Interest Rate Firm Size Taxation

Published Date: 02 Nov 2017

LITERATURE REVIEW

Introduction:

Accorind to Mahmood (2003) showed that economy is not good in Pakistan. Pakistan market capitalization and GDP growth are very low they have undeveloped equity market that is the reason of very high leverage ratio in Pakistan. A high proportion of fixed cost means that very high risk belongs to company. Government attention is not positively towards the textile sector. A high risk involved in the company so very low investment is carried out in the manufacturing sector and also high risk involvement means taking loans to the bank with high interest rate. Good economic policies requires for Pakistan and Japan textile sector

David J. Denis (1995) have searched that several academic studies have documented significant shareholder gains and operating improvements following highly leveraged transactions. These gains are generally attributed to changes in the incentive, monitoring, and governance structures of the firms. The results suggest that while high leverage is important in giving managers the incentive to generate cash, high managerial ownership of shares and improved monitoring from the board of directors are important in ensuring that cash is generated in a way that maximizes returns to shareholders.

Amponsah and Boadu (2002) the U.S. textile complex has experienced overcapacity of production, global financial crisis, changes in fashion trends and demand; and cheap imports from Asia. To become more competitive and profitable, U.S. textile manufacturers have focused on achieving greater speed, efficiency, and high quality production by investing heavily in automated technology Exports to Mexico and Canada were $9.5 billion, which constituted 51% of total exports. Low-priced Asian imports believed to have been caused by the currency devaluation of major textile exporters such as Hong Kong, India, Indonesia, Japan, Pakistan, Philippines, South Korea, Sri Lanka, Taiwan, and Thailand Asian currencies stabilized through 2000, and resumed their downward path. U.S. apparel manufacturers seem to have benefited from the cheaper Asian imports of textiles by the U.S. Global sourcing strategies by the industry in locating manufacturing. Sourcing is explained by the cost of investing in facilities and equipment, production costs, labor costs and availability, quality control, timing, risks which involved language, culture, political, etc. and reliability of product supply in the international market.

A foreign investor choosing to invest in a recipient or host country faces higher entry costs for direct participation within an industry, due to initial setup costs and uncertainty about fundamentals (i.e. asymmetric information at the entry level), and higher exit costs due to the difficulty of reselling a .rm (i.e. asymmetric information at the exit level).

These costs increase the observed volatility associated with portfolio investments, since only the foreign investors with .superior managerial skills.(Razin, 2002) will commit to FDI.

Firm size relation with leverage:

Shah and Hijazi (2004) took the test whose showed that tangibility, profitability, growth and size of the firm effect leverage in textile. There was positive relationship between the size of the firm and board size, high board size means number of directors, larger board means high’s leverage. Debt is taken more and more, that will affect the company equity. Leverage board size showed that more out siders, which possibly reflects debt, can act as a monitoring device and also showed that leverage was lower when the CEO had a long tenure in office.

Hijazi and Tariq (2006) analyzed size of firms and profitability was negatively correlated with leverage. Hence this rejects the static trade off theory, which showed a positive relation between size of the firm and profitability. This shows that firms in cement industry use more equity and less debt. Tangibility of Assets and growth found to be positively correlated with leverage. All the results were Significant except the size of the firm. Their results with Shah and Hijazi (2005) were found to be different in terms of growth and size of the firm. They concluded that in developing countries like Pakistan, cement industry usage of short term financing is high than long term financing.

Spuma, Waters, and Payne (1995) concerned with different variables that indicate the level of leverage in firm. It shows that there is a negative relation among growth and leverage of the firm. Size of the firm is negatively correlated with the leverage of the firm

Interest rate relation with leverage:

Myers and Majluf (1984) showed that there is a relationship between managerial operation and high leverage ratio; external investor not has enough information about the country policies, their environment, and firms operations. Inside investor can easily handle that situations comparison with external investor. Present share holder prefer debt financing because of firms need to issue debt when information is larger, stock price decrease etc. that could avoid under pricing and also show that the managerial share holder and long-term debt have a negative relationship. Interest is paid from net income it means more debt change to more interest and more interest means low income.

(Chhibber & K. Majumdar, 1998)

The size of a firm is known to affect a firm’s performance in many ways. Key features of a large firm are its diverse capabilities, the ability to exploit economies of scale, and the formalization of procedures. These characteristics make the implementation of operations more effective and allow larger firms not only to generate greater returns on assets and sales but also to capture more value as a proportion of the value of production than is possible for smaller firms. Alternatively, larger firms could be less efficient than smaller firms because of the loss of control by top managers over strategic and operational activities within the firm.

SIZE is an important control variable for another reason. While our data are cross-sectionally extensive, we do not have the ability to measure a firm’s market power or the level of concentration in the industries in which the firms in our sample operate. This is a major limitation of the data, and we cannot include controls for market-structure factors that are important determinants of economic performance. SIZE reflects the ability of firms to attain economies of scale as well as market power.35 Finally, the inclusion of SIZE allows us to avoid the criticism directed against much empirical work in this area. H. Short notes that ‘‘a major criticism that can be levied at the majority of the empirical studies is that they tend to concentrate on large firm samples, rather than taking a broad cross-section of firms of different sizes.’’

