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Joshua Abor and Nicholas Biekpe
University of Stellenbosch, Graduate School of Business

This paper seeks to empirically identify the determinants of the capital structure of
listed firms on the Ghana Stock Exchange during the most recent six-year period.
Ordinary Least Square model is used to estimate the regression equation. The
results indicate that, total debt constitutes more than half of the capital of listed
firms in Ghana. The results also show positive associations between debt ratio
(capital structure) and firm size and growth, while asset tangibility, risk, corporate
tax and profitability are negatively related to debt ratio. The results generally
support the pecking order theory proposed by the theoretical model.


The capital structure of a firm is actually a specific mixture of debt and equity a firm employs
in financing its operation. The capital structure decision is crucial for any business
organization. The decision is important because of the need to maximize returns to various
organizational constituencies, and also because of the impact such a decision has on an
organization’s ability to deal with its competitive environment. In an attempt to set a capital
structure that maximizes overall market value, firms do differ with regard to their capital
structure. That is why there are various theories of capital structure that try to explain this
cross-sectional variation.

Keywords: capital structure, leverage, debt ratio, Ghana

JEL Classification: G3, G32

Correspondence to
Joshua Abor

African Finance Journal, Volume 7, Part 1 2005 37

These theories examine the determinants of capital structure from different aspects and come
out with different conclusion as far as the choice of the determination of the level of financial
leverage is concerned. Empirical evidence, focusing mainly on developed economies has also
provided inconclusive results on the issue. It is important to examine capital structure from the
perspective of developing countries given the differences in levels of economic development.
This present study investigates the determinants of capital structure of listed firms on the
Ghana Stock Exchange (GSE) during the most recent six-year period (1998 – 2003). The
subject matter is an area that has not yet been explored in Ghanaian finance literature.

The paper is organized as follows. The next section gives a review of the extant theoretical and
empirical literature on the determinants of capital structure. Section three explains the
methodology adopted for the study. The empirical results are presented and discussed in
section four. Finally, section five summarizes the findings of the research and also concludes
the discussion.


A number of important theories have been advanced to explain the capital structure of firms.
These include tax benefits associated with debt use, the agency theory, bankruptcy cost, the
pecking order theory and the signaling theory. The tax benefits associated with debt use,
bankruptcy cost and the agency theory are described in terms of the static trade off theory.
These theories are discussed in turn.

Corporate taxes allow firms to deduct interest on debt in computing taxable profits. This
suggests that tax advantages derived from debt would lead firms to be completely financed
through debt. This benefit is created, as the interest payments associated with debt are tax
deductible, while payments associated with equity, such as dividends are not tax deductible.
Therefore, this tax effect encourages debt use by the firm, as more debt increases the after tax
proceeds to the owners (Modigliani & Miller, 1963; Miller, 1977).

Bankruptcy costs are the cost directly incurred when the perceived probability that the firm will
default on financing is greater than zero. The bankruptcy probability increases with debt level
since it increases the fear that the company might not be able to generate profits to pay back the
interest and the loans. The potential costs of bankruptcy may be both direct and indirect.
Examples of direct bankruptcy costs are the legal and administrative costs in the bankruptcy
process. Haugen and Senbet (1978) argue that bankruptcy costs must be trivial or nonexistent if
one assumes that capital market prices are competitively determined by rational investors.
Examples of indirect bankruptcy costs are the loss in profits incurred by the firm as a result of
the unwillingness of stakeholders to do business with them (Titman, 1984).

The use of debt in capital structure of the firm also leads to agency costs. Agency costs arise as
a result of the relationships between shareholders and managers and those between debt-
holders and shareholders (Jensen & Meckling, 1976). According to Harris and Raviv (1990),
the conflict between shareholders and managers arises because shareholders hold the entire
residual claim and consequently managers do not capture the entire gain from their profit-
enhancing activities but they do bear the entire cost of these activities. Separation of ownership
and control may result in managers exerting insufficient work, indulging in perquisites,
choosing inputs and outputs that suit their own preferences. On the other hand, the conflict
between debt-holders and shareholders is due to moral hazard.

38 The African Finance Journal, Volume 7, part 1, 2005

The conflict arises because equity-holders have an incentive to invest suboptimally in very
risky projects (Jensen and Meckling, 1976). In the event of an investment yielding large
returns, equity-holders receive the majority of the benefits. However, in the case of the
investment failing, debt-holders bear the majority of the consequences (Brander & Lewis,
1986). The need to balance gains and costs of debt financing emerged as a theory known as the
static trade-off theory by Myers (1984). It values the company as the value of the firm if
unlevered plus the present value of the tax shield minus the present value of bankruptcy and
agency costs.

