Testing Trade-off, Agency Cost and Pecking Order Predictions of Capital Structure: Lessons from the Pakistani Experience

Abstract

Why the financial structure is still believed to be relevant within business firms? A number of competing theories have been developed for explaining this question. The three theories that stand out are Pecking order, Trade off and Agency cost. However, the first two are frequently referred to and contradictory to each other. The ‘trade-off’ theory suggests that corporate taxes in combination with bankruptcy costs imply that there exists an optimal combination of debt and equity capital that management should search for in order to maximize shareholder value. The challenging ‘pecking order’ theory recognizes no such optimum, but instead states that there is a ranking order in the firms between different types of capital where the issuance of equity capital is seen only as a last resort. This paper examines the role and importance of different firm characteristics that explain financial structure as well as the theories that best fit in Pakistani context and considers concepts like optimal capital structure, risk, financial hierarchy and asymmetric information. The sample of the study consists of firms extracted from financial (70 firms) and non-financial (120 firms) sectors listed on the KSE for a period of 2000-2013. Secondary data is extracted from firm’s annual reports. The sources like SBP publications; Bloom burgee business week and KSE were used to collect data. The results indicate that firms in the two sectors prefer funds generated internally for financing their assets. Moreover debt will be preferred to equity once external funds are required. The pecking order appears to be a good description of financing behavior for a large sample of firms over a long time period after accounting for debt capacity. We have also studied agency theory of the firm however there was little evidence to support the Agency cost theory.