1

Capital Structure Management in

Nepalese Enterprises
MMM
M
Sovit Subedi

INTRODUCTION

1. Background

There are different theories of capital structure. David Durand propounded the net
income approach of capital structure in 1952 (Durand 1952). This approach states
that firm can increase its value or lower the cost of capital by using the debt
capital. Net operating income approach is converse to this approach. This
approach contends that the value of a firm and cost of the capital are independent
to capital structure. Thus, the firm cannot increase its value by judicial mixture of
debt and equity capital. These are two extreme approaches to capital structure.

Solomon developed the intermediate approach to the capital structure in 1963.

This traditional theory of capital structure pleads that value of the firm goes
increase to a certain level of debt capital and after then it tends to remain constant
with a moderate use of debt capital, and finally value of the firm decreases
(Solomon 1963). Thus, this theory holds the concept of optimal capital structure.

The modern theory of capital structure began with the celebrated paper of
Modigliani and Miller published in 1958 (Harris and Raviv 1991). Since the path
breaking seminal paper by Modigliani and Miller (1958), they supported the net
operating income approach and rejected the traditional theory of capital structure.
 2

And the issue of capital structure has generated great interests in finance literature.
It has provided a substantial boost in the development of the theoretical framework
within which various capital structure theories have been developed. Based on
very restrictive assumptions of perfect capital markets, homogenous expectations,
no taxes and no transaction costs, Modigliani and Miller concluded that financial
leverage does not affect the firms market value. In short, capital structure is
irrelevant to the value of firm, or value of levered firm and value of unlevered firm
will be equal if they are identical in every respect except capital structure.

The study of capital structure attempts to explain the mix of securities and
financing sources used by corporations to finance real investment (Myers, 2001, p.
81). In general, a firm can choose among many alternative capital structures. It can
issue either equity or debt capital or a large amount of debt capital and little
amount of equity capital and vice versa. It can arrange lease financing, use
warrants, issue convertible bonds and other hybrid securities. The firm can issue
dozens of distinct securities in different combinations; however, the rational
attempt is to find the particular combination, which maximizes overall market
value of the firm.

In respect to set an optimal capital structure, the practices of firms are different.
There are so many firm specific and external variables, which affect capital
structure management. One of the most perplexing issue facing financial managers
is the relationship between capital structure and the stock prices. That is why there
are various theories of capital structure that try to explain this cross-sectional
variation.

The presence of favorable tax treatment of interest payments and bankruptcy costs
associated with increasing debt lead to the notion of an optimal capital structure
which maximizes the value of the firm and respectively minimizes its average cost
of capital. Using debt capital provides tax shield on interest payment or interest is
tax-deductible expenses. Therefore, relaxing their earlier assumption of world
 3

without tax Modigliani and Miller (1963) proposed that firms should use as much
debt capital as possible in order to maximize their value. Increasing debt in one
hand increases the debt-tax shield but by the same time bankruptcy cost also
increases. It is the optimal level where the debt-tax shield tradeoffs the bankruptcy
cost and maximizes the value of the firm. Therefore the tax has been thoroughly
investigated as a factor that determines the capital structure.

According to static tradeoff models, the optimal capital structure does exist. A firm
is regarded as setting a target debt level and gradually moving towards it. The
theory states that capital structure is the result of an individual firms trading off
the benefits of increased leverage (for example, a tax. shield) against the potential
financial distress caused by heavy indebtedness. Accordingly, the trade-off theory
predicts moderate debt ratios. The tax-based and agency-cost-based models,
belong to the static tradeoff models are the result of works of prominent
researchers Modigliani and Miller (1958, 1963), Miller (1977), Kraus and
Litzenberger (1973), Kim (1978), Bradley, Jarrel and Kim (1984), Jensen and
Meckling (1976), Jensen (1986), Harris and Raviv (1990), and Stulz (1990).

These theories examine the determinants of capital structure from different aspects
and conclude in different outcomes as far as the choice of the determination of the
level of financial leverage is concerned. In the meanwhile, empirical evidence has
sometimes proven to be inconsistent to a particular theory that they examine. The
most striking example is that of the empirical testing of the pecking order theory,
where various researchers have concluded in different, inconsistent conclusions
(Myers, 1984; Harris and Raviv, 1991).

To sum up, there is no universal theory of capital structure yet. Several useful
conditional theories exist that attempt to approach the determination of optimal
capital structure. Researchers have been trying to test and develop different capital
structure theories through empirical studies. This study is one more attempt in this
direction.
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2. Statement of the Problem

The assets of a company can be financed by issuing ordinary shares or by retained

earnings and borrowings. Capital structure refers to the different options used by a
firm in financing its assets. It can combine bonds, lease financing bank loans or
many other options with equity in an overall attempt to boost the market value of
the firm. To maximize the overall value, firms differ with respect to capital
structures which have given birth to different capital structure theories that attempt
to explain the variation in capital structure firms over time or across regions. Many
researchers have tested the validity of the modern theory of finance. Numerous
studies have also investigated the capital structure of firms in various sectors of
the economy. The literature on corporate finance has contributed significant
progress since the seminal works of Modigliani and Miller (1958; 1963).
Theoretical advancement, particularly development of capital structure models
based on tax balancing and asymmetric information, and more recently, on
product-market and corporate control considerations (Harris and Raviv, 1981), has
managed to shed some light on the financing behavior of corporations. Many
researchers have tested the validity of the modern theory of finance. Numerous
studies have also investigated the capital structure of firms in various sectors of
the economy.

Most initial studies (Taggart, 1977; Marsh, 1982; Bradley et al., 1984; Jalilvand
and Harris, 1984; Titman and Wessels, 1988) examined the case of U.S. companies
and found that debt ratio is determined by non-debt tax shield, assets structure,
profitability, growth, industry classification and product uniqueness. In their
extensive survey of existing empirical studies, Harris and Raviv (1991) pointed
out that the leverage increase with fixed cost, non-debt tax shield, investment
opportunities (growth) and firm size, and decreases with volatility, advertising
expenses, probability of bankruptcy, profitability, and uniqueness of the product.
 5

Similarly, Rajan and Zingales (1995) is one of the first attempts to test the cross
section analysis for the G7 countries about the theoretical and empirical lessons
learnt from the U.S. studies. These authors find similar levels of leverage across
countries, thus refuting the idea that firms in bank-oriented countries are more
leveraged than those in market-oriented countries. However, they recognize that
this distinction is useful in analyzing the various sources of financing. Rajan and
Zingales (1995) find that the determinants of capital structure that have been
reported for the U.S. (size, growth, profitability, and tangible assets) are important
in other countries as well. They show that a good understanding of the relevant
institutional context

(bankruptcy law, fiscal treatment, ownership concentration, and accounting

standards) is required when identifying the fundamental determinants of capital
structure.The analysis by Booth et al. (2001) suggests that the same determinants
of capital structure prevail in ten developing countries. Booth et al. (2001) find
that developing countries have substantially lower amount of long-term debt.

These researches on the capital structure has received great importance in US and
other develeoping countries despite of being largely confined in these countries
itself, it has remained neglected in developing countries due to different economic
and legal constraints. However the economic liberalization and reformation
processes since 1980's in developing countries now have less institutional barriers.
Research in this field will contribute to signify the importance of capital structure
to value maximization objective of the firm. This study attempts to shed some
light on the capital structure issues in Nepalese context. It is a case of capital
structure in less developed countries. Including capital structure determinants, the
issue is to analyze capital structure practices of Nepalese companies. More
specifically, this study deals with following issues:

What are the factors that determine the capital structure of Nepalese listed
companies?
 6

What types of capital structure policies the Nepalese companies have

followed?

To what extent the capital structure theories can explain capital structure
choice of Nepalese firms?

3. Objective and Scope of the Study

The main objective of the study is to find out the factors which determine the capital

structure of Nepalese listed companies and sub objectives are:

To identify and analyze the determinants of capital structure.

To investigate the extent to which the capital structure theories can explain capital

structure choice by firms.

To examine managements views on various aspects of the capital structure.

To identify the relationship between the factors determining capital structure and

capital structure pattern

To identify the impact of those factors on capital structure of the companies.

4. Organization of the Study(Report Structure)

This study has been organized into five chapters as prescribed by the University.

Chapter One : Introduction

Chapter Two : Review of Literature
Chapter Three : Research Methodology
Chapter Four : Presentation and Analysis of Data
Chapter Five : Summary and Conclusion
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Chapter One contains general background of the study, statement of the

research problem and objectives and scope of the study. This chapter
signifies the rational of this study.

Chapter Two is devoted to theoretical foundation of capital structure

including hypothesis development, and review of empirical works.

Chapter Three consists of methodological approach employed in this study.

Particularly, it focuses on nature and sources of data, sampling techniques,
data collection, survey method, econometric modeling, description of
variables, the proxies of those variables and methodological limitations of
the study. This chapter is very important in case of empirical study because
the consistencies of the findings are solely based on empirical methodology
it has employed.

Chapter Four consists of presentation and analysis of data with different

financial and econometric tools. An analysis of survey of the respondents
opinion on various aspects of capital structure management has been also
presented.

Chapter Five consists of the summary and major findings of this study and
recommendation for further research.
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CHAPTER TWO

REVIEW OF LITERATURE
In Finance, The most debatable topic is capital and it has been receiving due
attention of researchers since the prominent work of Modigliani and Miller (1958).
Based on their theoretical framework, so many theories of capital structure have
been developing. The empirical studies in this regard have been contributing
significantly. This chapter briefly reviews the literature, which provides basic
foundations to this study. The various approaches employed in this study are
derived from different literature surveyed in this chapter.

This chapter has been organized into two sections: theoretical and empirical
capital structure. Theoretical and empirical capital structure studies have generated
many results that attempt to explain the determinants of capital structure. There
exist a number of determinants of capital structure derived from various theories.
Haris and Raviv (1991) demonstrate in their review article that the motives and
circumstances could determine capital structure choices which have been seen
nearly uncountable. According to Titman and Wessels (1988), the required
explanatory variable may frequently be imperfect proxies for the defined corporate
attributes.This chapter has been organized into two sections. The theoretical
framework has been dealt in Section 1 and review of empirical studies is carried
out in Section 2.

SECTION 1
The Theoretical Framework
1. Conceptual Considerations

The term capital structure and financial structure have been used interchangeably
in finance literature, a line of technical difference is there, that is, the financial
structure comprised of the total combination of equity capital, preferred capital,
long-term debt and short-term debt/liabilities, whereas, the capital structure
 9

excludes the short-term debt/liabilities. For its investment project, the firm can
choose either of the sources or combination of different sources in different forms
but the underlying question arising in this regard is which source or the
combination is better to maximize the value of the firm, the ultimate objective!
Therefore, the capital structure should be examined from the viewpoint of its
impact on the value of the firm. The optimal capital structure is that combination
of debt and equity, which maximizes the value of the firm. In this respect, the
capital structure can be interpreted in terms of target capital structure to strike a
balance between risks and returns for maximizing the value of the firm. Using
more debt raises the riskiness of the firms earnings stream. However, a higher
debt ratio generally leads to a higher expected rate of return. The higher risk tends
to lower a stock price, but a higher expected return raises it and drives toward
equilibrium.

In one hand, the equity capital provides investors to control over the firm as
owners. However the firm may not able to use only equity financing because the
rational objective is to maximize the value of the firm. The cost of new equity
would come across higher than existing one and since the risk pattern on equity is
higher, the higher expected rate drives to sell equity in lower price in the market.
On the other hand, the debt capital provides investors a certain fixed return and
right to first claim over the liquidation. Raising debt capital is also advantageous
to the firm in numerous ways. Firstly, interest is tax deductible, which lowers the
effective cost of debt. Secondly, debt holders are limited to a fixed return (the
coupon amount), so stockholders do not have to share profits if the business does
have excess profit. Thirdly, debt holders do not have voting rights, so the
stockholders can control a business however they are investing less money than
would otherwise be required.
 10

Therefore, the crux of the capital structure theories lies between and among these
two basic sources of capital, equity and debt, and interests of three major
stakeholders of the firm, stockholders, managers and the debt holders respectively.

2. Theories of Capital Structure

Theories of capital structure have been well documented in the finance literature.
The modern theory of capital structure began with the celebrated paper of
Modigliani and Miller published in 1958 (Harris and Raviv 1991). Most
influentially, the Modigliani and Miller (1958) work has given the theoretical
foundation for further enquiry into the capital structure theory. In this paper, they
supported the net operating income approach and rejected the traditional theory of
capital structure. They contend in their first proposition that the market value of
any firm is independent to its capital structure and is given by capitalizing its
expected return at the rate appropriate to the risk class (Modigliani and Miller
1958). This was theoretically very sound but was based on the assumptions of
perfect capital market and no tax world, which were not valid in reality. So, this
was corrected in 1963. In correction, they incorporated the effect of tax on value
and cost of the capital of the firm (Modigliani and Miller 1963); and contend that,
in the presence of corporate tax, the value of the firm varies with the variation of
the use of the debt due to tax benefit on interest bill (Baral 1996).

The contributions of various financial economists and researchers have given new
dimensions to capital structure theories, in particular by taking into account
corporate taxes (Modigliani and Miller, 1963), bankruptcy costs (Stiglitz, 1972;
Kraus and Litzenberger, 1973; Titman, 1984), agency cost (Jensen and Meckling,
1976; Myers, 1977; Jensen, 1986), personal taxes (Miller, 1977) and information
asymmetries (Ross, 1977; Myers and Majluf, 1984; Myers, 1984).
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This sub-section is devoted to get brief insight into these theories.1 Modigliani and
Miller's (1958) independent hypothesis is dealt separately and trade off theory and
other considerations are described separately.

I. Modigliani and Miller Independent Hypothesis

Modigliani and Miller's (1958) seminal paper on corporate capital structure is

founded upon a number of restrictive assumptions. Based on the assumptions of
perfect capital market, no taxes, homogeneous exceptions and homogeneous risk
class, riskless debt, and perpetual cash flows, Modigliani and Miller concluded
that value of the firm is independent to the leverage of the firm (MM Proposition
I). That is, the market value of any firm is independent of its capital structure and
is given by capitalizing its expected return at the rate k appropriate to its class
(p. 268). By the same token, the average cost of capital to any firm is completely
independent of its capital structure and is equal to the capitalization rate of a pure
equity stream of its class (pp. 268-9). Under the Proposition II, they further state
that the expected yield of a share of stock is equal to the appropriate capitalization
rate k for a pure equity stream in the class, plus a premium related to financial
risk (p. 271). That is, the expected rate of return on the stock of any company
belonging to the same class is a linear function of leverage.2

Therefore, from the composite picture of MM Propositions I and II, holding its
underlying assumptions, the value of the firm and the firm's overall cost of capital
are independent of its capital structure. Hence, the capital structure is irrelevant.

