the countries. results of the study showed extent to which firms are levered is evenhandedly similar across the G-7 countries except UK and Germany being relatively less levered.Sakurag awa (2001) conducted another study regarding the capital structure of banks under non-diversifiable risk. The purpose of the research was to study the design of optimal capital structure of a large financial corporation when it faces a non-diversifiable risk. When there is a non-diversifiable risk the mediator finds it profitable to issue equity because by way out equity it can reduce the cost and the probability of banks failure. The intermediary designs the optimal capital structure by balancing the marginal benefit of reducing probability of banks failure against the marginal cost of debt-equity swap. Results showed that a large corporation under weaker conditions realizes more efficient allocation by release both debt and equity than by issuing only debt.An African study was conducted by cole-man (2007) whose aim was to examine the impact of capital structure on the performance of microfinance institutions. Panel data covering the ten-year period 1995-2004 were analyzed with in the framework of fixed- and random-effects techniques. Results showed that the most of the microfinance institutions employ high leverage and finance their operations with long-term as against short-term debt. Results also revealed that the highly leveraged microfinance institutions perform best(p) by reaching out to more clientele, enjoy scale economies, and therefore are better able to deal with moral hazard and adverse selection, enhancing their ability to deal with risk.Fernandez (2003) analyzed the driving forces of capital structure in Chile for the period1990-2002. The purpose of the research was to study aggregate leverage and interest-bearing liabilities in isolation for all firms, and firms segmented by economic sector. Their sample of the study consisted of 64 firms having the complete information for the whole sample period of 1990-2002. Results while supporting the trade-off theory revealed that the firms favored equity over debt issues to cover their financing defi cit because of the Chiles tax and monetary policies.In order to find out the determinants of very small firms financial leverage Barbosa and Cristiana (2003) carried a research. Theydescribed the relationship between profitability and financial leverage asAs far as profitability is concerned, the most commonality expectation in the financial structure literature is for a negative relationship with financial leverage. Toy and others (1974 p.877), Marsh (1982 p.126 footnote 22), Friend and Lang (1988 p.277), Titman and Wessels (1988 p.6) and Barton and others (1989 p.40) all say that in different words. According to them, a firm with a high profit rate, ceteris paribus, would maintain a relatively lower debt ratio because of its ability to finance itself from internally generated funds. The preference for raising capital first from retained earnings may be due, according to Titman and Wessels (1988 p.6), to the costs of issuing new equity or debt that arise because of asymmetric info rmation or transaction costs. Marsh (1982 p.126 footnote 22) raises the possibility that the impact may be due to the tendency of firms to issue new equity immediately after periods of ab ordinarily good performance. Hall and Weiss (1967 p.328) assert that relatively profitable firms take some of their exceptional returns in the form of reduced risk, through retaining earnings, and, therefore, show lower debt to assets ratios. Rajan and Zingales (1995 p.1451) cite Jensen (1986) who predicts that, if the market for corporate control is ineffective, managers of profitable firms prefer to avoid the disciplinary role of debt. This preference would lead to a negative correlation between profitability and debt. Gupta (1969 p.522) speaks of a theory that extends the first flavor above mentioned from the firm level to the industry level. Accordingly, profitable industries, because of the greater handiness of internally generated funds related to their high profitability tend to have lower debt in their financial structure. Last, Gale (1972 p.417-8) interprets leverage as representing the degree of risk or otherwise in the industries in which the firm competes and hypothesizes that leverage should then be negatively related to profitability. This author himself acknowledges that his reasoning is somewhat at odds with previous discussions and theory, though. According to him, low debt to total capital ratios would glint high industry risk because of two aspects. First, the corresponding capital structures would be the result of higher investment on the part of entrepreneurs, who, differently from lenders, place a lower value on security relative to rewards. Second, bad industries are, at least theoretically, associated with higher profitability. Barbosa and Cristiana (2003)Results of their research concluded that the growth, entrepreneurs risk tolerance, size and operational cycle were positively correlated with the financial leverage whereas asset composition, infl ation, profitability and business risk are negatively correlated with financial leverage of very small firms.Chapter-3MethodologyIn this variance, we have explained the source of data, sample size, explanation and measurement of the variables, and the regression model.3.1 Source of DataIn this study financial data of firms listed on the Karachi Stock Exchange under Fuel and Energy sector of Pakistan is taken from the State Bank of Pakistan Publications relief Sheet Analysis of Joint Stock Companies Listed on the Karachi Stock Exchange 2003-2008.3.2 Sample sizeThis study is carried on the Fuel and