In the opening chapter, the background, problem discussion and purpose of the study were presented. The chapter ended with the targeted group and limitation of study. Capital structure was one of the most prolific domains of research in corporate finance. Research was spinning around a few theoretical models of capital structure since over than forty years but could not be able to provide the conclusive assistance to managers and practitioners for choosing between debt and equity in financial decisions. An important question that companies face in need of new finance was whether to raised debt or equity. A number of theories had been proposed to explain the variation in debt ratios across firms. The theories suggested that firms select capital structures depending on attributes that determined the various costs and benefits associated with debt and equity financing. In spite of the continuing theoretical debate on capital structure, there was relatively little empirical evidence on how companies actually select between financing instruments at a given point in time. The problem of capital structure choice had been heavily discussed by international researchers for the last few decades that: What were the determinants of capital structure choice? How did firms choose their capital structures? "Given the level of total capital necessary to support a company's activities, was there a way of dividing up that capital into debt and equity that maximize current firm's value? And, if so, what were the critical factors in setting the leverage ratios for a given company?" Modigliani and Miller (1958) theory was considered as fundamental corporate structure model in the modern corporate finance. The theory ascertained the irrelevance of capital structure to firm's value in perfect markets, without taxes and transaction costs. Following on the perfect classification of market, most subsequent research focused to demonstrate that a firm's capital structure decision was considered corporate and personal taxes, agency costs, bankruptcy cost, and other frictions. Those aspects of corporate environment were referred as "determinants of capital structure". Main research in corporate structure was focused on following two competitive theories: The first one was the traditional "static trade-off" theory, which derived form the Modigliani and Miller (1963) hypothesis of capital structure irrelevance and suggested that firms choose their optimal capital structures by trading off the benefits and costs of debt and equity. The main benefit of debt was tax deductibility of interest, which was balanced against bankruptcy costs Kim (1978) and agency costs (Jensen & Meckling, 1976; Myers, 1977). It suggested the existence of a target optimal capital structure, which companies tried to reached. Contrary to the above was the "pecking order" theory, developed by Myers and Majluf (1984) which emphasized that there was no target level of leverage and companies used debt only when their internal funds were insufficient, firms instead of aiming towards a target-specific capital structure, choose a type of capital according to the following preference order: internal finance, debt, equity. Myers (1984) and Myers and Majluf (1984) by referring to the existence of information asymmetry between managers (insiders) and investors (outsiders), Insiders knowing more about the value of the firm than outsiders, avoid issuing equity when the shares of the company were undervalued. Being aware of the above fact, outsiders tend to interpret a share issue as conveying unfavourable information as to the value of the firm. As a result, managers were reluctant to raise equity capital because it was typically followed by a decrease in valuation of the company's assets. Therefore, retained earnings were the most preferred sources of funds and, if external financing was needed, a firm first seeks low risk debt. According to the pecking order theory, external equity financing was used as a last resort. Titman and Wessels (1988), as well as Rajan and Zingales (1995), whose work were referred to as the most important empirical studies in the field, found strong negative relationships between debt ratios and profitability. This evidence was consistent with the pecking order behaviour and inconsistent with the trade-off theory. One of the latest papers in support of the pecking order theory was by Shyam-Sunder and Myers (1999), who explicitly compare it with the static trade-off theory using a panel of US firms. They conclude that, compared to the static trade-off model, the pecking order theory explained more of the variation in actual debt ratios. Even if companies in their sample had well-defined optimal debt ratios, their managers were not trying to obtain them. Many empirical studies had tried to explain the factors that affect on capital structure's choice. One of the most renowned initial empirical studies was made by Rajan and Zingales (1995) and they explain the various institutional factors of firm's capital structure in the leading industrial countries. Predominantly ongoing debate in corporate finance research sustained the significance of above discussed theories. Majority of research work was based on the facts taken from western and American's non-financial firms, For example, Rajan and Zingale's (1995) study was made on G-7 countries, Titman and Wessels (1988) studied U.S firms, Bevan and Danbolt (2002) studied U.K firms. There were few studies that cover non-financial firms from emerging economies. Although Booth, Aivazian, Demirguc-Kunt, and Maksimovic (2001) had included Pakistan, in his empirical study of developing countries but Hijazi and Shah (2005) were the first to study determinants of firm-level capital structure in Pakistan. They discussed the all listed non-financial firms from period 1997 to 2001. But so far chemical sector of Pakistan has not been analyzed independently. This report presented an empirical analysis of capital structure of chemical sector in Pakistan with most recent available data. The report attempted to extend the knowledge of capital structure and its determinants in Pakistani companies. The aim of the study was to analyze the determinants of capital structure of chemical sector of the Karachi stock exchange. A variety of variables that were potentially responsible for determining capital structure decisions in companies can be found in the literature. However in the study, the profitability and tangibility were tested as determinants of capital structure in chemical sector. Hypotheses: H1: There is a negative association between capital structure and profitability H2: There is a positive association between capital structure and tangibility
1.4 Outline of the study: Chapter 2 presented the literature review. Chapter 3 presented the research methods that illustrate the empirical methodology and statically tool that had been used. Chapter 4 presented the table assessment table followed by the results and findings. Chapter 5 presented the discussions, conclusion, implications and future research. Definitions 1.5.1 Capital Structure: A mix of a company's long-termÂ debt, specific short-term debt, common equity and preferred equity. The capital structure wasÂ how a firm finances its overall operations and growth byÂ using different sources of funds. Debt comes in the form of bond issues or long-term notes payable, while equityÂ was classified as common stock, preferred stock or retained earnings. Short-term debt such as working capital requirements was also considered to be part of the capital structure.