CHEN (2008) argued that high leverage ratio would increase the possibility of a firm’s bankruptcy. More debt means a higher level of interest payment each year, which is paid from net income. Once the operation of a firm goes into trouble and net income is not enough to pay the interest, the firm has to face the threat of bankruptcy. This is one of the main reasons why firms cannot employ debt financing as much as they want and keep high leverage ratios. Static trade-off is exactly a trade-off between marginal tax saving from debt and marginal expected bankruptcy cost. Later literature tends to replace the bankruptcy cost with financial stress. Too much interest payment would reduce the cash retained in the firm. Consequently the firm will not have enough budgets to hire capable workers and executives, to undertake positive NPV projects, to cope with emergencies, etc. Furthermore, a higher leverage ratio would reduce the credit level and increase the operation risk of the firm. When facing new financing needs, the firm would be unable to use debt financing anymore, or unable to collect enough capital, or suffer a higher interest rate when borrowing. Even using equity financing, due to the low credit level and high risk, the firm would have to pay a higher price. Larger firms have larger amount of fixed assets and this amount directly reflects the ability of using collateral debt. Thus larger firms could borrow more than smaller firms and could get a more favorable price- lower interest rate.

VERMA (2002) India’s international competitors have as high an interest cost as in India70.Interest cost as a percentage of sales in Indian manufacturing companies was close to5.5% compared to less than 4% in countries such as Indonesia, S Korea, Malaysia, Philippines and Thailand. The situation with regard to textiles is very severe. While interest as percentage of sales was 8.58%, interest as a share of value added was a high 12.9% for textiles. Garments is one sector which seems not be as adversely affected on this account. Its respective ratios were 2.05% and 3.3%. One important reason for this, according to some entrepreneurs, is the fact of predominant decentralized nature of garment sector in India. In Product Specific Cost- Supply Chain Management contain Factor cost (Cost of raw material), In Government Policy (Excise Policy, Technology Up gradation Fund, Strict labor laws), IN Economy-wide costs (Economy-Wide Costs, Transaction costs, Transportation, interest rate). In the Interest rate none of India’s international competitors have as high an interest cost as in India70. The situation with regard to textiles is very severe. While interest as percentage of sales was 8.58%, interest as a share of value added was a high 12.9% for textiles. Garments is one sector which seems not be as adversely affected on this account. Its respective ratios were 2.05% and 3.3%. One important reason for this, according to some entrepreneurs, is the fact of predominant decentralized nature of garment sector in India. Also discussed Non-Price Factors in which included (Allow Foreign Direct Investment, Reduce the import duty on textile, Promote fair competition, Remove policy-bias against synthetic fiber, modify Labor related Provisions, Collaborating to Compete- Policies on Investing Abroad). Furthermore, under the era of managed trade, too many textile and clothing

Manufacturers took a very narrow view of their production and market environment. They relied on selling in protected domestic markets and never needed to see the big picture. This is set to change. The textile and clothing industry is internationalizing rapidly. Despite technological advances, clothing sector remain labor-intensive globally, and hence its manufacturing is secularly shifting away from developed to developing countries. Textile production has seen considerable technology improvement, but that has only partially restored the comparative advantage of developed countries in textile manufacture. in the 1980s, for each of the varieties of cotton, Indian prices were lower than their international counterpart. This gave a cost advantage to Indian textile and garment exporters. About 40% of the selling price of a garment in India gets added up at the garment distribution stage. The level of technology in the spinning sector is relatively bettered compared to weaving sector. India appears to score over China only in the breadth of home market, quality of managerial workforce, and managerial practices. In Government policy discuss Excise Policy in which the excise duties applicable to the textile industry are the Basic Excise Duty (BED). Under the TUF scheme, manufacturing units are eligible for long and medium term loan from IDBI, SIDBI and IFCI, at interest rates that are 5% lower than the normal lending rates of banks. Transportation is one area where India compared very unfavorably with its competitors. For instance, shipping a container of textile or garments from India to the USA is costlier in India than in its Asian competitors. None of India’s international competitors have as high an interest cost as in India70. Interest cost as a percentage of sales in Indian manufacturing companies was close to 5.5% compared to less than 4% in countries such as Indonesia, S Korea, Malaysia, Philippines and Thailand. The situation with regard to textiles is very severe. While interest as percentage of sales was 8.58%, interest as a share of value added was a high 12.9% for textiles. Garments is one sector which seems not be as adversely affected on this account. Its respective ratios were 2.05% and 3.3%. One important reason for this, according to some entrepreneurs, is the fact of predominant decentralized nature of garment sector in India.

High cost of production relation with leverage:

High financing cost relation with leverage:

Taxation relation with leverage:

Wang et al.’s(2009) the global financial crisis has led to a rising number of unemployed textile and clothing workers in China. The global financial crisis has had a negative impact on economic growth in China. The orders received by textile and clothing companies at the China Import and Export Fair declined by 30 per cent in the autumn. The Ministry of Finance increased tax rebate rates on some textile and clothing exports from 11 per cent to 13 per cent. The global financial crisis has seriously affected the textile and clothing industry in China. Some of those firms have gone bankrupt as a result of the global financial crisis. More and more textile and clothing factories have been forced to relocate to the middle and western regions of China or to Asia-Pacific developing countries such as Bangladesh, Cambodia, Thailand and Viet Nam. China continues to maintain their unique competitive advantages arising from local textile and clothing industrial clusters with a comprehensive production chain, a pool of skilled labor, innovative fabric technology, sound infrastructure and economies of scale within the textile and clothing industry. The Government of China should continue to encourage the domestic large-scale textile and clothing enterprises to establish textile industrial parks in other developing countries. Provide a better financial package to support foreign direct investment by Chinese textile and clothing firms Improve infrastructure facilities and government efficiency in the least developed countries.