The concept of optimal capital structure is also expressed by Myers (1984) and Myers and
Majluf (1984) based on the notion of asymmetric information. The conclusion drawn from the
asymmetric information theories is that, there is a hierarchy of firms’ preferences with respect
to the financing of their investments (Myers and Majluf, 1984). This “pecking order” theory
suggests that firms will initially rely on internally generated funds, i.e. undistributed earnings,
where there is no existence of information asymmetry, then they will turn to debt if additional
funds are needed and finally they will issue equity to cover any remaining capital requirements.
The order of preferences reflects the relative costs of various financing options. Myers and
Majluf (1984) maintain that, firms would prefer internal sources to costly external finance.
Firms that are profitable or generate high earnings are therefore expected to use less debt
capital than those that do not generate high earnings

The pecking order theory would indicate that the profitability of a firm affects its financing
decisions. If it issues debt, this means that the firm has an investment opportunity that exceeds
its internally generated funds. So, changes in the capital structure often serves as a signal to
outsiders about the current situation of the firm as well as the managerial expectations
concerning future earnings. This is called the signalling theory. The debt offering is believed to
reveal information the management of a firm is expecting about future cash flows if it will
cover the debt costs. However, the bankruptcy fears still impact the signal and intensify the
cost of this signal (Asquith and Mullins, 1986; and Eckbo, 1986).

2.1 Capital Structure and Firm Characteristics

A number of firm-level characteristics have been identified in previous empirical studies
examining capital structure and these include; firm size, asset structure, profitability, risk,
growth and corporate tax. These are discussed in turn.

2.1.1 Firm Size

Size has been viewed as a determinant of a firm’s capital structure. Larger firms tend to be
more diversified and hence have lower variance of earnings, making them able to tolerate high
debt ratios (Castanias, 1983; Titman and Wessels, 1988; Wald, 1999). Smaller firms on the
other hand may find it relatively more costly to resolve information asymmetries with lenders,
thus, may present lower debt ratios (Castanias, 1983). Another explanation for smaller firms
having lower debt ratio is if the relative bankruptcy costs are an inverse function of firm size
(Titman and Wessels, 1988). This view is also explained differently by Castanias (1983). He
states that if the fixed portion of default costs tends to be large, then marginal default cost per
dollar of debt may be lower and increase more slowly for larger firms.

African Finance Journal, Volume 7, Part 1 2005 39

Empirical evidence on the relationship between size and capital structure of firms are quite
varying with respect to conclusions. Several works support a positive relationship between
firm size and leverage (Marsh, 1982; Friend and Lang 1988; Barton et al, 1989; Rajan and
Zingales, 1995; Cassar and Holmes, 2003, Al-Sakran, 2001, Hovakimian et al, 2004). Fischer
et al (1989) however found a negative relationship between size and debt ratio.

2.1.2 Asset Tangibility

The asset tangibility of a firm plays a significant role in determining its capital structure. The
degree to which the firm’s assets are tangible should result in the firm having greater
liquidation value (Harris and Raviv, 1991; Titman and Wessels, 1988). Bradley et al (1984)
assert that firms that invest heavily in tangible assets tend to have higher financial leverage
since they borrow at lower interest rates if their debt is secured with such assets. It is believed
that, debt may be more readily used if there are durable assets to serve as collateral (Wedig et
al, 1988). By pledging the firm’s assets as collateral, the cost associated with adverse selection
and moral hazards are reduced. This will result in firms with assets that have greater liquidation
value having relatively easier access to finance at lower cost, consequently, leading to higher
debt or outside financing in their capital structure. Empirical evidence suggests a positive
relationship consistent with theoretical argument between asset structure and leverage for large
firms (Bradley et al, 1984; Wedig et al, 1988; Friend and Lang 1988; Mackie-Mason, 1990;
Rajan and Zingles 1995; Shyam-Sunder and Myers 1999; Hovakimian et al, 2004). Kim and
Sorensen (1986) however found a significant and negative coefficient between depreciation
expense as a percentage of total assets and financial leverage.

