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Table of Contents

Chapter 3: Research Methodology.................................................................................................. 2 3.1 Sources of Data ..................................................................................................................... 2 3.2 Correlation Table and Regression Model ............................................................................. 2 3.3 Dependant and Independent Variables ................................................................................. 4 3.3.1 Dependant Variable ....................................................................................................... 4 3.3.2 Independent Variables ................................................................................................... 5 3.4 Hypothesis........................................................................................................................... 11

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Chapter 3: Research Methodology


This chapter provides information regarding sources of data set, sample, regression models and definitions of dependant and independent variables. Data Date is something or those attributes which are used to reveal draw results. Basically there are two types of data; Primary data and Secondary data. Primary data is a type of information that is obtained directly from first-hand sources by means of surveys, observation or experimentation etc. this type of data has not been previously published anywhere and is derived from a new study. Secondary data is the other type of information that is collected from published sources rather than first hand collection of information. This study uses secondary sources of data for analysis and collected data from the financial reports of Bao Tou Steel Limited.

3.1 Sources of Data


To determine the explanatory variables that can affect the capital structure, this study observed the selected variables of f Bao Tou Steel Limited over the period of 2002 to 2012. This study based on the data of Bao Tou Steel Limited over the period of ten years and all data has been collected from its balance sheets of respective years from 2002 to 2012. The relationship of Capital Structure has been observed with Firm Size, Growth, Profitability, Cash Flows, Firm Assets, Firm Age and Risk. 3.2 Correlation Table and Regression Model Correlation table is a two way tabulated presentation which relates the different variables in rows and columns. It measures the degree of association between the variables entered, and one of the most authentic way used to measure the effect of each variable with other variables. If we define Regression Model then we can say that it is a statistical measure that attempts to determine the strength of the relationship between one dependent variable (usually denoted by Y) and a series of other changing variables (known as independent variables). This regression model is also known as Ordinary Least Square (OLS) model and is also authentic and most preferred technique

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to measure the relationship between variables as it is used by so many studies discussed in literature Chiarella et al. (1991), Cassar and Holmes (2003) and Yee Low and Chen (2004) etc. Further this study uses SPSS statistical software for getting results from collected data. SPSS introduced by IBM Company and its completely name is IBM SPSS. SPSS help the researcher to calculate and compile huge data and getting desired results by one click. It is an integrated family of products that deals with the entire analytical processes, from planning to data collection to analysis, reporting and deployment. With more than a dozen fully integrated modules to choose from, you can find the specialized capabilities you need to increase revenue, outperform competitors, conduct research and make better decisions. This software has been chosen for data analysis due to its validity and reliability of results as it is also used by so many studies for data analysis tool. In order to determine the explanatory variables that can affect the capital structure of Bao Tou Steel Limited, seven independent variables i.e. size, growth, profitability, firm assets, age, risk and cash flows had observed with dependant variable i.e. leverage. Time series data from 2002 to 20012 is selected of Bao Tou Steel Limited and Ordinary Least Squares (OLS) regression model is employed for obtaining the final result. Further this study also developed co-relational table for all variables under consideration to evaluate the significance of results. Based on capital structure theories and empirical research on determinants of capital structure, model is as follows:

Model
LG = 0 + 1 (FZ) + 2 (GR) + 3 (PR) + 4 (CF) + 5 (FA) + 6 (AG) + 7 (RK) + Where:

LG = Leverage FZ = size GR = growth

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PR = profitability CF= cash flows FA= firm assets AG = age RK = risk = the error term

3.3 Dependant and Independent Variables


This section presents the description of dependant and independent variables, how these variables are measured in current study and what empirical findings have found by previous studies. This study is focused to determine the impact of the several control variables on the capital structure or leverage choice of Bao Tou Steel Ltd. For this purpose, one dependant variable and seven independent variables are used. Leverage or debt ratio is used as dependant variable while Independent variables include, size (SZ), profitability (PF), growth (GR), firm assets (FA), cash flow (CF), risk (RK) and age (AG). 3.3.1 Dependant Variable Leverage (LG) Leverage refers to proportion of assets that is financed by debt. Corporate finance literature reveals that level of leverage depends upon the size and nature of the business. Both book and market values have used to measure the value of leverage (Rajan and Zingales, 1995). The former measure divides book value of debt by book value of total assets and the later measure divides book value of debt by market value of assets or by book value of debt plus market value of equity (Davic and Krstic, 2001). Present study use book value of leverage because the use of debt provides tax shield that creates cash benefits and these benefits are not charged on the

