THE IMPACT OF DEBT FINANCING ON COMPANY

PERFORMANCE OF PAKISTAN
CHAPTER 1

INTRODUCTION TO THE REASERCH

1.1

INTRODUCTION

Debt financing is one of two methods through which companies can finance its assets . Equity is
another method of financing company's assets. Equity is more expensive as compared to debt
and among these two sources of finance.Debt is cheaper source of finance. Most companies
preferred debt financing because of higher the rate of debt that much will be tax reduces. A debt
can be defined a duty to pay money, deliver goods under an express agreement. One who owns is
a debtor. Debt played a significant role in modern economies. All institutions including
philanthropic organizations and government entities may rely on debt to fund operations in the
short term and long term.
The debt and equity are the two primary sources of financing that companies can turn to when
looking to generate capital. Each has prone and cones. Debt financing is the acquisitions of the
loan whereas equity financing involved the sales of shares of stock in the company and exchange
offunds. A primary advantage of debt financing relative to equity financing is ownership
retention. When the shares are sold it to raise funds, the turnover fractional ownership and voting
rights in the company. With debt financing ownership isnt lost and retains similar control on
overall strategic decisions and business matters. Rising debt is less complicated to perform and
monitor than shares selling. Debt financing at reasonable interest rate also makes for less
expensive financing over time. As the rate of debt financing increases that much a company paid
less amount of tax thats why it called as a tax deductible item.

Several studies have been conducted in the examining influences of debt finance on the company
performance. For instance different authors worked on debt financing in developed countries.
These authors are Khan, Khalid, Simon-oke,Afolabi,babatrunde ( management department
im sciences 2011) .They worked on different sectors like food and personal care

industry,engineeringsector,chemical sectors in Pakistan on debt financing. Aresearch done in

Nigeria on debt financing in industrial side. All these authors discussed a positive relation
between debt finance on company performance. They also mentioned that debt hasa positive
impact on the maintenance of ownerships of the owners.
Fortunately, there are many researches done on debt financing in Pakistan as well as in foreign
countries. In developed countries there is no organized structure of debt finance but, companies
take debt finance for the improvement of their company performance as compared to foreign
countries they have an organized structure of debt finance. There are some sectors in Pakistan
where there is no work done on debt financing. In airlines sector there is not much work done on
debt financing. This work will try to check the impact of debt financing in detail from the year
2007 to 2012.

1.2

STATEMENT OF PROBLEM

The statement of the problem is that to check the impact of debt financing in airlines sector either
.its impact exist or not .The purpose of This work is to identify the importance of debt financing
in the airlines sector of Pakistan. This will help new investors and existed investor to increase
their financing sources. This helps the overall development in the economy.

1.3

MAJOR ISSUE

Major issue if debt financing is that it helps to increase in the economic development. Debt
finance can maintain the ownership of the owner. The impact of debt on the profitability trended
to move in a positive way. Most of the investors do invest money in the airlines sector to earn
more profit. As debt is cheaper source of finance thats the way most of the companies take that
source of finance. In Pakistan although there is no organized structure of debt but companies still
take debt as a source of finance to improve their performance of the firms.
The sub problem is that to find the impact of debt financing on the profitability of the
airlines sector.

1.4 OBJECTIVES
The objective of this research is as follows;
The impact of debt finance on the company performance is in a positive way or negative way.
The impact of debt financing for the growth of the company is positive or negative.

1.5

SIGNIFANCE

The importance of the research can be classified in three points, which are;
It will increase the existing literature related to debt financing.
Help the investors to design their portfolio.
Open new inside for future researchers and students.

1.6

VALUE

The value of research is that to check the impact of debt financing on the medium firm in
Pakistan. Whether it impact is positive or negative on debt financing.

1.7

SCOPE

The scope of the research is that why companies do debt financing as compared to equity and
why companies take that as a source of finance and what should be the impact of debt on
company performance.
1.8

ORIGNALITY

This is the first study to study an individual sector like Airlines companies in Pakistan.

