Dynamics of Financial Structure Adjustments and Firms' Financial Performance By Sohail Amjed A research thesis submitted to the Department of Management & Social Sciences, Capital University of Science & Technology, Islamabad in partial fulfillment of the requirements for the degree of DOCTOR OF PHILOSOPHY IN MANAGEMENT SCIENCES (FINANCE) DEPARTMENT OF MANAGEMENT & SOCIAL SCIENCES CAPITAL UNIVERSITY OF SCIENCE & TECHNOLOGY ISLAMABAD AUGUST 2016 II Copyright© 2016 by Sohail Amjed All rights are reserved. No part of the material protected by this copy right notice may be reproduced or utilized in any form or any means, electronic or mechanical, including photocopying, recording or by any information storage and retrieval system, without the permission from the author. IV Please take certificate from Eng. Khalid and past here VI DEDICATION This dissertation is dedicated to my beloved family whose prayers always pave the way to success for me. VII TABLE OF CONTENTS CHAPTER NO.1 ................................................................................................................................ 1 Introduction ........................................................................................................................................ 1 1.1 Overview ................................................................................................................................... 1 1.2 Implication of Financial Structure ............................................................................................ 5 1.3 Research Gap ............................................................................................................................ 6 1.4 Research Motivations: .............................................................................................................. 9 1.5 Research questions .................................................................................................................... 9 1.6 Research objectives ................................................................................................................. 10 1.7 Significance of the study ......................................................................................................... 10 1.8 Research Contributions ........................................................................................................... 11 1.9 Organization of the dissertation .............................................................................................. 12 CHAPTER NO.2 .............................................................................................................................. 13 Financial environment and Corporate Sector of Pakistan ................................................................ 13 2.1 Financial environment of Pakistan.......................................................................................... 13 2.2 Corporate sector of Pakistan ................................................................................................... 14 2.2.1 Capital markets ................................................................................................................. 18 2.2.2 Equity Market ................................................................................................................... 18 2.2.3 Debt market ...................................................................................................................... 23 CHAPTER NO. 3 ............................................................................................................................. 27 Review of Literature ......................................................................................................................... 27 3.1 Brief Chronology of Important Capital Structure Theories .................................................... 27 3.2 Modigliani-Miller Irrelevance Theorem ................................................................................. 29 3.3 Pecking Order Theory ............................................................................................................. 31 3.4 Agency Theory........................................................................................................................ 33 3.5 Tradeoff Theory ...................................................................................................................... 35 3.5.1 Dynamic Tradeoff Model ................................................................................................. 37 3.5.2 Adjustment towards Target Capital Structure .................................................................. 40 VIII 2.6 Market timing theory .............................................................................................................. 44 2.7 Variables ................................................................................................................................. 45 2.7.1 Estimators of target capital structure ................................................................................ 46 2.8.2 Determinants of Adjustment Speed .................................................................................. 56 2.8 The relationship between capital structure and firm's performance ....................................... 60 2.9 Cost and availability of capital: A global perspective ............................................................ 62 2.9.1 The duality of debt finance ............................................................................................... 63 2.9.2 Capital structure puzzle .................................................................................................... 66 2.9.3 Towards the solution of capital structure puzzle ............................................................. 66 CHAPTER NO.4 .............................................................................................................................. 69 Methodology ..................................................................................................................................... 69 4.1 Research Philosophy ............................................................................................................... 69 4.2 Data and Sampling .................................................................................................................. 70 4.3 Graphical presentation of the model ....................................................................................... 77 4.4 Estimation scheme .................................................................................................................. 78 4.1.1 Variables ........................................................................................................................... 79 4.1.2 Statistical Model ............................................................................................................... 79 4.5 Estimation of Adjustment Speed: ........................................................................................... 83 4.6 Determinants of Adjustment Speed ........................................................................................ 86 4.7 Impact of adjustment speed on financial performance: .......................................................... 87 CHAPTER NO. 5 ............................................................................................................................. 88 Results and discussions .................................................................................................................... 88 5.1 Aggregate Descriptive Statistics: ............................................................................................ 88 5.2 Parameters Estimation ............................................................................................................ 96 5.2.1 Significance of the target Contractual Debt ratio determinants ....................................... 97 5.2.2 Coefficients of Target Long Term Debt ratio ................................................................ 101 5.2.3 Coefficients of target Total Debt ratio ........................................................................... 103 5.3 Capital Structure Adjustment Speed ..................................................................................... 106 5.3.1 Annual Adjustment Speed .............................................................................................. 108 5.3.2 Industry Adjustment Speed ............................................................................................ 111 5.4 Determinants of Adjustment Speed ...................................................................................... 113 IX 5.5 Impact of Adjustment Speed on Financial Performance ...................................................... 116 CHAPTER NO.6 ............................................................................................................................ 119 Conclusion and recommendations: ................................................................................................. 119 6.1 recommendations .................................................................................................................. 121 6.2 Research Limitations ............................................................................................................ 121 6.3 Future research ...................................................................................................................... 122 References ...................................................................................................................................... 123 APPENDIX-I .................................................................................................................................. 152 X LIST OF TABLES Title Page No Table 2.1: Companies registered under Companies Ordinance 1984 16 Table 2.2: Performance of KSE at glance 20 Table 2.3: Number of Listed Companies, fund Mobilized and Total 22 Turnover of Shares in Various Stock Exchanges Table 2.4: Number of companies issued debt instruments and Amount in 24 Billion Rupees of Debt Securities as on 30th June 2015 Table 4.1: Sector Wise List of Companies in BSA and Selected Sample 73 Table 4.2: List of Variables 79 Table 5.1: Summary Statistics of Variables 89 Table 5.2: Correlation Matrix 92 Table 5.3: Descriptive Statistics of Three Capital Structure Measures 96 Table 5.4: Determinants of Target Contractual Debt to Asset ratio 98 Table 5.5: Determinants of Target Long Term Debt to Asset ratio 102 Table 5.6: Determinants of Target Total Debt to Asset ratio 104 Table 5.7: Annual Capital Structure Adjustment Speed Overall 110 Table 5.8: Capital Structure Adjustment Speed summary statistics of 111 individual economic sectors Table 5.9: Determinants of Adjustment Speed 114 Table 5.10 Impact of Adjustment Speed on Financial Performance 117 XI LIST OF FIGURES Title Page No Figure.2.1: Year Wise new Company Incorporation 17 Figure 2.2: Corporate Debt Market at Glance 25 Figure 3.1: Graphical presentation of Tradeoff Model 36 Figure 4.1: Graphical Presentation of the Model 77 Figure 5.1: Average Return on Assets of Corporate Sector over 90 thirteen year period Figure 5.2: Corporate Sector Long Term Leverage history 93 Figure 5.3: Corporate Sector Contractual Debt history 94 Figure 5.4: Corporate Sector Total Debt history 95 Figure 5.5: Capital Structure Adjustment speed of Overall 109 Figure 5.6: Sector wise annual capital structure adjustment speed 112 XII ABBREVIATIONS CPs Commercial Papers DCs Domestic Companies GMM Generalized Method of Moments ISE Islamabad Stock Exchange KSE Karachi Stock Exchange LBO Leverage Buy outs LSE Lahore Stock Exchange MBO Management Buy Outs MNCs Multinational Companies OTC Over the Counter Market SBP State Bank of Pakistan SECP Securities and Exchange Commission of Pakistan SIC Standard Industrial Classification SMCs Single Member Company SMEs Small and Medium Enterprises TFCs Term Finance Certificates TSLS Two-Stage Least Squares XIII