Research Project

Determinants of capital structure:a study of cement sector in

Pakistan

Lahore school of accountancy and finance

To be submitted to Sir Amir Iqbal

( Head of department )

By:

Muhammad Khurram MS (A&F)

Sher Mutamir MS (A&F)

Abstract

The decisions relating to the capital structure have been one of

the most important decisions that have to be taken by the

financial managers in any organization. The cement sector of

Pakistan plays a vital role in economic development. Hence the

importance of decisions pertaining to its capital structure

can’t be denied.

This study investigates the effect of profitability,

tangibility, size and liquidity on capital structure decisions

of the listed companies in Karachi stock exchange of cement

sector in Pakistan. This research study provides the information

that would help the management of cement industry to make better

decisions related to the capital structure. Its provides a deep

insight of an optimal capital structure for the cement industry.

Which will then support in maximization of the share value of

firms on the one side and the minimization of cost of capital on

the other side, and overall it would have a significant effect

on the firm’s profitability which is the main objective of any

organization. The variables include leverage, profitability,

liquidity, Size, and tangibility.

Introduction

The main purpose of this research study is to examine the

determinants of the capital structure of the five selected

cement companies listed in Karachi stock exchange (K.S.E),

For the period of 10 years, from 2004 to 2013.

The capital structure is one of the most important part of any

organization. It’s the financial engine of the company. It has a

direct impact on the company as a whole

Capital structure is basically a combination of a company’s long

term debt, specific short-term debt, and equity. The capital

structure in other words is how well a firm finances its overall

operations and growth by using different sources of funds.

According to most of the theories the capital structure is

affected by many external and internal factors, such as tax,

political, social, management, and macro economical indicators.

The study carried on, will help the cement sector of Pakistan,

to better utilize its capital structure by making better

decisions, hence directly have a positive effect on the

profitability. Although many theories have been written on

capital structure, but there is no theory specific update theory

on cement sector of Pakistan. Hence our study work carries on a

further research.

The variables in this study are leverage, profitability,

liquidity, size, tangibility and liquidity.

Problem statement

When it comes to effective decision making, the capital

structure has to be considered. In present, lot of financial

representative’s in the cement industry are lacking in some of

the basic knowledge of capital structure. Although in past

decades the cement sector of Pakistan has had positive net cash

flows, but in present as compared with other nation’s cement

sector , the Pakistani cement sector has lost a significant

share of exports in the international market.

The cost of manufacturing cement is also high in the country.

One of the factors of high cost is the high transport cost and

fuel problems.

The cement industry in Pakistan has been importing coal as fuel

for manufacturing of cement, which is of very high cost.  In

order to reduce cost cement industry is looking for different

alternatives to reduce its fuel cost.

According to sources the fiscal year 2010-11 proved to be a

nightmare for the cement sector as 80 per cent of the cement

manufacturers suffered huge losses. Mainly because the

government failed for payment of inland freight subsidy that

could have boosted exports (All Pakistan Cement Manufacturers

Association).

These are problems, but of the main is that there isn’t

financial expertise when making the right decision while

considering the capital structure. Though macroeconomic

indicators cannot be controlled, but the management can be

controlled to make the best from the organization.

For example many cement companies in Pakistan are not following

up an optimal capital structure. Their leverage is not optimal.

So is the tangibility and size of the firm. The leverage of any

firm has a direct impact on its profitability. Many cement

companies listed in KSE are having net loss, the reason is

simple, they are not using their capital structure effectively.

Research question

To what extent Leverage, profitability, tangibility, size and

liquidity affect the capital structure decisions of the listed

companies in cement sector of Pakistan?

Research Objective

The study analyzes the effect of profitability, tangibility,

size and liquidity on capital structure decisions of the listed

companies in Karachi stock exchange (K.S.E) of cement sector of

Pakistan.