CHAPTER - 2

LITERATURE REVIEW
2.1

INTRODUCTION

Financing decisions are one of the most critical areas and the challenging job for the finance
managers, because, It has direct impact on the financial performance and capital structure of the
companies. The finance manager of every company is always looking to maximize the economic
welfare of the owners as represented by the market value of the firm. For this purpose, he has to
take number of decisions like investment, financing and dividend decisions. The financing
decision is mainly involves two choices. The first is the dividend choice the distribution of
retained earnings to be ploughed back and to be paid out as dividends. The second is a choice of
capital structure the proportion of external finance to be borrowed and the proportion to be
raised in the form of new equity. In real sense, the decisions about both the choice should not
impact on the value of the firm. Because these decisions are related to either the form of
distribution, type of security, or make up of the ownership structure, but not to the investment
decision. Generally, the firms have the internal and external sources of fund in its capital
structure to finance their investments. Internal sources include retained earnings and
depreciation; whereas the external sources consist of new borrowings or the issue of shares.
Debt financing is one of two methods through which companies can finance its assets. Equity is
another method of financing company's assets. Equity is more expensive as compared to debt
and among these two sources of finance. Debt is cheaper source of finance. Most companies
preferred debt financing because of higher the rate of debt that much will be tax reduces. A debt
can be defined a duty to pay money, deliver goods under an express agreement. One who owns is
a debtor. Debt played a significant role in modern economies. All institutions including
philanthropic organizations and government entities may rely on debt to fund operations in the
short term and long term.
The debt and equity are the two primary sources of financing that companies can turn to when
looking to generate capital. Several studies have been conducted in the examining influences of
debt finance on the company performance. For instance different authors worked on debt
financing in developed countries.

According to Sergio L. Schmukler In a global financial environment, firms from financially

underdeveloped economies gain access to mature financial markets, which are liquid and offer
long-term financing. This integration also helps to develop the domestic financial systems. As a
consequence, the cost of capital decreases and financing constraints are relaxed. Furthermore, by
issuing debt in foreign jurisdictions, with better contract enforcement institutions, the level of
risk for creditors decreases and debtors become more able to borrow long term. All these
potential advantages have prompted most emerging economies to liberalize their financial
systems around the first half of the 1990s.
Firms require capital to expand or support their sales. Two major sources of financing
That are available to firms are debt and equity. Firms can use any of these two sources to finance
their operations. They usually use mix of both debt and equity. The mixture of debt and equity is
called capital structure. Financial managers are concerned with the level of debt and equity. They
would like to have optimal capital structure; where the firms value is maximized and cost of
capital is minimized. The level of debt used varies across the industries and firms. The factors
that are considered by the firms while making capital structure decisions are: sales stability, asset
structure, growth rates, taxes, profitability, control issues, market conditions, non debt tax
shields, and lenders and rating agencies attitude etc.

The first scientific study conducted in the field of capital structure is of Franco Modigliani and
Merton Miller (1958). In their study, on the basis of certain unrealistic assumptions like zero
taxes, the concluded that a firms value is unaffected by the level of debt used. In their second
article in 1963, MM considered the corporate taxes and concluded that due to tax deductibility of
interest; the use of debt increases the value of the firm. So the firms can use 100% debt.

According to Simon Efficient financial markets are necessary to bring about adequate capital
formation and economic growth in an economy. If there were no financial assets other than
money, each economic unit could invest only to the extent that it saved. Without financial assets,
then, an economic unit would be greatly constrained in its investment behaviour. In the absence
of external financing, economic units that lacked sufficient savings would have to postpone or
abandon money worthwhile investment opportunities.

On more general grounds, corporate capital structure is seen to be a collection of organized

financial institutions that deal in financial instruments and assists business firms in sourcing for
funds, basically, medium and short term loans. Instruments traded include bonds, debentures and
stocks. Under the capital structure, financial firms claims can be categorized into equity and debt
instruments, the owner of equity instruments are stockholder while the holders of debt claims are
creditors to the firm. Capital structure is also said to be the performance financing of the firm.
According to (Murphy et al, 1996)., explains the concept of performance as a controversial issue
in the finance strategy of most corporate organizations due to its multidimensional meanings.
Research on firm performance emanates from organization theory and strategic management.
Performance measure could be in form of financial or organizational performances such as
maximizing profit on assets, profit maximization, and maximizing shareholders benefits. These
are at the core of the firms effectiveness.
According to (Chakravarthy 1986),Operational performance such as growth in sales and growth
in market share, provide a broad definition of performance as they focus on the factors that
ultimately lead to financial performance (Hoffer and Sandberg, 1987). Profit efficiency is
superior to cost efficiency for evaluating the performance of managers. This performance
measure is more embraced because it seeks to raise revenue against minimum costs, hence,
controlling costs to its barest minimum. It seems reasonable to assume that shareholders losses
from agency costs are close to proportional the losses of accounting profits that are measured by
profit efficiency. Other studies provide more direct evidence that firms adjust towards a target
debt ratio.
According to Taggart (1977), Marsh (1982), and Opler and Titman (1994) find mean reversion in
debt ratios or evidence that firms appear to adjust toward debt targets. Static trade off theory
suggests that if companies did have welldefined optimal debt ratios, it seems that their
managers were not interested in getting there. Another important explanation to capital structureperformance relationship is the agency theory which emphasizes the role of asymmetric
information because owners of companies do not have access to full information on performance
or the reason for underperformance. The separation of ownership and control, which is one of the
core principles of the theory, occurs as a result of the introduction of external investors, and
which eventually allow managers to represent the interest of the external owners. This implies

that the managers in most cases are not interested in choosing the capital structure, that is,
financial leverage that best maximizes the wealth of the shareholders rather, they are interested
in maximizing their own welfare. Allen (2002).
According to Harris and Raviv (1991), argued that capital structure is related to the trade off
between costs of liquidation and the gain from liquidation to both shareholders and managers.
So, firms may have more debt in their capital structure than is suitable as it gains benefits for
both shareholders and managers. Krishnam and Moyer, (1997) found a negative and significant
impact of total debt to total equity (TD/TE) on return on equity (ROE). Another study by
Gleason, Mathur and Mathur, (2000) found that firms capital structure has a negative and
significant impact on firms performance measures, return on assets (ROA), growth in sales (G
sales), and pretax income (P tax).Therefore, high levels of debt in the capital structure would
decrease the firms performance.