II. The trade-off theory

1
For an in-depth review of literature on capital structure, see Harris and Raviv (1991).
2
Mathematically, the Proposition I can be expressed as VL = VU = EBIT/k where VL and VU
denote the value of levered and unlevered firm respectively, the k is the required rate of return
for an unlevered firm and EBIT is earning before interest and taxes. The Proposition II can be
expressed as i = k + (k r) D/S where i is expected return on stock, r is interest rate on debt, D
is debt and S is equity.
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Different theories give different predictions on how tangibility is related to

leverage. On the relationship between tangibility and capital structure, the trade-
off and agency theories state that tangibility is positively related to leverage. If a
companys tangible assets are high, then these assets can be used as collateral,
diminishing the lenders risk of suffering such agency costs of debt. Moreover, in
firms with more intangible assets, the costs of controlling capital expenditures are
higher, as monitoring is more difficult. The trade-off theory of the capital structure
suggests that a firms target leverage is driven by three competing forces: taxes,
cost of bankruptcy (financial distress), and the agency conflict. Therefore, the firm
seeks debt level that balances the tax advantages of additional debt against the
costs of the possible financial distress and agency conflict. Therefore, a firm sets
target leverage ratio and gradually moves toward it.

In 1976, Miller propounded the next version of irrelevancy theory of capital

structure. He pleaded in his presidential address to Annual Meeting of American
Finance Association held on September 17, 1976 in Atlanta City, New Jersey that
capital structure decisions of firms with both corporate and personal taxes are
irrelevant (Miller 1977). In 1974, Myers and Pogue developed three theories-the
lenders chickens out first, the managers chickens out first, and the shareholders
chickens out first-of debt capacity (Myers and Pogue 1974). The third theory-the
shareholders chickens out first-pleads the optimal capital structure. In the 1970s, a
number of scholars developed debt capacity theory. Among them, Scotts multi
period model of debt is considerable debt capacity theory. This theory pleads that
the value of non-bankrupt firm is a function of expected earnings and the
liquidating value of its assets and the optimal level of debt is an increasing
function of liquidating value of the firms assets, the corporate tax rate, and the
size of the firm (Scott 1976). Martin and others summarized the debt capacity
theories developed by different scholars during 1970s and concluded that the value
of the firm is maximized when marginal benefit of debt is equal to the marginal
cost of debt (1988, 356).
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Jensen and Meckling developed the capital structure theory based on the agency
costs in 1976. Firm incurs two types of agency costs-cost associated with the
outside equity holders and cost associated with the presence of debt in capital
structure (Jensen and Meckling 1976). Total agency cost first decreases and after
certain level of outside equity capital in capital structure, it increases. The total
agency cost becomes minimal at certain level of outside equity capital. Thus, this
theory pleads the concept of optimal capital structure. Two sets of capital structure
theories were developed during the latter half of the 1970s and first half of the
1980s. Ross developed one set of capital structure theories based on the
asymmetric information in 1977, and Myers and Majluf developed the next set in
1984. The first set pleads that the choice of firms capital structure signals to
outside investors the information of insiders, and the second set contends that
capital structure is designed to mitigate the inefficiency in the investment decision
caused by the information asymmetry (Harris and Ravis 1991). In the course of the
development of capital structure theory, Myers elaborated and brought out the
Pecking order theory in 1984 originally developed by Donaldson in 1961.
According to this theory, management strongly favors internal generation as a
source of new funds even to the exclusion of external sources except for
occasional unavoidable bulge in the need for funds (Donaldson 1961). This theory
explains the negative relation between profitability and debt ratio and contends
that there is no target debt-equity ratio. In financing, first, management prefers the
internal equity financing, and then debt financing and finally external equity
financing (Martin and others 1988). Thus, this theory explains the financing
behavior of management.

Other Considerations

There are some other aspects put forth by different authors/researchers. Harris and
Raviv (1991) in their comprehensive review of capital structure theories outline
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product/market interaction aspect and corporate control aspect. These aspects are
still in infancy and lots of empirical works are required to refine these approaches.

The capital structure models are based on product/market interaction between

capital structure and either product market strategy or characteristic of
product/inputs (Harris and Raviv, 1991). Product price and quantity are considered
as the strategic variables. Models involving product or input characteristics have
focused on the effect of capital structure on the future availability of products,
parts and serves, product quality, and the bargaining game between management
and input suppliers (Harris and Raviv, 1991). The oligopolists will tend to have
more debt than firms in competitive industries or monopolists (Brander and Lewis,
1986). And the firms that produce products that are unique or require service
and/or parts and firms for which a reputation for producing high quality products
is important may be expected to have less debt (Titman, 1984).

The growing importance of merger and acquisition activities during 1980's in US

and large European counties, the finance literature has been to examine the linkage
between the market for corporate control and the capital structure (Harris and
Raviv, 1991). Stulz (1988) argues that the capital structure affects the outcome of
takeover contests through its effect on the voting rights of equity and claimants of
debts. Harris and Raviv (1991) argue that the capital structure affects the value of
the firm, the probability of takeover, and the price effect of takeover. They further
write that the optimal ownership share is determined by the incumbent manager
who trades off capital gains on his stake against the loss of any personal benefits
derived from being in control. Since the manager's ownership is determined
indirectly by the firms capital structure, this trade-off results in a theory of capital
structure.

3. Determinants of Capital Structure

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Capital structure of a firm is determined by various internal and external factors.

The macro variables of the economy of a country like tax policy of government,
inflation rate, capital market condition, are the major external factors that affect
the capital structure of a firm. The characteristics of an individual firm, which are
termed here as micro factors (internal), also affect the capital structure of
enterprises. This section presents how the micro-factors affect the capital structure
of a firm with reference to the relevant capital structure theories stated earlier.
Different capital structure models yield a numbers of insights. Here, the attributes
that different theories of capital structure suggest may affect the firm's debt-equity
choice have been described. The firm-specific variables or attributes, viz.; tax
shields, asset structure, profitability, size, growth, volatility, liquidity and product
uniqueness are considered as the key determinants of capital structure decisions.
The attributes and their relation to determine capital structure choice are discussed
below (Titman and Wessels, 1988).

Taxation: Taxation has been scrupulously investigated as a factor that determines

the capital structure of the firms. The key feature of the taxation is that interest is a
tax-deductible expense. A firm that pays taxes receives a partially offsetting
interest tax-shield in the form of lower taxes paid. Therefore, as Modigliani and
Miller (1963) propose, firms should use as much debt capital as possible in order
to maximize their value. Along with corporate taxation, researchers were also
interested in analyzing the case of personal taxes imposed on individuals. Miller
(1977), based on the tax legislation of the U.S., discerns three tax rates that
determine the total value of the firm. These are the corporate tax rate, the tax rate
imposed on the income of the dividends and the tax rate imposed on the income of
interest inflows. According to Miller, the value of the firm depends on the relative
height of each tax rate, compared with the other two.

Asset Structures: Titman and Wessels (1988), Rajan and Zingales (1995) and
Fama and French (2000) argue that the ratio of fixed to total tangible assets should
 16

be an important factor for leverage. The tangibility of assets represents the effect
of the collateral value of assets of the firms gearing level. Scott (1976) argues that
a firm determining the optimal capital structure will issue as much as secured debt
as possible, because the agency costs of secured debt are lower than unsecured
debt. By the same token, the degree to which the firm's assets are tangible and
generic should result in the firm having a greater liquidation value (Titman and
Wessels, 1988). This will reduce the magnitude of financial loss incurred by
financiers should the company default. Hence, the trade-off theory predicts a
positive relationship between leverage and the proportion of tangible assets.

Profitability: One of the main theoretical controversies concerns the relationship

between leverage and profitability of the firm. From the trade-off theory
perspective, when the firms are profitable, they prefer debt because the expected
bankruptcy cost declines with increasing profitability as well as the interest tax-
shield will drive for higher profitability. Jensen and Meckling (1976), Easterbrook
(1984), and Jensen (1986) suggest that higher leverage helps to control agency
problems by forcing managers to pay out more of the firms excess cash.

Size: The size of the firm is also an important factor to determine the leverage or
the capital structure of the firm. Warner (1977) and Ang et at. (1982) suggest that
bankruptcy costs are relatively higher for smaller firms. In a similar vein, Titman
and Wessels (1988) argue that larger firms tend to be more diversified and fail less
often. Accordingly, the trade-off theory predicts an inverse relationship between
size and the probability of bankruptcy, that is, a positive relationship between size
and leverage. Jensen (1986) and Easternbrook (1986) agree that the size has a
positive impact on the supply of debt.

On the other hand, size can be regarded as a notion for information asymmetry
between firm insiders and the capital markets. Large firms are more closely
observed by analysts and should therefore be more capable of issuing
informationally more sensitive equity, and have lower debt. Accordingly, the
 17

pecking order theory of the capital structure predicts a negative relationship

between leverage and size, with larger firms exhibiting increasing preference for
equity relative to debt.

Growth: Firms with a high proportion of non-collateralizable assets (such as

growth opportunities) could find it more expensive to obtain credit because of the
asset substitution effect (Titman and Wessels, 1988). Similarly, firms in growing
industries may have greater flexibility in their choice of investments, allowing
equity holders to capture wealth from bondholders. Either way, firms with
important growth opportunities are likely to face high agency costs of debt and
hence are likely to rely more on equity funds. For companies with growth
opportunities, the use of debt is limited as in the case of bankruptcy, the value of
growth opportunities will be close to zero (Gaud et al., 2005, p. 53). Hence, the
trade-off model predicts that firms with more investment opportunities have less
leverage.

Volatility: One firm variable which impacts upon this exposure is firm operating
risk, in that more volatile firm earnings streams, the greater the chance of the firm
defaulting and being exposed to such cost. Consequently, these firms with
relatively higher operating risk will have incentives to have lower leverage than
other more stable earning. Myers (1977) suggests that underinvestment problem
increases with the volatility of the firms cash flow because firm with high
volatility of cash flow tries to accumulate cash. Firms with stable cash flows
should suffer from overinvestment problems and these firms have more leverage
(Easterbrook, 1984; Jensen, 1986). Hence, trade-off theory predicts negative
relationship between leverage and volatility of cash flows.

Liquidity: Liquidity may have mixed impact on the capital structure decision.
First firms with higher liquidity ratios might support a relatively higher debt ratio
due to greater ability to meet short-term obligations when they fall due. This
would imply a positive relationship between a firm's liquidity position and its debt
 18

ratio. On the other hand, firm with greater liquid assets may use these assets to
finance their investments. Prowse (1990) argues that the liquidity of the company's
assets can be used to show the extent to which these assets can be manipulated by
shareholders at the expenses of bondholders. Ozkan (2001) finds that liquidity is
inversely related to leverage.

Product Uniqueness and Industry Classification: Titman (1984) shows that a

firms capital structure should depend on the uniqueness of its product. If a firm
offers unique products or services, its consumers may find it difficult to find
alternatives in case of liquidation, and hence, the costs of bankruptcy increase.
Accordingly, uniqueness is expected to the negatively related to debt ratios. The
indicators of uniqueness include expenditure on research and development (R&D)
and advertisement expenditure. The firms that produce products that are unique or
require service and/or parts and firms for which a reputation for producing high
quality products is important may be expected to have less debt (Titman, 1984).
The most basic facts concerning industry characteristics and capital structure are
that firms within an industry are more similar than those in different industries.
And it is obvious that the firms within an industry are similar in most of other
respect like assets structure, production/service technology, legal framework etc.

Besides the firm specific attributes described above, other firm specific attributes
as well as macroeconomic factors, such as, economic growth rate, inflation rate,
capital market development, government policies etc., also play important roles to
determine the capital structure decision of the firms. The common practices of
firm, the competencies of financial managers, age of incorporation, the availability
of financing alternatives, and other institutional context are some other
determinants of capital structure. Research works in this regard are contributing to
enrich the capital structure theories.

Based on trade-off theory of capital structure the following hypotheses were

developed for this study:
 19

Non-debt tax shield will be negatively related to the leverage. Large the
non-debt tax shields, the lesser will be the leverage (DeAngelo and Masulis,
1980).
The tangible assets will be positively related to the leverage. The higher the
proportion of fixed tangible assets, the higher will be the leverage
(DeAngelo and Masulis, 1980).
Profitability will be positively related to the leverage. There is positive
relationship between profitability and leverage (Harris and Raviv, 1991;
Rajan and Zingales, 1995; Booth et al., 2001).
The firm size will be positively related to the leverage. The size has a
positive impact on the supply of the debt (Jensen, 1986; Easternbrook,
1986; Rajan and Zingales, 1995).
The growth opportunities will be negatively related to the leverage. The
firm with high growth opportunities is limited to use of debt as the case of
bankruptcy (Titman and Wessels, 1998; Gaud et al., 2005).
The liquidity will be positively related to leverage. The higher short-term
debt tends to increase leverage ratio (Ozkan, 2001).
The cash flow volatility will be negatively related to the leverage. Firms
with relatively higher operating risk will have incentives to have lower
leverage (Myers, 1977; DeAngelo and Masulis, 1980).
Nepalese firms are less levered and the long-debt ratio is low. Developing
countries are comparatively less levered than developed countries and have
substantially lower amount of long-term debt (Demirgue-Kunt and
Maksimovic, 1999; Booth et al., 2001).

Having discussed the theoretical framework, the study now focuses on review of
empirical works.
 20

SECTION 2

Review of Empirical Studies

Capital structure is one of the most continuously explored subjects in finance.
Numerous empirical works have been done after the MM works in 1958. The early
studies were concentrated on MM Hypothesis. Since 1970s, the capital structure
determinants have been receiving due attention of researchers. Various authors
have examined determinants of capital structure from different perspectives.

Review of Empirical Studies

I. The Modigliani and Miller Study (Modigliani and Miller, 1958):

Modigliani and Miller (1958) used the cross-sectional data taken from 43 electric
utilities during 1947-1948 and 42 oil companies during 1953. They estimated the
weighted average cost of capital (WACC) as net operating cash flows after taxes
divided by the market value of the firm. The financial leverage, measured as the
ratio of the market value of debt to the market value of the firm, was considered as
explanatory variable. Modigliani and Miller (1966) in their latter study also found
results that were consistent with a gain from leverage.

II. The Taggart Study (Taggart, 1977):

Robert Taggart (Jr.), in his study presented an integrated model of corporate

financing pattern. In his study of non-financial firms during 1957-1972, he used
stock-adjustment model and observed that the level of sales had positive effect on
liquid assets (p. 1475); timing considerations appeared to exert a significant
influence on corporate financing decision. He stated that when the debt-equity
ratio is below target, firms issue more bonds and less stock and when permanent
capital is below the target, firms issue more of both bonds and stock (p. 1475).
Further, Taggart concluded that bonds are substituted for equity issue when the
stock market is depressed (p. 1476) and market value of debt-equity ratio is
 21

determinants of long-term debt capacity (pp. 1483-84). Firms base their stock and
bond issue decision on the need of permanent capital and their long-term debt
capacity (p. 1483). Taggart's study was more concern with financing decision of
how and when firm issue corporate securities. Therefore, his study has not shed
light on capital structure determinants. Further, Taggart concluded that bonds are
substituted for equity issue when the stock market is depressed (p. 1476) and
market value of debt-equity ratio is determinants of long-term debt capacity (pp.
1483-84). Firms base their stock and bond issue decision on the need of permanent
capital and their long-term debt capacity (p. 1483).