Significance of the study

The study has its significant for the financial experts mainly related to the cement sector. By studying this research study, they can make better decisions related to the capital structure.Furthermore the study is also important for investors, who can get deep understanding of the financial engineering of the organization. The students will find this study helpful for carrying on this study in their own studies.

Literature review

There have been many theories related to the capital structure

decisions, depending upon the sector and time scale. Most of the

studies find that the capital structure does have a significant

effect on the organization as a whole.

One of the most famous study has been of Modigliani and Miller,

according to their study Tax benefits on debt financing has been

the most important determinant of capital structure, while

ignoring the dividend. (Modigliani and Miller, 1963).

More leverage means where the debt financing is in excess.

The liquidity of a company and its effect on optimal capital

structure has

been showing various trends. It has been found that liquidity of

assets has both positive and negative effect on the leverage.

(Williamson 1988),

In other study capital structure of a firm is usually achieved

when the financial benefits of debt financing exceed the

financial costs of debt charged by debt providers such as banks

etc (Myers & Majluf, 1984).

There are strong evidences of sizeable and costs of distress in

relation to changes in leverage and the associated cost and the

benefits of the leverage of the firm (Sibilkov2009).

There are results that debt financing has been changing as per

the market trends of debt issues (Doukas, Guo & Zhou 2011).

The differences of capital structure also varies from country to

country basis, every country has its own macro economical

indicators. (Muzir, 2011).

Krauseova (1995) described the capital structure of Czech

firms in the period from 1990 to 1993. Bauer and Bubak (2003)

also test for the existence of optimal capital structure and for

relevance of signaling theory in the case of Czech listed firms.

Myers and Majluf (1984) discussed that firms prefer to finance

with internal funds rather than debt if internal equity is

sufficient due to the asymmetric information. Hence,

profitability is expected to have negative

relation with leverage.

Delimitation

We delimit this study to cement sector of Pakistan.

Hypothesis

The relationship between the Leverage of cement industry and its independent variables have been explained, this study make’s a set of hypothesis.

H1: There is a significant positive relation between leverage and

firm size of cement industry of Pakistan.

H2: There is a significant negative relationship between leverage

and firm size of cement industry of Pakistan.

H3: There is a significant positive relationship between leverage

and profitability of cement industry of Pakistan.

H4: There is a significant negative relationship between leverage

and profitability of cement industry of Pakistan.

H5: There is a significant positive relation relationship between

leverage and tangibility of cement industry of Pakistan.

H6: There is a significant negative relationship between leverage

and tangibility of cement industry of Pakistan.

H7: There is a significant positive relationship between leverage

and liquidity of cement industry of Pakistan.

H8: There is a significant negative relationship between leverage

and liquidity of cement industry of Pakistan.

Research Methodology

The purpose of this research is to contribute towards the very

important aspects of the financial management, known as the

Capital structure and its effect on firm’s performance. Here the

investigation of relationship between the different variables of

capital structure, such as profitability, tangibility, size and

liquidity are studied of the cement sector made for a period of

10 years, from 2004 to 2013, of 5 cement companies listed in

KSE.

The variables and firms included in this research study will

also be discussed; the distribution patterns of data and the

other statistical techniques in investigating the relationship

between these variables will be studied.

PopulationIn Karachi stock exchange there are total 17 cement companies

listed. Our population size is 17.

SampleOut of 17 listed companies of cement sector, we selected a

sample of 5 companies due to date availability. In the study our

sample size is 5.

Instrumentation

The research will carry the SPSS software to conduct research.

The statistical tools which will be used are Pearson correlation

and linear regression.

Data Collection

The data collected for this research was taken from annual

reports of the selected cement companies. The data has been

taken from year 2005 to 2013.

Data Analysis

Regression is used to estimate the association between the

studied variables. The following model is thus developed for

testing.

Descriptive statistics

The quantitative data is taken from the different financial

statements of the listed cement companies.

Inferential statistics

The financial ratios are used to make the predications of the

data.

Theoretical Framework

In this research study we will see relationship between Leverage

and firm size, tangibility, liquidity and profitability.

