How a companies distinctiveness

affects capital structure

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Capital structure the "term" has vast meaning in Finance and Accounting. As we
know all firms need operating capital to support their sales. To acquire that operating
capital, funds must be raised, usually as a combination of equity and debt. The firm's
mixture of debt and equity is called its capital structure. Although actual levels of
debt and equity may vary somewhat over time, most firms try to keep their financing
mix close to a target capital structure. The capital structure decision includes a firm's
choice of a target capital structure, the average maturity of its debt, and the specific
sources of financing it chooses at any particular time. As with operating decisions,
managers should make capital structure decisions designed to maximize the firm's
value.
As researchers moved on examining deeper the notion of capital structure, several
theories emerged, all of which conclude on the existence of an optimal capital
structure based on balancing the benefits and costs of debt financing. The main
benefit of debt financing is the fact that interest payments are deducted in calculating
taxable Income, allowing a ''tax shield'' for the firms. This ''tax shield'' allows firms to
pay lower taxes than they should, when using debt capital instead of using only their
own capital. The costs of debt can be viewed mainly from two different aspects. First,
there is an increased probability that a firm may not be able to successfully deal with
its Debt obligations (i.e. interest payments); thus, there is an increased probability of
bankruptcy. Second, there are agency costs of the lender's monitoring and
controlling the firm's actions. There are additional costs concerning the notion of
capital structure of the firm that arise from the fact that managers possess more
information about the Firm's future prospects than do investors.

The effect of taxation on capital structure has been thoroughly investigated as a

determinant of capital structure. Except for the tax aspects there are also some other
approaches that attempt to explain the determination of the capital structure. These
approaches examine the debt level determination from the perspective of asymmetric
information and agency costs, as already mentioned above.

(Jensen & Meckling 1976) identify the existence of the agency problem which arises
due to the conflicts either between managers and shareholders (agency costs of
equity) or between shareholders and debt holders. After the concise but brief
background discussion of capital structure we will have a look on company's
background which is included in our research.

Pakistan State Oil Ltd:

PSO was established in the mid-1970s when the Government of Pakistan merged
three "Oil Marketing Companies": 1.Esso Eastern, 2.Pakistan National Oil (PNO) and
3.Dawood Petroleum as part of its "Nationalization Plan".
Pakistan State Oil Company Limited is that country's foremost oil marketing and
supplying company. Formerly a state-run agency, Pakistan State Oil occupying just
about 70% of Pakistan's total refined petroleum products market, and more than
80% of the total furnace oil market, the major petroleum market in the country.
Pakistan State Oil also supplying 60% of the country's diesel oil market. in spite of a
countrywide working network of more than 3,750 PSO-branded filling stations,
several of which incorporate ease stores, PSO's share of the customer gas and
lubricants markets has dropped to presently 40%, due to Shell Pakistan's forceful
spreading out of its own retail network. Shell remains PSO's largest challenger in the
nation state, with an oil and gas market of more than 25%.

The Shell Pakistan Ltd:

The Shell trade name has been enjoying a 100-year history in this division of the
globe, if we just look back to 1899 while Asiatic Petroleum, the faraway eastern
advertising arm of two companies: Shell transportation Company and Royal Dutch
Petroleum Company started importing kerosene oil from Azerbaijan to the
subcontinent. Even in the present day, the legacy of the long-ago is observable in a
storage tank moving the date - 1898.
The familiar history of Royal Dutch Shell plc, in subcontinent dating back to 190, it
was the time when joint venture was took place between The Royal Dutch Petroleum
Company and The Shell Transport & Trading Company for supply of petroleum
products to Asia.
on the way to improve their distribution capabilities in 1982, the business concern of
the Burma Oil Company Limited and the Royal Dutch Shell plc were amalgamated
and in the result Burma Shell Oil Storage & Distribution Company of India was came

into existence. After the freedom of Pakistan in 1947, the name was altered to the
Burma Shell Oil supplying Company of Pakistan. When 51% of the shareholding
power was transferred to Pakistani investors, the name was changed to Pakistan
Burma Shell (PBS) Limited; this was the period of 1970.

Attock Petroleum Ltd:

Attock Petroleum is one of the fastest rising oil marketing companies in Pakistan,
with successfully established its system of petrol pumps in Punjab and KhyberPakhtunkhwa. Attock Petroleum is currently strengthening its being there in most
important metropolitan areas such as upper Punjab, Karachi, and Lahore. Attock
Petroleum is also operating a quality assurance unit for enhanced controls and
improved customer service at sites, for on-site testing of petroleum products. At
present Attock Petroleum has 149 outlets in Pakistan.