Taggart's study was more concern with financing decision of how and when firm
issue corporate securities. Therefore, his study has not shed light on capital
structure determinants.

VI. The Titman and Wessels Study (Titman and Wessels, 1988):

In their study, the Titman and Wessels (1988) introduced a factor-analytic

technique for estimating the impact of unobservable attributes on the choice of
corporate debt ratios. More comprehensively, the authors delineated the
appropriate proxies to firm specific attributes of capital structure determinants. In
their study they incorporated eight independent variables, viz.; collateral value of
asset, non-debt tax shield, growth, product uniqueness, industry classification,
size, volatility, and profitability as determinants of capital structure. With the
dataset of 469 firms from 1974 to 1982, and using the maximum-likelihood
method of estimation, they found that the product uniqueness and profitability
were statistically significant and negatively related to leverage ratio. Their
empirical estimate for product uniqueness supported that the firm that can
potentially impose high cost on their customers, workers and suppliers in the event
of liquidation has lower debt ratios (Titman, 1982).
 22

However the empirical findings were not conclusive because of statically not
significant estimates, their paper has given the empirical regularities.

VIII. The Rajan and Zingales Study (Rajan and Zingales, 1995):

Rajan and Zingales, in their study, investigated the determinants of capital

structure choice by analyzing the financing decisions of the public firm in the
major industrialized countries, the G-7. Their cross sectional study was based on
total 4557 non-financial firms from 1987 to 1991. They studied extent of leverage
in different countries with different measures of leverage. As in earlier studies,
they focused on four factors as determinants of capital structure, viz.; tangibility of
assets, investment opportunities (growth), firm size and profitability. The basic
econometric model they used to estimate cross-sectional determinants of capital
structure was as follow:

(2.4)

However the authors used four proxies for leverage. On an average, they observed
Germany and United Kingdom as lowest levered. The ratio of long-term debt plus
short-term debt to total assets for Germany was 16%; for UK was 18%; and for
other countries the statistics was around 30%. However the total leverage ratio
(nonequity liabilities to total assets) figures were significantly high for those
countries, among others.

In their study, the authors found that the tangibility of assets and the size were
positively related to leverage and growth opportunities and profitability were
negatively related to leverage. Italy was the case of exception where any of these
statistics were not statistically significant. They also observed that firm in which
the state has a majority ownership appeared to have higher leverage (p. 1735).

From their cross-section study the concluded that factors influencing capital
structure in US are important in other G-7 countries, however, the institutional
 23

context influences the capital structure decisions. Leverage ratios they observed
across the countries were not consistent with early studies because of different
measures of leverage, adjustment in accounting differences and varying in
database.

IX. The Booth, Aivazian, Demirgue-Kunt and Maksimovic Study (Booth et

al., 2001):

Perhaps the study of Booth et al. (2001) is first of its type, which focuses on
capital structure in developing countries. By using new data set they assessed
capital structure theory across the developing countries with different institutional
structure. They analyzed capital structure choice of firms in 10 developing
countries (India, Pakistan, Thailand, Malaysia, Turkey, Zimbabwe, Mexico, Brazil,
Jordan and Korea) by using both firm specific attributes and macroeconomic
indicators. In their empirical model, leverage ratio as dependent variable was
measured with three proxies; total debt ratio (total liabilities to total liabilities plus
net worth), long-term book-debt ratio (total liabilities minus current liabilities
divided by total liabilities minus current liabilities plus net worth), and long-term
market-debt ratio (total liabilities minus current liabilities divided by total
liabilities minus current liabilities plus market value of equity). The tax (average
tax rate), business risk (standard deviation of EBIT), tangibility of asset (total
assets minus current assets to total asset ratio), size (natural logarithm of sales
multiplied by 100), ROA (EBT/total assets), market-to-book ratio (market value to
book value of equity) were used as firm specific explanatory variables whereas
stock market value/GDP, liquid liabilities/GDP, real GDP growth rate, inflation
rate, and miller tax term 3 were used as macroeconomic explanatory variables. The
major empirical model they employed was

3
Miller tax advantage is 1 [{(1 Tc )(1 Te )} /(1 Ti )] , where Tc is corporate tax rate, Te
is personal income tax on equity and Ti is personal income tax on interest.
 24

(2.5)

where Xi,j,t is the jth explanatory variable for the ith firm at time t, i,t is the random
error term for firm i at time t, Di,t/Vi,t debt ratios for the ith firm at time t and is
the intercept.

By running separate models to test the significances of firm specific and

macroeconomic variables, the authors arrived in following findings and
conclusions:

Profitability was found the most successful independent variable and negatively
related to leverage. In overall, the size and tangibility were observed to be
positively related with leverage ratio. The results of risk variable were mixed.

They also found that there was Miller tax advantage over equity in most of these
developing countries (p. 96). The statistic was significant.

The macroeconomic influences over capital structure were observed as, with some
statistical limitations, all three measure of leverage ratio vary negatively with the
equity market capitalization; except for the long-term market-debt ratio, the debt
ratios vary positively with the proportion of liquid liabilities to GDP (p. 98); the
real economic growth tends to increase total debt ratio and long-term book-debt
ratio; and higher inflation leads to decrease such ratios.

The debt ratios in developing countries were found comparatively lower than
advance economy countries (G-7) and the long-term debt ratio was observed
significantly lower in developing countries.

From their cross-country study, the authors concluded that the debt ratios in
developing countries seem to be affected in the same way and by the same types of
variables that are significant in developed countries however in developing
countries, they have low long-term debt. Also, there are systematic difference in
 25

the way these ratios are affected by country factors, such GDP growth rages,
inflation rates and the development of capital markets (p.118). They also noted
that the origin of the country is as important as size to determine the leverage.
However, their study has shed light on capital structure in developing countries. In
their study, there were some methodological limitations of data sources (p. 119)
and less significant of empirical estimates (p.118).

XI. Other Studies:

Some recent studies have focused country specific determinants of capital

structure. Bhaduri (2002) studied the capital structure determinants of Indian
corporate sector and found that growth, cashflow, size and product and industry
characteristic were important determinants of capital structure, however the result
of estimates were mixed for different models. Casser and Holmes (2003) studied
the capital structure and financing for small and medium size enterprises of
Australia and found that profitability, assets structure were negatively positively
related to leverage and growth and was observed positively related and there was
no consistency on risk estimates. He, further, concluded that factors effecting large
firms are equally applicable to small and medium size firms. Vasiliou et al. (2003),
on their study of Greek firms found that assets structure and size were positively
related to leverage and profitability was negatively related to leverage.

Gaud et al. (2005), following the same methodology of Ozkan (2001), studied 104
non-financial firm listed in Swiss stock exchange. They found size and assets
structure positively related to leverage and profitability and growth were found
negatively related to leverage. Financial distress cost was observed positive but
statistically not significant. The speed of adjustment to target capital structure was
observed very slow. The adjustment coefficient was observed less than 0.20.

2. Review of Empirical Studies in Nepal

There is scarcity of studies in Nepalese context. Most of the early studies were
clustered around capital structure pattern of public enterprises. Shrestha (1985) in
 26

his study, by applying ratio analysis, observed that there were low capital gearing
and even unbalance pattern of capital structure in PEs. Shrestha (1993) in her
study of listed companies found that most of the companies were more levered
however the profitability was negative and interest payment on debt was serious
issue. She, further, concluded that most of the PEs have no transparent capital
structure and companies adhockly determined their capital structure without
realistic parameters.

Pradhan and Ang (1994), in their study, surveyed 78 major enterprises, including
24 public enterprises of Nepal, focusing on finance functions, sources and types of
financing, effects of taxes on capital structure decision, financial distress and
dividend policy. In their extensive survey of top level executives, the authors
observed that working capital function was most important followed by capital
structure decision function, whereas, the agency relation function was least
important. They further observed that bank loan and retained earning were the two
most widely used sources of financing. The retained earning was most preferred
source of financing because of its lower cost. This evidence is inline with pecking
order hypothesis (Myers and Majluf, 1984). The average debt ratio was observed
38%. The authors also observed that there was no definite time to borrow and
issue stock; however the enterprises preferred for bank loan at lower level of debt
because of flexible in interest rate and loan covenant. The authors further observed
that enterprise would increase the debt level in response to increase in tax rate. The
respondents in their study signaled for target debt ratio. Bank loan was found as
major sources of financing in case of shortage of cash. The default probability of
the enterprises was found 14%.

Pradhan (1994), in his study of financial distress in Nepalese organizations

observed that government policy, problem of raw materials, power, skilled labor
and poor management were the major causes of financial distress. In his study, the
signals of financial distress as perceived by the respondents were decline in
capacity utilization, and decline in quality of products and services. The author
 27

further observed that persistent shortage of cash and default in payments to

suppliers, employees, banks etc. were important symptoms of financial distress.
The author suggested taking various steps such as to provide soft loan to industries
under financial distress, to merge units under financial distress into healthy ones,
to change management, and to make various institutional arrangements for
industries under financial distress. In the same regard, the study by Pradhan et al.
(2002) was analysis of financial distress cost in Nepalese public sector. The
authors collected data from 1997 to 1999 and used portfolio analysis and
econometric analysis. The authors observed that more than 50% public enterprises
were in loss; labor productivity and debt coverage ratios were deteriorated by
increased financial distress; the profitability and liquidity were lower in financially
distressed enterprises; and the return on equity, liquidity, labor productivity and
debt capacity were also lower in financially distressed enterprises. The authors
further found that there was lack of legal frameworks to corporate restructuring.
However, these studies were focused on financial distress (bankruptcy) aspect of
capital structure, other aspects of capital structure remained unexplored.

K.C. (1994) in his study of 37 large and medium size joint stock companies found
significant positive relationship of long-term debt with growth, assets structure
and age of incorporation (cit. from Baral, 1999, p. 112). Poudel (1994), in his
study of 15 listed companies and 20 PEs for 1983-1992, concluded that size,
profitability, growth, assets structure and cashflow variability have the influence
on the capital structure (cit. from Baral, 1999, pp. 112-113). He observed that size
and growth were positively related to leverage and risk, profitability and assets
structure were negatively related to leverage for both listed companies and PEs.
Baral (1996) in his study of capital structure and cost of capital of PEs, by using
Pearson's correlation analysis, found positive relationship of leverage with growth
opportunities, profitability, non-debt tax shield (statistically not significant),
interest coverage ratio, and operating cash flows; and negative relationship of
leverage with business risk. He further concluded that the capital structures of
 28

public enterprises are not sound; debt capital has not been raised to reap
advantages of leverage.

Besides this, some authors have examined the relationship of capital structure and
cost of capital, by using econometric models, of particular firm or comparative
study across the firms or the industries. Among others, in comparative study
between trading and manufacturing sector and banking and financial sector,
Ghimire (1999) observed negative relationship of average cost of capital with
leverage, size, growth, payout ratio and positive relationship with earning
variability and liquidity in trading and manufacturing sector. However, he further
observed positive relationship of average cost with leverage, growth, earning
variability and liquidity and negative relation with size and payout ratio in banking
and financial section. Surprisingly, none of his estimates was statistically
significant.

3. Concluding Remarks
The debt has tax shield value, which helps to maximize the value of the firm,
ceteris paribus, is no more subject of debate in finance literature. However, how
companies finance their financing requirements and what factors stimulate to
prefer particular class of securities is one of the controversial issues. Different
models of capital structure theories explain this cross-sectional variation from
different perspective. The notion of 'optimal capital structure' as suggested by
tradeoff theory advocates that the increasing debt in one hand increases the tax
shield benefit but on the other hand increasing debt increases bankruptcy costs and
agency costs. Therefore, optimal capital structure exists in moderate level of
leverage. From the behavioral aspect, pecking order theory advocates that
managers prefer internal financing than debt and external equity. The empirical
works in foreign countries reviewed above have supported either or both of these
aspects. In case of Nepal, among other studies, Pradhan (1994), Pradhan and Ang
(1994) and Pradhan et al. (2002) studies were focused on financial distress
 29

(bankruptcy) aspect of capital structure and other aspect of capital structure

remained to explore. There is also lack of study, which encompasses the relevance
of capital structure theories in Nepalese context and factors influence on capital
structure decision. This study, therefore, tests the capital structure hypotheses
concerning capital structure determinants in Nepalese context. Furthermore, this
study explores on capital structure pattern in Nepalese firms and shows some
prospect for future financing decisions.
 30

CHAPTER THREE

RESEARCH METHODOLOGY

Research methodology is important to carry out a research, which describes the

entire methodological approaches employed in the study. Mostly, in the case of the
empirical studies, the consistencies of the findings are solely based on empirical
methodologies it has employed. Therefore, this chapter focuses on research design,
nature and sources of data, selection of samples, method of analysis and the
methodological limitations of this study and described in consecutive sections.

1. Research Design

This empirical study attempts to analyze the capital structure patterns and
determinants of Nepalese firms. It tries to analyze and describe the magnitude and
direction of relationship between leverage (dependent variable) and firm specific
attributes viz.; non-debt tax shield, assets structure, profitability, firm size, growth
opportunities and earning volatility (independent variables). Hence, this empirical
study has followed both analytical and descriptive research design. Furthermore, it
also follows the field research method to study capital structure from managerial
perspective.

2. Nature and Sources of Data

This study is based on accounting data of firms listed in Nepal Stock Exchange
Limited (NEPSE) for the period of 1992-2004. The required data have been
extracted from annual reports and financial statements of the firms available in
Securities Board (SEBO) database and NEPSE database. Hence, this study mainly
relies on secondary data. However some data have also been collected from
primary sources. The opinions of financial managers, company secretaries, middle
level business executives and directors have been surveyed by using direct
personal interview schedule. The interview was conducted during June-July 2005
 31

in Kathmandu. The proforma of interview schedule has been presented in

Appendix B.