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market value of debt once it is issued (Shah and Khan, 2007). Hence, this makes the market value of debt irrelevant for computation of taxes. On the other hand, when the firm goes into bankruptcy then only book value is considered a relevant value for calculations. Another important consideration is to deciding the use of total or long term debt as a percentage of total assets for measuring the leverage. Several studies (Devic and Krstic, 2001; Cassar and Holmes, 2003; Mittoo and Zhang, 2008) have used both total and long term debt for calculate the value of leverage. According to the booth et al (1999), developing countries (including China) are preferred to use short term financing than long term financing. Finally, following ratio is used for measuring leverage: LG = TD / TA Where, LG = Leverage TD = Total debt at the end of the accounting year TA = Total assets at the end of the accounting year 3.3.2 Independent Variables Size (SZ)

Size is considered a key factor that can influence the financial structure of the firm. It has extensively used by the corporate finance researchers as control variable in the empirical analysis of determining the capital structure of the firm and found that proportion of debt and equity formulates according to the size of the firm (Scott and Martin, 1976; Booth et al., 2001). Various studies report a positive relationship between size and leverage (Hamaifer et al, 1994; Al-Sakran, 2001; Antoniou et al, 2002; Gaud, 2005) while several studies intended negative relationship between debt ratio and firms size (Rajan and Zingales, 1995; Bevan and Danbolt, 2002). According to the Rajan and Zingales (1995), the relationship between size and leverage could be negative because larger firms have less asymmetric information that reduces the chances of undervaluation of issuing new stock, preferred to issue more equity than debt.

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On the other hand, Static Trade-off hypothesis explores a positive relationship between size and firm because larger firms are diversified in nature and considered less risky, hence, prefer to utilize more debt. In addition, larger firms are preferred to issue more debt because it reduces direct bankruptcy costs due to market confidence (Warner, 1977). Moreover, smaller firms prefer to acquire lower debt because, these firms might face the risk of liquidation at the time of financial distress (Ozkan, 1996). Consistent with the results of Static Trade-Off theory, current study predicts a positive relationship between size and debt ratio. The natural log of sales or the natural log of assets is generally used as a proxy to determine the size of the firm. Current study use natural log of sale (premiums) to measure the size Bao Tou Steel Limited. It is given by SZ = Firm Sales Therefore, first hypothesis is that there is positive relationship between leverage and size of the firm. Profitability (PF)

Theoretical predictions yield no consistent relationship between debt ratio and profitability. Jensen (1986) intended that profitable firms use debt as a tool that enforce managers to invest in more disciplined way and as a result reduce free cash flows, which implied a positive relationship. Static Trade-off model also predicts a positive relationship between profitability and debt ratio due to the tax shield benefits. But according to the Pecking Order Theory (Myers and Majluf, 1984), firms prefer to use internal source of financing (retained earnings), then debt and finally issue external equity if more funds are required. Therefore, the more profitable the firms are the more retained earnings they will have, which exhibit a lower debt is utilized in formation of capital structure. This shows a negative relationship between profitability and leverage of the firm. In addition, profitable firms are avoid to get loan in inefficient markets due to disciplinary role of debt (Agency Theory).Various studies (Gonedes et al, 1988; Friend and Hasbrouck,1989; Shah and Khan, 2007) also reported a negative relationship between profitability and debt ratio. Present study also predicts a negative

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relationship between profitability and leverage. Following proxy is used for measuring the profitability: PT = NIBT Where, PT = Profitability of the firm at the end of fiscal year NIBT = Net income before tax Thus, second hypothesis is that there is negative relationship between leverage and profitability of the firm. Growth (GT)

According to the Pecking Order Theory, a firm firstly uses retained earnings or internally generated funds for running the operations of business, but these funds are insufficient for future growth of the firm. For this purpose, firm uses debt financing which helps for enhancing the business activities. This implies that growing firms expected to have high leverage (Drobetz and Fix, 2003). However, agency cost of debt is expected to be higher of growing firms because these firms have more flexibility with respect to the future investments. The rationale is that the lenders may feel fear that such firms would invest in more risky projects in future as they have diversified in nature and have more flexibility related to selection of investments (Titman and Wessels, 1988). Therefore, lenders impose higher costs at lending to reduce their risk. This forces the firm to utilize less amount of debt and more equity for investments to reduce the higher cost of debt. Myers (1977), Barclay et al. (1995) and Rajan and Zingales (1995) are proposed a negative relationship between leverage and growth. Consistent with the capital structure literature, current study also be expecting a negative relationship between growth and ratio of debt. Different studies have used different proxies for measuring the growth; market to book value of equity, market value of assets to the book value of assets, research expenditure to total sales and