According to (Kest, 1986). Titman and Wessels (1988) and Rajan and Zingales (1995) find
strong negative relationship between ratios and past profitability. Models based on trade off of
tax benefit, debt and the cost of financial distress predicts a positive relation.

According to Yasir and Hijazi (2006) conducted the empirical study on the determinants of
capital structure in cement industry of Pakistan. Following the Rajan, Zingles (1995) they used
four independent variables of size, tangibility, growth, and profitability. They found growth, and
tangibility to be negatively correlated with debt. Profitability and size were found to be
negatively correlated with debt (leverage).
According to Attaullah Shah, Safiullah Khan (2007), conducted another empirical study on
determinants of capital structure of the Karachi Stock Exchange listed non-financial firms. In this
study they used six independent variables. They were tangibility, size, growth, earning volatility,
non-debttax shield, and profitability. They found that Tangibility is significantly related to debt.
Size, measured by natural log of sale, has a positive correlation with leverage but is insignificant.
Growth variable was found to be negatively correlated with and significant at 10% level.
Profitability was found to be the most significant explanatory variable and negatively related to
leverage.

A company applies its assets in its business to generate a stream of operating cash flows. After
paying taxes, the firm makes distributions to the providers of its capital and retains the balance
for use in its business. If company is all equity financed, the entire after-tax operating cash flow
each period accrues to the benefit of its shareholders (in the form of dividend and retained
earnings). If instead the company has borrowed a portion of its capital, it must dedicate a portion
of the cash flow stream to service this debt. Moreover, debt holders have the senior claim to a
companys cash flow; shareholders are only entitled to the residual. The companys choice of
capital structure determines the allocation of its operating cash flow each period between debt
holders and shareholders. The debate over the significance of a companys choice of capital
structure is esoteric. But, in essence, it concerns the impact on the total market value of the
company (i.e.; the combined value of its debt and its equity) of splitting the cash flow stream into
a debt component and earn equity component. Financial experts traditionally believed that
increasing a companys leverage, i.e. increasing the proportion of debt in the companys capital
structure, would increase value up to a point. But beyond that point, further increases in leverage
would increase the companys overall cost of capital and decrease its total market value.

Modigliani and Miller challenged that view in their famous 1958 article. They argued that
the market values the earning power of a companys real assets and that if the companys capital
investment program is held fixed and certain other assumptions are satisfied, the combined
market value of a companys debt and equity is independent of its choice of capital structure.
Since Modigliani and Miller published their capital structure irrelevancy paper, much attention
has focused on the reasonableness of these other assumptions, which include the absence of
taxes, bankruptcy costs, and other imperfections those exist in the real world. Because of these
imperfections, a companys choice of capital structure undoubtedly does affect its total market
value; the significance of corporate leverage is reflected in the articles that have appeared in the
financial press following periods like the 1970s when leverage increased significantly. However,
the extent to which a companys choice of capital structure affects its market value is debated.

The essence of financial management is the creation of shareholder value. According to

Ehrhard and Bringham (2003), the value of a business based on the going concern.
Expectation is the present value of all the expected future cash flows to be generated by

