The Journal of Developing Areas

Volume 51 No. 1 Winter 2017

CAPITAL STRUCTURE AND CORPORATE

GOVERNANCE
Muhammad Akram Naseem
Xi’an Jiaotong University, China
Huanping Zhang
Xian Siyuan University, China
Fizzah Malik
Xi’an Jiaotong University, China
Ramiz-Ur-Rehman
The University of Lahore, Pakistan

ABSTRACT

Capital structure determination is considered as one of the key corporate financing decisions and
managers often face difficulty in finding the optimal one. There are various theories regarding this
phenomenon in the finance literature and this issue has been discussed since long. No theory can be
regarded as the conclusive one as varying evidences found regarding this complex issue. Presently,
the need to determine an optimal capital structure has become more troublesome as well as
important due to the emergence of a need of the best corporate governance practices. To mitigate
agency problem, the organizations may implement code of corporate governance. This study aims
to investigate about the impact of corporate governance on capital structure determination.
Secondly, this study focuses on three well known capital structure theories i.e. trade-off theory,
agency theory and pecking-order theory. Quantitative research design is used for this empirical
study. Sample consists of panel data of the non-financial sector companies listed at Pakistan Stock
Exchange for five years 2009-2013.The data of the variables of interest are collected from annual
reports published by companies and the publications of State Bank of Pakistan. The companies are
selected by taking a representative sample from the whole non-financial sector. Stratified Random
Sampling technique is used by taking 10% of each sector and final selected firms are 40.Then,
simple random sampling technique is used for the selection of a representative sample by using
random number method. Panel data analysis and Hausman test reveal that fixed effects model is
better than other options and Board size has a significant impact on Debt to equity ratio in positive
direction in case of Pakistani firms operating in nonfinancial sector. We may infer that Pakistani
firms have positive relationship between managerial ownership and capital structure. Since this
relationship is insignificant in all regressions. The negative relationship of return on assets (ROA)
and debt to equity ratio suggests that Pakistani firms earn higher returns on assets and such firms
rely more on internal financing resulting in less use of debt, strong negative association has been
found between liquidity and debt to equity whereas the relationship with firm size is observed
negative as well as insignificant. The findings of this study can help to policy makers to give
importance to Board size as it is an important determinant of capital structure as larger the size of
board is, the better the monitoring and decision making process

JEL Classifications: G310, G340

Keywords: Capital Structure, Corporate Governance
Corresponding Author’s Email Address: iqra4ever@hotmail.com
 34

INTRODUCTION

Financing decisions of a firm are of critical importance to the management of a firm.

These decisions include the determination of an optimal capital structure of a firm.
Theoretically, there are a number of capital structure theories available in this regard.
Since Modigliani and Miller (1958) presented the irrelevance theory, there have been an
ongoing discussion about the relevance of capital structure, but theoretically, there is
rather conflicting evidence regarding this phenomenon. Debt to Equity ratio (D/E ratio) is
commonly used as a measure of capital structure. Investors and lenders are particularly
interested in the D/E ratio so as to analyze the firm’s excessive use of debt and chances of
bankruptcy.
While making financing decisions, the element of corporate governance should
also be kept in mind. There is an emerging concept of corporate governance that has
gained wide popularity in the last decade. While discussing the definition of corporate
governance, there are varying points of view found that actually depends on one’s
perception about the world. Corporate governance mechanisms are viewed as a complex
system of controls from a broader perspective (Zingales, 1998). Some define the concept
like Shleifer and Vishny(1997)as the means by which suppliers of finance to companies
can make sure that they would get a return on their investment. Broadly speaking on the
issues, corporate governance is defined as the system of rules, laws and factors that take
control of operational activities in a company (Gillan & Starks, 1998). Regardless of any
specific definition, corporate governance mechanisms are viewed as two distinct groups
i.e. internal to firms and external to firms (Stuart, 2006).
The root cause of the corporate governance mechanism is the agency problem.
As managers involve in financing decisions of a company, they could influence the level
of leverage that is financed by the external sources according to their own self-driven
interests. A very well-known theory of capital structure is pecking-order theory which
leads to the agency theory. According to agency theory, conflicts between management
and owners of the company arise agency problems. These agency problems then create
conflicts between the interests of managers and those of shareholders. This is the
common point where the two concepts, i.e. corporate governance and capital structure
meet. In other words, when managers make financing decisions about the use of leverage
in the capital structure of a firm, the element of corporate governance should also be
brought under consideration (ROSC, 2005).
According to ROSC (2005) “Corporate governance is defined as the structure,
function and procedure for the maintenance and supervision of organizations. Good
corporate governance contributes to sustainable economic growth by improving the
overall presentation of companies and escalating their access to outside capital corporate
governance concerns with the associations between the management, Board of Directors,
shareholder and other stakeholders.”
In Pakistan, controls of internal as well as external corporate mechanism are still
weak as compared to the developed economies. To improve the situation, Pakistani
government has carried out numerous arrangements such as in 1991, allowing the foreign
investors just as local investors in the secondary market. Further, the Securities and
Exchange Commission (SECP) has been operating since January1, 1991 for the
 35