1.5.2 Profitability: the ratio of net profit before tax (EBIT), to the book value of total assets PROFITABILTIY=EBIT/TA
1.5.3 Tangibility: the ratio of the book value of depreciated fixed assets (FA) to that of total assets TANGIBILITY=FA/TA
CHAPTER 2: LITERATURE REVIEW A capable economic system calls for a reliable system to assign its labour, Capital, resources and optimized leadership of land. This allocation process consists mainly of a set of concealed decisions, which were aimed at by a flexible prices and network of free markets. Imperative with these were capital investments decisions that were very important at two levels, the prospect operability of the firm making the investment, and for the whole economy of the state. Capital investment decisions had inference for many features of operations, and frequently exert a vital impact on endurance, profitability and growth at the firm level. At the state level, the appropriate planning and distribution of capital investment were vital to a well-organized utilization of resources; inadequately placed investment decrease the efficiency of labour and materials and sets an inferior ceiling on the potential output of economy (Rajan & Zingales, 1995). The Capital structure was the combination of equity and debt financing. Its option and determinants interrelated with many different factors. Capital structure of a firm illustrates the mode in which a firm increase capital needed to set up and expand its company activities. It was an assortment of various types of debt and equity capital a firm maintained resultant from the financing decisions of firm (Sun Tong, 2002). The capital structure of a corporation was a meticulous combination of equity, debt and other resources of finance that it utilizes to fund its long term asset. The main dissection in capital structure was between equity and debt. The amount of debt financial support was measured by or leverages. There were different aspects that involve a firm's capital structure and a firm must effort to found out what it's optimal or mix of financing. But determining the precise best capital structure was not a skill, so after analyzing a numeral of factors, a firm institutes a target capital structure which it consider was most favorable (Ramlall, 2009). Capital structure policy besides involves a trade-off among risk and return. By means of more debt elevates the threat in the firm's earnings torrent, but a higher amount of debt usually show the way to a higher predictable rate of return and the higher risk connected with greater debt had a propensity to inferior the stock's price. At the same time, however, the higher predictable rate of return makes the stock further eye-catching to investors; in turn, eventually enlarge the stock's price. Therefore, the best capital structure was the one that hit a balance among return and risk to achieve our definitive goal of exploit the stock prices (Barclay & Smith, 1999). Around four decades ago the theory established called modern theory of capital structure. Capital structure choice has stirred and enthralled many researchers. Innumerable studies explored into the elucidations of firms' capital structure selection, both empirical ones and theoretical studies which signify the most favorable choice of capital structure by firms was equilibrium of corporate tax shield in opposition to the bankruptcy cost and agency cost. Although pecking order theory flings doubt on the subsistence of target capital structure, suggestive that firms use debt merely when the inner financing was not available (Rajan & Zingales, 1995). Capital structure was principally enduring long term financing of an organization as well as common stock, long term, retain earning and preferred stocks . Even though there has been abundance of study focusing on the main determinants of the capital structure, there was still difference regarding which factors considerably influence a firm's capital structure (Titman & Wessels, 1988). The association between a firm and capital structure value has been the matter of substantial debate, both in theory and in experiential research. Throughout the past research, discussion has centered on whether there was a best capital structure for a firm or whether the percentage of debt usage was immaterial to the single firm's value. Research reveals that in a frictionless world, monetary leverage was not related to firm value, except in a world with tax deductible interest costs, capital structure and firm value were absolutely related further personal taxes to the study and established that best debt usage take place on a macro altitude, although it did not subsist at the firm level. Interest deductibility at the organizations level was counterbalance at the investor level (Dodd & Warner, 1983). Capital structure was the firm's range of sources of finances used to funding it's by and large operations and growth. Short term debt like working capital requirements was also considered part of the capital structure. The stable long term financing of a corporation, together with common stock, long-term debt, preferred stock and retained earnings diverge from financial structure that includes accounts payable and short-term debt. Analysts consider capital structure of its overall adequacy (Ramlall, 2009). Capital structure was necessary for the continued existence, performance and growth of an organization. There has been a rising interest globally in recognizing the factors linked among debt leverage. Still, nothing has been done in divergent medium, large sized enterprises (LSEs) and small sized enterprises (SMEs) on these facets. SMEs were very imperative for employment and growth in the manufacturing sector. Experiential studies illustrate that factors