DETERMINANTS OF CAPITAL STRUCTURE CHOICE

Determinants of Capital Structure Choice: Evidence From Pakistan

Determinants of capital Structure Choice: Evidence from Pakistan

Chapter II: Literature Review

Theoretical Framework

Literature shows diverse ways to measure leverage of a company. As Rajan and Zingales (1995) state: "clearly, the extent of leverage and the most relevant measure depends on the objective of the analysis." However, some studies show common measures of capital structure. The broadest definition is the stock leverage which is the ratio of total liabilities to total assets. It can be viewed as a proxy for what is left for shareholders in the case of liquidation. It also reflects the residual value to shareholders. However two other definitions of capital structure are widely used in the studies - one is the total amount of debt used by firm to finance its operations and firm's ability to serve the loans. Therefore, we are focusing on the total debt to equity ratio of the firm, being the true measure of leverage in the sense that fixed interest commitment acts as a lever to enlarge return to shareholders. It measures debt as a proportion of the book value of equity in the firm. The second one is the ratio of short term debt. Bevan and Danbolt (2000) point out that capital structure studies examining the determinants of leverage based on total debt may disguise the significant differences between long-term and short-term debt. Short-term debt ratio reflects the dependency of firm on short term debt and trade credit. Demirguc and Maksimovic (1999) and Kai. Li et al. (2006) show in their respective studies that firms in developing countries tend to employ more short term debt as compared to long term debt. Therefore, we compute short term debt ratio as a third measure of leverage. In this study we will focus on three measures of leverage:

Levy (2001) develops an agency model in which debt aligns managers' interests, which include private benefit extraction, with those of the outside shareholders. In recessions, levered managers' wealth is reduced relative to outside shareholders. This shift in relative wealth exacerbates the agency problem and increases the optimal amount of leverage in order to realign managers' incentives with those of the shareholders. This leads to counter-cyclical leverage for those firms that are not severely constrained. The model provides one motivation for our use of business-cycle variables that proxy for relative aggregate managerial wealth when estimating target leverage.

The results add to the credit channel literature that analyzes the relation between debt issues, financial constraints, monetary policy, credit conditions, and the business cycle. The literature, which often uses size or the degree of bank dependance as proxies for the level of financial constraints, generally agrees with the proposition that firms that face greater financial constraints find it difficult to borrow to smooth cash flows following negative shocks to the economy. Gertler and Gilchrist (1993) find that aggregate net debt issues, following recessions associated with a monetary contraction, increase for large firms but remain stable for small firms that rely on ...