Asset Turnover relation with leverage:

Fama (1990) mentioned in firm size, the proportion of tangible assets would probably play a role in debt or equity financing. he discussed that assets with a substantial and stable liquidation value would be a good guarantee for the firm’s investors. Compared with intangible assets, tangible assets are easier to be valuated and information is less asymmetric. In case of default and bankruptcy, tangible assets are easily to be changed into cash to pay for debt. Thus a firm with larger proportion of tangible assets tends to use more debt. Moreover, the guarantee effect of tangible assets depends on whether resale market is easily accessed. First, plants, machines and other properties that could be adopted by other firms would generally sale at a good bargain and thus are better guarantees for collateral debt. Assets that are unique and could not be directly used by other firms would not. Second, removable assets or assets that are close to market or to potential buyers would easily be resold for cash and thus would be better as collateral. Not only proportion of tangible assets, but also characters of assets would play a role in leverage ratio.

J Ilyas (2008) use proportion of tangible assets in total assets as a proxy for assets composition. Due to availability of data, characters of assets will not be precisely analyzed. the guarantee effect of tangible assets depends on whether resale market is easily accessed. First, plants, machines and other properties that could be adopted by other firms would generally sale at a good bargain and thus are better guarantees for collateral debt. Assets that are unique and could not be directly used by other firms would not. Second, removable assets or assets that are close to market or to potential buyers would easily be resold for cash and thus would be better as collateral. Not only proportion of tangible assets, but also characters of assets would play a role in leverage ratio. in frim size firm size’s influence on leverage ratio is not necessarily positive. Due to asymmetry information, small firms are more likely to be underpriced by investors than large firms and could not get favorable price when financing through equity. While using debt with a fixed interest rate, small firms could suffer less loss from mispricing. Thus small firms should tend to consider using more debt, compared to large firms. his study involves 142 cotton textiles firms out of 161 firms in the sector. Firm’s Profitability in cotton textile sector is found to be negatively related to firm’s leverage. study found that with the increase in the Growth of the firm, the debt financing of the firm in this sector reduces.profits plays more important role in firm’s leverage decisions as compared to other determinants of the capital structure.Tangibility of the firm is found to be negatively related to the leverage of the firm

Miao (2005) provides a competitive equilibrium model of capital structure and industry dynamics. In the model, firms make financing, investment, entry, and exit decisions subject to idiosyncratic technology shocks. The capital structure choice reflects the tradeoff between the tax benefits of debt and associated bankruptcy and agency costs. The interaction between financing and production decisions influences the stationary distribution of firms and their survival probabilities. The analysis demonstrates that the "equilibrium" output price has an important feedback effect. This effect has a number of testable implications. For example it implies that high growth industries have relatively lower leverage and turnover rates. the higher the difference between ROA and cost of capital the higher is the return on equity because of the leverage effects. Similarly the higher turnover of assets results in higher return on assets, which in turn results in higher return on equity. Thus the assets tangibility ratio i.e., ratio between fixed assets and total assets becomes important as capital structure determinant.

Spuma, Waters, and Payne (1995) hence smaller firms are accepted to increase the profitability of going private, concluded that firms with less investment opportunities apply more leverage that is in accordance to both theories and leverage has a direct relation with the tangibility of assets. They also suggest that more profitable firms use less leverage

.

Shyam-Sunder and Myers (1999) find that firms with higher financial deficits, i.e., firms that raise more external capital, tend to increase their leverage. They examine the tendency of managers to time the equity markets by interacting the market-to-book ratio with the amount of capital that a firm raises (i.e., its financial deficit). Their evidence suggests that firms tend to reduce their leverage ratios when they raise substantial amounts of capital when the equity market is perceived to be more favorable, (i.e., when market-to-book ratios are higher). There seems to be a consensus in the literature that suggests that these variables affect capital structures, at least temporarily.

Rajan and Zingales (1995) compared leverage and its determinates across G-7 Countries that are united states, Germany, Canada, Italy, France, Japan and united Kingdom. They analyzed there was a positive relationship of leverage and profitability. Tangibility is positively correlated in all countries. Size is positively correlated with leverage except Germany. Investigated determinants of capital structure and leverage ratio of French, German and British firms with the help of penal data. Their results suggested that size of the firm positively affect the leverage ratio. They analyze relation of profitability, size of firms, fixed assets. This study identifies a positive impact on firm’s size on leverage. While the relationship between fixed asset ratio and level of leverage was mixed means positive in Germany but negative in France and UK. This shows that tangibility of assets is more significant in bank borrowing in Germany. The effect of all these factors on leverage depends on financial environment and tradition of the country in which firm operates investigated that there are a large number of variables that appear to be related to debt ratio of the firm but only few factors have significant effect on debt ratio. They found that relation between leverage and size of firm is positive. For tangibility of assets Empirical results showed a positive relation among leverage and tangibility of assets of firm.

Harris and Raviv (1988), a high leverage ratio would decrease the value of a firm’s equity. This provides opportunity for managers to buy more shares with the same amount of fortune. Meanwhile, external investors might be reluctant to invest in such firms, as high leverage is often linked with high risk. They also argued that managerial ownership is determined endogenously. Thus it is not safe and proper to assume an exogenous ownership structure and a dependent capital structure. They try to use lagged control variables to get rid of endogenously. One way to address this issue is to use lagged variable. As there is no reason a priori that historical ownership structure would be correlated with current leverage ratio, we try to include historical ownership concentration in the regression. The variable they use ownership concentration during the year of the first listing. It could also be considered as an instrument of current year ownership concentration, if ownership is determined endogenously indeed.