effecting capital structure distinguish with firm size. Past study showed that profitability was a main determinant for both size groups of capital structure. However, assets growth and proficient assets management were found necessary for the debt structure of large sized enterprises as contrasting to effectiveness of size, sales growth, current assets and high fixed assets (Titman & Wessels, 1988). Capital structure of a firm explains the way in which a firm increased capital to establish and develop its business activities. It was a combination of different types of debt capital and equity a firm continue consequential from the financing decisions of firms. Capital structure has encouraged and fascinated many researchers. Innumerable studies examine into the clarification of capital structure choice of firms, both empirical ones and theoretical studies. For instance, theory claims the accessible of the best capital structure, point out the optimal choice of firm's capital structure that was equilibrium of corporate tax shield in opposition to the agency cost and bankruptcy cost. Past research throw reservation on the subsistence of target capital structure, signifying that firms only use debt once the inner financing was not available (Dodd & Warner, 1983). The affiliation between capital structure and industry membership has acknowledged considerable attention. It was generally acknowledged that firms in a known business would had alike leverage ratios while vary across industries recognized a relationship between capital structure and industry. These studies all originate that particular industries contain a common leverage ratio which overtime, was comparatively stable. Using industry membership as a substitute for risk class, originate that levered beta principles within dissimilar industries diverse more than unlevered values (Titman & Wessesls, 1988). There was a association between the financial leverage and cost of equity, documentation of the industry outcome as one quarrel for the occurrence of an industry allied best capital structure and entail that it was the tax rate and tax code differences across industries that basis the inter industry similarity in leverage ratios (Cook, 1977). It was likely that the expansion of a firm may had an effect on the market response to debt declaration. One might anticipate that a high growth firm could pay to had better financial leverage for the reason that it might generate sufficient earnings to sustain the additional attention expense. Conversely, it may be riskier for a small growth firm to augment its financial leverage as its income may not add to enough to cover the additional fixed obligations. The issuance of debt by providing a device for controlling and monitoring managers by decisive the market response to debt issuance by firm's with dissimilar expansion rates (Bradley, Jarrell, & Kim, 1984). Large firms were evidently compulsory to accomplish economies of scale in research, production and marketing. The strength of these advantages has been growing as enhanced communications, deregulated capital and rising globalization had preferential multi-national companies. Large sized enterprises by investing in Research and development can innovate directly and consequently lead to a raise of general economic progress. It was also extensively accepted that small sized enterprises had an imperative role in maintaining rivalry and in the utilization of new improvement that might be afterward commercialized by large firms (Niu, 2008). Capital structure decisions were the most imperative and vital decisions for any company for the reason of their result on cost and value of the company. Capital structure, a vital feature in a firm's performance has engaged economic researchers for a long time. Perfect capital market propositions of the firm were developed on the capital structure can be classified into three categories: agency cost theories, asymmetric information theories and tax based theories. But not any of the above theories makes difference among small and large firms (Dodd &Warner, 1983). A competent economic system describes for a reliable instrument to apportion its labor and Capital, resources and optimized management of land. This distribution process consists mostly of a set of classified decisions directed by a set of connections of free markets and elastic prices. Significant among these conclusions were the decisions regarding capital investments that were essential at two levels first one was for the future operability of the firm building the investment and secondly for the economy of the country as a complete (Bradley et al., 1984). Capital investment decisions had insinuation for numerous aspects of processes, and often apply a vital impact on continued existence, profitability and growth at the firm level. At the national level, the appropriate development and allocation of capital investment were important to a competent utilization of resources; inadequately placed investment decreases the productivity of labor and materials in addition to sets an inferior ceiling on the potential output of economy (Cook, 1977). In broad-spectrum, debt ratios in rising countries seem to be exaggerated in the similar way and by the identical types of variables that were important in developed countries. However, there were methodical differences in the way these ratios were pretentious by country aspect, such as inflation rates, GDP growth rates and the development of capital markets (Rajan & Zingales, 1995). Empirical capital structure studies had generated numerous results that attempt to clarify the determinants of capital structure. Consequently a result of these studies, a number of broad kinds of capital structure determinants