Following is the table showing the dependent and independent

variables,

Independent Variables Dependent Variable

Firm size of cementfirms

Profitability of cementfirms

Tangibility of cementfirms

Liquidity of cementfirms

Leverage of cement firms

Variables

The variables have been chosen, on the recommendations from

previous research indications.

Dependent Variable

Leverage (Debt/equity ratio):

A measure of a company's financial leverage, calculated by

dividing its total liabilities by stockholders' equity. It

indicates what proportion of equity and debt the company is

using to finance its assets.

Independent Variables

Firm size (log of sales):

Firm size represents the overall size of the firm. There are

various methods to calculate the size of firm. We have chosen Net

sales, as a medium of firm size, by according to the previous

research study by Patrick Bauer Empirical Evidence from the Czech

Republic (2004). Here Log of net sales has been taken.

Profitability (ROTA):

The independent variable profitability is calculated using the

financial ratio, Return of total assets (ROTA). Its calculated by

EBIT divided by Net assets. The ratio is used as an indicator ofhow effectively a company is using its assets to generate

earnings.

Liquidity (current ratio ):

A liquidity ratio that measures a company's ability to pay short-

term obligations. It is calculated by current assets divided by

current liabilities.

Tangibility ( Fixed assets to total net assets)

The variable tangibility is measured by the financial ration,

fixed asset to total asset ratio. A measure of the extent to

which fixed assets are financed with respect to total assets. A

higher return indicates that the fixed assets are used

efficiently with respect to total assets.

Model Specification

The econometric model is defined as follows:

The regression model explains the relationship between the

dependent variable and independent variable.

LVRG it= β0 + β1 (Fms it) + β2 ( PBT it) + β3 (TNG it) + β4 (LQTY it) + e

LGi,t = the leverage of the firm i at time tPBTi,t = profitability of the firm i at time tCRi,t = current ratio of firm I at time tFMSi,t = the size of the firm i at time tTNGi,t = tangibility of the firm i at time t

Data Analysis and DiscussionDescriptive Analysis

Descriptive Statistics

N Range Minimum Maximum Sum MeanStd.

Deviation

StatisticStatisti

cStatisti

c StatisticStatisti

cStatisti

cStd.Error Statistic

LVRGE 50 7.19 .00 7.19 86.12 1.7224 .26493 1.87336

FSIZE 50 3.76 6.29 10.05 369.79 7.3957 .15786 1.11626

PB 50 10.93 -.83 10.10 67.92 1.3584 .38992 2.75712

TANG 50 6.45 .08 6.53 46.53 .9307 .12727 .89995

LQDTY 50 3.12 .26 3.38 50.95 1.0190 .09221 .65200

Valid N (listwise)

50

In this table the data analyzed by spss software shows the sum,mean and standard deviation of each variable.

Correlations

LVRGE FSIZE PB TANG LQDTY

LVRGE Pearson Correlation

1 .626** -.156 -.176 -.290*

Sig. (2-tailed) .000 .279 .221 .041

N 50 50 50 50 50

FSIZE Pearson Correlation

.626** 1 -.238 -.212 .121

Sig. (2-tailed) .000 .096 .140 .401

N 50 50 50 50 50

PB Pearson Correlation

-.156 -.238 1 .522** .107

Sig. (2-tailed) .279 .096 .000 .460

N 50 50 50 50 50

TANG Pearson Correlation

-.176 -.212 .522** 1 .134

Sig. (2-tailed) .221 .140 .000 .354

N 50 50 50 50 50

LQDTY Pearson Correlation

-.290* .121 .107 .134 1

Sig. (2-tailed) .041 .401 .460 .354

N 50 50 50 50 50

**. Correlation is significant at the 0.01 level (2-tailed).

*. Correlation is significant at the 0.05 level (2-tailed).

The correlation shows relationship between the variables. We can

see that the firm size is positive correlated with leverage, 1 %

increase in leverage will tend to increase .626% of firm size.