2.1.3 Profitability
The relationship between firm profitability and capital structure can be explained in terms of
the pecking order theory. According to this theory, firms prefer internal sources of finance to
external sources. The order of the preference is from the one which is least sensitive (and least
risky) to the one which is most sensitive (and most risky) that arise because of asymmetric
information between corporate insiders and less well-informed market participants (Myers
1984). By this token, profitable firms, which have access to retained profits, can rely on it as
opposed to depending on outside sources (debt). Titman and Wessels (1988) and Barton et al
(1989), agree that firms with high profit rates, all things being equal, would maintain relatively
lower debt ratio since they are able to generate such funds from internal sources. Empirical
evidence from previous studies seems to be consistent with the pecking order theory. Most
studies found a negative relationship between profitability and capital structure (Friend and
Lang, 1988; Barton et al, 1989; Shydam-Sunder and Myers, 1999; Jordan et al, 1998; Mishra
and Mc Conanghy, 1999, Al-Sakran, 2001; Hovakimian et al, 2004).

2.1.4 Firm Risk

The level of risk is said to be one of the primary determinants of a firm’s capital structure (Kale
et al, 1991). The tax shelter-bankruptcy cost theory of capital structure determines a firm’s
optimal leverage as a function of business risk (Castanias, 1983). Given agency and bankruptcy
costs, there are incentives for the firm not to fully utilize the tax benefits of 100% debt within a
static framework model. The more likely a firm will be exposed to such costs, the greater their
incentive to reduce their level of debt within the capital structure of the firm.

40 The African Finance Journal, Volume 7, part 1, 2005

One firm variable which impacts upon this exposure is the firm’s operating risk, in that, the
more volatile the firm’s earnings stream, the greater the chance of the firm defaulting and being
exposed to such costs. According to Johnson (1997), firms with more volatile earnings growth
may experience more states where cash flows are too low for debt service. Kim and Sorensen
(1986) also observed that, firms with high degree of business risk have less capacity to sustain
financial risks and thus, use less debt. A number of works have indicated an inverse
relationship between risk and debt ratio (Kale et al, 1991; Bradley et al, 1984; Titman and
Wessel, 1988; Friend and Lang 1988; Mackie-Mason 1990; Kim et al, 1998).

2.1.5 Growth
The relationship between growth and capital structure can also be explained by the pecking
order hypothesis. Growing firms place a greater demand on the internally generated funds of
the firm. According to Marsh (1982), firms with high growth will capture relatively higher debt
ratios. There is also a relationship between the degree of previous growth and future growth.
Michaelas et al (1999) argue that future opportunities will be positively related to leverage, in
particular short term leverage. They argue that agency problem and consequentially the cost of
financing are reduced if the firm issues short term rather than long-term debt. Myers (1977)
however, holds that view that firms with growth opportunities will have smaller proportion of
debt in their capital structure. This is due to the fact that, conflicts between debt and equity
holders are especially serious for assets that give the firm the option to under take such growth
opportunities in the future. Empirical evidence seems inconclusive. Some researchers found
positive relationship between sales growth and leverage. (Kester, 1986; Titman and Wessels,
1988; Barton et al, 1989). Other evidence showed that higher growth firms use less debt, as
such indicated negative relationship between growth and debt ratio (Kim and Sorensen, 1986;
Stulz, 1990; Rajan and Zingales, 1995; Mehran, 1992; Roden and Lewellen, 1995; Al-Sakran,

2.1.6 Taxation
There have been numerous empirical studies of the impact of taxation on corporate financing
decisions in the major industrial countries. Some are concerned directly with tax policy, for
example: Auerbach (1984), Mackie-Mason (1990), Shum (1996), and Graham (1996, 1999).
MacKie-Mason (1990) studied the tax effect on corporate financing decisions. The study
provided evidence of substantial tax effect on the choice between debt and equity. He
concluded that changes in the marginal tax rate for any firm should affect financing decisions.
When already exhausted (with loss carry forwards) or with a high probability of facing a zero
tax rate, a firm with high tax shield is less likely to finance with debt. The reason is that tax
shields lower the effective marginal tax rate on interest deduction. Graham (2002) concluded
that, in general, taxes do affect corporate financial decisions, but the magnitude of the effect is
mostly “not large”. On the other hand, DeAngelo and Masulis (1980) show that there are other
alternative tax shields such as depreciation, research and development expenses, investment
deductions, etc., that could substitute the fiscal role of debt. Empirically, this substitution effect
is difficult to measure as finding an accurate proxy for tax reduction that excludes the effect of
economic depreciation and expenses is tedious (Titman and Wessels, 1998).

African Finance Journal, Volume 7, Part 1 2005 41

This study sampled all firms that have been listed on the GSE over the recent six year period
(1998-2003). Twenty two firms qualified to be included in the study sample. All the companies
that were included in the sample fulfil two basic criteria. First, all of the firms were listed on
the GSE as at 1997. Secondly, none of the sample firms was delisted during the period under
investigation. The data used in the empirical analysis was derived from the annual reports of
the firms during the period 1998-2003.