establishment of a sound and efficient capital market that could contribute to the
economic growth of the country. Moreover, SECP launched the Code of Corporate
Governance (CCG) in order to ensure the best practices in the corporate sector under the
efficient management of its directors alongside protecting the interests of its widespread
stakeholders (Sheikh & Wang, 2012). After the promulgation of CCG on March22, 2002
by SECP, it became mandatory for the listed companies at KSE to follow the rules and
regulations thereof. CCG regulations comply with the internationally recognized
regulatory standards and aim at ensuring openness, accountability and transparent
procedures and disclosures for listed companies at PSE.
Capital structure determination is considered as one of the key corporate
financing decisions and managers often face difficulty in finding the optimal one. There
are various theories regarding this phenomenon in the finance literature and this issue has
been discussed since long. No theory can be regarded as the conclusive one as varying
evidences found regarding this complex issue. Presently, the need to determine an
optimal capital structure has become more troublesome as well as important due to the
emergence of a need of the best corporate governance practices.
The key objective of this research aims at exploring the role of corporate
governance in determination of capital structure in context of Pakistani firms. An effort is
made to achieve this objective by taking Pakistan as an emerging economy while
considering a stratified random sample of listed firms operating in non-financial sector.
Secondly, this study aims to fill the gap in the existing body of knowledge on the said
topic by taking into consideration the whole non-financial sector listed on Pakistan Stock
Exchange (PSE). According to the best of the researcher’s knowledge, although Hasan
and Butt (2009) and Sheikh and Wang(2012)have studied this topic by taking a sample of
non-financial firms but no study has yet captured the whole non-financial sector
regarding this topic.
Moreover, the most recent data set chosen for the study will be particularly
beneficial for the parties such as listed companies, banks, credit providers, government
and financial institutions, interested in exploring the role of corporate governance in
making capital structure decisions.
Further, this study is expected to add value in the existing body of knowledge
consisting of developing countries for example Abor (2007) and Wen et al (2002)
because most of the literature have been found on this topic that consist of developed
economies (Anderson, Mansi, & Reeb, 2004; Berger, Ofek, & Yermack, 1997).
In this study, Panel data analysis reveals that fixed effect model is better than Random
effect model to assess the determinats of capital structure. Board size has a significant
and positive impact on debt to equity ratio under fixed effects model whereas managerial
ownership concentration is found to be positive but insignificant effect on capital
structure under all models of panel data analysis. The rest of the paper is organized as
follows. Section 2 consists on literature review and hypothesis development and section 3
explain the methodology. Section 4 covers the Data analysis and interpretations, section 5
comprise on Discussion and conclusion and the last 6 th section describe the limitations of
the current study as well as some future guidelines.
 36

LITERARURE REVIEW

Trade off Theory

Since Modigliani and Miller (1958) proposed the irrelevance hypothesis of capital
structure, there has been an on-going discussion on the topic. Afterwards, with the
introduction of taxes, bankruptcy costs, borrowing costs differences and realization of
asymmetric information, Modigliani and Miller (1963) introduced the tradeoff theory.
According to tradeoff theory, the tax advantage gained as a result of increased level of
leverage is traded off against the costs of higher level debt such as bankruptcy and
administrative costs.