3. Selection of Firms

Among the firms listed in NEPSE for the period of 1992-2004, banks, finance
companies and insurance companies are excluded from the sample. This is
motivated by the fact that such firms do not provide a good platform for the study
of capital structure. Also those firms have to comply with very stringent legal
requirements pertaining to their financing (Ozkan, 2001; Gaud et al., 2005).
Table 3.1
Sample Selections
S.N. Name of listedSample period No. of observation
companies
1 Arun Vanaspati Udhyog 96-98, 00-04 8
Ltd.
2 Bishal Bazar Co. Ltd. 92-04 13
3 Bottlers Nepal (Terai)93-94, 96-04 11
Ltd.
4 Bottlers Nepal Ltd. 97-04 8
5 Fluer Himalayan Ltd. 00-03 4
6 Juddha Match Factory99-01 3
Ltd.
7 Jyoti Spinning Mills92, 94-04 12
Ltd.
8 Necon Air Ltd. 93-01 9
9 Nepal Battery Co. Ltd. 92-98 7
10 Nepal Khadya Udhyog 98-00 3
Ltd.
11 Nepal Lever Ltd. 95-04 10
12 Nepal Lube Oil Ltd. 93-03 11
13 Nepal Trading Ltd. 96-98, 01 4
14 Nepal United Co Ltd. 92-97 6
15 Nepal Vanaspati Ghee95-04 10
Udhyog Ltd.
16 Salt Trading92-96, 99-01 9
Corporation Ltd.
17 Shree Bhrikuti Pulp&99-03 5
Paper Ltd.
18 Shree Ram Sugar Mills99-02 4
Ltd
19 Soaltee Hotel Ltd. 92-04 13
20 Yak and Yeti Hotel Ltd. 94-04 11
Total number of 161
observations from
 32

1992-2004

Therefore, the sample contains manufacturing, commercial and service firms.

Firms are then chosen which have data for at least three continuous years during
the sample period. As a result, this study is based on 20 firms and 161
observations. Table 3.1 summarizes the sample firms, sample duration and the
number of observations.

4. Variables and Measures

Variables (dependent and independent) used in this study are described in

following paragraphs. Table 3.2 summarizes the variables used in this study and
their appropriate proxies.

Leverage: Following the Rajan and Zingales (1995), the ratio of book value of
total debt to total assets is defined as leverage ratio and it is 'more appropriate
definition of financial leverage' (p. 1429). Other two proxies are also considered in
this study to analyze the debt composition (i.e. decompositional study) on total
capital structure viz.; the second proxy refers to the ratio of long-term debt to total
assets; and the third proxy refers to the ratio of short-term debt to total assets.
Therefore, leverage ratio (DR):

Total debt ratio (TD) = Total debt (short-term + long-term) / Total assets
Long-term debt ratio (LTD) = Total long-term / Total assets
Short-term debt ratio (STD) = Total current liabilities / Total assets
Table 3.2
Variables and Their Proxies.
Variables Proxy Measures
Leverage Ratio Total debt ratio = Total debt/Total assets
Long-term debt ratio = Long-term debt/Total assets
Short-term debt ratio = Short-term debt/Total assets
Non-debt tax shield Annual Depreciation/Total Assets
Asset structures (Fixed Assets+Inventories)/Total Assets
Profitability EBITDA/Total Assets
Size ln(Sales)
Growth Percentage change in sales i.e. (St - St-1) / St-1
Volatility Standard deviation of EBITDA.
 33

Non-Debt Tax Shield: As suggested by Titman and Wessels (1988), and

Following the Ozkan (2001), the ratio of annual depreciation to total assets is
taken as proxy for non-debt tax shield. Therefore,

Non-debt tax shield (NDT) = Annual Depreciation / Total Assets.

Asset Structure: As suggested by Titman and Wessels (1988) and following the
Gaud et al., (2005), the ratio of fixed assets plus inventory to total assets is
considered as proxy to collateral assets. Therefore,

Collateral assets structure (AS) = (Fixed Assets + Inventories) / Total assets

Profitability: The ratio of earning before interest, tax and depreciation, EBITDA
to total assets is considered as proxy to profitability (Titman and Wessels, 1988;
Ozkan, 2001; and Gaud et al., 2005). Therefore,

Profitability (PRO) = EBITDA / Total Assets

Size: Titman and Wessels (1988) suggest natural logarithm of sales as indicator of
size. In this study, as suggested by Titman and Wessels (1988) the net sales has
been taken. The net sales based on Rs. million have been transferred into natural
log. Therefore,

Size (SIZE) = ln(Sales)

Growth: Many researchers have used ratio of book-to-market equity as proxy for
the growth (Ozkan, 2001; and Gaud et al., 2005) but in this study due to the
market value of equity is not available to most of the sample firms therefore as
suggested by Titman and Wessels (1988), the growth rate of sales is considered as
the proxy for growth. And it is simple arithmetic growth rate. Therefore,

Growth (GW) = (St - St-1) / St-1

where,
St = Current year sales
St-1 = Previous year sales
 34

Liquidity: As suggested by Ozkan (2001), the ratio of current assets to current

liabilities has been chosen as proxy for liquidity. Therefore,

Liquidity (CR) = Current Assets/Current Liabilities

Volatility: As suggested by Titman and Wessels (1988), the proxy to the volatility
is the standard deviation of the percentage change in operating income and 'it is
the single value for the all years' (Booth et al., 2001, p. 101). Therefore,

Volatility (RISK) = Standard Deviation of EBITDA

Besides above variables, some other variables have also been used and they are
described under respective method of analysis in section 5 below.

5. Method of Analysis

The method of analysis employed in this study includes, (i) ratio analysis, (ii)
decompositional analysis, (iii) properties of portfolio analysis, and (iv)
econometric analysis, all of which are described in the following paragraphs.

I. Ratio Analysis

In this study, the different ratios related to assess capital structure have been used
and analyzed. It has served as auxiliary on other different methods of analysis. In
this study, among others, following ratios has been used:

Return on Assets = Net profit after tax/Total Assets

Time-Interest Earned Ratio = EBIT/Interest
Current Ratio = Current assets/Current liabilities
Assets turnover ratio = Total sales/Total Assets

II. Decompositional Analysis

Under the decompositional analysis, the analysis has been done by decomposing
total debt ratio into long-term debt ratio and short-term debt ratio. The relations
and effects among theses debt ratios have been analyzed. For the decompositional
 35

study the sample period is restricted to 10-years from 1995-2004, which

encompasses total 137 observations.

III. Properties of Portfolio Analysis

In this study, for properties of portfolio analysis, three portfolios have been
constructed based on total debt ratio (leverage). Portfolio I, which is regarded as
less levered portfolio consists of 26 observations having total debt ratio 0-40%.
The portfolio II, which is regarded as moderately levered portfolio consists of 44
observations having total debt ratio 40-60%. Finally, the portfolio III, which is also
regarded as highly levered portfolio consists of total 91 observations having total
debt ratio more than 60%. The properties of portfolios have been analyzed with
different financial ratios.

IV. Econometric Analysis:

In this study, econometric models have been used to describe the capital structure
determinants. Different econometric models used in this study are based on
theoretical foundation suggested by capital structure theories as follows:

The debt-equity choice of the firm is depend on the non-debt tax shield, proportion
of collateral assets, profitability of the firm, and size of the firm, firm's growth
opportunities, liquidity, and earning variability.

As a first approximation to the theory, the function may be written as

Leverage = f(non-debt tax shield, assets structure, profitability,

size, growth, liquidity, risk)
(3.1)

The equation (3.1) can be expressed as

D kXk
k

(3.2)
where, D is leverage ratio, is explained in terms of K explanatory variables X1,
X2, , Xk, as used in equation (3.1), and 's are the unknown parameters.
 36

Cross-Section Pooled Data Econometric Model: Based on equation (3.1) and

(3.2), the following the empirical model has been used to analyze capital structure
determinants.
DRi , t 1 ASi , t 2CRi , t 3GWi , t

4 NDTi , t 5 PROi , t 6 RISKi , t 7 SIZEi , t i , t (3.3)

where i denotes firm and t denotes the time, is y-intercept and i is error term.
The dependent variable(s) and independent variables are as defined in section 4.

First-Difference Econometric Model: In the presence of autocorrelation, OLS as

well as GLS (Cross-Section Weighted White Heteroskedasticity-Consistent
Standard Error and Covariance)4 estimators may lack the efficiency. In such case,
Madala (1992)5 and Gujarati (2004)6 suggest to use the First-Difference Method.

The First-Difference Model is:

Yt - Yt-1 = (Xt Xt-1) + (t t-1)
or
Yt = Xt + t
(3.4)
where is the first difference operator. In equation (3.4), the error term, t is free
from serial correlation to run the regression (Gujarati, 2003, p. 478).

The first-difference model for this study can be derived from equation (3.3) and
(3.4).
DRi , t 1ASi , t 2 CRi , t 3GWi , t

4 NDTi , t 5 PROi , t 6 SIZEi , t i , t

(3.5)
4
White's Heteroscedasticity-Consistent Variance and Standard Error can be performed so that
asymptotically valid statistical inferences can be made about the true parameter value even if
there is Heteroscedasticity (White, 1980).
5
Use the first-different form whenever the d < R2 (Madala, 1992, p. 232, cited in Gujarati, 2003,
p. 478).
6
The first transformation may be appropriate if the coefficient of autocorrelation is very high,
say in excess of 0.8, or the Durbin-Watson d is quite low (Gujarati, 2003, p. 478).
 37

In the first-difference model, there is no intercept that means that the regression
line passes through the origin (Gujarati, 2003). RISK is omitted from the
explanatory variables because of same value for all the time series. Only the total
debt ratio has been used as dependent variable in first-difference model study.

In macroeconomic influence study, the total leverage is regressed by GDP growth

rate, inflation rate and ratio of capital market capitalization to GDP. The time
series model is:
DRt 1GDPt 2 INFLt 3 MCGDPt t

(3.6)
where, DR is total leverage ratio over the 10 year period, a is y-intercept, 's are
unknown parameters, is error term and it is assumed stochastic. GDP is gross
domestic product at factor cost; INFL is inflation rate measured as annual
percentage change in consumer price index; and MCGDP is ratio of market
capitalization to gross domestic product. In this model, it is assumed that the
underlying time series is stationary (Johnston and DiNardo, 1997).

5. Limitations of the Study

This study holds some methodological and conceptual limitations, which are as
follows:

The data are collected from listed companies, which have data available for
at least 3 consecutive years during the sample period from 1992 to 2004.
This time frame is considered as sufficient time frame to study the
determinants of capital structure.

This study mainly relies on the secondary data, which are collected from
annual financial statements. Hence the study suffers from all those
limitations that are associated with annual financial statements.
 38

The accounting year is read in form of AD calendar, for example,

accounting year 2060/061 BS as 2004 AD.

The assumptions and limitations of the econometrics are inherent in

econometric modeling. In first-difference model, risk has been excluded
from the study because of the same value for all the time series.

For quantitative analysis, SPSS 11.0 and EVIEWS 3.0 software programs
have been used. Hence the limitations of these programs are also inherent.

There is abundant literature in capital structure theories including hundreds

of empirical studies; this study was not able to review all those literature.

This study is focused on determinants of capital structure and capital

structure patterns. This study does not shed light on cost of capital, which is
another most important parameter of capital structure theory.

6. Definition of Key Terms

The Annual Report of the firms is in specific standard accounting format and
some accounting conceptual differences are there in annual reports across the
firms. However, the database of NEPSE has its own specific format. Therefore, it
is better to define accounting key terms used in this study to avoid
misunderstanding.

Sales: Sales means trading sales only and it does not incorporate miscellaneous
income or income from other sources. In case of service firms, sales means income
from specific service they are stand mainly to provide that particular service.

Operating Income and Earning before Income and Taxes: Operating income
means before tax income except income from other sources where as EBIT simply
refers to net earning before interest and taxes.

EBITDA: This variable is EBIT plus Depreciation, which simply measures the
operating cashflow.
 39

Fixed Assets: The fixed assets of the firms consist of ordinary fixed assets like
land and building, plant and machinery, fixture and furniture etc. It is the net fixed
asset that is fixed assets after depreciation adjustment. The fixed assets used in this
study excludes the investment and under construction capital expenditure.

Total Assets: Total Assets is the sum of Total fixed assets including investment
and capital expenditure and current assets. The current assets incorporate general
accounting variables inventories, receivables, cash and marketable securities and
miscellaneous current assets.

Long-term Debt: Long-term debt means secured and unsecured mid-term and
long-term loan i.e. loan having more than one is term period. It includes bank loan
and debentures. Long-term debt is also denoted as deferred liabilities.

Short-term Debt: In this study, the total current liability is used as short-term
debt, which includes loan and advances, creditors, misc. short-term liabilities and
provision for taxation.

Total Debt: In this study total debt is sum of long-term debt and short-term debt
as described above.

Depreciation: Depreciation means the annual depreciation on fixed assets.

 40

CHAPTER FOUR
PRESENTATION AND ANALYSIS OF DATA

Capital structure decision involves the choice of optimal mix of debt and equity,
which optimize the value of the firm under the given contextual or institutional
framework. The firms may follow different approaches while managing capital
structure. The capital structure theories provide basic guidelines in this respect
however, a particular theory will not sufficient to deal with these issues. On one
hand, macroeconomic scenario plays significant role, while on the other hand, the
internal firm specific factors are in the first instance. This chapter is fully devoted
to analyzing various issues of the study in the context of Nepalese enterprises. One
of the issues raised in this chapter relates to assessing the patterns and policies of
capital structure in Nepalese enterprises. Another issue dealt with in this chapter
relates to capital structure determinants.

The empirical analysis in this chapter has been organized in four sections. In
section 1, pattern of capital structure in Nepalese enterprises has been analyzed by
using decompositional analysis and properties of portfolio formed based on
leverage ratio. Furthermore, the average debt ratios of Nepalese enterprises have
been compared with some developed and developing countries. In section 2, firm
specific capital structure determinants have been identified and analyzed by using
econometric models. The microeconomic influences on firms capital structure
have been studied under section 3. Finally, in section 4, various aspects of the
capital structure management has been analyzed from managerial perspective.

SECTION 1
Analysis of Capital Structure Pattern

The problem of how firms choose and adjust their strategic mix of debt-equity has
called a great deal of attention and debate among corporate financial economists
and practitioners. Actually, the analysis of how firms choose their financing mix
 41

has been primarily a practical issue. The tradeoff theory says that firms seek debt
levels that balance the tax advantages of additional debt against the costs of
possible financial distress. The tradeoff theory predicts moderate borrowing by
tax-paying firms (Myers, 2001, p. 81). The pecking order theory says that firms
will borrow, rather than issuing equity, when internal cash flow is not sufficient to
fund investment projects. In addition, Booth et al. (2001) state that factors
influencing capital structure in advanced countries are equally applicable in
developing countries, however the developing countries have substantially lower
long-term debt and institutional constraints are important. In this section, the
patterns of capital structure on Nepalese firms have been analyzed by using
decompositional and portfolio analysis.

Table 4.1 provides a summary of the descriptive statistics of the different variables
used in this study. The mean (median) of the total debt ratio, defined as ratio of
total liabilities to total assets, of the sample firms over the 1992-2004 is 0.743
(0.643) with total observations of 161. When the sample is restricted 7 to debt ratio
not more than 1, then the total debt ratio is 0.597 (0.58) with total observation of
131. The average long-term debt ratio, defined as ratio of long-term debt to total
assets, is 0.274 (0.189) and 0.244 (0.178) when restricted. The short-term debt
ratio, which is defined as current liabilities divided by total assets, is 0.469 (0.378)
and it is 0.353 (0.356) when restricted. On an average, mean statistics of others
variables are similar in both cases. The median, standard deviation, maximum and
minimum values are presented for statistical inferences.