the assets, discounted at the companys weighted average cost of capital (WACC). From this it
can be seen that the WACC has a direct impact on the value of a business.
(Johannes and Dhanraj, 2007). The choice between debt and equity aims to find the right capital
structure that will maximize stockholder wealth. WACC is used to define a firms value by
discounting future cash flows. Minimizing WACC of any firm will maximize value of the firm
(Messbacher, 2004).
Debt policy and equity ownership structure matter and the way in which they matter
differs between firms with many and firms with few positive net present value project
(McConnel and Servaes, 1995). Leland and Pyle (1977) propose that managers will take debtequity ratio as a signal, by the fact that high leverage implies higher bankruptcy risk (and costs)
for low quality firms. Since managers always have information advantage over the outsiders, the
debt structure may be considered as a signal to the market. Rosss (1977) model suggests that the
values of firms will rise with leverage, since increasing the markets perception of value. In their
second seminal paper on corporate capital structure, Modigliani and Mill (1963) show that firm
value is an increasing function of leverage due to the tax deductibility of interest payments at the
corporate level. In the 30 years since, enormous academic effort has gone into identifying the
relevant costs associated with debt financing that firms presumably trade off against this
substantial corporate tax benefit. Although direct bankruptcy costs are probably small, other
potentially important factors include personal tax, agency cost, asymmetric information,
product/input market interactions, andcorporate control considerations. Surveys of this literature
include Bradley, Jarrell, andKim (1984), Harris and Raviv (1991), Masulis (1988) and Miller
(1998).
Early empirical evidence on the trade-off theory (e.g., Bradley, Jarrell, and Kim, 1984) yielded
mixed results. However, recent studies examining capital structure response to change
incorporate tax exposure (Givoly et al., 1992; Mackie-Mason, 1990; Trezevant, (1992) provide
evidence supporting the trade-off theory. Myers (1984) argues that the trade-off theory also fails
to predict the wide degree of cross-sectional and time variation of observed debt ratios. Return
on stock increases for any announcement of issuer exchange offers. Overall, 55 percent of the
variance in stock announcement period returns is explained (Masulis, 1983). Under some
conditions capital structure does not affect the value of the firm. Splitting a fund into some mix

of shares relating to debt, dividend and capital directly adds value to the company (Gemmille,
2001).

Firms are likely to suffer increased costs and decrease performance if they do not adopt
suitable governance structures in their transactions with potential suppliers of funds
(Kochhar, 1997). It is considered customer-driven financial distress where prices for the firm
output decline whenever firm has poor financial status. Employee driven financial distress
originates from loss of intangible assets when firm revenue decline. Babenko (2003) examines
the state tax effect on optimal leverage and yield spreads to find out the optimal capital structure
at the time of financial distress. A negative relationship exists between the ownership of
shareholders with large blocks, on the one hand, and the degree of control, on the other hand,
with regard to firm value, the second relationship being significant. However, endogenous
treatment of these variables then reveals a positive effect for the ownership of the major
shareholders on firm value.
Leland and Pyle (1977) and Ross (1977) propose that managers will take debt/equity ratio as a
signal, by the fact that high leverage implies higher bankruptcy risk (and cost) for low quality
firms. Since managers always have information advantage over the outsiders, the debt structure
may be considered as a signal to the market. Rosss model suggests that the value of firms will
rise with leverage, since increasing leverage increases the markets perception of value. Suppose
there is no agency problem, i.e. management acts in the interest of all shareholders. The manager
will maximize company value by choosing the optimal capital structure; highest possible debt
ratio. High-quality firms need to signal their quality to the market, while the low-quality firms
managers will try to imitate. According to this argument, the debt level should be positively
related to the value of the firm.
Furthermore, according to Gleason et al. (2000), the utilization of different levels of debt and
equity in the firms capital structure is one such firm-specific strategy used by managers in the
search for improved performance. Hence, most firms have strived to achieve an optimal capital
structure in order to minimize the cost of capital or to maximize the firm value, thereby
improving its competitive advantage in the marketplace through a mixture of debt and equity
financing. Thus, selecting the right type of debt is an equally important issue as opting for an
appropriate debt to equity ratio. However, as noted by Myer (2001), each theory works under its

own assumptions and propositions, hence, none of the theories can give a complete picture of the
practice of capital structure.

Ross (1977), Heinkel (1982) and Noe (1988) suggest that increasing leverage, by acquiring debt
should have positive implications for firm value and performance. Furthermore, this result is also
supported by Hadlock and James (2002) where they concluded that companies prefer debt (loan)
financing because they anticipate a higher
return. According to Champion (1999), the use of leverage is one way to improve the
performance of the firm.
Due to the lack of a consensus about what would qualify as optimal capital structure, it is
pertinent to examine the effect of debt utilization on firms performance. Several such studies
were conducted in European countries and in the United States. They found contradictory results
when Gleason (2000) supported a negative impact of leverage on the profitability of the firm
while Roden and Lewellen (1995) found a significant positive association between profitability
and total debt as a percentage of the total buyout-financing package in their study on leveraged
buyouts. Thus, there is no universal theory about debt-equity choices and have different views
regarding the financing option.
According to Brigham and Gapenski (1997) The extent to which a firm uses debt financing, or
financial leverage, has three important implications: (1) By raising funds through debt,
stockholders can control a firm with a limited investment. (2) Creditors look to the equity or
owner-supplied funds, to provide a margin of safety, so if the stockholders have provided only a
small proportion of the total financing, the risks of the enterprise are borne mainly by its
creditors. (3) If the firm earns more on investments financed with borrowed funds than it pays in
interest, the rate of return on owners capital is magnified, or leveraged.