had emerged. Though, point out that the selection of suitable descriptive variables was potentially controversial (Myers, 1984). Researchers argue that the tax environment, legal environment, technological capabilities, the economic system influence the capital structure in the European countries examined in their study argue that both firm-specific factors and macroeconomic conditions had an consequence on firm's financing choices (Sun Tong, 2002). The asymmetry theory of capital structure presume that firm executives or insiders possess confidential information about the distinctiveness of the firm's return river or investment opportunity, which was not recognized to common investors. In an effort to elucidate some financing behaviour was to not steady with the prophecy of static trade-off theory that shows a negative relationship between leverage and profitability give emphasis to that external funds and internal funds were used hierarchically. Firms had a inclination to finance new investment, primary internally with retained earnings and then with debt and lastly with an matter of new equity. The more profitable firms were supposed to hold not as much of debt, because high levels of profits give internal funds at high level (Myers, 1984). Issuing debt protected by collateral may decrease the asymmetric information connected costs in financing. The dissimilarity in information sets among the parties involved may show the way to the moral danger problem (hidden action) or diverse choice (hidden information). Therefore, debt held by collateral may alleviate asymmetric information related charge in financing. Consequently, a positive relationship between financial leverage and tangibility may be expected (Sun Tong, 2002). The use of temporary sources of debt, conversely, may alleviate the agency problems, as some attempt by shareholders to take out wealth from debt holders was probable to confine the firms' access to interim debt in the instant future (Sun Tong, 2002). The prospective for shareholders to take on actions dissimilar to the benefit of debt holders that was most stern for companies whose worth was predominately accounted for prospect investment opportunities. Growth companies may perhaps also be unwilling to receive on debt in the case if high interest rates or limiting convention compel constraints on their prospect maneuverability. Constant with these forecasts, numerous researchers discover a negative association between the level of gearing and growth opportunities (Niu, 2008). The link between gearing and growth opportunities might be different for long term and short term forms of debt. The problem of agency was mitigated if the organizations issues short term to a certain extent than long-term debt. However, even as they found a positive association between the short term debt and growth opportunities, they moreover found long term debt to be positively associated to the MTB (market-to-book) variable although not significant. Thus, the past research indicates the evidence on the impact of growth opportunities in corporate gearing on the cross-sectional variation was quite mixed (Ramlall, 2009). Profitability was defined as the "ability of an investment, or a company to make a profit after all costs, overheads, etc". It was also defined as "the ratio of profits to the capital that had to be invested to generate these profits." Profit margin was awfully helpful while comparing companies in comparable industries. A higher profit margin signifies a more profitable company that has good control and command over its costs and overheads compared to its competitors (Bradley et al., 1984). Larger firms had a propensity to be more diversified and fall short less often, so size may be a contrary substitute for the likelihood of insolvency. The agency conflict between lenders and shareholders may be mainly relentless for miniature companies. Lenders can handle the risk of lending to these companies by restricting the span of maturity offered. These companies can consequently be predictable to contain less long term arrears although probably more short term debt comparing to the larger companies (Jensen & Meckling, 1976). The tax deduction of interest payments companies may have a preference debt to equity. This would propose that exceptionally profitable firms would pick to have high levels of debt in classify to attain attractive tax shields. It has been also argued that interest tax shields might be insignificant to companies by means of other tax shields as depreciation. Due to the clash of interest among shareholders and debt providers, lenders come across to risk of undesirable selection and ethical hazard. Lenders may demand sanctuary, and collateral value may be a key determinant of debt finance accessible to companies In particular, Average debt and mainly short term debt ratios in the sample firms come into view to be declining during economic boom and ever-increasing during the economic recession whereas the contradictory was correct for the long term debt (Harris & Raviv, 1991). Profitable firms may have improved admittance to debt finance than low profitable firms; the requirement for debt finance might perhaps be at the lower side for high profitable firms if their retained earnings were enough to fund new investments. The pragmatic association between earnings and debt might thus replicate the demand and supply relations. Supply limitation might have had grown to be increasingly marked and thus emerge to become more careful in their lending and increasingly dependent upon sufficient earnings capability of the firm. Previous consequences demonstrate that the largest part noteworthy shift in regression coefficients narrate to the impact on capital structure of