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annual percentage change in assets or sales. Present study use percentage change in sales (premiums) as a proxy to measure the growth. It is given by, GR = % change in (P) Where, GR = Growth of the firm P = Premiums (sales) of the firm Therefore, third hypothesis is that there is negative relationship between leverage and growth of the firm. Firm Assets Assets are considered to have an impact on borrowing decisions because they have greater value in case of bankruptcy .A firm with large portion of fixed assets can easily raise debt at relatively lower rates by providing the collateral of these assets to the creditors. Having the incentive of getting the loan at nominal rates, these types of firms are expected to borrow more as compared to those firms where cost of borrowing is higher due to less proportion of fixed assets (Suto, 1990). Hence, firms with large proportion of fixed assets are preferred to employ more debt for getting the advantage of this opportunity. In the contrary, negative relationship has also been reported between leverage and fixed assets in small and medium firms (Daskalakis and Psillaki, 2007) and in less developed economies (Joever, 2006). Therefore, current study is expected to have negative relationship between leverage and assets. The amount of net fixed assets indicates the cost of fixed assets less depreciation. It is given by, FA = Total Assets at the end of accounting period. Therefore, forth hypothesis is that there is negative relationship between leverage and assets of the firm.

Cash Flows

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Cash Flow specifies the ability of the firm to cover its short term liabilities but also shows the liquidity position of the firm. Firms with higher cash flows are preferred to acquire more debt because of great ability to meet short term obligations (Ozkan, 2001). This shows a positive relationship between the cash flows and firms liquidity position. On the other hand, when firms have more liquid assets then it may prefer to use these assets to finance their investments and discourage to raise external funds (Pecking Order Theory). Currently this study assumes positive relationship between CF and Leverage for Bao Tou Steel Limited. CF = Cash flow generated from the operation of the business Therefore, fifth hypothesis is that there is a negative relationship between leverage and cash flows of the firm. Age (AG) Corporate finance literature reveals that age of the firm is also considered one the key control variable that can have an impact on the capital structure decisions of the firm. Mixed results have found about the relationship between leverage and age of the firm. A firms age reflects the experience in the particular business and eventually reflects its maturity. Greater business experience negatively effects or reduces the probability of bankruptcy and as a result reflects high debt ratio for older firms (Trade-off Theory). On the other hand, when firm survives in business for a long time then it can accumulates more funds for running the operations of the business and subsequently keeps away the firm to go for debt financing (Nivorozhkin, 2005). This trend shows the negative relationship between the leverage and age of the firm. Moreover, positive relationship between leverage and age is not likely to apply in transition economies because experience or maturity of the firms before economic reforms is likely to be limited (AlBahsh and Sentis, 2008). Present study is expected to have negative relationship between age and capital structure of Bao Tou Steel Limited because China is considered a transition economy. Difference between the establishment year and the observation year of the firm is used as a proxy to measure the age. It is given by,

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AG = OY EY Where, AG = Age of the firm OY = Observation year of the firm EY = Establishment year of the firm Therefore, sixth hypothesis is that there is negative relationship between leverage and age of the firm Risk (RK) Risk is another key explanatory variable that may affects the capital structure of the firm. It is considered to be either the inherent business risk or it may arise in the firm as a result of inefficient management practices. Firms with high volatility in earnings might face higher risk that forces the management to reduce the debt level because higher risk increases the chances of bankruptcy (Pandy, 2001). This predicts a negative relationship between leverage and risk and this result is also consistent with trade-off and pecking order hypothesis. Consistent with the results of Pecking Order Theory and Static Trade-off Theory, present study is expected to have a negative relationship between risk and leverage. Several proxies have used in empirical studies to measure the risk of the firm such as standard deviation of the difference in operating cash flows to total assets, standard deviation of returns on net income, and standard deviation of percentage change in net income (Xiaoyan, 2008). So this study assumes percentage change in net income considered as risk attached to Bao Tou Steel Ltd. RK= %age change in net income Therefore, seventh hypothesis is that there is negative relationship between leverage and risk of the firm.

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3.4 Hypothesis
This research study uses following seven hypotheses for the analysis: Hypotheses 1: There is positive relationship between leverage and size of the firm. Hypotheses 2: There is negative relationship between leverage and profitability of the firm. Hypotheses 3: There is negative relationship between leverage and growth of the firm. Hypotheses 4: There is negative relationship between leverage and assets of the firm. Hypotheses 5: There is a negative relationship between leverage and cash flows of the firm. Hypotheses 6: There is negative relationship between leverage and age of the firm. Hypotheses 7: There is negative relationship between leverage and risk of the firm.

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