Fatehi (1996), 30 to 50 percent of all the expatriate placements do not work out as anticipated. Besides the direct financial costs involved with a failed expatriate assignment, the firm may incur other costs, including voided business deals, loss of valuable employees, the break up of joint ventures, and poor relations with the host Government. Fortunately, many MNCs have now realized the importance of cross-cultural training and the number of organizations involved in making preparations and arranging training prior to the departure of managers in foreign countries has increased lately.

(hussain, 2012)

2. A Review of the Literature

The empirical research on the determinants of corporate profitability can be classified into two categories: (i) structure-conduct performance models, and (ii) firm effect models (Mauri & Michaels, 1998; Schmalensee, 1989; Stierwald, 2010). The first explain profitability based on industry effects (concentration) while the second explain profitability based on variations in firms’ characteristics (Stierwald, 2010). As noted by Bain (1951), a high industry concentration allows firms to exercise higher monopoly power in the market and makes collusion possible between firms, and thus gives them an opportunity to earn more profits. Barriers to entry of new firms allow existing firms to earn higher profits (Bain, 1956).

Lambson (1991), Jovanovic (1982), and Bartelsman and Doms (2000) highlight the persistent variation in firms’ productivity. Demsetz (1973) points out that there is substantial variation in firms’ characteristics, and that firms with higher productivity or efficiency earn higher profits. Ammar, Hanna, Nordheim, and Russell (2003) note that small, medium, and large firms differ significantly from one other in terms of their profit rate—profitability drops as firms grow beyond USD 50 million in sales.

Treacy (1980) identifies a strong negative correlation between firm size and the variance in returns on equity, and a moderate correlation between firm size and average returns on equity. As noted by Whittington (1980), the positive relationship between size and profitability is interesting because the larger firm size contributes to the high degree of concentration and monopoly power, and also to efficient cost structure due to scale economies.

Using a nonparametric approach, Grazzi (2009) proves that exporting activity is not systematically associated with firms’ higher profitability. Based on the pecking order theory and using six years’ data 36 Ijaz Hussain

on textile firms in Pakistan, Amjed (2007) confirms the negative relationship between long-term debt and profitability, and the positive relationship between short-term debt and profitability. Ali (2011) analyze the association between working capital management and profitability in Pakistan’s textile sector. He finds that average days in inventory, average days receivable, and average days payable have a significant economic impact upon return on assets.

Chhapra and Naqvi (2010) show that there is a strong positive and significant relationship between working capital management and firm profitability in Pakistan’s textile sector. They also establish a significant relationship between the cost of production, size (capital), and profitability. Their results, however, indicate a significant negative relationship between a firm’s debt and its profitability. Finally, Raza, Farooq, and Khan (forthcoming) provide evidence of a significant relationship between firm effects, industry effects, and market share and two measures of profitability, i.e., returns on equity and returns on assets.

(Ali, 2011)

Literature on the subject matter suggests a number of factors, which may affect firms’ financing decision. See,

for example, Titman & Wessles (1988), Harris & Raviv (1991), Rajan & Zingales (1995), Huang & Song (2002), Akhtar & Oliver (2009) and references cited therein. This study examines the impact of five firmspecific

factors – firm size, firm growth rate, non-debt tax shields, profitability, and asset tangibility, on the

leverage decision of textile companies in India.

Firm size is measured by taking the natural logarithm of the total assets. The trade-off theory expects a positive

relation between leverage and firm size. Since larger firms are likely to be more diversified, have more stable

cash flows; lower bankruptcy risk, and have relatively easier access to credit markets. Firm size has been found

to be a positive determinant of leverage in most of the empirical studies (e.g., Agrawal & Nagarajan, 1990;

Rajan & Zingales, 1995; Wald 1999; Buferna et al., 2005; Supanvanij, 2006; and Akhtar & Oliver, 2009).

However, with respect to the pecking order theory, larger firms are expected to have lower information

asymmetries making equity issues more attractive. Rajan & Zingales (1995) also argued that the relationship

between firm size and leverage should be negative.

Growth is measured as the change in total assets between two consecutive years divided by previous year total

assets. Growth opportunities are viewed as intangible assets of firm. Firms with significant future growth

opportunities are likely to face difficulties in raising finance from debt market because intangible assets are not

fully collateralisable. Thus, firms with high intangible growth opportunities will use more of equity rather than

debt in their capital structure. The empirical studies that support the above theoretical prediction include: Titman

& Wessels, 1988; Rajan & Zingales, 1995; Gaud et al. 2005; and Akhtar & Oliver, 2009. However, pecking

order theory suggests that firms with high growth opportunities are anticipated to have higher information

asymmetries, and are expected to have more of debt and less of equity in their capital structure.

Non-debt tax shield (NDTS) is defined as a ratio of total annual depreciation to total assets. Non-debt tax shields

such as tax deduction for depreciation and investment tax credits are considered to be the substitutes for tax

benefits of debt financing (DeAngelo & Masulis, 1980). Therefore non-debt tax shields are expected to have

negative impact on leverage. The empirical studies that support above theoretical prediction include Kim &

Sorensen (1986), Wald (1999) and Huang & Song (2002).