Debt ratios in Table 4.1 shows that Nepalese firms are tend to have higher portion
of debt capital in their capital structure. The contribution of short-term debt is

7
The rational behind restriction is that the leverage ratio more than 1, or 100% does not hold theoretical
significance, it is more accounting issue.
 42

Table 4.1
Descriptive Statistics
This table presents descriptive statistics for the variables used in this study. The data are from NEPSE
database and SEBO database. The sample contains 20 non-financial firms listed in the NEPSE for which
there is a minimum of 3 consecutive years of data for the period 1992-2004. TD is the ratio of total debt to
total assets where the total debt is measured long-term debt plus total current liabilities. LTD is the ratio of
long-term debt to total assets. STD is ratio of total current liabilities to total assets. AS is the ratio of fixed
assets plus inventory to total assets. PRO is ratio of EBITDA to total assets. NDT is ratio of annual
depreciation to total assets. GW is the percentage change in sales in respect to previous year. RISK is the
time series standard deviation of EBITDA. CR is the ratio of current assets to current liabilities; QR is the
ratio of current assets minus inventories to current liabilities. ATR is ratio of sales to total assets. TIE is
ratio of EBIT to interest. ROA is EAT divided by total assets. gTA is arithmetic growth rate of total assets.
Panel A shows the sample statistics of total observations and Panel B shows the restricted sample statistics
where total debt ratio is not more than one or 100%.
Variables Mean Median SM
tia
dnx
.i
m
Du
em
v
.
Panel A: Total Sample Statistics (n=161)
TD 0.749 0.625 002
..
308
951
890
LTD 0.275 0.189 001
..
202
70
903
STD 0.474 0.380 002
..
307
823
008
AS 0.627 0.640 00
..
209
007
995
PRO 0.111 0.115 0-0
.0.
1.4
354
397
0
NDT 0.034 0.031 00
 43

..
001
20
616
SIZE 5.374 5.770 127
..
35
087
239
GW 0.346 0.053 2-2
.63
1.
12
229
14
RISK 34.023 29.592 201
7.1
.54
88.
117
54
1
CR 1.945 1.111 404
..3
10.
398
18
9
QR 1.103 0.655 101
..3
80.
132
489
5
ATR 1.113 0.802 004
..
806
495
890
TIE 46.63 1.477 2-2
352
883
.13
8.
07
ROA 0.002 0.005 0-0
.0.
1.3
472
010
6
 44

gTA 0.099 0.035 0-1

.0.
2.3
438
672
2
Panel B: Restricted Sample Statistics (n=127)
TD 0.590 0.583 00
..
209
058
990
LTD 0.236 0.164 00
..
209
401
207
STD 0.354 0.350 00
..
107
439
269
AS 0.605 0.617 00
..
209
107
695
PRO 0.133 0.119 0-0
.0.
1.4
014
757
8
NDT 0.035 0.034 00
..
001
20
816
SIZE 5.386 5.741 127
..
265
87
739
GW 0.416 0.062 2-2
.63
3.
62
729
14
RISK 33.839 29.592 201
9.1
 45

.54
18.
917
74
1
CR 1.958 1.332 201
..8
60.
898
985
9
QR 1.212 0.842 101
..2
60.
730
884
7
ATR 1.136 0.787 004
..
806
995
690
TIE 59.210 2.244 2-2
652
783
.13
6.
707
205
0
ROA 0.035 0.026 0-0
.0.
1.3
02
040
7
gTA 0.118 0.065 0-1
.0.
2.3
538
902
7
Source: Appendix A
 46

Table 4.2
Pearson Correlation Coefficients between Variables

This table presents the Pearson correlation coefficients for the variables (dependents and independents) used in this study. The data are from NEPSE database and
SEBO database. The sample contains 20 non-financial firms listed on the NEPSE for the period 1992-2004. TD is the ratio of total debt to total assets where the
total debt is measured as long-term debt plus total current liabilities. LTD is the ratio of long-term debt to total assets. STD is ratio of total current liabilities to
total assets. AS is the ratio of fixed assets plus inventory to total assets. GW is the percentage change in sales in respect to previous year. PRO is ratio of EBITDA
to total assets. NDT is ratio of annual depreciation to total assets. SIZE is the natural logarithm of sales (million based). GW is the percentage change in sales
based on previous year. RISK is the time series standard deviation of EBITDA. CR is the ratio of current assets to current liabilities. ** indicates the correlation
is significant at the 0.01 level (2-tailed). * indicates the correlation is significant at the 0.05 level (2-tailed).
TD LTD STD AS PRO NDT SIZE GW RISK CR
TD 1
LTD 0.41** 1
STD 0.74** -0.30** 1
AS 0.15 0.24** -0.01 1
PRO -0.40** -0.27** -0.22** 0.08 1
NDT -0.21** -0.10 -0.15 0.48** 0.33** 1
SIZE 0.00 0.35** -0.26** 0.03 0.16* 0.12 1
GW -0.02 0.00 -0.02 0.08 0.09 0.03 0.05 1
RISK 0.09 0.40** -0.20* 0.36** 0.08 0.25** 0.57** 0.07 1
CR -0.06 0.27** -0.26** -0.26** -0.15 -0.26** -0.03 -0.03 -0.18* 1
Source: Appendix A
 47

significantly high on total debt than long-term debt. The profitability measures are
low. The return on asset is only 0.2% and it is 3.3% when restricted.

The AS, defined as ratio of fixed assets plus inventory to total assets, statistic
shows that the firms have on an average 60% collateral assets. When the firms are
needed to use borrowing capital (bank loans, etc.), the collateral assets can be
pledged. The average sales growth rate, GW has been observed to be very high,
however the median statistic shows that the growth rate is normal at 5.3%. The
variability of mean statistics indicates the inconsistency of mean estimate. Another
proxy of growth opportunities measure, total assets growth rate has been observed
on an average 10%. The liquidity indicators are more or less near to standard
norms.

The correlation coefficients between different variables are reported in Table 4.2.
Correlations are generally low, with some exceptions. The correlation between
short-term debt and total debt; and size and risk is high. The correlation
coefficients are 0.74 and 0.57 respectively. The correlation coefficient between
total debt and size is found zero, however it is statistically not significant. The
correlation coefficient between assets structure and SIZE is also very low. The
assets structure is less correlated with short-term debt and the size. In both cases,
the coefficient is very small.

1. Decompositional Analysis

The total debt is the composite frame of both long-term debt and short-term debt.
These two variables directly affect leverage ratio in same direction and on one-to-
one manner, ceteris paribus. Obviously, an increase in long-term debt or short-
term debt increases the leverage ratio and vice-versa. However, it is not necessary
that increase in long-term debt increases or decreases short-term debt. To some
extent, long-term debt and short-term debt do not hold direct relation. The debt
ratios decompostional study helps to scrutinize the relationship among total debt
 48

Table 4.3
Debt Ratios
The table shows mean and standard deviation (SD) figures of different annual cross-sectional debt ratios for
non-financial listed Nepalese companies from 1995-2004 by using unbalanced panel data set. Total debt
ratio is measured as total long-term liabilities plus current liabilities divided by total assets. Long-term debt
ratio is measured as long-term liabilities divided by total assets. The ratio of current liabilities to total assets
is measured as short-term debt ratio.
Year Total Debt Ratio Long-term Debt Ratio Short-term Debt Ratio No.
(%) (%) (%) of
Observation
Mean Median SD Mean Median SD Mean Median SD
1995 57 53 22 26 21 24 31 27 15 11
1996 69 66 20 28 22 25 41 38 17 14
1997 64 58 25 23 13 26 41 38 22 14
1998 70 60 34 33 25 32 37 36 24 15
1999 75 68 38 37 42 32 38 39 15 15
2000 81 81 38 34 29 33 47 37 39 17
2001 85 75 44 30 29 27 55 33 44 17
2002 88 81 55 21 3 31 67 43 57 13
2003 85 62 57 20 2 30 64 44 56 12
2004 88 59 79 17 7 26 70 36 79 9
Source: Appendix A

ratio, long-term debt ratio and short-term debt ratio. In this section, the evolution
of total debt ratio and its decompositional (long-term and short-term debt ratio)
figures have been presented and analyzed for the 1995-2004, 10-years period. The
yearly mean, median and standard deviation (SD) figures for the three different
debt ratios are presented in Table 4.3. The yearly average statistics are the derived
from yearly observations.

Interestingly, the Table 4.3 shows that the total debt ratio is high over the 10-year
period. The 1995 cross-sectional average is 57% and the statistic for 2004 is 88%,
which is highest. The total debt ratio has been increasing over the period, which
can also be observed from Figure 4.1; it has been increasing gradually. However,
the median statistics are slightly deviated from mean statistics. The median of total
debt in 1995 has been observed 53% and the statistic for 2004 is 59%. The median
statistic of total debt ratio is highest in 2000, which is 81%.

From the Table 4.3, it is also observed that the contribution of long-term debt on
total debt is comparatively lower then the contribution of short-term debt. The
 49

trend of long-term debt ratio has been found decreasing function over the period.
The average long-term debt ratio in 1995 has been observed 26% and the statistics
is highest in 1999, which is 37%. In 2004, it is 17%. The median statistics shows
that the long-term debt ratio has substantially decreased in 2002. The trend of
long-term debt ratio can also be observed from Figure 4.1. The correlation
coefficient between total debt and long-term debt, as shown in Table 4.2, is 0.41. It
implies that under the bivariate analysis, approximately 17% of variation in total
debt is explained by long-term debt.
Figure 4.1
Evolutions of Debt Ratios

The contribution of short-term debt over total debt ratio is significantly higher. The
short-term debt ratio has followed the same direction as total debt ratio, which is
increasing over the periods. The 1995 mean statistics is 31% and it increased to
70% in 2004. The pace of changes in short-term debt ratio over the 10-year period
can also be observed from Figure 4.1. The correlation coefficient between total
debt ratio and short-term debt ratio, as shown in Table 4.2, is 0.74. It signifies that,
under bivariate analysis, approximately 55% variation in total debt ratio is
explained by short-term debt ratio. Interestingly, the relationship between short-
 50

term debt and long-term debt has been observed significantly inverse. The
correlation coefficient between long-term debt and short-term debt is -0.36. This
statistic implies that the trend or evolution of these two components of total debt is
inverse and this movement can also be observed from Figure 4.1.

From the above decompositional analysis, it has been observed that the total debt
ratio is very high and the trend is increasing. This evidence shows that Nepalese
firms finance their financing requirement mostly from debt capital, particularly
from short-term debt. This evidence can also be interpreted as Nepalese firm rely
more on short-term debt than long-term debt. From the sample, it is also observed
that there is lack of practices of long-term debt securities among sample firms.
Also, it is found that the firms having majority government ownership are more
levered. This finding is consistent with Rajan and Zingales (1995) and Booth et al.
(2001).

2. Debt Ratios: An International Comparison

Some early studies in international sphere stated that firms in developed countries
are more levered than firms in developing countries and the major difference
between developing countries and developed countries is that developing countries
have substantially lower amount of long-term debt (Rajan and Zingales, 1995;
Demirguc-Kunt and Maksimovic, 1999; Booth et. al., 2001). These findings
motivated to make a brief comparison on debt ratios of Nepalese firms with
findings of Rajan and Zingales (1995) and Booth et al. (2005). In this international
comparison, the statistic estimates come from different time period, therefore, it is
assumed that the estimates may not suffer from potential business cycle bias.

The leverage statistics presented in Table 4.1 and Table 4.3 support the early
findings in international studies (Rajan and Zingales, 1995; Demirguc-Kunt and
 51

Table 4.4
Debt Ratios: An International Comparison
This table presents median debt ratios for Nepal, 10 developing countries and G-7 countries over different
time period. Total debt ratio is defined as total liabilities (nonequity) divided by total assets. Long-term debt
ratio is defined as total long-term debt to total assets. Data are from 20 non-financial firms listed in NEPSE.
Data for 10-developing countries are from Booth et al. (2001, Table I) and their estimate for long-term debt
ratio excludes current liabilities from total assets. Data for G-7 countries are from Rajan and Zingales
(1995, Table IIIa) and their estimate for long-term debt ratio includes all nonequity liabilities.
No. of Time Total Long-term
Firms Period Debt Ratio Debt Ratio
(%) (%)
Nepal 20 1992-2004 58 16
Brazil 49 1985-1991 30 10
Mexico 99 1984-1990 35 14
India 99 1980-1990 67 34
South Korea 93 1980-1990 73 49
Jordan 38 1983-1990 47 12
Malaysia 96 1983-1990 42 13
Pakistan 96 1980-1987 66 26
Thailand 64 1983-1990 49 N/A
Turkey 45 1983-1990 59 24
Zimbabwe 48 1990-1988 42 13
United States 2580 1991 58 37
Japan 514 1991 69 53
Germany 191 1991 73 38
France 225 1991 71 48
Italy 118 1991 70 47
United Kingdom 608 1991 54 28
Canada 318 1991 56 39
N/A: Not Available.

Maksimovic, 1999; Booth et. al., 2001). The median statistics of total debt ratio
and long-term debt ratio of Nepal along with G-7 countries (Rajan and Zingales,
1995) and 10-developing countries (Booth et al., 2001) are presented in Table 4.4.

The median value of total leverage (restricted), as shown in Table 4.4, is below the
median value of the G-7 countries except USA, UK and Canada (Rajan and
Zingales, 1995). However, this estimate is higher than six developing countries,
viz.; Brazil, Mexico, Jordan, Malaysia, Thailand and Zimbabwe and lower than
India, South Korea, Pakistan and Turkey. South Korea has the highest median total
leverage, which is 73.4%, and the Brazil has the lowest total leverage, which is
 52

30.3%. It may give support to the prediction, the hypothesis, that Nepalese firms
are less levered.

Similarly, the median statistics of long-term debt ratio is comparatively lower than
in G-7 countries, South Korea, Pakistan and Turkey. It implies that the Nepalese
firms have employed lower long-term debt in their capital structure and rely more
on short-term financing. Japan has the highest long-term debt ratio, which is 53%,
and Brazil has the lowest long-term debt ratio, which is 10%. This statistics also
supports the hypothesis that Nepalese firms have low long-term debt.

However, this comparative study shows that Nepalese firms are less levered than
some advanced country and similar to some developing countries, some
precautions should be kept in mind. The proxy for total debt ratio may overstate
the leverage ratio (Booth et al., 2001) because the proxy for short-term debt is
total current liabilities, which include provisions and account payables. Since the
manufacturing firms have dominated the samples, the portion of account payable
in current liabilities would be high. Therefore, in such a case, the long-term debt
ratio would be the alternative proxy for leverage measure.