Sui Southern Gas Company:

The Sui Southern Gas Company (Formerly Sui Gas Transmission Company Limited)
was incorporated in 1954. The present shape of the company was incorporated on
March 30, 1989, with the mergers of three new companies, that is to say Karachi Gas
Company Limited, Sui Gas Transmission Company Limited and Indus Gas Company
Limited.
SSGC is Pakistan's top integrated gas company. The company is occupied the
business of transmission and supply of natural gas in southern division of Pakistan.
SSGC transmission system extends from Sui (Baluchistan) to Karachi (Sindh).

Sui Northern Gas Pipelines Ltd:

The SNGPL is the leading natural gas company in North and Central Pakistan in the
course of a widespread network in Khyber-Pakhtunkhwa and Punjab. Sui Northern
Gas Pipelines was integrated as a private limited Company in 1963 and transformed
into a public limited company in January 1964, and also listed on all the three Stock
Exchanges of Pakistan. The Company has more 42 years of extensive working
experience in operation and maintenance of high-pressure gas transmission and gas
circulation systems. It has also extended its activities to carry out the designing,
planning and construction of pipelines, both for other organizations and itself.

According to the OGDCL Report of oil and gas industry, Pakistan has normally daily
natural gas production of 73 net million cubic feet and oil production is about 3,800
net barrels. In spite of such a huge potential, Petroleum department of Pakistan has
reported high trade deficit due to key difference between export and import value.
Imported oil products of Pakistan have reached $6.5 billion in 2009 and government
plan at formulating policies to reduce import reliance and promote self-reliance by
triggering exploitation.
Pakistan's emerging economic market requires a great intension of Policy makers,
Leaders, and specially the educational institution and student researcher. Previously
in Pakistan research have been done only in few fields of capital structure like:
Listed non-financial firm's Capital Structure by Attaullah Shah & Safiullah Khan.
Cement Industry's Capital Structure by Syed Tahir Hijazi & Yasir Bin Tariq.
Stock Exchange listed Firm's Capital Structure by Waliullah & Mohammed Nishat.
Capital structure refers to the mix of debt and equity used by a firm in financing its
assets. The capital structure choice is one of the important decisions made by
financial management. In our thesis we have analyzed the oil and gas marketing
companies on the basis of capital structure. The reason behind this analysis was that
only few of the researches were taken on this topic. In Pakistan like many developing
countries the corporate financial structure choices heavily depend on the existence of
functioning markets and legal system in which investors can diversify risk. Before
1990s the financial sector mainly accommodated the financial needs of the corporate
sector.
As a result economic efficiency remained low and growth suffered from poor
mobilization of resources. The financial market in Pakistan is quite vulnerable to
shocks and has several imperfections because of weak institutional framework and
macro-economic Instability. Another most important factor that affects the local and
foreign investors is the poor law and order situation and lack of trust in the
government of Pakistan.
Our paper shed light on the determinants of the capital structure of the major
Pakistani oil and gas firms listed on the Karachi stock exchange.
When we had to start our thesis we focused on many areas on which the research was
not done, after lot of thinking and research and by taking our supervisor in

confidence we came on a conclusion to do our research work on the determinants of

the capital structure. We then took oil and gas marketing companies of Pakistan for
analysis. For our research we have seen the impact of independent variables on
dependent variable leverage.

PURPOSE OF THE STUDY:

Purpose of this study is to identify firm's characteristics that may have influence on
leverage. There are several characteristics that must play role while deciding upon
capital structure of leverage. For instance; Market conditions, risk, size of firm, time
frame in business, earning volatility and many others. Finally the purpose is to check
which factors are important for money lenders, financial institution and bond
holders.

PROBLEM STATEMENT:
In Pakistan formally research has been not very serious issue to consider, but now
most of universities and especially HEC is funding to many research projects in
education. These research papers are not only contributing fruitfully towards student
understanding but also toward corporate sector of country.
Previously in Pakistan research has been done only very few areas, oil and gas
marketing companies still remains unexplored. So we have found a room to get into
with the hope this research would be helpful for students as well as corporate sector.
A hypothetical situation has been narrated here to solve the problem. These
problems company's manger may face time to time. Oil and Gas Market companies
have been a very famous company in their business. They aimed to expand their
business in various cities of Pakistan. But they have been facing a shortage of capital
structure. Now company interested to change their mix of capital structure. We being
a student of Air University hired to come up with the solution of this problem.
Whether they go for equity finance or debt finance? Which factors would effects
companies leveraging process? How company can get optimal capital structure?.

