Capital Structure Theories and Leverage Behaviour of Pakistani Firms

This study examines the applicability of two capital structure theories; i.e., Pecking Order Theory (POT) and Trade-Off Theory (TOT). An extensive panel dataset of 293 non-financial firms listed on the Karachi Stock Exchange (KSE) for the period 2001 to 2013 is used to test those hypotheses. The data is analyzed in three phases. First, we check the leverage behavior of all listed non-financial firms of Pakistan. Second, we test the applicability of capital structure theories for manufacturing and non-manufacturing firms separately, and third, the data is segregated into large and small firms based on asset size to test the relevance of theories. Besides, firm-specific variables, three macroeconomic variables are also included, such as lending rate, inflation, and market capitalization to GDP to observe how such factors influence the leverage behavior of Pakistani firms. Two regression techniques are applied to investigate the relationship: 1) Panel regression with industry fixed effects and 2) Heteroskedasticity & Autocorrelation (HAC) consistent standard errors regression. Moreover, the validity of two hypotheses are tested based on two equations/models. Evidence of first model suggests negative relationship of profitability, size, and growth with the firm's leverage, which confirms that, on average, Pakistani firms follow pecking order theory. In the second model leverage has positive and significant relationship with last year dividend, which shows firms with higher dividend payout ratios borrow more in subsequent year/(s). Lending rate has a positive impact on leverage, whereas, inflation, and market capitalization to GDP have insignificant impact on firms' leverage. Overall, the financing behavior is in favor of POT for the non-financial firms listed at KSE