3. Analysis of Properties of Portfolios

The theory and practice of corporate finance suggests that the debt ratio is not
constant within a sector or an industry, but depends on certain firm characteristics.
In this section, financial ratios are used as firms' characteristics. Financial ratios
are the most commonly used measures in the analysis of a firms financial
performance. They provide a meaningful and unbiased quantitative representation
of the results of internal decisions and external conditions. In this study, different
measures of financial indicators are presented and analyzed by forming 3
portfolios on the basis of leverage ratio over the sample period of 1992-2004. The
debt ratio below 40% has been considered as less leveraged and studies under
portfolio I; debt ratio from 40 % to 60% is considered as moderately levered and
 53

Table 4.5
Financial Indicators of Different Portfolios
This table presents different financial indicators (ratios). The data are from NEPSE database and SEBO database. The sample contains 20 non-financial firms
listed on the NEPSE. The portfolios are constructed based on leverage ratio. Portfolio I contains 26 observations having total debt ratio less than 0.4 or 40%.
Portfolio II contains total 44 observations, which have total debt ratio ranging from 0.4 to 0.6. Portfolio III contains 91 observations, which have debt ratio more
than 0.60. TD is the ratio of total debt to total assets where the total debt is measured as long-term debt plus total current liabilities. LTD is the ratio of long-term
debt to total assets. STD is ratio of total current liabilities to total assets. TIE is ratio of EBIT to interest expenses. ROA is ratio of net income to total assets. GW
is arithmetic growth rate of sales based on previous year. gTA is arithmetic growth rate of total assets based on previous year. AS is the proportion of collateral
assets to total assets. ATR is sales divided by total assets. NDT is the ratio of annual depreciation to total assets. CR is the ratio of current assets to current
liabilities. QR is the ratio of current assets minus inventory to current liabilities.
Financial Indicators (ratios) Portfolio I (TD<0.40) Portfolio II (40<TD<60) Portfolio III (TD>0.60)
Mean Median SD Mean Median SD Mean Median SD
TD, Total debt ratio 0.316 0.343 0.092 0.506 0.516 0.063 0.991 0.913 0.368
LTD, Long-term debt ratio 0.041 0.000 0.072 0.100 0.048 0.116 0.427 0.454 0.275
STD, Short-term debt ratio 0.275 0.285 0.096 0.406 0.418 0.110 0.563 0.430 0.476
TIE, Time-Interest earned 96.42 16.96 271.25 108.98 5.00 399.32 2.260 0.755 11.80
EBITDA/TA 0.133 0.118 0.112 0.183 0.160 0.107 0.071 0.085 0.136
EBT/TA 0.094 0.071 0.121 0.111 0.105 0.104 -0.042 -0.027 0.144
ROA, EAT/TA 0.041 0.031 0.092 0.079 0.054 0.106 -0.047 -0.028 0.147
SIZE (Rs. in Millions) 4.932 5.179 1.229 5.361 5.858 1.307 5.506 5.852 1.305
GW, Sales Growth rate 0.087 0.038 0.453 0.210 0.069 1.508 0.485 0.038 2.595
gTA, Assets growth rate 0.065 0.021 0.186 0.076 0.061 0.223 0.119 0.035 0.271
AS, Collateral assets ratio 0.505 0.576 0.211 0.615 0.617 0.171 0.667 0.686 0.214
ATR, Assets turnover ratio 1.257 0.697 1.302 1.081 0.773 0.764 1.087 0.908 0.722
NDT, non-debt tax shield 0.033 0.031 0.027 0.046 0.046 0.026 0.028 0.022 0.025
CR, Current Ratio 3.020 1.947 4.169 1.180 1.222 0.612 2.008 0.861 4.970
QR, Quick Ratio 2.018 1.218 2.727 0.786 0.830 0.426 0.994 0.457 1.842
Source: Appendix A
 54

studied under portfolio II; and debt ratio higher than 60% is considered as
highly levered and studied under portfolio III.

Table 4.5 presents important financial indictors separately for three portfolios
formed, which, among others reveals as follows:

At the lower level of capital gearing, firms tend to employ more short-
term debt than long-term debt and firms gradually shift on long-term
borrowing in respect to increasing leverage. In portfolio I, the proportion
of short-term debt on total debt is 87% (0.2750.316) and it decreased to
56% (0.5630.991) in portfolio III

Increasing leverage drives to decrease debt capacity measured by time-

interest earned ratio, TIE. The median statistics for TIE signify it. The
very high variability of mean statistics, measured by standard deviation
(SD), signalize to inconsistent estimate of mean average. The TIE
(median) decreases from 16.96 times in portfolio I to 0.76 times in
portfolio III. The TIE belongs to portfolio II is found 5 times.

The profitability measures belong to less levered firms is lower than

moderately levered firms but higher than highly levered firm. The
profitability measures of highly levered firms are minimum and even
negative. The ratio of EBITDA to total asset in portfolio I is 13.3%. It
increases to 18.3% in portfolio II and decreases to 7.1% in portfolio III.
The return on assets is 4.1% for portfolio I, 7.9% for portfolio II and
-4.7% for portfolio III. Similarly, the before tax return is 9.4% for
portfolio I, 11.1% for portfolio II, and -4.2% for portfolio III. All these
profitability measures show that portfolio II or moderately levered firms
have optimal profitability. It implies that increasing debt ratio initially
increases the profitability through debt tax shield but after certain level,
the profitability declines because of increasing bankruptcy, financial
distress and agency costs due to increase in leverage ratio. This evidence
is consistent with tradeoff theory.
 55

Smaller firms tend to have less leverage ratio and vice versa. The firms
having higher growth rate rely more on debt capital for their financing
requirements. The average growth rate of sales for less levered firms is
8.7%, for moderately levered firms is 21% and it has been observed
48.5% for highly levered firm. The median statistic in this regard is
somewhat different.

The firms having the higher leverage ratios have higher collateralizable
assets and higher total assets growth rate. On an average, most of the
firms have more than 50% collateralizable assets. The ratio of
collateralizable assets, measured by ratio of fixed assets plus inventory
to total asset, for less levered firm is 50.5%; for moderately levered firm
is 61.5%; and for highly levered firm is 66.7%. The evidence is obvious
because the collateralizable assets help to raise borrowing capital by
pledging. The assets growth rate increased from 6.5% in portfolio I to
7.6% in portfolio II and it further increased to 11.9% in portfolio III. In
addition, the total assets turn over ratio for all three portfolios are
similar. It is 1.25 times for portfolio I and 1.08 for portfolios II and III.

The non-debt tax shield, measured by ratio of depreciation to total assets

is 3.3% for portfolio I, 4.6% for portfolio II and 2.8% in portfolio III.

The firms having the lower leverage have higher the liquidity. The
median statistics of current ratio of portfolio I is 1.95 and it decreases to
0.86 in portfolio III. This evidence shows that liquidity is the decreasing
function of leverage. It also implies that increasing leverage leads to
short-term insolvency, which may drive to bankruptcy.

From the above, it is clear that the firms having moderate level of debt have the
better financial indicators than having lower debt or heavy debt.

Furthermore, to scrutinize the relationship between leverage and profitability,

the return on assets, ROA curve is developed by splitting leverage ratio less or
equals to one into five classes and taking mean ROA of each class, which is
 56

shown in Figure 4.2. The graph plots return on assets over leverage. The X-axis
reports leverage ratio and Y-axis reports return on assets.

In Figure 4.2, the ROA curve initially decreases slightly (because of

smoothing) with increase in leverage ratio; however, it rises faster than increase
in leverage. After certain level, around 50-55% level, the ROA curve declines
in faster rate than speed of increase in leverage because the both increasing and
decreasing slope of the ROA curve is steep/vertical. The curve looks concave to
the origin.
Figure 4.2
Relationship between Leverage and ROA

The tradeoff theory states that the increasing debt capital increases the debt-tax
shield but at lower level of leverage, the bankruptcy cost, agency costs and
financial distress cost may not exist, even if exist it will be mitigated by the
debt tax shield but after certain level of debt ratio, the cost function of debt
capital increases faster than tax-shield benefit function. Hence, this empirical
evidence is consistent with tradeoff theory and signifies the notion of 'optimal
capital structure'.
 57

In nutshell, from the above analysis, it has been observed that higher the
leverage ratio, initially, tends to increase the profit after certain level (say,
moderate level) it declines; highly levered firms are larger in size and higher in
sales growth rate than moderately and less levered firms, however, poor to
maintain liquidity position; and the size and sales of Nepalese firms are, on an
average equal, however the sales growth rate is higher than assets growth rate.

SECTION 2

Analysis of Capital Structure Determinants

Interest in the study of the capital structure determinants in Nepalese context

has been stimulated by the empirical works in the same regard in international
sphere where since 1970s lots of researches have been conducting to
investigate empirically how capital structure is determined. Modigliani and
Miller (1963) in their second paper noted that the debt has tax shield value,
therefore, tax rate is important determinant of capital structure. DeAngelo and
Masulis (1980) state that depreciation tax-shield could be the substitute for
debt-tax shield. Rajan and Zingales (1995) support that the collateralizable
assets backup to increase debt and the firm size has positive impact on
investors (Jensen, 1986). From the pecking order theory perspective Myers
(1984) suggests that the higher profitability signals for lower debt requirement
because internal financing is the first preference of managers. Titman and
Wessels (1988) state that the growth opportunities, and risk are some other
factors, which influence capital structure decisions. Ozkan (2001) further states
that liquidity is also an important firm specific attributes that influence on
capital structure.

The notion of optimal capital structure shows the dynamic nature of capital
structure i.e. firm holds the target level of debt ratio and moves toward it. Some
of the early the works are done based on static concept of capital structure and
the recent works are done based on dynamic concept of capital structure. Due
to the methodological limitation, the study relies on static concept of capital
 58

structure. In this section what firm specific factors determines the capital
structure have been dealt with stronger econometric estimation techniques.

1. Econometric Analysis

Econometric analysis is one of the most importance tools in economic studies,

which measure the functional relationship of dependent and independent
economic variables at the same time. And the econometric analysis is very
commonly used technique to study capital structure determinants (Taub, 1975;
Taggart, 1977; Ferri and Jones, 1979; Rajan and Zingales, 1995; Booth et al.,
2001; Ozkan, 2001; and Gaud et al., 2005). This section analyzes the
relationship of dependent variable with independent variables as stated in
theoretical framework in Chapter 2, however, as argued by Titman and Wessels
(1988), the choosing of explanatory variables in the analysis of capital structure
is fraught with difficulty. Following the Titman and Wessels (1988) and Ozkan
(2001), seven key independent variables viz.; assets structure, current ratio,
growth opportunities, non-debt tax shield, profitability, risk and size are
adopted for the study.

The Ordinary Least Square (OLS) and Generalized Least Square (GLS)
estimates are presented in Table 4.6 and 4.7 respectively. The basic model of
estimation is:
DRi , t 1 ASi , t 2CRi , t 3GWi , t

4 NDTi , t 5 PROi , t 6 RISKi , t 7 SIZEi , t i , t

(4.1)

In equation (4.1), it is assumed that the y-intercept, is constant over the

period and across the firms and it is not correlated with error term, .

The results from OLS in Table 4.6 denote that the independent variables
explain 21.2% variability in total debt ratio, 42% variability in the long-term
debt ratio and 18.4% variability in short-term debt ratio measured by adjusted
 59

Table 4.6
OLS Estimates of Capital Structure Determinants
Here in this table, estimates from Ordinary Least Square (OLS) are presented. The data are from
NEPSE and SEBO database and the sample contains 20 non-financial firms listed on the NEPSE for
the period 1992-2004. TD is the ratio of total debt to total assets where the total debt is measured long-
term debt plus total current liabilities. LTD is the ratio of long-term debt to total assets. STD is ratio of
total current liabilities to total assets. AS is the ratio of fixed assets plus inventory to total assets. CR is
the ratio of current assets to current liabilities. GW is the percentage change in sales in respect to
previous year. NDT is ratio of annual depreciation to total assets. PRO is ratio of EBITDA to total
assets. RISK is the time series standard deviation of EBITDA. SIZE is the natural logarithm of sales.
Standard errors are displayed in parentheses below the coefficients. p-values are given in italics below
the standard error value. In Total Model, total debt ratio is dependent variable. In Long-term Model,
long-term debt ratio is dependent model. In Short-term Model, short-term debt ratio is dependent
variable. The estimated model is:
DRi , t 1 ASi , t 2CRi , t 3GWi , t 4 NDTi , t 5 PROi , t 6 RISKi , t 7 SIZEi , t i , t

Variable Total Model Long-term Model Short-term Model

C 0.592 -0.321 0.912
(0.167) (0.100) (0.162)
[0.001] [0.002] [0.000]
AS 0.502 0.438 0.063
(0.166) (0.100) (0.161)
[0.003] [0.000] [0.694]
CR -0.010 0.022 -0.032
(0.007) (0.004) (0.007)
[0.169] [0.000] [0.000]
GW -0.001 -0.002 0.001
(0.013) (0.008) (0.013)
[0.942] [0.790] [0.929]
NDT -3.935 -1.917 -2.018
(1.296) (0.779) (1.259)
[0.003] [0.015] [0.111]
PRO -1.068 -0.507 -0.561
(0.228) (0.137) (0.221)
[0.000] [0.000] [0.012]
RISK 0.000 0.002 -0.002
(0.001) (0.001) (0.001)
[0.715] [0.003] [0.133]
SIZE 0.018 0.059 -0.041
(0.027) (0.016) (0.026)
[0.503] [0.000] [0.127]
R-squared 0.247 0.445 0.220
Adjusted R-squared 0.212 0.420 0.184
S.E. of regression 0.353 0.212 0.343
F-statistic 7.163 17.541 6.150
Prob (F-statistic) 0.000 0.000 0.000
Durbin-Watson stat 0.322 0.546 0.230
n 161 161 161
 60

Table 4.7
GLS Estimates of Capital Structure Determinants
Here in this table, estimates from Generalized Least Square (GLS) are presented. The data are from
NEPSE and SEBO database and the sample contains 20 non-financial firms listed on the NEPSE for
the period 1992-2004. TD is the ratio of total debt to total assets where the total debt is measured long-
term debt plus total current liabilities. LTD is the ratio of long-term debt to total assets. STD is ratio of
total current liabilities to total assets. AS is the ratio of fixed assets plus inventory to total assets. CR is
the ratio of current assets to current liabilities. GW is the percentage change in sales in respect to
previous year. NDT is ratio of annual depreciation to total assets. PRO is ratio of EBITDA to total
assets. RISK is the time series standard deviation of EBITDA. SIZE is the natural logarithm of sales.
White standard errors are displayed in parentheses below the coefficients. p-values are given in italics
below the white standard error value. Total debt ratio, long-term debt ratio and short-term debt ratio
are the dependent variables in Total Model, Long-term Model, and Short-term Model respectively. The
estimated model is:
DRi , t 1 ASi , t 2CRi , t 3GWi , t 4 NDTi , t 5 PROi , t 6 RISKi , t 7 SIZEi , t i , t

VariableTotal ModelLong-term ModelShort-term ModelC0.365-0.2630.605(0.020)(0.056)

(0.016)[0.000][0.000][0.000]AS0.0490.3240.015(0.022)(0.054)(0.014)[0.027][0.000]
[0.297]CR-0.0360.018-0.030(0.002)(0.008)(0.001)[0.000][0.035][0.000]GW0.002-
0.0010.009(0.003)(0.005)(0.003)[0.458][0.871][0.002]NDT-4.370-1.873-1.469(0.134)(0.440)
(0.068)[0.000][0.000][0.000]PRO-0.240-0.3300.020(0.052)(0.051)(0.023)[0.000][0.000]
[0.384]RISK0.0000.003-0.001(0.000)(0.000)(0.000)[0.003][0.000][0.000]SIZE0.0840.051-
0.020(0.003)(0.011)(0.002)[0.000][0.000][0.000]R-squared0.9560.4700.837Adjusted R-
squared0.9540.4460.830S.E. of regression0.4300.2060.377F-statistic469.919.41112.6Prob (F-
statistic)0.0000.0000.000Durbin-Watson stat0.7010.4990.856n161161161Note: GLS estimates
are Cross-Section Weighted White Heteroskedasticity-Consistent Standard Errors and
Covariance (White, 1980; Gujarati, 2003).
R-squared8. The F-statistics of three OLS models are statistically significant at
1% level. The signs of the coefficients in total debt model and short-term debt
model are similar except the risk and size.