THEORETICAL FRAMEWORK
INDEPENDENT VARIABLES
Profitability (PF)

Tangibility (TN)
Size (SZ)
Current ratio (CR)
Debt to Equity ratio (DE)

DEPENDENT VARIABLE
Leverage (LG)

Complete detail of theoratical framework has give at the end of chapter Two.

HYPOTHESIS DEVELOPMENT
Current ratio:
Ho: There is a negative relationship between Current ratio and Leverage.
H1: Higher the current ratio, higher the availability of external funds/Leverage.

Size:
Ho: There is a negative relationship between size and leverage.
H1: size and leverage has positive relationship.

Profitability:
Ho: Firms with higher profitability will have higher leverage.
H1: there is negative significant relationship between profitability and leverage.

Tangibility:
Ho: There is a negative relationship between tangibility and leverage.
H1: There is positive significant relationship between tangibility and leverage.

Debt to Equity Ratio:

Ho: There is a positive relation between debt-equity ratio and leverage
H1: There is a negative relation between debt-equity ratio and leverage.

ACRONYMS:
LG = Leverage of firms
PF = Profitability of firms
TN = Tangibility of firms
SZ = Firm size
CR = Current ratio of company
DE = Debt to Equity ratio of company

CHAPTER TWO
LITERATURE REVIEW:
The capital structure of an every firm is very significant since it linked with the
capability of the firm to meet up the needs of its stakeholders. (Modigliani & Miller,
1958) were the first ones to point out the topic of capital structure and he argued that
capital structure is immaterial in shaping the firm's value and its future performance.
(Modigliani & Miller, 1963, pp.443- 453) showed that their model is only valid if
there is no more concept of tax system. And tax relaxation on interest of debt
payments will grounds a rise in firm's value if equity is traded for debt. Capital
structure is pretty much important decision for firms, so that they can get the most
out of returns to their various stakeholders. In addition to a suitable capital structure
is also very important to firm as it will help in dealing with the competitive
surroundings within which the firm operates. (Modigliani & Miller 1958) said that an
"optimal" capital structure exists if the risks of going bankruptcy are offset by the tax
savings advantage of debt. If this optimal capital structure is recognized, a firm
would be able to take full advantage of returns to its stakeholders further these
returns would be pretty much greater than returns obtained from a firm whose
capital is mixture of only equity (all equity firm).

Modigliani and Miller (MM theory):

Contemporary capital structure theory began in 1958, when professors Franco
Modigliani and Merton Miller (hereafter MM) published what has been called the
most influential finance article ever written.9 MMs study was based on some strong
assumption, including the following:
No brokerage costs.
Zero or no taxes.
There is no bankruptcy cost.
Investors and corporations can borrow at the same rate.
Free information flow to investors same as company's managers about the future
investments opportunities.
EBIT has not been affected by the use of debt.
So if above assumptions hold true, MM theory proved that the firm's value have not
been affected by change of capital structure. hence the following situation must exist:
VL = Vu = SL + D
Here VL is the value is the value of a levered firm, which is equal to VU, the value of
an identical but unlevered firm. SL is the value of the levered firm's stock, and D is
the value of its debt. MM theory also suggests that if assumption holds true, it does
not matter how a firm finances its operations, so capital structure decisions would be
irrelevant.
MM also provided us with evidences about what has been necessary for capital
structure to be relevant and hereafter to affect a firm's value. MM's work marked the
beginning of modern capital structure investigation, and later research has been
focused on relaxing the MM theory assumptions for the development of a more
accurate concept of capital structure.

Trade-off theory:
The pioneering work of (Modigliani and Miller 1958) is the catalyst for all the
aforesaid capital structure theories. Amongst which trade-off theory says if tax and

bankruptcy cost do exist, there remains an optimal capital structure which the firms
predetermine and try to move towards it in due course of time. This optimal capital
structure involves a trade off amongst the major three variables namely corporate
and personal taxes, bankruptcy cost and agency conflicts. Increasing debt in the
capital structure reduces the tax liability of the firm because of the tax shield on
interest. Hence, it increases the after tax cash flow to the firm. As the tax shield offers
higher post tax return, it is positively related to leverage. Again, when the debt
increases significantly there is a risk for firms to get defaulted on their payment. This
perceived default risk increases the cost of debt in the form of bankruptcy cost. The
optimal Capital structure endeavors to trade off the benefits of tax shield in the form
of after tax cash inflow and the cost of bankruptcy at higher debt equity ratio.