Agency Theory

Another contribution to capital structure literature is made by Jensen and Meckling(1976)

in the form of agency theory. According to this theory, separation of ownership and
management creates agency problems due to conflict of interests. To resolve this
problem, the concept of corporate governance evolved. Thus, firms with good corporate
governance are less likely to be affected by agency issues.

Pecking-order Theory

Pecking order hypothesis by Myers (1984) provides that managers prefer internal sources
of financing over the other sources and if found it insufficient then debt is used and
equity is chosen as a last resort. Keeping in view all of the above capital structure
theories, the relationship of capital structure choice decisions with the corporate
governance attributes is explained below.
A number of studies have been carried out to study the impact of these attributes
on financing decisions of a firm such as (Abor, 2007; Anderson, Mansi, & Reeb, 2004;
Berger, Ofek, & Yermack, 1997; Booth, Aivazian, Demirguc-Kunt, & Maksimovic,
2001; Fosberg, 2004; Friend & Lang, 1988; Kyereboah-coleman & Biekpe, 2006; Sheikh
& Wang, 2012; Wen, Rwegasira, & Bilderbeek, 2002; Wiwattanakantang, 1999).
There is not a single factor or determinant of capital structure rather, it is the
product of firm-specific factors and along with that firm’s governance mechanisms, legal
environment and institutional framework all of these contribute jointly in determination
of an optimal capital structure (Deesomsak, Paudyal, & Pescetto, 2004). Specifically,
Jiraporn et al(2012) have discussed about governance quality and leverage in their study.
They argued that more leveraged firms are those which have weak governance systems
leading to the argument that leverage can be a substitute of corporate governance to
mitigate agency problems. Thus, they proved that governance attributes have material
impact on financing decisions of a firm just like the issue being discussed here.Arping
and Sautner (2010)’s findings of the study of Netherlands’ firms confirmed the above
argument that if corporate governance systems are brought to improvements, companies
will be implied to use low levels of debt.
 37

In a study of Iranian firms listed on Tehran Stock Exchange (TSE) conducted by

Moeinadin (2013), there have been found a significant impact of governance attribute
over the capital structure decisions and the above hypothesis is also confirmed. Thus, it is
crucial for a firm to strengthen its governance quality in order to confront the agency
problem. Laws and their implementation is crucial for a country to run smoothly and
develop a protective environment for the strength of its economy. In weak legal systems,
firms are more leveraged as a result of weakened governance quality so, it is important to
make firm-level governance so strong that these firms could compensate for information
asymmetries and ensure investor protection (Klapper & Love, 2004).

Debt to Equity Ratio and Board Size

An effective board of directors is crucial for the successful operations of a company. As

important and strategic direction of a company depends upon the consensus of the board
members so board size is considered relevant in determination of financing mix of the
company. Boards are considered to be important factor as they affect the reliability of
annual reports (Anderson, Mansi, & Reeb, 2004). Board size has an inverse relationship
with the cost of debt as concluded by Anderson et al (2004) in their research and it leads
to the finding that larger boards can more effectively monitor financial reporting which is
considered one of the core responsibilities of boards.
Mixed evidence is found on the board size and capital structure in the literature.
Adams and Mehran (2003) concluded that a larger board in size can take better decisions
and can monitor management in a better way than otherwise. Whereas, Lipton and
Lorsch(1992) found that larger boards are a waste of resources and smaller boards are
more effective and efficient than larger boards. A negative significant relationship is
observed between leverage and board size (Berger, Ofek, & Yermack, 1997)
Hussainey and Alfieri (2012) and Wiwattanakantang(1999) found a negative but
insignificant relationship between the two. Anderson et al(2004) suggested a larger board
as he found that an additional member on the board bring the benefit of lower cost of debt
financing. Conversely, Abor(2007) and Bokpin and Arco(2009) conducted a study on
Ghanaian firms and found that there is a significant positive relationship between the
capital structure and board size. In case of Chinese listed firms, Wen et al(2002) also
found positive association but the relationship found to be insignificant.Although,there is
mixed evidence available on this relationship between these two variables, most of the
literature hypothesized positive association between board size and leverage. So, our 1 st
hypothesis is as follows:

H1a: Board size has a significant positive impact on D/E ratio.