In the same manner, the coefficients of constant and CR are inverse in the case
of total model and long-term model. Among other, from the OLS estimates,
assets structure, risk and size have positive influence on leverage and liquidity,
growth, non-debt tax shield and profitability have negative influence on
leverage.

The GLS estimates, presented in Table 4.7 are more efficient because GLS has
adjusted Cross-Section Weighted White Heteroscedasticity-Consistent Standard
Error and Covariance (Gujarati, 2003, p. 415). Also, the lower R-squared
motivated to use GLS method of estimation, which results BLUE (best linear
unbiased estimates).
8
The adjusted R2 incorporates degree of freedom associated with explained variation (Gujarati, 2003).
Theil (1978) suggests that it is good practice to use adjusted R2 rather than R2 because R2 tends to
give an overly optimistic picture of the fit of the regression, particularly when the number of
explanatory variables is not very small compared with the number of observations (p. 135).
 61

The GLS models have the almost similar signs of estimates as on OLS models
but the adjusted R2 value have been changed significantly. The adjusted R2 value
of total model increased to 95.4%. The adjusted R2 of long-term model
increased to 44.6%. Similarly, the adjusted R2 of short-term model increased to
83% from 18.4% in OLS. Therefore, the results from GLS denote that the
independent variables explain 95.4% variation in total debt ratio, 44.6%
variation in long-term debt ratio and 83% variation in short-term debt ratio. The
F-statistic of GLS models is significant at 1% level, or 99% confidence level.
In following paragraphs, the estimates of GLS models, presented in Table 4.7,
are described in detail, particularly focusing on total model.

The coefficient of assets structure, AS is positive and significant at 5% level in

total model, however it is positive and significant at 1% in long-term model
and not significant in case of short-term model. The positive impact of assets
structure on leverage might reveal several feature of borrowing behavior of the
firms. It may give support to the prediction, the hypothesis that firms having
higher collateral assets tend to have higher leverage. The rational underlying
this factor is that tangible assets are easy to collateralize and thus they reduce
the agency costs of debt (Rajan and Zingales, 1995, p. 1455). This evidence is
also consistent with the view that the greater proportion of tangible assets, the
more willing should lenders be to supply, and leverage would be higher. The
early studies of Rajan and Zingales (1995), Booth et al. (2001), Casser and
Holmes, (2003) and Gaud et al. (2005) also find the same evidence in their
cross-sectional study. This finding is in line with the tradeoff theory.

The coefficient of current ratio, CR (proxy for the liquidity) is negative in total
model and short-term model however positive with long-term model and it is
statistically significant at 1% and 5% level respectively. The findings are in line
with the view that liquidity of firms exerts a negative impact on firms'
borrowing decisions. This negative effect might be due to potential conflicts
between debtholders and shareholders of firms (Ozkan, 2001, p. 190). In other
words, firms having higher liquidity hold more liquid assets and have lower
short-term debt, which decreases short-term debt ratio and total debt ratio by
 62

the same time. However, the relation of liquidity with long-term debt is
somewhat puzzling. It indicates that increasing liquidity increases the long-
term debt ratio. It might imply that, to some extent, higher liquidity could
backup to increase long-term debt.

The coefficient of growth opportunities, GW (as proxied by the arithmetic

growth rate in sales) is approximately zeros in all the six models presented in
Table 4.6, however it is not statistically significant except in short-term GLS
model. The evidence does not provide any meaningful statistical inference. The
evidence indicates that the changes in sales does not significantly influence on
the capital structure decision of the firm. As hypothesized, the firm with high
growth opportunities is limited to use debt, as case of bankruptcy is not
supported by the empirical evidence.

The coefficient of non-debt tax shield, NDT (as proxied by depreciation

expenses divided by total assets) is negative and statistically significant at 1%
level. As hypothesized, firms with high level of non-debt tax shields, which can
be deducted from the taxable income, are expected to have less debt than other
firms ceteris paribus, the evidence confirms it. The evidence is also consistent
with tradeoff theory and early studies (DeAngelo and Masulis, 1980; and
Ozkan, 2001). The contribution of debt tax shield can be substituted by non-
debt tax shield e.g. depreciation, investment tax credit etc.

The coefficient of profitability, PRO (as proxied by ratio of EBITDA to total

assets) is negative and statistically significant at 1% level. As hypothesized,
when the firms are profitable, they prefer debt because the expected bankruptcy
cost declines with increasing profitability as well as the interest tax-shield will
drive for higher profitability, the evidence does not support it. The negative
sign of profitability is consistent with the pecking order theory that predicts a
preference for internal financing rather than over external financing (Myers,
1984; and Myers and Majluf, 1984). This evidence implies that the capital
investments of the firms are wavy and positively serially correlated and
internally generated cash flows. The finding is also consistent with early
 63

findings of Rajan and Zingales (1995), Booth et al. (2001), Ozkan (2001), and
Gaud et al. (2005).

The coefficient of risk, RISK (as proxied by time series standard deviation of
firms EBITDA) is approximately zeros it is statistically significant. It indicates
the possibility of not direct relationship between risk and leverage. It indicates
the independency of leverage ratio and risk, in Nepalese practices, which is
contradicting evidence on capital structure theory. The theories suggest that
firms with relatively higher operating volatility will have incentive to have
lower leverage (Myers, 1977; and DeAngelo and Masulis, 1980). However, it
evidence might be the consequence of the methodological limitation where the
same time series standard deviation of EBITDA was used for all the years.

Size is positively related to leverage ratio. The coefficient is statistically

significant at 1% level. It indicates that the bigger the firm, the more debt it
will use. The evidence supports the hypothesis that the size has a positive
impact on the supply of the debt. The evidence is consistent with tradeoff
theory of capital structure and early studies (Jalilvand and Harris, 1984; Rajan
and Zingales, 1995; Ozkan, 2001; and Gaud et al., 2005).

From the above analysis it is reviled that firm specific attributes plays
important role in capital structure management of Nepalese enterprises.

2. Limitation of the Models:

The OLS and GLS models presented in Table 4.6 and 4.7 have low Durbin-
Watson statistic, which shows the possibility of the presence of autocorrelation.
The null hypothesis of 'no autocorrelation' is rejected. 9 In the presence of
autocorrelation, the estimators may not efficient (Gujarati, 2003). Therefore,
OLS as well as GLS (Cross-Section Weighted White Heteroskedasticity-
Consistent Standard Error and Covariance) estimators may lack the efficiency.

9
H0: No autocorrelation, or = 0
H1: Yes autocorrelation, or 0
At 1% level of significance, the tabulated d L and dU are 1.53 and 1.72 approximately for n = 161. The
d statistics of all the models do not fulfill the requirement of d U < d < 4- dU to accept the null
hypothesis. Therefore, it suggests the possibility of presence of autocorrelation.
 64

In such case Madala (1992) and Gujarati (2003) 10 suggest to use the First-
Difference Method.

The First-Difference Model is:

Yt - Yt-1 = (Xt Xt-1) + (t t-1)

or
Table 4.8
First-Difference Model Estimates
This table presents the estimates from the first-difference model. Data are from NEPSE and SEBO
database and contains 20 non-financial firms listed in NEPSE. The both dependent and independent
variables are transformed into first difference and regressed against total debt ratio. The DAS, DCR,
DGW, DNDT, DPRO, and DSIZE are the first-difference operators of assets structure, current ratio,
growth, non-debt tax shield and size respectively. The first difference reduced the sample size into 136.
The model is:
DRi , t 1ASi , t 2 CRi , t 3GWi , t 4 NDTi , t 5PROi , t 6 SIZEi , t i , t
.
Independent Variables Coefficient White Std. t-Statistic Prob.
Error
DAS 0.052 0.024 2.123 0.036
DCR -0.034 0.015 -2.230 0.027
DGW 0.005 0.001 4.839 0.000
DNDT 0.219 0.186 1.172 0.243
DPRO -0.302 0.023 -12.98 0.000
DSIZE 0.062 0.016 3.985 0.000
R-squared 0.333
Adjusted R-squared 0.307
S.E. of regression 0.208
F-statistic 12.970
Prob (F-statistic) 0.000
Durbin-Watson stat 1.784
n 136
Note: The first-difference model estimates are Cross-Section Weighted White
Heteroskedasticity-Consistent Standard Errors & Covariance (Gujarati, 2003).

Yt = Xt + t
(4.2)
where is the first difference operator. In equation (4.2), the error term, t is
free from serial correlation to run the regression (Gujarati, 2003, p. 478).

The first-difference model for this study can be derived from equation (4.2).

10
Use the first-different form whenever the d < R2 (Madala, 1992, p. 232). Use the first-different form
whenever the d < R2 (Madala, 1992, p. 232). The first transformation may be appropriate if the
coefficient of autocorrelation is very high, say in excess of 0.8, or the Durbin-Watson d is quite low
(Gajarati, 2003, p. 478).
 65

DRi , t 1ASi , t 2 CRi , t 3GWi , t

4 NDTi , t 5 PROi , t 6 SIZEi , t i , t

(4.3)

In the first-difference model there is no intercept that means that the regression
line passes through the origin (Gujarati, 2003). RISK is omitted from the
explanatory variables because of same value for all the time series. When
regressed the first-difference model with first-difference operators of
explanatory variables, the results are as shown in Table 4.8.

The Durbin-Watson statistic has increased dramatically to 1.784, which fulfills

the condition to accept the null hypothesis of 'no autocorrelation'. So the
estimates are more efficient. The R2 has dropped considerably. This is generally
the case because by taking the first differences, the study tries to explore on the
behavior of the variables around their (linear) trend value and the R2 of models
in Table 4.6 and Table 4.7 can not be compared directly because the dependent
variables in these models are different (Gujarati, 2003).

The signs of the first difference operators in Table 4.8 are similar to total model
(GLS) in Table 4.7 except non-debt tax shield, NDT. The sign of first-
difference operator of non-debt tax shield is positive, however, it is not
statistically significant at normal levels. This evidence is somewhat puzzling
and contradictive with GLS estimate, however, it is noteworthy to mention that
in first different model, the independent variables are regressed against first-
difference operator of total debt ratio rather than total debt ratio itself where
some methodological issues may rises.

The coefficient of first-difference operator belongs to assets structure, AS is

positive and significant at 5% level. The coefficient of first-difference operator
belongs to liquidity, CR is negative and significant at 5% level. The coefficient
of first-difference operator belongs to growth opportunities, GW is positive and
significant at 1% level. The coefficient of first-difference operator belongs to
profitability, PRO is negative and significant at 1% level. The coefficient of
 66

first-difference operator belongs to size, SIZE is positive and significant at 1%

level.

SECTION 3

Analysis of Macroeconomic Influences on Capital Structure

The macroeconomic variables play significant role in firms' capital structure

decision. The fiscal policy and monetary policy are major macroeconomic
directives in this regard. An increase in corporate tax rate raises the leverage
ratio because of debt tax shield and vice versa (Modigliani and Miller, 1963;
and Miller, 1977). In the same manner, the monetary policy determines the
interest rate (Friedman, 1959), which ultimately influence on debt-equity
Table 4.9
Macro Financial Data
This table presents some macro financial data for Nepal from 1995 to 2004. Data are extracted from
Economic Survey 2004/05 (MOF, 2005) and SEBO Annual Report 2003/04 (SEBO, 2004). The GDP
figure is GDP at factor cost. Inflation rate is based on annual percentage change in consumer price
index (annual average, 1995/96=100). The Market Capitalization to GDP is measured as total market
capitalization amount divided by total gross domestic product at factor cost. The Average figure is the
arithmetic mean over the 10 years.
Year GDP Inflation Market Market NEPSE No. of Listed
Growth Rate Capitalization Capitalization to Index Companies
Rate (%) (Rs. million) GDP
(%) (%)
1995 2.7 7.7 12963 6.17 195.48 79
1996 5.4 8.1 12295 5.14 185.61 89
1997 4.8 8.1 12698 4.71 176.31 95
1998 3.3 8.4 14289 4.93 163.35 101
1999 4.5 11.4 23508 7.12 216.93 107
2000 6.1 3.5 43123 11.77 360.7 110
2001 4.9 2.4 46349 11.78 348.43 115
2002 -0.3 2.9 34704 8.56 227.54 96
2003 3.1 4.8 35240 8.09 204.86 108
2004 3.3 4.0 41425 8.77 222.04 114
Average 3.78 5.47 27659.4 7.7 230.13

choice. The development of capital market also influences on capital structure

(Booth et al., 2001). In aggregate, the economic development of the country
influence on firms' capital structure decision (Rajan and Zingales, 1995; Booth
et al., 2001). Therefore, in macro economic perspective, the debt ratio of the
 67

firm is the function of economic growth rate, inflation rate, capital market
development, liquid liabilities and Miller's tax advantage (Booth et al., 2001).