With respect to the variables used in the analysis, the capital structure or debt ratio, which is
the dependent variable, is defined as the ratio of total debt divided by the total capital. Total
debt contains both long-term and short-term debts. The strict notion of capital structure refers
exclusively to long-term leverage. However, firms in Ghana use either very little or no long-
term capital, mainly because of the difficulty in obtaining long-term financing from the
banking sector with attractive terms. As a result, they mostly turn to short-term borrowing to
finance their long-term projects. Thus, debt includes both long-term and short-term debt
financing. The explanatory variables include size, asset tangibility, profitability, risk, growth
and corporate tax. The debt ratio is regressed against the six explanatory variables.

The panel character of the data allows for the use of panel data methodology. Panel data
involves the pooling of observations on a cross-section of units over several time periods and
provides results that are simply not detectable in pure cross-sections or pure time-series studies.
The panel regression equation differs from a regular time-series or cross section regression by
the double subscript attached to each variable. The general form of the panel data model can be
specified more compactly as:

Yit = α i + β X it + ë it (1)

with the subscript i denoting the cross-sectional dimension and t representing the time-series
dimension. The left-hand variable Yit , represents the dependent variable in the model, which is
the firm's debt ratio. X it contains the set of explanatory variables in the estimation model, αi
is taken to be constant overtime t and specific to the individual cross-sectional unit i. If αi is
taken to be same across units, Ordinary Least Squares (OLS) provides a consistent and
efficient estimate of α and β . The model for estimating the determinants of capital structure
based on the variables discussed in section 2.1 is therefore given as follows:

DRit = β 0 + β1 SIZEit + β 2TANGit + β 3 ROAit + β 4 RISK it + β 5 GROWit + β 6TAX it + ë it (2)

DRit = leverage (total debt/ equity + debt) for firm i in time t

SIZEit = the size of the firm (log of total assets) for firm i in time t
TANGit = fixed tangible assets divided by total assets for firm i in time t
ROAit = earnings before interest and taxes divided by total assets for firm i in time t
RISK it = the squared difference between the firm’s profitability in time t and the mean
profitability for firm i,

42 The African Finance Journal, Volume 7, part 1, 2005

GROWit = growth in sales for firm i in time t
TAXit = the ratio of tax paid to operating income for firm i in time t
ë = the error term


4.1 Summary Statistics

Table 1 provides a summary of the descriptive statistics of the dependent and independent
variables. This shows the average indicators of variables computed from the financial
statements. The mean (median) debt ratio (measured by total debt /total capital) of the sample
firms was 0.5850 (0.5443). Total debt appears to constitute more than half of the capital of the
firms. This suggests that, 58.5% of total assets are financed by debt capital. Equity capital
therefore represents 41.5%. Size, determined as the natural logarithm of total assets had a mean
(median) of 18.3286 (18.0726). Asset tangibility had a mean of 0.3834. This indicates that, on
average, fixed assets accounted for 38.34% of total assets. Profitability, given as the ratio of
EBIT to total assets, registered a mean value of 0.1156 suggesting a return on assets of 11.56%.
Risk is measured as the variability of EBIT and this showed a mean (median) of 0.9097
(0.6472). The mean growth (measured as growth in sales) was 0.3252. This indicates that, on
average, growth rate in sales was 32.52% during the six-year period. Corporate tax rate on
average was 23.27%.

Table 1: Descriptive statistics of dependent and independent variables

Mean Std. Dev. Minimum Median Maximum
DR 0.5850 0.2006 0.1787 0.5443 1.1018
SIZE 18.3286 1.9179 14.5760 18.0726 22.6666
TANG 0.3834 0.2268 0.0177 0.4124 0.9650
ROA 0.1156 0.1125 -0.1408 0.0993 0.5415
RISK 0.9097 4.5442 -22.7185 0.6472 22.3320
GROW 0.3252 0.3463 -0.7500 0.2553 1.3597
TAX 0.2327 0.1609 0.0000 0.2695 0.5794

4.2 Regression Analysis

Regression analysis is used to investigate the relationship between the firm-level variables and
leverage. Ordinary Least Square (OLS) regression results are presented in Table 2. The results
indicate a statistically significant positive relationship between size and leverage. The results
suggest that the bigger the firm, the more debt it will use. One reason is that, larger firms are
more diversified and hence have lower variance of earnings, making them able to tolerate high
debt ratios. Lenders are more willing to lend to larger companies because they are perceived to
have lower risk levels. On the other hand, smaller firms may find it relatively more costly to
resolve information asymmetries with lenders, thus, may present lower debt ratios. This result
is expected from financial theory.