On the other hand most capital structure theories have argued that type of property that is owned
by the company impact on the companys capital structure. Mayers and Mejlove (1984) have
stated that guaranteed loan and credit payment has some advantages. Their model has proven
companys executives try to communicate better information to stakeholder about company
status, therefore payment of collateralized debt and credit by property and business assets,
prevent from loss of debt and credit. For this reason, companies with assets that can be used as

collateral, getting more loans and credits and could use investment opportunities well that arise
in the future. Jencen and Meckling (1976) have stated that if the debt is collateralized and funds
are limited for a project, creditors will have more assurance about their claims. When there is
not such condition, creditors may seek more favorable conditions from the company. Despite
many researchers have been done on corporate governance issues or financing through debt.
Becker, et al.(2008) find that block holders increase firm profitability and dividend and reduce
executive compensation. Berger, et al. (1997) also found , pressure from major shareholders can
mitigate the amount of benefit management to its own benefit , however based on past studies
such management benefit can increase conflict between shareholders and creditors.

Generally, loan and capital are two main types of the capital structure formers and financial
managers are always involved in decision making related to financing with the attitude of costbenefit analysis of each method and also adjusting rate of return on investments and interest
payable rate. This phenomenon due to the appearance of agency paradigm and also efficiency
changes and risks resulting from companies financing, is one of the most challenging topics of
area of funding markets. Factors influencing the attitude of financial executives in connection
with the sources and capital expenditure will determine why and how to select a specific
resource according to the requirements of the outside environment and the dominant phenomena
of the company (Sinaee&Rezaiyan, 2005). Different researches has been done regarding
methods of companys financing which is representing the relationship between ownership
structure and capital structure; Gonzales et al (2009) in their study on 506 companies from seven
Latin American countries studied the relationship between ownership structure and capital
structure. Their research results indicate that between concentration of ownership and financial
Leverage there is a positive relationship. These results are consistent with the argument that
companies with more concentrated ownership are unwilling to finance lease because they are
worried about losing their control. This study also shows that factors such as firm size, growth
opportunities, and property observantly profitability and tax have statically and economically
significant role in expanding capital structure in a sample of Latin American company. They
found just that larger companies have larger growth opportunities and fewer profitability and use
of greater debt.

Jensen (1976) defined debt as a disciplinary tool to ensure that managers give preference to
wealth creation for the equity-holders. Thus, in the companies that have high cash flow and
profitability , increasing of debts can be used as a tool of reducing the scope for managers until
resources of company may not be waste as a result of their individual purposes. The other
conflicting problem is that managers may not receive all the benefits of their activities.
This is seen when managers share in ownership of company is low. When the managers
increase stock is high, this inefficiency decreases. Therefore, it is appropriate that by increasing
debts instead of stock issuance prevent from decreasing of managers share of ownership interest
(Huang, Song, 2005). Stulz (1990) like Jensen believes that debts payment decreases cash flows
available for managers. But, on the other hand, he states that this decrease will decrease the
opportunities of profitable investing. Thus, companies with less debt have more opportunities for
investment and in comparison with other active firms in industry, have more liquidity.
Additional costs of debt include potential bankruptcy costs, and agency costs associated with the
monitoring of investments by bondholders. Costs and benefits of alternate financial sources are
traded off until the marginal cost of equity equals the marginal cost of debt, yielding the
optimal capital structure, and maximizing the value of the firm.

The alternative theory, discussed by Meyers (1984), Myers and Majluf (1984) and Fama&
French (2002), describes a firms debt position as the accumulated outcome of past investment
and capital decisions. In this theory, commonly called the Pecking Order theory, firms with
positive net present value investments will finance new investments first using internal funds,
and in the absence of internal funds will finance them with safe debt, then risky debt, then with
equity, but only if there is no other alternative. Thus, financing investments using internally
generated funds may be the cheapest source, and the firms financial structure is the outcome of
past cash flows and investment opportunities. The conflict between benefits of share holders and
creditors has consequences like increase of interest rate by creditors, addition of supervision
costs and decrease of investment. So, this conflict demonstrates that high leverage leads to poor
performance (Williams J, 1987).

Managers in comparison to investors have more information about operation. Myers and Majluf
(1984) believe that this causes that pricing the stock with investors be understate. In this
condition that there is asymmetric information, companies prefer financing by internal sources to
stock issuance and where there is not adequate internal sources, they refer to borrowing.
Consequently asymmetric information is the base of choice picking order theory of financing.
The main conclusion drawn from the asymmetric information theories is that there is a hierarchy
of firm preferences with respect to the financing of their investments (Myers &Majluf, 1984).
This hierarchy of preferences suggests that firms finance their investments first using internally
available funds, followed by debt, and finally through external equity. Dimitrov and Jain (2003)
with operational performance of firms proposed another theory. They argued that if manager
have access to private information about becoming worse in future operational performance they
will be increase debt. Thus, increasing the leverage is a negative sign and demonstrates poor
forward performance. Rajan and Zingales (1995) argue that larger firms tend to disclose more
information to outside investors than smaller ones. Overall, larger firms with less asymmetric
information problems should tend to have more equity than debt and thus have lower leverage.