Profitability is defined as earnings before interest and taxes scaled by book value of assets. The pecking-order

theory postulates that firms with higher profits (high internally generated funds) prefer to borrow less because it

is easier and more cost effective to finance from internal fund sources. So, as per this theory, there will be a

negative relation between leverage and profitability. In contrast, trade-off theory suggests that this relationship

would be positive. Since profitable firms are less likely to go bankrupt, and hence can avail more debt at cheaper

rates of interest. But most empirical studies find a negative relationship between leverage and profitability in

line with the pecking-order theory (e.g., Titman & Wessels, 1988; Rajan & Zingales, 1995; Wald, 1999; Chen,

2003; Supanvanij, 2006; Kim & Berger, 2008; and Akhtar & Oliver, 2009, among many others).

Tangibility is measured as a ratio of net fixed assets divided by total assets. Since tangible assets are used as

collateral, firms with large amount of fixed assets can borrow on favourable terms by providing the security of

these assets to the lenders. Therefore, a high ratio of fixed assets-to-total assets should have a positive impact on

firm leverage. Empirical as well as theoretical studies generally predict a positive relation between leverage and

asset tangibility. The positive relation between tangibility and leverage is found in Titman & Wessels (1988),

Rajan & Zingales (1995), Wald (1999), Chen (2003), Supanvanij (2006), and Akhtar & Oliver (2009).

This study expects a positive impact of firm size and tangibility on leverage, and a negative relationship of

growth, NDTS and profitability with leverage. The leverage ratio, Leverage, is measured as book value of longterm

debt/book value of total assets. Table 1 summarizes the determinants of leverage, theoretical predicted

effects of explanatory variables on leverage and the results of major empirical studies.

(Tanveer & Zafar, 2012)

3. Cost of Production

Increase cost of production has made difficult for the textile industry to compete in international

market (Arifeen, 2009). During last few years, cost of production has been increased considerably.

Major reasons of this increasing trend are: all time highest raw material rates, increasing wage rates,

increasing power cost, higher freight cost, souring inflation, highest interest rate as compare to

competitive countries, and decreasing value of currency.

Textile sector which was already having some serious problems, currently awful about the

tremendous unpredictability of raw material prices and finished goods prices within short period of

time. Increasing prices of raw cotton has made difficult for textile mills to fulfill their contracts.

Industry would bear heavy losses due to higher cotton prices and would face decrease in demand.

Local production of cotton is well short than the demand of textile industry which result in momentous

increase in import of cotton to fulfill demand. In 2007-8 sessions, Pakistan was second largest

importer- is another source of rise in cost (Salam, 2008).

During last five years wages have been increased two fold with no improvement in

productivity. Government has increased minimum wage from Rs. 6000 to Rs.7000 which enhances the

fixed cost of the textile products while customer has become more demanding and not ready to share

this sort of cost. It has surged the price of textile products and makes difficult for textile industry to

compete with neighboring countries (Tanveer et al, 2012).

Energy crises have affected industry in many ways, it creates hurdle for the industry to work at

its full capacity and reduces the capacity up to 30% (Khan & Khan, 2010). Power crises increase cost

of production due to high tariff and costly substitutes of electricity (Tanveer et al, 2012). Extensive

period of load shedding has chucked the industry in a bottomless crisis which is facing difficulties to

fulfill export orders and most of time it remains unable to execute the promises on time. Some textile

units have become self reliance in electricity, but most of small units remain workless during load

shedding of WAPDA. The industry faces financial losses due to cancellation of export orders. Power

360 Muhammad Asif Tanveer and Sarah Zafar

crises also reduces customers base, as they are switching their orders to competing countries of

Pakistan (Daily Times, 2011).

Textile mills which belong to Punjab cannot compete with textile mills located in Sindh and

Karachi as they would have to get imported dyes and other finishing materials and then to ship finished

goods from Karachi port. All this process increases cost for textile mills in Punjab, because of this

price competition increase between Sindh and Punjab exporters. Pakistan railway is in crises situation,

less accessibility of locomotive engines, single tracks, fuel prices, long delays in trains and corruption

has made it infeasible for textile exporter to transport textile product container to Karachi. Exporter use

trailer as a last option to transport container Karachi which is expensive than railway charges and also

takes more time which reduce the profit margin of textile mills (Ahmad, 2011). Road infrastructure can

play an important role in reducing cost. China which is having better infrastructure has to pay 50% less

transportation cost as compare to Pakistan (Pakissan, 2007).

Inflation is a consistent rise in price. Since 2007, there is double digit inflation in Pakistan. It

increases the cost of production which is cause of surge in price for the international market. Inflation

also reduces demand in local market, as purchasing power of Pakistan’s consumer is diminished. Many

small units have been shut down due to inflation because they remain unable to provide their products

according customers required prices.

During last few years, government has shown a tight control on monetary policy. High cost of

capital has made difficult for the textile industry to compete in international market. It works in

twofold, reduced production due to shortage of resources and increases cost of production. State Bank

of Pakistan (SBP) is offering interest rate of 12%, while the commercial banks provide loan 4 to 6

percent more above than SBP. Meanwhile, textile producers of India are getting loan at 8.5% with no

more premiums and also 5% subsidy on the loan for technology upgrading. The discount rate of

Bangladesh for Textile is 5% and the rate of China is 6.5%, and also these countries have much less

inflation as compared to Pakistan. High interest rate has slow down the investment in industry, which

will make industry future more difficult (Ahmad, 2012).

(A. Khan & Khan, 2010)

Increasing Cost of Production

The cost of production of textile rises due to many reasons like increasing interest rate, double digit

inflation & decreasing value of Pakistani rupee. The above all reason increased the cost of production

of textile industry which create problem for a textile industry to compete in international market.

h. Removal of subsidy on Textile sector

The provisions of Finance Bill 2009-10 are not textile industry friendly at all. Provisions like

reintroduction of 0.5% minimum tax on domestic sales, 1% withholding tax on import of textile and

articles etc., are nothing but last strick on industry’s back. Reintroduction of minimum tax on domestic

sales would invite unavoidable liquidity problem, which is already reached to the alarming level. The

textile industry was facing negative generation of funds due to unaffordable mark up rate.