Agency cost theory:

This theory envisages that the agency cost i.e. the cost due to conflict of interest
between principal and agent is a major determinant of capital structure. (Jensen &
Meckling 1976) were the first one to develop the research in this area, building on the
earlier work of (Fama & Miller 1972). Jensen & Meckling identified two types of
conflict, firstly conflict between shareholders and managers, secondly between
shareholders and debt holders.
Argument between shareholders and managers arises for the reason that managers
are not the claimants of the profit but receive managerial remuneration. So they want
to raise their pay off by increasing "perquisites" such as private jets, plush offices etc,
that add to the cost of the company and lower profit. Increasing debt commits the
firm to pay out cash. So it reduces the amount of free cash flows offered to the
managers and the opportunities of such profligacy and empire building (Jensen
1986). Moreover increase in the share of debt in the capital structure by holding the
absolute investment of manager's constant, increases managers' share of equity, if
any, and mitigate the loss arising out of the conflict between the mangers and
shareholders.
Conflict between the debt holders and shareholders arises because of the difference
in the risk appetite and the expected return. Debt holders are concerned about the
current profit as it will ensure their return whereas equity shareholders might be
willing to forgo the current profit for long-term capital appreciation. As a result
equity shareholders could invest even in risky projects with long gestation periods,
which damage the interest of debt holders.

Managers of firms have been acting as agents of the owners. They were hired by
owner to work for him and have been given benefits by owners. However managers
are mainly interested in accomplishing their own targets which may differ from the
maximization of the firm value which is the maximization of the owners' benefit.
They will act in their own interests seeking perquisites, higher salaries, job security
and different cases have been reported that they directly exploit firm's cash flows. It
is obvious that the interests of the manager not only differ but in many cases they
even oppose to those of the owners. Consequently, an interest conflict has been
raised between the shareholders and the managers.
However, the managers have attained the authority to manage the firm. Thus, the
owners may only try to discourage these value transfers through controlling
monitoring, such as administration by independent directors; these monitoring and
control actions presuppose costs, the so-called agency costs. Perfect control is
however extremely costly and thus, shareholders pursue to be dependent on
solutions that has not been much expensive but kept on eye over managers
operations. A reliable tool can be the use of debt capital which even adds value to the
firm. Leverage has been one of the tools that will force managers to make and pay out
cash, simply because interest payments are compulsory. Interest payments will
reduce the amount of remaining cash flows - the so-called free cash flows after the
investment decisions of managers. Thus, debt can be viewed as a smart device to
minimize the cost of agency. In this situation, the optimal capital structure will be
resulting by the equilibrium between the benefit of debt against costs of debt; so firm
preferred that amount of debt which will minimize its overall agency cost.

Pecking-order theory:
(Myers & Majluf 1984) in their pioneering work on pecking-order theory show that if
the investors are not well informed about the information which the insiders have,
the equity of that firm may be severely mispriced. In their paper they also show that
if any firm wants to fund its new project by new equity then the equity can be so
undervalued that the new investors will be better off by getting more value than the
project's NPV. So the organization will go for such a source which is not underpriced
by the market like internal funds or riskless debt. So, in case of information
asymmetry companies should follow an order of financing. (Myers 1984) refers to
this order as the pecking order. As per the pecking order the firm first goes for
internal funds and then for low risk debt and finally equity. As we have three major
capital structure theories in the literature, it becomes an interesting task to test
which theory characterizes the behavior of Indian firms in their determining the

capital structure during the bullish phase of capital market. There are many
empirical studies (Bradley, Jarrell, & Kim 1984), (Titman & Wessels 1988), (Rajan &
Zingales 1995), (Wald 1999) and (Booth et al. 2001) which have been done to test the
applicability of the above mentioned capital structure theories in the developed and
developing countries.

Market Timing Theory:

Market timing, a comparatively old initiative (Myers, 1984), is having a new surge of
fame in the academic literature. In study by (Graham & Harvey 2001), managers
carry on to offer support for the plan. Consistent with the behavior of market timing,
firms inclined to issue equity subsequent a stock price run-up. Furthermore,
researches that analyze long-run stock profits following business financing events
find proof reliable with market timing. (Lucas & McDonald 1990) investigate a
dynamic adverse selection model that mix essentials of the pecking order with the
market timing theory, which can give details of pre-issue run-ups but not post issue
Under performance. (Baker & Wurgler 2002) said that capital structure is best
perceived as the cumulative effect of precedent attempts to time the market. The
basic suggestion is that managers look at existing circumstances in both debt market
and equity markets. If they found a need of financing, they use whichever market
presently looks more favorable. If neither market looks positive, they may go for
defer issuances. On the other hand, if present conditions look strangely favorable,
funds possibly will be raised still if the firm has no need for any funds at this time.
While this idea seems reasonable, it has not anything to say about most of the factors
conventionally considered in studies of corporate financing. However, it does
propose that stock returns and debt market circumstances will play a significant role
in capital structure decisions.
The first paper on capital structure was written by (Miller & Modigliani in 1958)
Showing that subject to some restrictive situation, the impact of leveraging on the
worth of firm is immaterial; the conceptually provided that the worth of firm is not
dependent upon the capital structure decision given that certain conditions are met.
Because of the unrealistic assumptions in MM irrelevance theory, research on capital
structure gave birth to other theories.
According to the traditional (or static) trade-of theory (TOT), firms select optimal
capital structure by comparing the tax benefits of the debt, the costs of bankruptcy
and the costs of agency of debt and equity, that is to say the corrective role of debt
and the fact that debt effects from informational cost than outside equity.

(Modigliani & Miller 1963), (Stiglitz 1972), (Jensen & Meckling 1976), (Myers 1977)
and (Titman 1984).
The Trade Off theory says that a firms adjustment toward an optimal leverage is
influenced by three factors namely taxes, costs of financial distress and agency costs.
(Baxter 1967) argued that the extensive use of debt increases the chances of
bankruptcy because of which creditors demand extra risk premium. He said that
firms should not use debt beyond the point where the cost of debt becomes larger
than the tax advantage. In the so-called Pecking Order Theory (POT) (Donaldson,
1961), (Myers & Majluf 1984), (Myers 1984) because of asymmetries of information
between insiders and outsiders, the company will prefer to be financed first by
internal resources, then by debt and finally by stockholders' equity. The debt ratio
depends then on the degree of information asymmetry, on the capacity of selffinancing and on the various constraints which the company meets in the access to
the various sources of financing. So, in the pecking order world, observed leverage
reflects the past profitability and investment opportunities of the companies.
The dynamic trade-off theory (DTOT) tries a compromise between TOT and POT
(Fischer et al 1989) and (Leland 1994). Although, due to information asymmetries,
market imperfections and transaction costs, many companies allow their leverage
ratios to drift away from their targets for a time, when the distance becomes large
enough managers take steps to move their companies back toward the targets. While
the POT explains short-run deviation from the target, the traditional TOT holds in
the long run. Following this approach, leverage must converge toward a target
leverage ratio. That would not bee the case following POT because managers make
no effort to turn around changes in leverage.
Two additional theories also reject the idea of timely meeting toward a target
leverage ratio. According to the theories of market timing and inertia, the capital
structure is the result at a given time of an historical process. Supporters of the
market timing approach (Jalilvand & Harris 1984), (Korajczyk et al., 1991) and
(Lucas & McDonald 1990) also (Jung et al., 1996), (Loughran et al., 1994) and (Baker
& Wurgler 2002) argue that companies will sell overpriced equity shares. Company's
share prices will fluctuate around their factual value, and managers inclined to issue
shares when the market-to-book ratio is high. A small debt ratio must thus follow a
long period of high market-to-book ratio. According to the managerial inertia
approach (Welch 2004) companies do not adjust their debt ratio to the fluctuations
of the market value of their equity. High market-to-book ratio must thus be
accompanied by small debt.

(Graham and Harvey 2001) find that chief financial officers in the USA express
concern about earnings' volatility in capital structure choices. According to
(Mohammad M Omran & John Pointon 2009) study, one of our issues of interest is
whether debt is negatively associated with earnings' volatility, in which case firms
react to the risk, and manage it by reducing debt. On the other hand, if debt is found
to be positively associated with earnings' volatility, then they do not appear to
manage the risk.
(Ayesha Mazhar & Mohamed Nisar 1997) have been discussed the determining factor
of capital structure of Pakistani firms. They selected a sample from Pakistani
companies registered on Islamabad Stock Exchange. The sample is divided into two
sub-samples of private and government owned companies to make comparison
between both sectors. The sample comprised 91 Pakistani companies out of which 80
companies are private and 11 are government owned covering the period of 19992006. They have taken debt to equity as a proxy of leverage of a firm, and tangibility
of assets, profitability, size, growth, tax provision and return on assets as
independent variables. They use correlation to determine the degree of association
between different variables. Spearmen correlation is used for all independent
variables association with dependent variables. Regression is also used to measure
the relationship between dependent and independent variables.
(Attaullah shah and saifullah khan 2007) they used two variants of penal data i.e.
constant coefficient model and fixed effect model to calculate the determinants of
capital structure of Karachi Stock Exchange listed non-financial firm's from1994
to2002. Pooled regression investigation was applied with the hypothesis that there
were no industry or time effects. Though, by means of fixed effect dummy variable
regression, the coefficients for an amount of industries were significant displaying
there were significant industry effects later we accepted the late model for our
investigation. He had measured effect of seven explanatory variables is measured on
leverage ratio which is designed by dividing the total debt by total assets.
(Safdar Ali Butt & ArshadHasan 2009) had explores the association between capital
structure and corporate governance of stock exchange listed companies in an equity
market. The study considered the period of 2002 to 2005 for which 58 randomly
selected non-financial listed companies from Karachi Stock Exchange has been
investigated by using multivariate regression line analysis with fixed effect model
method. Managerial ownership has negative relationship with debt to equity ratio
indicating that concentration of ownership induces the managers to lower the
gearing levels. Institutional ownership has positive relationship with capital