Studies showed contradictory results about the relationship between increased use of debt in
capital structure and firms performance. Some studies (Taub, 1975; Roden and Lewellen, 1995;
Champion, 1999; Ghosh et al., 2000; Hadlock and James, 2002, Berger and Bonaccorsi di Patti,
2006) showed positive relationship and some (Kester, 1986; Friend and Lang, 1988, Fama and
French, 1998, Gleason et al., 2000; Simerly and Li, 2000, Booth et al., 2001 Ibrahim, 2009)
showed negative or weak/no relationship between firms performance and leverage level. In a
study of listed firms in Ghana, Abor (2005) found that Short-term and Total Debt are positively
related with firm's ROE, whereas Long-term Debt is negatively related with firm's ROE. While
examining the relationship between capital structure and performance of Jordan firms, Zeitun
and Tian (2007) found that debt level is negatively related with performance. In a similar study
on microfinance institutions in sub-Saharan Africa, Kyereboah-Coleman (2007) found that high
leverage is positively related with performance (i.e. ROA and ROE) and Abor (2007) on small
and medium-sized enterprises in Ghana and South Africa showed that long-term and total debt
level is negatively related with performance. A study by Ibrahim El-SayedEbaid, (2009) based
on a sample of non-financial Egyptian listed firms from 1997 to 2005 reveals that capital

structure choice decision, in general terms, has a weak-to-no impact on firm's performance
Results of some studies (Myers, 2001; Eldomiaty, 2007) show that capital structure is not the
only way to explain financial decisions. Probably this explains the contradictory results of the
studies that empirically tested the predictions of relationship between leverage and firm's
performance. As explained by Jermias (2008), only the direct effect of financial leverage on
performance is examined by prior studies however leverage-performance relationship may be
affected by some other factors like competitive intensity and business strategy.
There is vast literature available that examines relationship of capital structure and performance
of firms in developed nations but very less tested empirically for developing and emerging
economies. As compared to the developed markets like Europe, America etc. it is found by the
Eldomiaty (2007) that capital markets are less efficient and suffers from higher level of
asymmetry in terms of information in emerging and developing markets than capital markets in
developed countries.
Basically, most companies have some debts in their capital structure. Debt financing is
considered as external financing which induce monitoring by lenders (Agrawal and Knoeber,
1996; Ang et al., 2000). As the leverage increases, so does the risk of default, hence the incentive
for the lenders to monitor the organisation. This is supported by a study by Ang et al. (2000),
which finds that agency costs are lower with greater monitoring by banks. In addition, banks also
lead organizations to operate more efficiently by better utilising assets and moderating perquisite
consumptions in order to improve the organizations reported financial performance to the banks
(Ang et al., 2000). This is agreed by Jensen (1986) who states that the action of managers of
organisation with high debts will be monitored by the debt holders and controlled by the debt
contracts. This is to ensure that the managers adhere to and follow the debt contracts as the debt
holders depend on it in the event of bankruptcy. Therefore it is argued that in an organisation
which has high debt, managers will be more cautious in their actions as they realised that they
are being scrutinised and monitored (Bryan et al., 2005), and this also spur from the need to
report good performance to the bank. As a result there will be less expropriation of shareholders
wealth, less conflict and less agency problem, thus leading to less monitoring needed. Hence, the
company performance will be high.

Most companies use some debt in their capital structure. Debt structures are claimed to be one of
the important determinants of a companys success and motivate its sustainable growth (Madan,
2007) Thus, decisions concerning debt structure are vital for the business survival (Ahmed
Sheikh and Wang, 2011). However the
selection of debt structure is not easy and any wrong decision may lead the company to financial
distress and bankruptcy. Many recent studies have attempted to explain debt structure decisions
made by managers. The relationship between debt structure and firm value has been extensively
investigated (Abor, 2007; Abor, 2005).

According to Krisman and Moyer, 1997), various dimension of debt financing in relation to
other factors has also been examined, such as debts and compensation (Bryan et al., 2005),
information role of debt (Haris and Raviv, 1990), ownership structure and debt (Cespedes, 2010;
Bopkin and Arko, 2009; Su, 2010; Berger et al., 1997; Fleming et
al., 2005) and debt financing and audit fees (Tauringana and Clarke, 2000; Chow, 1982).
However, the findings of these studies do not lead to a consensus with regard to the determinants
of debt structure. In addition, it is also claimed that existing literature has not been able to clearly
explain the reasons of leverage choice by companies
(Rajan and Zingles, 1995; Morri and Cristanziani, 2009).