(Afza & Hussain, 2011)

2. LITERATURE REVIEW Many empirical researchers have explored the determinants of capital structure from different point of views and in different environments related to developed and developing economies. Titman and Wessels (1988) analyzed the explanatory power of some of the recent theories of optimal debt equity ratio. They found that financing with debt was negatively related to firm’s uniqueness regarding its type of business. Transactions costs might be an influencing determinant of capital structure decision and the results were consistent with existing theories. Another study on testing the static trade off theory and pecking order theory was done by Cassar and Holmes, (2003) and the results of regression analysis showed that the asset structure, profitability and growth were important factors which affected the debt equity ratio of the firms. Size and risk showed weaker influences on the debt financing of the firms. Their results were consistent with the static trade off, pecking order and agency cost theories. They proved that the theories applicable on capital structure of large firms are valid for small and medium enterprises of Australia. Rajan and Zingales (1995) pointed out that factors examined by previous researchers as correlated with the firm leverage in the United States, having similar relationship in other countries also. Booth et. al. (2001) analyzed data from ten underdeveloped countries including Pakistan and empirically proved that some of the characteristics of modern finance theory were transferable across countries. In a subsequent study, Mitton T (2007) explained the tendency of firms in the emerging market for debt financing. In a recent study, Cespedes et.al. (2009) explained the behavior of firms in Latin America covering seven countries. They experienced that ownership oriented firms preferred equity financing due to lower tax shields and higher bankruptcy costs. Jong et. al. (2008) analyzed that the debt equity ratio was related to a number of country specific factors such as bond market development, protection of creditors’ right and growth rate of gross domestic product. Although many foreign researchers have studied the attributes affecting the choice of debt and equity of firms in developed countries, few of them researched on firms in developing countries. In the perspective of Pakistan, Rahman (1990) studied the Industry and Size as determinants of Capital Structure decisions and the results showed that Engineering and Tobacco industries were heavily geared. Focusing on the factors affecting capital structure decisions of firms of Japan, Malaysia and Pakistan, Mahmood, (2003) found that firms in Japan and Pakistan showed very high leverage ratios because of Japanese developed market status and underdeveloped capital market of Pakistan which forces firms to opt for bank loan rather than raising equity. Qureshi and Azid (2006) identified that the public sector preferred financing through debts due to low corporate governance, favorable terms and conditions of commercial banks and lesser accountability than private sector. Shah and Khan (2007) examined that there was highest leverage ratio for textile industry and the average profitability of textile industry was negative due to understatement of profit by family controlled firms. Hijazi (2006) examined the cement sector of Pakistan and the results, except for firm size, were found to be highly significant and rejected the static trade off theory. International Journal of Humanities and Social Science Vol. 1 No. 12; September 2011 256

(Rayan, 2008)

Kanwar (2007) explained the attributes of Capital Structure in Sugar industry of Pakistan and the results depicted that return on assets, asset tangibility, market to book ratio and size were found to be significant except tax rate. The developed provinces of Pakistan showed highest debt ratios. Rafiq et. al. (2008) examined the chemical industry of Pakistan regarding capital structure choice and suggested that chemical sector preferred more equity financing than the debt financing. Size and growth variables showed static trade off behavior of the firms.On the basis of theoretical frame work of Ranjan and Zingales (1995) and previous empirical results, we have developed the following hypotheses to analyze the impact of tangibility, size of firm, tax, profitability, liquidity, non-debt tax shield and cost of debt on leverage.

H01 = A firm with higher percentage of fixed assets will not prefer leverage.

Ha1 = A firm with higher percentage of fixed assets will prefer leverage. H02 = The size of a firm does not have negative relationship with leverage. Ha2 = The size of a firm has negative relationship with leverage.

H03 = The profitability of a firm does not have negative relationship with leverage.

Ha3 = The profitability of a firm has negative relationship with leverage.

H04 = The higher rate of taxes does not have positive relationship with leverage.

Ha4 = The higher rate of taxes has positive relationship with leverage.

H05 = The higher cost of debt does not have negative relationship with leverage

Ha5 = The higher cost of debt has negative relationship with leverage

H06 = The firm with more current assets does not have less leverage

Ha6 = The firm with more current assets has less leverage

H07 = The firm with higher rate of depreciation does not have less leverage

Ha7 = The firm with higher rate of depreciation has less leverage

(SHAH, 2007)

2. LITERATURE REVIEW

Capital Structure Theories

Static trade off theory: Finance managers often think of the firm’s debt-equity

decision as a trade off between interest tax shield and the cost of financial distress. Trade

off theory of capital structure recognises that target debt ratios may vary from industry to

industry. Industries where assets are mostly tangible, borrow heavily because their assets

are collateral and relatively safe, however, the trade off capital structure advocates

moderate debt ratio.

Rajan and Zingales (1995) compared leverage and its determinates across G-7

countries that are united states, Germany, Canada, Italy, France, Japan and united

kingdom. They analysed there was a positive relationship of leverage and profitability

only in Germany. Tangibility is positively correlated in all countries. Size is positively

correlated with leverage except Germany.