Debt to Equity Ratio and Managerial Ownership

Managerial ownership includes the shares owned by CEO, directors, their spouses and
children. CEO and managing director is the same position held by the person heading all
the management in a firm. If managers own shares in a company they are less likely to
consume additional perks or investing the resources of organization below cost of capital.
 38

Thus, agency problems mitigate through managerial ownership because of alignment of

interests of both the parties (Jensen & Meckling, 1976).
Mixed empirical evidence is found on this phenomenon in the literature.
Wiwattanakantang (1999) in his study found no significant relationship between the CEO
and managerial holding and debt ratio. Conversely, Fosberg (2004) suggested a negative
significant relationship between CEO holdings and leverage employed in capital
structure. He argued that CEO will prefer his personal incentives over the interests of
shareholders. Another study carried out by Bathala et al (1994) also found a significant
negative association between firm debt and managerial ownership. They stated that for
controlling the agency costs, firms use to trade-off debt and shares owned by managers.
A study of Chinese listed firms has also reported an inverse relationship between
managerial holdings and debt ratio (Huang & Song, 2006).Bokpin and Arco (2009)
revealed a significant positive impact of managerial holdings on debt-equity choice of
Ghanaian listed firms. Berger et al(1997)also found a significant positive relationship
between CEO’s holdings and level of debt. Deesomsak et al (2004) have also considered
ownership concentration as an important firm-specific factor along with firm size, growth
opportunities, no-tax shield and liquidity for determination of capital structure. As the
matter of corporate governance is concerned, a highly concentrated firm might be more
disciplined as compared to a firm with disbursed shareholders (Suto, 2003).Thus, we
hypothesize that:

H1b: Managerial ownership has a significant positive

relationship with D/E ratio.

METHODOLOGY

Data

To explore the impact of corporate governance on capital structure in emerging market

using Pakistanis non financial companies listed in Pakistan Stock Exchange (PSE).The
data for this study are drawn from multiple sources , companies annual reports, State
Bank of Pakistan’s publications which is considered as the most reliable source for
financial data of the country. The annual data is collected for the period 2009-2013.
Sample data is preferred due to the non availability of the data of number of companies.
Companies are divided in twelve different sectors and 10% of the companies from each
sector are selected for this study. From 396 total companies listed in Pakistan Stock
Exchange (PSE), selected companies are 40 and each selected company has observations
from 2009-2013, so our total number of observation are 200 for analysis

Variables and Measurement

This sub section represents the variables used in this study, their definitions and
way they are measured as well.
Debt to Equity Ratio (DR) is used as representative of capital structure which is defined
as the ratio of total debt to total assets, which is also a dependent variable in this study.
 39

Board Size (BS) is one of the important variables of corporate governance is used as
explanatory variable in this study and defined as total number of executive and non
executive board members.

Managerial Ownership (MOWN) is another explanatory variables for this research is

defined and obtained as ratio of shares held by Chief Executive officer (CEO), directors,
their family members to total holdings

Firm size (FS) is used as one of the control variable and the indicator of firm size is
taken as total assets.

Return on Assets (ROA) is defined as the ratio of profit before taxes to total assets and
used as control variable in this study.

Liquidity (LIQ) is obtained as the ratio of current assets to current liabilities and LIQ
serve as a control variable for this study

Econometric Model

Considering the firm-year data, the generally accepted technique, Panel data as pooled
regression, fixed effect and random effect model employed in this study. The following
models are estimated for estimating the relationship between capital structure and
corporate governance.

Pooled Regression Model 1

The intercept and slope co-efficient remain constant over time and individual sector

------------ (A)

Fixed Effect Model 2

The intercept varies between sectors but slope co-efficient remain same over the time
period and between sectors

------------- (B)
 40

Random Effect Model 3

The intercept and slope co-efficient vary with respect to sectors

Where, i = 1, 2, 3,……, 40, t = 1,…., 5

DATA ANALYSIS AND INTERPRETATIONS

Descriptive Statistics

TABLE 1: DESCRIPTIVE STATISTICS OF VARIABLES USED IN THE STUDY

Variable Observations Minimum Maximum Mean Std. Dev.