The coefficient of asset tangibility variable is negative and significant for the panel data
estimations. The results suggest that, for Ghanaian firms, a higher proportion of fixed assets
lead to the use of less debt financing in relative terms.

African Finance Journal, Volume 7, Part 1 2005 43

A plausible reason is that higher proportions of fixed assets denote higher operating risks
therefore firms may not want to be exposed to more risk from the use of more debt capital.
Alternatively, a higher proportion of fixed assets would also suggest that a company has the
required capital which may qualify it to get listed on the stock market. Since listing
requirements on the Ghanaian Stock Exchange include stated capital this is likely to influence
the choice of equity over debt.

The regression coefficient for the effect of profitability on leverage is negative and highly
statistically significant. The results, which are also consistent with previous studies show that,
higher profits increase the level of internal financing. Firms that generate internal funds,
generally tend to avoid gearing (debt). While profitable firms may have better access to debt
finance than less profitable ones, the need for debt finance may possibly be lower for highly
profitable firms if the retained earnings are sufficient to fund new investments. The findings
clearly provide support for the pecking order theory that denotes that profitable firms prefer
internal financing to external financing.

The negative impact of risk for the OLS estimation implies that, firms which perform below
average are less leveraged. In other words, companies with high operating risk try to control
total risk by limiting financial risk which is associated with debt financing. Firms with high
degree of business risk have less capacity to sustain financial risks and thus, use less debt. High
risk firms are also said to have low cash flow for debt service.

The results show a positive sign of growth. The sample of listed firms in this study suggests
that growth is associated in a direct manner with financial leverage. If this is generally the case,
then firms with high growth will require more external financing to finance their growth and
should therefore display higher leverage. This view is supported by previous empirical studies
(Kester, 1986; Titman and Wessels, 1988; Barton et al, 1989).

The empirical results in this study also show a negative relationship between corporate tax and
capital structure. In Ghana, the relationship could be attributable to the special tax rebate for
listed firms. Firms that go public tend to enjoy tax reduction compared to unlisted firms.
Companies have an incentive to get listed given the tax incentive they receive. Thus, a general
increase in corporate tax would be associated with increasing equity capital since firms would
be encouraged to go public and enjoy the special tax rebate. This position appears to be
contrary to traditional capital structure theory but may be reasonable in the Ghanaian context.

Table 2: Regression Model Results

Variable Coefficient t-Statistic Prob.
SIZE 0.0202 5.5278 0.0000
TANG -0.6057 -20.6096 0.0000
ROA -0.5696 -7.4059 0.0000
RISK -0.0022 -3.6064 0.0005
GROW 0.0143 1.9666 0.0520
TAX -0.0941 -3.1576 0.0021
R-squared 0.986828
S.E. of regression 0.127475
F-statistic 1248.6490
Prob(F-statistics) 0.000000

44 The African Finance Journal, Volume 7, part 1, 2005


This paper presents a study of the determinants of capital structure of listed firms in Ghana.
The analyses are performed using data derived from the financial statements listed firms on the
GSE during the most recent six-year period. Ordinary Least Square model is used to estimate
the regression equation. The results indicate that, total debt constitutes about 59% of the total
capital of listed firms in Ghana. The results also show that the capital structure of the firms
studied is positively related to firm size and growth. The analysis suggests that, larger firms
employ more debt capital in comparison with smaller firms. Also, firms with high growth
require more external financing to finance their growth and therefore display higher leverage.
Asset tangibility, risk, corporate tax and profitability also have negative impacts on leverage.
The peculiar negative relationship between asset tangibility and capital structure suggests that
higher proportion of fixed assets leads to the use of less debt financing. The results also
indicate that firms with high degree of business risk have less capacity to sustain financial risk
which is associated with debt financing and thus, use less debt. The negative relationship
between corporate tax and capital structure could be attributed the special tax rebate listed
firms in Ghana enjoy. Companies therefore have an incentive to get listed given the tax
incentive they receive. The negative association between profitability and leverage also
suggests that, firms with high profitability tend to use less debt. This finding is consistent with
the activities following the financing procedure implied by the pecking order theory. High
profitable firms generate high internal cash flows to finance their investment. The results of
this study generally support the pecking order argument proposed by the theoretical model.

African Finance Journal, Volume 7, Part 1 2005 45

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48 The African Finance Journal, Volume 7, part 1, 2005