Jose ( n.d.) have studied the relationship between capital structure and profitability

of the Brazilian firms. They have concluded that in short run there was a positive

relationship between debt and profitability. However, in the long urn there was inverse

relationship between debt and profitability.

Antonoiu, Guney, and Paudyal (2002) investigated determinants of capital

structure and leverage ratio of French, German and British firms with the help of penal

data. Their results suggested that size of the firm positively affect the leverage ratio. They

analyse relation of profitability, size of firms, fixed assets. This study identifies a positive

impact on firm’s size on leverage. While the relationship between fixed asset ratio and

level of leverage was mixed means positive in Germany but negative in France and UK.

This shows that tangibility of assets is more significant in bank borrowing in Germany.

The effect of all these factors on leverage depends on financial environment and tradition

of the country in which firm operates.

Frank and Vidhan (2005) investigated that there are a large number of variables

that appear to be related to debt ratio of the firm but only few factors have significant

effect on debt ratio. They found that relation between leverage and size of firm is

positive. For tangibility of assets Empirical results showed a positive relation among

leverage and tangibility of assets of firm.

On the basis above literature review on static trade off theory, following

hypothesis can be developed and tested whether static trade off theory is relevant in

Pakistan textile sector.

H1: There is a positive relationship between leverage ratios and profitability.

H2: There is positive relationship between leverage ratios and tangibility.

H3: There is positive relationship between leverage rations and size.

Pecking Order Theory

Asymmetric information affects the choice between internal and external financing

and between new issues of debt and equity securities, this lead to pecking order theory.

Myers and Majluf (1984)

suggested that retained earning is better than debt but on the

other hand debt is better than equity if external financing is used. Hence profitability

should have inverse relationship with leverage. Managers use private information about

the characteristics of firm’s return on investment or investment opportunities which is not

known to common investors.

Antonios, Guney, and Paudyal (2002) investigated determinants of capital

structure and leverage ratio of French, German and British firms with the help of penal

data. This study identifies a positive impact on firm’s size on leverage. They also find an

inverse relationship among profitability and leverage only in France and UK, which

supports pecking order theory in these countries. While the relationship between fixed

asset ratio and level of leverage was mixed means positive in Germany but negative in

France and UK. This shows that tangibility of assets is more significant in bank

borrowing in Germany. The effect of all these factors on leverage depends on financial

environment and tradition of the country in which firm operates.

Frank and Vidhan (2005) found that relation between leverage and size of firm is

positive. For tangibility of assets empirical results showed a positive relation among

leverage and tangibility of assets of firm. The results showed a negative relation between

profitability and leverage.

Hijazi and Tariq (2006) analysed determinants of capital structure of cement

industry of Pakistan with the help of OLS regression. They found that size of firms and

profitability were negatively correlated with leverage. Hence this rejects the static trade

off theory, which showed a positive relation between size of the firm and profitability.

This shows that firms in cement industry use more equity and less debt. Tangibility of

assets and growth found to be positively correlated with leverage. All the results were

significant except the size of the firm. Their results with Shah and Hijazi (2005) were

found to be different in terms of growth and size of the firm. They concluded that in

developing countries like Pakistan, cement industry usage of short term financing is

higher than long term financing.

Spuma, Waters, and Payne (1995) concerned with those variables that indicate the

level of leverage in firm. It shows that there is a negative relation among growth and

leverage of the firm. Size of the firm is negatively correlated with the leverage of the firm

hence smaller firms are accepted to increase the profitability of going private.

Scot (1976) stated that firm will issue secured debt to the possible extent in order

to attain the optimal capital structure. He argues the agency costs of secured debt as lower

as compared to unsecured debt. Thus, firms with fixed assets issue more debt.

Keister (2000) stated that in the economic transition times, shortage of finance in

companies affect the capital structure of companies.

Titman and Wessels (1988) argues that size has an affect on financial leverage

across countries. Research carried out on U.S. U.K, Japan, France, and Israel data. It

concluded that there was more variation in financial leverage across countries.

Korajczyk and Levy (2003) highlighted the affect of macroeconomic conditions

and firm specific factors and stated that both have an effect on firms financing choices.

Antonios, et al. (2002) argued that surrounding environment has impact on the

capital structure decisions of firms besides it own characteristics. There may be different

reasons; the environment affects the company’s capital structure like the improvement in

the state of economy, the existence of a stock market and/or the size of banks sector.

Leverage can be changed due to an active decision of the firm to issue repurchase

468 S. M. Amir Shah

securities. Leverage can also be changed when the firms circumstances changes or when

its stock prices changes.

Rajan and Zingales (1995) concluded profitability is negatively correlated in

all G-7 countries except Germany and analysed that size is positively correlated with

leverage except Germany. Tangiblity is positively correlated with leverage in all

countries.

Wolfgang and Fix (2003) concluded that firms with less investment opportunities

apply more leverage that is in accordance to both theories and leverage has a direct

relation with the tangibility of assets. They also suggest that more profitable firms use

less leverage.

On the basis of above literature review on Pecking order theory, following

hypothesis can be developed and tested whether Pecking order theory is relevant in

Pakistan textile sector.

H4: There is a negative relationship between leverage ratios and profitability.

H5: There is positive relationship between leverage ratios and tangibility.

H6: There is positive relationship between leverage rations and growth.