structure which is consistent with corporate governance philosophy but this relation
is statistically insignificant. Traditional determinants of capital structure like size and
profitability have significantly effect on corporate financing decisions. Profitability is
negatively related with debt to equity ratio and it is consistent with pecking order
hypothesis. Similarly, size has positive relationship which shows that large firms can
arrange debt financing due to long term Relationship and better collateral offering.
(NengjiuJu, Robert Parrino, Allen M. Poteshman, and Michael S. Weisbach 2005)
these paper inspect optimal capital structure choice by means of a dynamic capital
structure model that is standardized to reflect genuine firm features. They also
examine the relation between firm value and capital structure. They estimate indicate
that the impact on firm value of moderate deviations from optimal capital structure
is small. This paper suggests that the trade-off model performs reasonably well in
predicting capital structures for firms with typical levels of debt. This paper also
shows that the major forces affecting a firm's financing decisions are corporate taxes
and bankruptcy costs.
(Mohammad H. Mohammad, 1995) .they examined the determinants of firms' capital
structure in Malaysia covering the period "between" 1986 to 1990. There are
significant inter-industry differences in capital structure among Malaysian
companies. Highly-leveraged firms are more likely to earn higher profits than lessleveraged firms. Similarly the relation between firm's profit and equity ratio is also
positive and is reflected in terms of the importance of efficient capital markets.
(Laurence Booth, VaroujAivazian, AsliDemirguc-Kunt and Vojislav Maksimovic
1999) has analyzed capital structure of firms in ten developing countries and
provides indication that these choices are affected by the same variables as in
advanced countries. But, there are constantly repeated differences across countries,
when corporations choose to use of debt financing; they are altering some
predictable future cash flows away from equity pretenders in exchange for cash up
front. The issues that drive this decision remain mysterious regardless of a vast
theoretical literature and years of experimental tests. The quantity of proof is large,
and so it is frequently all too relaxed to provide some pragmatic support for nearly
any idea. It is satisfactory for a given paper but more challenging for the general
expansion of our thoughtful of capital structure choice. As an outcome, in current
decades the literature has not had a concrete experimental basis to differentiate the
strengths and weaknesses of important theories.

Numerous theories of capital structure have been proposed which theory shall we
take seriously? Of course, opinions differ. Remarkably, nearly all corporate finance
textbooks inclined to the trade-off theory because deadweight taxation and
bankruptcy has been considered key operators. (Myers 1984) projected the pecking
order theory in which there is a financing order of retained earnings, debt, and in the
last equity. In recent times, the idea that firms are engage in market timing has gain
popularity. In conclusion, agency theory lurks in the background of a lot theoretical
conversation. Agency concerns are frequently collected into the trade-off structure
largely interpreted. Advocates of these types of models are frequently point to
experimental proof to support their preferred theory.
(Harris & Raviv 1991) and (Titman & Wessels 1988). Both these two standard papers
point up a serious empirical difficulty. They have been augmented over basic facts.
According to (Harris & Raviv 1991), the accessible studies normally agree that
leverage increases with tangible fixed assets, growth opportunities, non debt tax
shields, firm's size and shrinkages with promotion expenses, instability, R&D
expenditures, expected bankruptcy, profitability and exceptionality of the product.
On the other hand, (Titman & Wessels 1988) found that their outcome do not
provide sustain for an effect on debt ratios due to non debt tax shields, indemnity
value, future growth and volatility.
(Myers 1977). managers emphasis on book value of leverage because debt has been
well supported by assets than by growth opportunities. Book leverage has given
preference due to fluctuation of financial market. And managers believe that market
leverage facts are not reliable in making the corporate financial policy. According to
(Graham & Harvey 2001), various number of managers point out that they do not
remix their capital structure in reaction to equity market engagements. This is
because of adjustment costs avert firms from rebalancing each time.
Supporters of market leverage claim that the book value of equity is mainly a "plug
number" used to set of scales to both sides of the balance sheet instead of
administratively relevant number (see, Welch 2004). (Welch 2004) additionally
point out that the book value of equity can be negative also while assets cannot be.
The book value represents the old data that what has happened in the past. So book
value measurements have been backward looking. It measures what has been taken
place in past. Market value changes with the time so it is assumed to be forward
looking. So there is no point these two methods of measurements must match
(Barclay, Morellec and Smith 2006).