On the other hand, there is a significant negative correlation

between leverage and profitability. If there is 1 % increase in

leverage it will decrease -1.56 % of profitability.

Moreover tangibility is also negatively correlated with leverage.

An increase of 1 in leverage affects the tangibility to move at a

significant negative direction at 1.76.Similarly liquidity is

also negative correlated with leverage, as an increase of 1 % in

leverage will tend to decline liquidity negatively at .290.

It’s clear that only firm size is positively correlated with

leverage.

As for the previous research studies on capital structure

decision, this phenomenon of capital structure is the same for

mainly the countries belonging to the developing world.

Model Summaryb

Model RR

SquareAdjusted R

Square

Std. Errorof the

Estimate

Change Statistics

Durbin-Watson

R SquareChange

FChange df1 df2

Sig. FChange

1 .728a .531 .489 1.33935 .531 12.716 4 45 .000 .722

a. Predictors: (Constant), LQDTY, PB, FSIZE, TANG

b. Dependent Variable: LVRGE

The value of F-statistic is significant thus it shows reliability

ofthe model. Adjusted R2 shows that the independent variables

explain the 0.489 of the leverage. R2 shows

Overall model perfectness, it explains that almost .53% of the

variation in the leverage is due to changes in

the explanatory variables. The remaining 47% variation is owing

to the unknown variables.

Durbin-Watson stat is .722, that shows the positive correlation

and predicts that there is no multi collinearly and auto

correlation in the model due to errors.

Coefficientsa

Model

UnstandardizedCoefficients

Standardized

Coefficients

t Sig.

Correlations

B Std. Error Beta Zero-order Partial Part

1(Constant) -5.678 1.383 -4.106 .000

FSIZE 1.146 .180 .683 6.369 .000 .626 .689 .651

PB .035 .083 .051 .418 .678 -.156 .062 .043

TANG -.016 .252 -.008 -.063 .950 -.176 -.009 -.006

LQDTY -1.084 .300 -.377 -3.609 .001 -.290 -.474 -.369

a. Dependent Variable: LVRGE

The results are based upon the regression model. The information

to pay attention to here is the probability shown as “Sig.” in

the table. If this probability is below 0.05, we conclude that

the F-statistic is large enough so that we can reject the

hypothesis that none of the explanatory variables help explain

variation in Y.

As for the firm size, its unstandardized co efficient B is 1.46,

which indicates that if there is an increase of 1 unit of

dependent variable the firm size will move to the positive

direction at 1.146.

Moroever its level of significance is less than 0.05 alpha level,

so its significant to the dependent variable.

Similarly the liquidity’s coeffient is negative -1.084, this

means that 1 unit increase in dependent variable will cause

liquidity to decline by -1.084. While its level of significance

is less than the alpha level .001 < 0.05, it indicates its

significant.

On the other hand, Profitability is positive at 0.35 while

tangibility is negative at -0.16, but both of these variables

have significance level greater than alpha level , .678 > 0.05

and .950 > .05. This shows that both of the variables are not

significane.

Conclusion

The research study taken had significant results, and it is

thereby concluded that the way in which capital structure is

managed it has significant impact on the overall organization,

specifically the cement sector.

There is a significant positive relation between leverage and

firm size, we accept H1. On the other hand, liquidity has a

significant negative relation with the leverage. Moreover

tangibility and profitability are insigficant.

Bibliography

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Modigliani, Merton H. Miller (1963), Corporate Income Taxes and the Cost of Capital: ACorrection, The American Economic Review, Vol. 53, No. 3, pp. 433-443

Myers & majluf (1984) Corporate Financing and investment decision when firms have information that investorsdo not have

Williamson (1988), Asset liquidity and capital structure

Douksas, Gua, Zhou (2010)Hot Debt Markets and Capital Structure,European Financial Management, Vol. 17, No. 1, pp. 46-99, 2010.

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