DR 200 0.03 5.19 1.329 1.031

BS 200 5 14 8.470 1.928

MOWN 200 0 0.9251 0.240 0.267

ROA 200 -9.93 53.13 13.297 11.703

LIQ 200 -6.62 14.43 1.744 1.858

FS 200 12.75 19.84 16.051 1.441

Descriptive statistics in table 1 shows the summary of descriptive statistics including

maximum, minimum values, average and standard deviation of both dependent as well as
explanatory variables. The mean value of debt equity ratio is 1.330 with the standard
deviation of 1.031 which shows excessive use of debt by Pakistani firms that belong to
nonfinancial sector. A higher debt ratio is the indicator of higher risk and volatility in
earnings due to higher interest payments. It is evident from the above table that during
2009-13, Pakistani firms used minimum debt of 0.03 i.e. 3% of total equity and
maximum of 5.19 i.e. 5.19 times of total equity.
 41

Board size indicates the number of executive and non-executive directors on the
board. Directors on board range from 5 to 14 in number and on average, there are 9
directors with a standard deviation of 1.928 in Pakistani firms in nonfinancial sector. The
other measure of corporate governance employed here is managerial ownership
(MOWN). MOWN ranges from 0 to 92.51% and average Pakistani firms in nonfinancial
sector have 24.09% managerial ownership.
Range of profitability varies between -9.93 and 53.13. The negative value shows
failure of management in generating returns out of firm’s assets. The higher the ROA of a
firm is, the better the firm is utilizing its assets in generating profits. So, the highest value
of ROA in our sample is 53.13 which indicate a very efficient utilization of firm’s assets
but this is not the case with most of the firms. On the other hand, it is observed that there
is high volatility in earnings of these firms may be due to excessive utilization of debt
which is evident from the high value of standard deviation of 11.703.Its mean value is
positive which shows that nonfinancial firms are profitable on average.
Liquidity of a firm is calculated by using current ratio and it ranges from
minimum value of -6.62 and maximum value of 14.43. Generally, a firm with a higher
current ratio is considered as better off whereas the firm with a lower current ratio is
supposed to be worse. On average, firms have CR of 1.744 with a standard deviation of
1.858 which is quite normal but it also depends on the size of the firm, type of industry,
volume of sales and other factors as well.
Finally, by looking at SIZE, we can find that the smallest firm in our sample has
a value of 12.74 and the largest firm has a value of 19.84. On average, firms have size of
16.05
 42

Correlation Analysis

TABLE 2: CORRELATION MATRIX SHOWING CORRELATION AMONG

INDEPENDENT VARIABLES

Variable BS MOWN ROA LIQ FS

BS 1

MOWN - 0.27 1

ROA 0.29 - 0.22 1

LIQ 0.18 - 0.26 0.26 1

FS 0.37 - 0.28 0.16 - 0.01 1

From the above table showing the correlation matrix of independent variables, we can see
that there is no issue of serious multi-co linearity.

Panel Data Analysis

The table-3 shows the pooled regression outcomes, fixed effect and Random effect
outcomes of the models. R2, coefficient of determination of pooled regression outcomes
is 0.323 that means 32.30% of the variation in DR is explained by the explanatory
variables under assumption of Pooled regression whereas 11.6% and 25.4% under fixed
and random affect case respectively. Overall all models have a good fit and seems highly
significant as evident from the Prob.>F-statistic = 0.00. Looking at the β coefficients, the
table shows that the measure of corporate governance i.e. board size (BS) has a positive
but insignificant (p>0.10) effect on capital structure but significant impact at 1% and 5%
level of significance under the assumption of fixed effect and random effect respectively.
Under fixed effect model BS has larger rate of change as compare with random effect
model. Profitability has negative and significant impact on capital structure in all the
 43

three models. Liquidity has negative and significant impact on capital structure in all
models.
Size of the firm has mixed type of effect on capital structure. In pooled and
random effect case, size of the firm has positive and significant impact whereas in case of
fixed effect size has negative and insignificant impact on capital structure. Managerial
ownership is positively correlated with the DR although its coefficient is insignificant in
all cases. Hausman test is carried out to decide between using a fixed effect model or
random effects model. According to probability of Wald which is less than 0.05,
fixed effects model is better off for analysis purpose