Examining the agency costs of debt from the debt holders' point of view we have to
analyze the moneylender and borrower relationship. When a money lender offers
funds to a firm, the interest rate charged has been based on the lender's valuation of
the firm's risk. This arrangement creates incentives for the firm to increase its risk
without increasing current borrowing costs. An agency cost of debt has been arising
when there is a risk of default. If company debt is free of default risk, then debt
holders have not been concerned with the value and risk of firm. After obtaining a
loan at certain, locked rate from a bank or through the sale of bonds, the firm can
increase its risk. Managers may be tempted to take actions that transfer value from
the firm's creditors to its shareholders.
For example, managers borrowed more and pay cash to shareholders or may invest
in risky projects. To avoid this situation lenders impose certain monitoring and
controlling techniques on borrowers. Debt holders typically protect themselves by
including provisions that prohibit the management of the firm to significantly alter
its business or financial risk. These limitations normally refer to the asset
acquisition, dividends payments, executive salaries and level of networking capital.
These protective covenants allow the lender to monitor and control the firm's risk.
Alternatively, if no protective covenants are accepted by the firm, creditors may
demand high returns in form of high interest rates. However all these actions enclose
some direct or indirect costs that the firm is subject to; these are the agency costs of
debt, from the debt holders' point of view. In exchange for incurring agency costs by
agreeing to cope with the restrictions placed by the lenders, the firm and its owners
benefit by obtaining funds at a lower cost. The optimal capital structure has been
shaped at this specific level when the paybacks of the loan that shareholder has been
received, equilibrium with the interest of debt enforced by the debt holders.
(Myers & Majluf 1984) assumed that managers make decisions with the goal to
maximize the wealth of existing shareholders. Therefore, they avoid issuing
undervalued stock unless the value of transferred share from old to new shareholders
is additional as compared to off-setted net present value of the growth chance. This
suggested that the new shares only be issued at a lesser price as compared the
imposed price estimation of firm value by real market analysis. Therefore, the public
offering of new equity issuance has been unswervingly inferred as a negative signal,
in the logic that existing stockholders possess overestimated shares. This negative
signal results in the stock price decline. Indeed, several studies have confirmed that
the announcement of a stock issue have resulted in a decline of the stock price. That
is why several firms tend to follow the ''pecking order'' financing pattern. The
pecking order theory suggested that firms firstly will go for retained earnings, if there

is no point of asymmetry information then they will prefer debt and lastly they will
move to issuance of new equity for any further requirements of equity. Consequently,
highly profitable firms likely to use less debt as compared to those firms that have
not been very money-spinning. Numerous scholars have been confirmed the effects
of profitability on firm's leverage. (Kester 1986) and (Friend & Lang 1988) concluded
that there is a significantly negative relation between profitability and leverage ratio.
(Rajan & Zingales 1995) and (Wald 1999) also found a significantly negative
relationship among profitability and leverage ratios for the USA, UK and Japan. At
this point we should mention that the notion of information asymmetry implies that
firms should maintain some reserve borrowing capacity which will allow them to take
advantage of good investment opportunities by issuing debt capital if necessary. The
notion of asymmetric information is also used to combine the growth opportunities
of a firm with its capital structure. Growth causes variations in the value of a firm.
Larger variations in the value of the firm are often interpreted as greater risk. That is
why a firm that has considerable growth opportunities will be considered as a risky
firm and will face difficulties in raising debt capital with favorable terms. Thus, it will
employ less debt in its capital structure. On the other hand, the cash flows of a firm
which value is most likely to remain stable in the future are predictable and its
capital requirements can be financed with debt more easily than these of a firm with
growth potential.
(Myers 1977) argues that firms with growth potential will tend to have lower
leverage. The bottom line, there has been no worldwide theory of the debt or equity
choice. There are numerous useful provisional theories that have been used to
approach the determinant of capital structure, each one with different view. In our
thesis work we analyzed few specific factors that played a role in determining the
capital structure of Oil and Gas marketing companies of Pakistan.