Prior studies also attempted to explain debt structure decisions made by managers in a variety of
industries, such as Upneja and Dalbor (2001) in restaurant industry, MorriandCristanziani (2009)
in real estate industry, Karadeniz et al. (2009) in logding industry, Madan (2007) in hotel
industry and Ahmad Sheikh and Wang (2011) in manufacturing sectors. It has been observed
that organisations are constrained to a certain degree, particularly, in the short run, by
opportunities in the industry (Coles et al., 2001). Different industries may have different pattern
of expenses and investment in assets structure as well as in information system. It has also been
found that controlling
for the effect of industry can significantly improve the degree the variables tested being
explained by an organisation or individual factors (Eaton & Rosen, 1983).

Since the work of Modigliani and Miller (1958) on capital structure, numerous studies have been
carried out in an attempt to explain the capital structure decisions. Many theories have been
proposed and studied to link the debt structure decisions and firm specific characteristics. Among
others are trade off-theory (Modigliani and Miller, 1958; Zhang and Kanazaki, 2007), pecking
order theory (Myers and Majluf, 1984; Myers, 1984; Zhang and Kanazaki, 2007) and agency
theory (Jensen and Meckling, 1976). This study will particularly examine the validity of pecking
order theory and trade-off theory in relation to the debt structure of Malaysian companies.

Modigliani and Miller (1958) is said to be the milestone among the capital structure studies.
They claim that market is efficient when there is no tax, thus financing decisions affect neither
cost of capital or market value. Later, in their second proposition, they claimed that tax
advantage motivates the optimal capital structure, where the
companies are said to alter their capital structure to increase the value of their companies
(Modigliani and Miller, 2004; Karadeniz et al, 2009; Forsberg, 2004).

Another famous theory being associated with debt is the pecking order theory (Myers and
Majluf, 1984). Myers and Majluf assert that information asymmetry exist among the investors.
Investors are said to generally have less information than insiders, thus resulted in the
undervalued of the companies common-shares. This would then lead to positive relationship
between growth of the companies and debt level, when the companies have more growth
opportunities than the assets they have . Unlike, trade-off theory, companies do not have target
capital structure, however, it is assumed that companies would prefer internal to external fund;
and prefer debt to equity. They would only use external financing when their internal funds are
insufficient (Myers and Majluf, 1984; Myers 1984). Pecking order emphasizes on information
assymety. Companies with more fixed assets are said to have less information asymmetry (Myers
and Majluf, 1984; Kardeniz et al., 2009). Information asymmetry is also considered to be less
severe in larger companies, as a consequent, larger companies cost of capital would be less than
that of small companies (Kardeniz et al., 2009). This theory also posits that profitable companies
are able to generate internal funds, and do not like to use external funds, if the needs arise for
external fund, they would prefer debt to equity. This preference for debt compared to equity is
also related to their unwillingness to lose the control of the companies if more equity are issued.

And it is claimed that this relationship will be more pronounced in concentrated ownership
structure (Cespedes et al., 2010).
We can also calculated company performance accordance to future cash flow discounted
method, while future cash flow stays invariably and there is no change in the cost of capital, so
liability has no effect on enterprise value (Modigliani and Miller, 1958). MM theory of this
phase is established on the premise of the perfect market and a large number of assumptions.
Therefore, it is a far cry from the objective circumstances. The amendment of the MM theory
considers the tax deductible effect of interest caused by debt financing in income tax. From the
revised theoretical MM model it can be seen: the weighted cost of capital with debt is less than
the cost of equity without debt, and debt management can bring tax-saving value for enterprises
(Modigliani and Miller, 1963). The study by Jensen and Meckling (1976) gives the general
meaning of the agency cost of equity financing, and points out that in the principal-agent
relationship between shareholders and managers, there are moral hazards as no hard working,
perquisite consumption, overinvestment and underinvestment of operators, resulting in the equity
agency costs. Townsends high cost state verification model (1979) points out that the use of
debt can help the client to monitor the manager. Enterprises having not paid a debt on schedule
will expose a high agency cost, so debt can verify the profitability of the enterprise and restrains
the agency cost of the manager. Considering the event of debt default, Harris and Raviv (1990)
think the debtor is entitled to recommend the exercise of the liquidation proceedings forcing
managers to liquidate inefficient business, and manager does not have the residual claims after
the liquidation resulting in debt financings constraints to enterprise manager.

The negative impact of debt financing on company performance is reflected in the cost of
bankruptcy and debt agency costs. Bankruptcy cost means excessive corporate debts making
enterprises difficult to achieve financial stability results in low efficiency of business or
bankruptcy. Bankruptcy costs include direct costs and indirect costs. Direct costs include fees as
legal, accounting and other professional services costs, debt and reorganization costs. Indirect
costs include profits decline resulting from sell decline, input costs increase, loss of key
employees, managers time and effort loss (Malu, 2004)[. Jensen and Meckling (1976) put
forward another kind of agency cost is debt agency cost. Because the creditors are not directly
involved in business management, business managers tend to choose the investment which can
maximize their own interests. The interest of the manager is the residual claim, so managers tend
to choose investment projects more risky and more profitable. This will lead to a transfer of risk
behavior. If the investment is successful, creditors will not get additional benefits but managers

will receive greater benefits, while the debtor bears the risk of insolvent creditors when the
investment fails. So the creditor makes borrowing and lending agreement, limits the enterprise
investment or increase the cost of debt when lending the debt, thus affecting the company
performance.