profitability. All forms of gearing were pessimistically associated with the point of profitability (Ramlall, 2009). Profitable firms had bigger needs to guard income from corporate tax and should scrounge more than low profitable firms. Whereas pecking order theory proposes an inverse association between the level of debt and profitability. Organizations were assumed to desire internal financing to external financing according to the theory. This liking leads organizations to use retained income as investment funds and shift to external financing simply when retained earnings were inadequate. When facing the preference between equity and bonds, firms would have had a preference debt issue to equity issue. Profitable firms were probable to contain less debt in the case (Barclay & Smith, 1999). When organizations were able to pledge assets as investment, collateral and borrowing become endogenous. These assets prop up more borrowings that allow for more investment in pledge able assets (Cook, 1977). Investment cash flow sensitivities were rising in the amount of tangibility of controlled firms' assets. If firms were unimpeded, investment cash flow sensitivities were unaltered by asset tangibility. Asset tangibility itself may found out whether an organization faces credit constraints with more tangible possessions may had better access to external funds indicating that the association between cash flows and capital expenditure was non monotonic in the asset tangibility (Myers, 1984). Tangibility was defined as the book value of, plants, property and equipment scaled by total assets. The tangible assets were capable to be used as securities in external borrowing, the existence of a big fraction of tangible assets facilitate to obtain bank loans at an inferior interest rate. Also, it helps to decrease the threat the lender suffering from the cost of debt (Barclay & Smith, 1999). In view of the fact that the debts can be safe of tangible assets by the collateralization, the firm's prospect to connect in asset replacement was abridged by the existence of a large portion of secured debts. For those firms that had more intangible assets, than the costs of capital were at the higher side as monitoring was more complicated. Therefore, firms that had a large fraction of tangible assets were probable to have more debt (Ramlall, 2009). To a large extent of the presumption in corporate sector was based on the supposition that the objective of firm must be to make the most of the wealth of its present shareholders. The main reason of setting the goal was financial ratio (Bradley et al., 1984). One of main factors area under discussion to intense contest in capital structure was whether to employ the market cost or the book value of equity and debt as the accurate measure of leverage. The main cost of borrowing was the anticipated cost of financial suffering in the happening of insolvency. Financial distress affects the average cost of capital and accordingly the optimal leverage. In the situation, the worth of the distressed firm was ended to its book value. Changes in the market worth of debt do not change the interest tax shield cash investments. Furthermore, if insolvency occurs, the accurate measure of debt-holders' liability was the book value of debt and not the market value of debt (Jensen & Meckling, 1976). Book values were more effortlessly accessible, accurately recorded and also not focus to market volatility unlike market values. Those who have a preference the market value to book value squabble that the market value eventually decides the real value of an organization. It was probable for an organization to have a negative book value of equity though simultaneously benefit from an affirmative market value. This was achievable for the reason that a negative book value replicates previous sufferers whereas a positive market value indicates the firm's expected future cash flows. In practice, both procedures of market and book values were often used. Previous research demonstrated that adjusted value and market value measures of capital structure in contrast with book value procedures had stronger connection with performance. This way market value must be taken more into consideration in evaluating capital structure (Myers, 1984). Different theories on the subject of capital structure discussed that in competent markets the debt equity option was immaterial to the worth of the firm and remuneration of using debts would recompense with reduce of companies stock (Bradley et al., 1984). Conventional perception believed that by means of financial leverage raise Company's worth. In this admiration, an optimized capital structure that decreases capital costs. It has showed in past research that in capital market imperfection, interest expenses were tax deductible and firm value would raised with privileged financial leverage. Models on impact of tax, propose that profitable companies must had further debts these firms that more need for tax organization in corporation's earnings. Conversely, rising debt may results in possibility of increasing bankruptcy. Therefore, the best capital structure corresponds to a level of influence that balances insolvency costs and reimbursement of debt finance. Firm's most favorable capital structure would engage the exchange among the effects of personal and corporate taxes, insolvency costs and agency costs, etc (Harris & Raviv, 1991). Research theory proposes separation of possession and direct and conflicts of attention between groups of agents. One of the main problems that effect conflict among shareholders and managers was free cash flows. therefore, in the companies that had soaring cash flow and profitability , rising of debts can be used as a contrivance of