THEORATICAL FRAME WORK

INDEPENDENT VARIABLES
Profitability (PF)
Tangibility (TN)
Size (SZ)
Current ratio (CR)

Debt to Equity ratio (DE)

Dependent Variable
Leverage (LG)
We have taken six variables out of which leverage is taken as a dependent variable.
We take the total Debt (Total Liability) to total asset ratio as proxy for Leverage
(dependent variable). For potential determinants of leverage, we study five
independent variables namely Tangibility, Size, Profitability, Debt to Equity ratio and
Current ratio.

EXPLANATION OF VARIABLES:
In cross-sectional study of the capital structure determinants, (Rajan &
Zingales1995) has been examined the factors which may explain the used of leverage.
namely, market-to-book ratio i.e. growth, size, profitability, and tangibility. But our
study of capital structure follows the framework of (Nikolaos Eriotis & Zoe Ventoura
2007) they used tangibility of assets, Firm size, Profitability. But in our study we
have also used two more variable that measure more reasonably leverage of firm i.e.
Debt to Equity ratio and Current Ratio. For detail measure of variables and formulas
used please consult appendix Table II

DEPENDENT VARIABLE
Measure of Leverage (LG)
In the literature the term "Leverage" can be interpreted in different ways. The
specific choice of the term leverage depends on the objective of the research. We take
leverage as the ratio of total liability to net total assets. Net total assets are the total
assets excluding all the fictitious assets and revaluation reserves and debit balance of
profit and loss account. One question that has been raised is whether we should take
the book value or the market value of debt. (Thies & Klock 1992) and (Fama & French
2000) support the consideration of book value of leverage. As the market value of
debt is dependent on so many exogenous factors, which are outside the control of an
organization, book value better reflects the true value of the firm's leverage. So, we
take book value of debt (total liability proxy) as well as of net total asset.
The Leverage denotes to the proportion of assets funded by debt. Earlier
investigations have been used diverse measures of leverage. (Frank & Goyal 2003b)

mentioned that the dissimilarity between debt ratios grounded on market value. And
other grounded on book values is that the previous inclined to absorb firm's future
condition. However the later mirrors the past state. (Fama & French 2002) identified
few irregularities arising due to the used of two unlike ratios. Conferring to them
Pecking Order and Static Tradeoff theories applied to the book value of debt, but not
sure about the market value of debt.
One more consideration of explaining the reasonable calculation of leverage is by
taking total or long term debt numerator and total assets in denominator. However
theories of capital structure study only long term debt to denote leverage, but we
have been used the long term and short term debt (total debt) because in Pakistan
firms are of average size or small size, so they some time have short debt for
leveraging their projects. Due to this getting access to capital markets have been
difficult in terms of technical formalities and cost of debt (shah & Hijazi 2005).
In Pakistan short term debt has been one of the favorite leveraging technique,
because commercial banks are primary lenders so they don't preferred long term
debt. Since 1994 firms has been discouraging to rely upon market based debt, but
after the 1994 government changed the corporate rules and regulations to allow
companies to get debt from the market in form of TFC (term finance certificate).
(Booth et.al. 1995) had also mentioned this point that developing countries including
Pakistan prefer short term financing than long term financing.

INDEPENDENT VARIABLES
Tangibility of Assets (TG)
(Titman & Wessels 1988), (Rajan & Zingales 1995) and (Fama & French 2000)
support the importance of the tangibility (ratio of fixed to total assets) for leverage.
The value of collateral of fixed assets for the gearing level of the firm is manifested by
the tangibility of that firm. However, the direction of influencing the level of leverage
is not clear by any of these studies. (Galai & Masulis 1976), (Jensen & Meckling 1976)
and (Myers 1977) in their papers present the argument that stockholders of levered
firms are prone to overinvest that gives rise to the classical conflict between
shareholders and bondholders. But if the debt is secured against the fixed assets, the
firm is restricted to use the borrowed funds for the same project for which it has
borrowed. By this fact, creditors get an improved guarantee of repayment, and thus
the chances of recovery are higher. Since this does not happen without
collateralization of the fixed assets, the proportion of debt increases with the

availability of more fixed assets in the balance sheet of the firm. Hence, the trade-off
theory predicts a positive relationship between the tangibility and leverage in any
firm. In contrast, the agency cost model predicts a negative relationship of tangibility
with leverage in any firm (Grossman & Hart 1982). We calculate tangibility by
finding out the ratio of the total fixed assets (gross fixed assets excluding intangible
assets) and 30 days average market capitalization of the firm.