Energy sector of Pakistan. There are 27 firms of that sector which are listed on the Karachi Stock Exchange. But after screening the firms with incomplete data, we have selected 22 firms having complete data for six years from 2003-2008 as our study covers the period from 2003-2008. So we have 132 firm years for the panel data analysis.3.3 Explanation and meter of the variablesBasically our study follows the framework of Shah and Tahir (2005). We include only two variables in our study. First variable is leverage (dependent variable) and another is profitability (Independent variable). In this section we describe these two variables and explain how they are measured.3.3.1 Leverage (Dependent variable)Leverage is explained as percentage of assets financed by debts. Different researchers have measured leverage differently. candid and Goyal (2003) differentiated between two debt ratios, one based on market value while the other on book value. Debt ratio based on market value relates with the firms future situation whereas on the other hand debt ratio based on book value tends to reflect the past situation.While in our study measuring leverage through book value, we have mainly two reasons in our encephalon. First, one of the main benefits of debt is tax shield that is the interest payments are tax deductible expense, resulting in cash savings. Once the debt is issue d these tax shield advantages do not vary by the market value of the debt. Second point in our mind while measuring leverage through book value is the relationship of debt with bankruptcy risk. The probability of bankruptcy increases with the increase in the debt. Moreover, in case of bankruptcy of a firm, the value of the debt through the book value of the debt is more relevant than the market value of debt.While measuring the financial leverage we faced a problem of choosing either total debt or only long term debt as percentage of total assets. Interestingly many capital structure theories favor long term debt but we have used total debt because the average firm size in Pakistan is small which limits their access to capital market because of technical difficulties and cost involved. So the firms in Pakistan prefer short term borrowing because of the fact that the major lenders in Pakistan are commercial banks and they discourage long term borrowing. Firms in Pakistan did not rely on the market based debt upto 1994, but in the mid of 1994 Government while amending Company Law, allowed firms to raise debt directly in the form of TFCs (Term Finance Certificates) from the market.Thus in our study we have measured the leverage through total debt to total asset ratio.3.3.2 Profitability (Independent Variable)Profitability has been the main point of distinction between the Static Trade-off Theory and the Pecking Order Theory. Static Trade-off Theory explains that the firm with higher profitability has more reasons to issue more debt while taking tax shield benefit. While on the other hand, Pecking Order Theory presupposes that firms with larger earnings tend to use its internally generated funds i.e. retained earnings initially to follow through their financial needs then they go for debt. Thus, Static Trade-off Theory expects a positive and direct relationship between profitability and leverage of a firm while Pecking Order Theory suggests negative relationship between the two above said variables.We have measured the profitability as the ratio of Net Income before Tax divided by the total assets.3.4 Research hypothesisThis research study supports the Pecking Order Theory hypothesis and our proposed research hypothesis is There is significant negative relationship between profitability and leverage of a firm.Ho There is significant negative relationship between profitability and leverage of a firm3.5 Regression ModelLinear Regression analysis has been used in this study. Basically we have used pooled regression type of panel data analysis. By saying this we mean that the companys financial data and time serial data are pooled together in a column.The equation for our regression model will beLG= 0 + 1 (PF) + .WhereLG= Leverage0= ConstantPF= Profitability= Error termChapter 4Results of the test and interpretation.This chapter contains the results of the descriptive statistics and linear regression test. There are 27 firms in Energy and fuel sector which are listed on the Karachi Stock Exchange. But after screening the firms with incomplete data, we have selected 22 firms having complete data for the six years from 2003-2008 as our study covers that specified period. So we have 132 firm years for the panel data analysis.4.1 Data ConsiderationFor data consideration to be suitable for linear regression we graph the P-P fleck of dependent and independent variable in order to check that the data is normally distributed. The P-P plots of profitability and leverage are as follows.Above Normal P-P darn of Independent variable (Profitability) shows that the variable follows a normal distribution. On the other hand dependent variable (leverage) is also said to be fairly normally distributed.In order to show the linear regression model is appropriate for the data or not we graph a turn out plot between profitability and leverage which is as followsScatter plot shows that whether linear regression model is appropriate for the data or not. however above scatter plot appears to be suitable for linear regression.4.2 Results of the testAfter running the linear regression test on SPSS we have the following results.Table-1Descriptive StatisticsTotal NoMinimumMaximum squiffyStandard DeviationProfitability (PF)132-0.220.430.05150.12441Leverage (LV)132.001.270.55880.27425Valid No (list wise)132Table-1 contains the descriptive