TABLE -3: PANEL REGRESSION -DEBT TO EQUITY RATIO(DR) AS DEPENDENT

VARIABLE

Pooled Model
Fixed Effects Model Random Effects Model

Items Model-1 Model-2 Model-3

Intercept -1.84(0.00)*** 1.05(0.04)** -1.04(0.33)

BS 0.121(0.72) 0.16(0.00)*** 0.09(0.09)*

MOWN 0.08(0.75) 0.21(0.56) 0.10(0.73)

FS 0.231(0.00)*** -0.03(0.57) 0.14(0.04)**

ROA -0.22(0.00)*** -0.03(0.02)** -0.03(0.00)***

LIQ -0.20(0.00)*** -0.07(0.77) -0.09(0.00)***

Adjusted R2 0.32 0.12 0.25

N 200 200 200

Hausman Test

Chi-Square 27.05(0.00)***

Notes: (1) Numbers before parentheses are the coefficient estimates and values in the
parentheses are the p-values. (2) * if p < 0.10; ** if p < 0.05; *** if p < 0.01
 44

DISCUSSION AND CONCLUSIONS

The study finds some evidence that Board size (BS) may play a role in determining
firms’ capital structure. Our result confirms the findings of Adam and Mehran (2003)
who concluded that a larger board in size can take better decisions and can monitor
management in a better way than otherwise. Anderson et al (2004)also suggested a larger
board as he found that an additional member on the board bring the benefit of lower cost
of debt financing.(Abor, 2007)and(Bokpin & Arco, 2009) conducted a study on Ghanaian
firms and found that there is a significant positive relationship between the capital
structure and board size.
Managerial holdings are considered to be an effective tool against agency
problems. Higher holdings of CEO, managers, their spouse, children etc. point towards
higher use of debt and it is the indication of alignment of interest of shareholders and
management (Jensen & Meckling, 1976). In model 2, Managerial ownership found to
have positive but insignificant impact on DR in pooled regression, fixed effects model
and random effects panel regression. Since this relationship is insignificant in all
regressions.
The negative relationship of profitability and leverage suggests that Pakistani
firms earn higher returns on assets and such firms rely more on internal financing
resulting in less use of debt. This finding is consistent with pecking order theory of
capital structure proposed by Myers (1984). Earlier studies on the subject such as Myers
(1984), Zingales (1998), Booth et al (2001) , Huang and Song (2006) and Chhapra and
Asim(2012) alsoconfirmed these outcomes
Liquidity and DR relationship is found to be significantly negative in pooled and
random effects regression. In fixed effects panel regression, the relationship is found to
be insignificant. A study examining the relationship between liquidity and capital
structure by Lipson and Mortal (2009), strong negative association has been found
leading to the argument that firms with higher liquidity of equity enjoy the benefit of
lower transaction costs resulting in choice of equity to finance their projects.
Consequently, more liquid firms have lower leverage. It also holds true in case of
Pakistani firms.
Firm size is found to be an important determinant of capital structure as it
directly affects the amount of debt a firm uses in its financing activities. According to
trade off theory, firm size and debt are positively associated with each other as larger the
firm is, lower the chances of its bankruptcy and eventually lower the bankruptcy costs.
Further, it is argued in the previous studies that larger the firm size is, smaller the agency
costs.
Although, this study has put an effort into providing a better insight into the
topic yet some of the aspects may remained to be covered under this study. The
limitations of this study along with some suggestion for future research are as:
It was not possible to take into account the whole non-financial sector consisting
of about 396 companies in total due to the non availability of the data. This study covers
only two aspects of corporate governance, Future studies may include more aspects such
as impact of director’s remuneration, CEO duality, Board structure, Number of meetings,
CEO compensation and CEO characteristics. This research has been focused on non-
 45

financial sector. Financial sector of Pakistan is much developed and it should be studied
by the future researchers.SME sector is an important representative of our economy. In
this study, this aspect could not be covered but it could be taken as a future research
direction.

ENDNOTE

*
We would like to thank an anonymous referee for many helpful comments. However, any
remaining errors are solely ours.

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