(De Socio & Nigro, 2012)

Abstract

We evaluate the relation between firm leverage and taxation of corporate income using

a dataset of mostly unlisted European corporations, highly representative of medium-sizedand large firms. We use a correlated random effect approach in order to take into account unobserved heterogeneity and to assess the contribution of cross-sectional variation of the regressors. We also apply quantile regressions to evaluate a possible differential impact of taxation on leverage across firms. Our results suggest that corporate income taxation is positively related to leverage and explains part of the cross-country variability, showing a stronger effect for less levered firms. In accordance with the theory of the debt tax shield, the relation between debt and taxation is stronger for highly profitable firms. These findings are robust to the inclusion of different measures of the financial development and characteristics of the legal system of the country where firms are located.

intro

The existence and the magnitude of a tax effect on firm leverage have been investigated by an extensive body of applied corporate finance literature focusing on the simplifying assumptions underlying the irrelevance proposition of Modigliani and Miller (1958), namely the role of taxation, the cost of bankruptcy, agency problems and asymmetric information. The results of these studies are inconclusive. They vary depending on two key empirical issues. The first is the nature of the indicator measuring the impact of taxation. The second issue concerns the characteristics of the firms included in the sample. For instance, using data of listed as opposed to unlisted firms can lead to very different findings, because listed firms can raise capital more easily thanks to less severe agency problems and asymmetric information.

Rajan and Zingales (1995) consider companies of the G-7 countries and find that whether taxation is linked to leverage or not is highly sensitive to assumptions about the marginal investor tax rate (e.g. if the investor is tax-exempt or is taxed at the top rate). de Jong et al. (2008) use the effective tax rate (defined as taxes paid over pre-tax income) and find no relation between taxation and debt measures in a sample of companies from 42 countries. Fan et al. (2012) study the impact of institutional factors on leverage of firms from 39 countries and show that taxation, measured using Miller index (which considers the personal tax on interest and dividend along with the corporate tax rate), has a positive effect on leverage in developed countries but not in emerging economies.

2.1 Debt and non-debt tax shield

The influence of taxation on financial structure stems from the possibility for firms to deduct some costs from taxable income: interest expense, thus obtaining a debt tax shield; depreciation and similar expenses, offering a non-debt tax shield (NDTS; DeAngelo and Masulis, 1980).

In particular, debt is positively correlated with the marginal corporate tax rate and the ratio of personal taxation of equity income to interest income, and negatively with non-debt tax shield, existing interest rate deductions and the probability of future losses (Graham, 2006).

The survey of Harris and Raviv (1991) shows that leverage is positively related to firms’

tangible assets, NDTS, growth opportunities, and size, while it is negatively related to volatility, bankruptcy probability, intangible assets, profitability, and uniqueness of the product. In a more recent survey, Murray and Vidhan (2009) confirm that leverage calculated at market value is positively associated with industry leverage, tangible assets and size and negatively linked to profitability, while the relation with growth is negative. However, the impact of size and growth becomes no longer significant when leverage is calculated at book value.

. (A. Sheikh & Wang, 2010)

A. Profitability

The trade-off and pecking order theories have opposite implications about the relationship between profitability and leverage. According to trade-off theory, high profitability promotes the use of debt finance and provides an incentive to firms to avail the benefit of tax shield on interest payment. So, this theory predicts a positive relationship between profitability and leverage. Pecking order theory states that firms prefer to finance new investment first with internal resources and then by issuing safest security that is debt, there after convertibles and finally with new equity. Firms follow this financing pattern due to costs that arise because of asymmetric information, or they can be transaction costs.

Thus, this theory suggests a negative relationship between profitability and leverage. Several empirical studies that have shown a significant negative relationship between leverage and profitability include Baskin [2], Booth et al. [4], Eriotis etal. [7], Fama and French [9], Huang and song [13], Karadenizet al. [16], Rajan and Zingales [26], Titman and Wessels [28], Wald [31] and Zou and Xiao [32].

We use the ratio of net profit before taxes over total assets as a measure of firm profitability.

B. Size

According to trade-off theory, larger firms should borrow more because these firms tend to be more diversified and less prone to bankruptcy and smaller firms should operate with low leverage because these firms are more likely to be liquidated when facing financial distress. Moreover, larger firms have lower agency costs of debt i.e. relatively low monitoring costs because of less volatile cash flows and easy access to capital market. Thus, this theory predicts a positive relationship between size and leverage. Pecking order theory suggests a negative relationship between firm size and leverage as the problem of information asymmetry is less severe in large firms. Empirical evidence concerning the relationship between firm size and leverage is unclear. Chen [5] and Ezeoha [8] reported a significant negative relationship between firm size and leverage which is consistent with the predictions of pecking order theory which suggests that large firms should use more equity due to the relativity of the cost of equity financing owing to asymmetric information which is small for such firms. Wald [31] finds a significant positive relationship for firms in USA, UK and Japan, and insignificant negative/positive relationships for firms in Germany/France. Fama and French [9], Huang and Song [13], Marsh [17], Taub [27] and Zou and Xiao [32] have found a significant positive relationship between size and leverage which is consistent with the predictions of trade-off theory. We use natural logarithm of sales as a proxy of firm size.

Referencing

(Mahmood (2003) The Pakistan Development Review 42 : 4 Part II pp. 727–750)

Harris, Milton and Raviv, (1991), The Theory of Capital Structure, The Journal of Finance, Vol. 46, No. 1. (Mar., 1991), 297-355

Hijazi, S. and Y. B. Tariq (2006) Determinants of Capital of Structure: A Case for Pakistani Cement Industry. The Lahore Journal of Economics 11:1, 63–80.

Ilyas J, (2008), Analysis of Non Financial Firms Listed in Karachi Stock Exchange in Pakistan, Journal of Managerial Sciences, Volume II, Number 2