2.2

THEORETICAL FRAMEWORK

A number of theories, models and studies have been put forth to study the various facets of debt
financing. In this study, the variables have been selected with due consideration as independent
to various debt hypothesis and/ theories and the maximum availability of reliable data from
airlines companies of Pakistan for our empirical research work.
The dependent variable of the study is debt financing while the independent variables are return
on asset, return on equity, inflation, earnings, and agency problems.

FIG;01 Theoretical Framework

fFf

HYPOTHESES
NULL HYPOTHESES;
There is insignificant relationship between debt financing and company performance of Pakistan.

ALTERNATIVE HYPOTHESES
There is significant relationship between debt financing and company performance of Pakistan.

CHAPTER-03

RESEARCH METHODOLOGY
3.1

INTRODUCTION

In this chapter the research type, population and sample size, methodology will be studied. Data
is categorized in this chapter. Different data sources, econometrics model and variables are
explained in detail with their respective formulas.

3.2

TYPE OF RESEARCH

Nature of this research is empirical. Descriptive statistics tools are used for finding, analyzing
and summarizing the data. This is an exploratory research as well. The descriptive nature of the
research is because statistical paraphernalia are used to identify the association between the
variables and their influence on one another. The research is exploratory as well because this
research explores new variables, which determine the dividend strategy of the companies in

Pakistan. The descriptive nature is to find out the significance of the total number of
observations, either they are significant or not? Each and every single variable is described in
this research and the findings are matched with the studies previously done by other researchers.

3.3

POPULATION AND SAMPLE SIZE OF THE RESEARCH

The total number of observations made for this research are, which compiles the data different
Airlines including in the sample.

3.4

STATISTICAL TESTS

In order to find out relationship between the dependent and independent variables to find out the
confidence level of the hypothesis, different statistical tools would be applied to conclude how
independent variables influence the dependent variable. Regression analysis will be conducted to
study the scenario of relationship and dependency of the variables.

3.5

DATA SOURCES

The research conducted is empirical in nature and is exploratory research including various tools
of descriptive statistics. The major portion of the research is based on the secondary sources of
data. To obtain secondary data, various sources have been used. The main source that is used is
to obtain the secondary data is a well-known search engine name Google. Other web sites mainly
Ask.com, Amazon.com are used to obtain secondary data of the firms. These search engines
were the sources to get the financial reports of the Airlines companies from the year 2008 to
2012.The main reason for not including the data from recently passed years is the fact that many
of the companies from the sample did not have updated data, which could have influence my
research findings and conclusions. The company for which the data was not available on search
engines, their data was obtained by exploring their official sites.

Data base is developed including a number of financial data i.e. Net income of the firms, number
of shares, Equity of the firm, total Sales, Stock prices, Earning before interest and taxation,
Dividend per share, Total Debts of the firms, Total Assets, fixed Assets and Free Cash Flows.
The data is gathered from the year 2008 to 2013 and the examination interval is set for five
years. Some of the blank places will be replaced by putting their value zero. This financial data is
used to find out some important ratios, based on which we will be conducting different tests and
will be applying different statistical tools. Financial ratios will be used to find out the
determinants which are return on asset, return on equity, earnings, and inflation.
Many independent variables in my investigation are going to be tested. The plan of this research
paper is to uncover and measure the determinants of debt policy of Pakistan. In this research
paper, debt Financing will be dependent variable and to test whether debt Financing is influenced
by other factor or not, other independent variables will also be checked. Debt itself is not used in
this research because of the fact that there is a considerable fluctuation in the debt financing of
the firms. The data is pooled data so there is no need to use a dummy variable.

3.6

MODEL FOR THE RESEARCH

The regression model will be used in this research thesis. No other models were used in
that research because all the requirements which are needed can be through this model
which mentioned in the early of this paragraph.
3.7

VARIABLES OF THE RESEARCH

Many variables are going to be examined and tested in this research. Mainly they are dependent
and independent variables. The dependent variable is debt financing and the independent
variables are return on assets, return on equity, earnings, inflation.

3.8

INSTRUMENTS AND MEASUREMENT OF VARIABLES

The different type of research variables are discussed one by one as below.

3.8.1 RELIANT/DEPENDENT VARIABLE

The reliant variable in this study is Debt financing, which is checked over a period of five years.

3.8.2 INDEPENDENT/AUTONOMOUS VARIABLES

Four independent variables are used in this research, which are return on assets, return on equity,
earnings, inflation, and financial leverage.

Equation 3.2 return on assets

ROA= net income/total assets