Financial Reforms and Dynamics of Capital Structure Choice: A Case of Publically Listed Firms of Pakistan

Abstract

The present paper is an attempt to integrate financial reforms and corporate finance in a dynamic setup. Determinants of capital structure choice are analyzed dynamically using panel data of 374 non-financial firms listed on Karachi Stock Exchange (KSE) of Pakistan for the period 1988-2008. To capture the dynamic nature of capital structure choice the Arellano-Bond Dynamic Panel-Data Estimation technique is used to avoid the problems of endogeneity, heteroscedasticity and autocorrelation which arise due to dynamic panel data estimation. 

Reforms, it is found, has a negative impact on leverage of the firm suggesting that with liberalization and strengthening of institutions, there is a massive decrease in leverage; indicating that firms shifted from debt to equity market once the financial constraints are eased out. Lagged leverage, it is found, affects leverage positively, substantiating the fact that capital structure requires costs for adjustment; hence the adjustment process is delayed. The results furthers confirms the use of tangible assets as collateral; tangibility is positively correlated with Leverage which is contrary to Pecking Order Hypothesis but well explained by the trade-off theory of capital structure choice. However, the results substantiate Pecking order Hypothesis for profitability, size and growth. Profitability, size and growth, as espoused by pecking order hypothesis, are negatively correlated with leverage. That is highly profitable firms use equity financing instead of debt financing. Similar is the case with big firms and firms with high growth opportunities. As firms size increase its leverage decreases. Earning volatility confirms the trade off theory of capital structure choice. Moreover, the results reveal that firms owned by government are financed heavily through debt using banks loans as their primary instrument for financing their projects. In addition to these findings, the results suggest that the choice of capital structure varies across different industries.