This section provides some macroeconomic information on the financing

choice of Nepalese enterprises and the interest in the study has been stimulated
by Booth et al. (2001). The authors, in their cross-sectional study, observed
negative influences of stock market ratio (on GDP) and inflation rate on total
debt ratio and long-term debt ratio; and the positive influences of GDP growth
rate, Miller's tax advantage and liquid liabilities/GDP ratio. Table 4.9 provides
information about some basic institutional information on macroeconomic
variables of Nepal. The data are obtained from the Economic Survey 2004/05
 68

Table 4.10
Macroeconomic Influences on Capital Structure Choice
The table shows the results of regression of various debt measures against a set of independent macroeconomics variables. Data for independent variables are from
Table 4.9 and data from depended variables are from Table 4.3. In total model, dependent variable is total debt ratio, measured as total debt divided by total assets. In
long-term model, long-term debt ratio is dependent variable and measured as ratio long-term debt to total assets. In short-term model, the dependent variable is
short-term debt ratio. GDP growth is measured at factor cost. Inflation (INFL) is based on annual percentage change is consumer price index (annual average,
1994/95=100). MCGDP is the ratio of market capitalization to GDP. The estimated basic model is: DRt 1GDPt 2 INFLt 3 MCGDPt t 11
Independent Variables Total Model Long-term Mod
CoefficientStd. ErrorProb.CoefficientStd. ErrorProb.CoefficientStd. ErrorProb.
Intercept66.67220.9300.019-7.74212.7080.56573.57026.3050.031
GDP-1.5381.7430.4120.6211.0580.579-2.1472.1900.365
INFL-0.6811.6460.6932.4190.9990.052-3.0382.0680.192
MCGDP2.5331.8560.2212.2681.1270.0910.2952.3330.904
R-squared 0.628 0.632
Adjusted R-squared 0.443 0.448
S.E. of regression 8.124 4.933
F-statistic 3.381 3.437
Prob. (F-statistic) 0.095 0.093
Durbin-Watson stat 1.316 1.806
n 10 10

11
In this model, it is assumed that the underlying time series is stationary (Johnston and DiNardo, 1997; and Gajarati, 2003).
 6
9

(MOF, 2005) and SEBO Annual Report (SEBO, 2004). The data from
Economic Survey 2004/05 is said to be different and updated (MOF, 2005, p.
2). Nepal has experienced highest GDP growth rate in 2001 during last 10
years and it is lowest in 2002, which is -0.3%. The GDP growth rate is
decreasing; the latest statistic is around 2% (MOF, 2005). The 10-year average
statistic of GDP growth rate is 3.8%, which is nominal in case of developing
countries.

The inflation rate for 1999 is the highest during last 10 years and the 10-year
average statistic is 5.5%. The ratio of stock market capitalization to GDP is, on
an average, 7.7%. It is higher than 10-developing countries except Jordan and
Malaysia (Booth et al., 2001, Table II). NEPSE is only one stock market in
Nepal. The stock market index in 2000 is the highest during last 10 years. The
index is decreasing over the years thereafter; however, it is slightly improved in
2004.

Table 4.10 offers some preliminary conclusions on the relation between capital
structures and intuitional characteristics. These conclusions are generated by
time series data from 1995 to 2004. Table 4.10 shows the result of the time
series regressions in which the dependent variables are the three debt ratios,
viz.; total debt ratio, long-term debt ratio and short-term debt ratio. The
independent variables are GDP growth, inflation rate and ratio of stock market
capitalization to GDP.

The obvious caveat to the results in Table 4.10 is that with only 10 years, the
standard errors of the coefficients are too large for the coefficients to be judged
significant at normal level. However, coefficient of inflation and the market
capitalization to GDP are significant at 10% level in long-term model. All three
models are significant at 10% level.

With some econometric limitations, the results show some interesting

generalizations in Nepalese context. The GDP growth rate is negatively related
to total debt ratio and short-term debt ratio. It is positively related to long-term
debt ratio. The higher economic growth tends to cause to use more long-term
 7
0

debt and less short-term debt. Since the contribution of short-term debt on total
leverage is significantly high, the evidence is obvious. This evidence implies
that the Nepalese companies prefer long-term debt securities and rely less on
short-term borrowing when the economic growth is higher. The inflation rate is
negatively related to total debt ratio and short-term debt ratio, whereas, it is
positively related to long-term debt ratio. It implies that increasing inflation
supports to increase long-term debt and decrease short-term debt. To some
extent, in short-run, the higher inflation decreases the interest rate, which could
foster long-term borrowing. Finally, both debt ratios vary positively with
market capitalization. It implies that as capital markets become more
developed, they become a viable option for corporate financing.

However, the institutional data and econometric analysis offers tantalizing

glimpses of what macroeconomic factors really mean, rigorous study in this
regard is inevitable.

SECTION 4
Analysis of Survey of Capital Structure: A Managerial Perspective
The purpose of conducting a field research is to shed some lights on how
managers perceive about capital structure decisions. This study is motivated by
the works of Allen (1991), and Pradhan and Ang (1994). In their extensive
survey of financial managers, Allen (1991) found that internal financing was
the most preferred source of financing. In Nepalese context, Pradhan and Ang
(1994) found the results similar to Allen (1991).

This section is devoted to analyzing the results of the opinion survey on major
aspects of capital structure management in Nepalese enterprises. The opinion
survey consists of interviewing 20 respondents. Of the total 20 respondents
interviewed, three were company secretaries, four were middle level business
executives, seven were financial managers, and six were directors/executive
directors. The prorforma of interview schedule is presented in Appendix B.

For the purpose of the study, the personal interview was conducted during
June-July 2005 in Kathmandu. The interview schedule mainly contained
 7
1

questions on background information on respondents, sources of financing

used, capital structure pattern and debt ratios, financing alternatives, effect of
taxes, and firm specific attributes influencing capital structure decisions.

This section is organized into four parts. Part 1 describes the respondents'
opinion about capital structure pattern and debt ratios while part 2 deals with
capital structure policy. The analysis of responses on tax effect on capital
structure has been undertaken in part 3. Finally, part 4 deals with firm specific
attributes influencing leverage ratio.

1. Capital Structure Pattern and Debt Ratios

When the respondents were asked about the pattern of capital structure
employed by them, it is revealed that that they prefer a mixed type of capital
structure. They are not in favor of using equity alone in capital structure. They
prefer a mix of different types of capital. They have used short-term debt, and
equity. Surprisingly, none of them have used long-term debt and hybrid
securities, e.g., debenture, preferred stock, or debt with warrants attached or
convertibles yet.

About the debt capital, the majority of the respondents (65%) answered that
they have moderate level of debt ratio (ranging from 40-60%). However, a 30%
of respondent indicated that they have employed a very high debt ratio
(something above 60%).

Since, debt is a cheaper type of capital and interest payments are tax
deductible, a great majority of companies would like to use as much of debt as
possible. Hence one of the fundamental issues in capital structure
management is to find out if there is a limit on debt. In this connection, a
majority of respondents opined that (about 85%) there is a limit on what they
can borrow. Of them, 55% reported that they are at or very near the debt limit.

The respondents were also asked if they have any definite preference for any
debt level or a leverage ratio. The discussion revealed that the majority of
respondents (about 60 percent) have a preference for 60 percent debt, that is, 60
percent of total assets should be financed by debt. Thus they not opined that
 7
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there exists optimal capital structure but they also opined that the optimal
capital structure means 60 percent debt to total assets ratio. In other words, the
acceptance of optimal capital structure means rejection of pecking order
hypothesis in Nepalese enterprises.

2. Capital Structure Policy

One of the fundamental issues in capital structure management is whether the

companies have a written or formal capital structure policy as such. During the
survey, it was however revealed that there is nothing like capital structure
policy in Nepalese enterprises. They do not have any formal or written policy
as such as far as the use of debt in capital structure is concerned.

The next aspect of survey dealt with respondents most preferred source of
financing. Table 4.11 clearly shows that the most preferred source of financing
has been the retained earning, followed by bank loan. The external equity and
other sources such as trade credit are not preferred source of financing. The
respondents have no preference for hybrid securities at all. This result is very
surprising because through out the world hybrid type of financing has received
much more attention in recent years.
Table 4.11
Respondents' Preference over Financing Alternatives
Financing Alternatives Rank
1 2 3 4 5
Bank Loan 7 10 3 0 0
Retained Earning 11 7 1 0 1
Debt and Hybrid Securities 0 0 5 6 9
External Equity 1 1 2 8 8
Others (Trade Credit, etc.) 1 2 9 6 2

In other words, when the respondents were asked to rank different

sources/types of financing, they gave the first priority to retained earning; the
second priority to bank loan; the third priority to other sources, like trade
credit; the forth priority to external equity; and the last priority to the debt and
hybrid securities.

3. Tax Effects
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3

One of the important issues in capital structure management is the tax effects,
that is, the tax deductibility of interest payments on debt. About 60% of
respondents opined that tax has an important influence on their capital structure
decisions. Of them, the majority of respondents (about 75%) are in favor of
increasing debt in capital structure from the present level but there are 15% of
respondents who are not willing to increase the present debt level. According to
DeAngelo and Masulis (1980), higher non-debt tax shields, for example,
depreciation expenses and investment tax credit may lead to lower leverage.

4. Influence of Firm Specific Attributes on Leverage

The majority of respondents believe that assets structure and firm size have
positive influence on leverage; and profitability and business risk have negative
influence on leverage. The asset structure refers to whether the firm has more
of long-term assets or more of short-term assets. If the firm has more of long-
term assets, it would employ more leverage, other things remaining the same or
vice versa. As regards the firm size, greater the size of the firms, greater is the
capacity to take risks and higher would be the leverage. As regards the
profitability, higher the profitability, lower would be the leverage, other things
remaining the same or vice versa. Similarly, if the business risk is on higher
side, the firms tend to use less debt in the capital structure. The various factors
affecting the debt level are presented in Table 4.12.

As regards non-debt tax shield, a great majority of respondents are not very
familiar with it. However some 15 percent of respondents opined that that non-
debt tax shield has negative influence on leverage, that is, if the non-debt tax
shield is higher, the lower would be the debt. They would not interest in debt
tax shield and hence would use lower level debt. Thus the debt level depends
on the extent to which the firm has non-debt tax shield. The respondents also
opined that growth has positive impact on leverage. The higher the growth,
more funds would be required for financing the growth and higher would be
the debt ratios.
Table 4.12
Influence of Firm Specific Attributes on Leverage.
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4

Firm Specific Attributes Positive Influence Negative Influence Don't Know/Undecided

Non-Debt Tax Shield --- 15% 85%
Assets Structure 65% 5% 30%
Profitability 25% 70% 5%
Firm Size 70% --- 30%
Growth 45% 15% 40%
Liquidity 25% 45% 30%
Business Risk --- 55% 45%

Regarding the influence of liquidity on leverage, a great majority of

respondents (about 45 percent) opined that liquidity has negatively influence on
leverage. As against this, some 25 % of respondents revealed that there is
positive influence. The survey respondents also believed that leverage ratio
depends on the product market and industry classification.

The above analysis revealed some further facts, which were not revealed by the
analysis of secondary data. The Nepalese financial executives believe that there
exists optimal capital structure. This finding is important which indicates the
need for further research in the area of optimal capital structure.
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5

CHAPTER FIVE

SUMMARY AND CONCLUSION

1. Summary and Conclusion

This study mainly aims at examining the pattern and determinants of capital
structure in Nepalese firms. Its specific objectives are: (i) to determine
structural pattern of the capital structure; (ii) to examine the relationship of
leverage with different financial indicators (ratios); (iii) to make an
international comparison of debt ratios; (iv) to assess the determinants of
capital structure; (v) to investigate whether and to what extent the capital
structure theories can explain capital structure choice of Nepalese firms; and
(vi) to examine managements views on various aspects of the capital structure.

This is perhaps the first study of its kind in Nepal. This study covers 20-non
financial firms listed in NEPSE for the period 1992-2004. For the purpose of
the study, the necessary data were collected from NEPSE database and SEBO
database. The opinions of managers were collected by direct interview.

This study has used ratio analysis to accomplish some of the objectives. More
specifically, it has employed decompositional analysis and properties of
portfolio analysis to assess the pattern of capital structure of the firms.
Econometric models have been employed to analyze the capital structure
determinants both at micro and macro level.

The major findings of the study may be summarized as under:

- Nepalese firms are found highly levered. The decompositional analysis

shows that, on an average, the total debt ratio is 75% and it is 59% when
restricted. The median statistics are 63% and 58% for total and restricted
observations respectively. The long-term debt is found significantly low.
The mean and median statistics of long-term debt are 28% and 19% and
it decrease to 24% and 16% respectively when restricted. The trend of
 7
6

long-term debt is decreasing since 1999. The short-term debt in total

capital is significantly higher. The mean and median statistics of short-
term debt ratio are 47% and 38%; and it decreases to 35% for both mean
and median when restricted. The speed of increase of short-term debt is
higher since 1999. The high contribution of short-term debt ratio over
total leverage and low contribution of long-term debt ratio over total
leverage show the importance of short-term financing over long-term
financing for Nepalese firms. The trend of total debt ratio supported by
short-term debt ratio is increasing. It might be the cause of economic
(business) cycle. The debt ratio tends to increase during recessions and
fall during expansionary periods (Booth et al., 2001, p. 91). The firms
where government has majority ownership have higher leverage ratio
and even more than 100% debt ratio. The government's guarantee for the
loan would be the factor leading higher debt ratio. This evidence is
consistent with early finding of Rajan and Zingales (1995) that firm in
which the state has a majority ownership appeared to have higher
leverage (p. 1735).

- Based on the median value of leverage, Nepalese firms are found less
levered than the G-7 countries except USA, UK and Canada (Rajan and
Zingales, 1995) and four developing countries viz.; India, South Korea,
Pakistan and Turkey. South Korea has the highest median total leverage,
which is 73.4%. However, Nepalese firms have higher leverage than
other 6 developing countries, viz.; Brazil, Mexico, Jordan, Malaysia,
Thailand and Zimbabwe. The Brazil, among all, has the lowest total
leverage ratio, which is 30.3%. Similarly, the Japan has highest long-
term debt ratio, which is 53%, and Brazil has the lowest debt ratio,
which is 10%.

- The study of properties of the portfolio shows that at the lower level of
leverages, firm tends to employ more short-term debt than long-term
 7
7

debt and firm shifts to long-term debt from short-term debt in respect to
increasing leverage ratio. The moderately levered firm are higher
profitable than less levered and highly levered firms. Among others, the
ratio of EBITDA to total asset increases in portfolio is 13.3%. It
increases to 18.3% in portfolio II and decreases to 7.1% in portfolio III.
The profitability measures show that profitability is the concave
function of leverage. On an average, all the firms have more than 50%
collateralizable assets and the firm size and the sales are approximately
equal. The firms having the lower leverage have higher the liquidity.
The median statistics of current ratio of portfolio I is 1.95 and it
decreases to 0.86 in portfolio III. Therefore, the liquidity is the
decreasing function of leverage.

- The econometric analysis has shown that assets structure, liquidity,

growth opportunities, non-debt tax shield, profitability, risk and size are
the major firm specific determinants of the capital structure decision.
The coefficient of estimated parameters of the assets structure and size
are positive; and liquidity, growth opportunities, non-debt tax shield, and
profitability are negative. Therefore, there is positive influence of assets
structure and size and negative influence of the liquidity, growth
opportunities, non-debt tax shield, and profitability on leverage. The
coefficient of RISK is approximately zero, which implies that there is no
relationship between leverage and business risk, however it might be the
consequences of problem in measurement of risk factor. All the
estimates are statistically significant at 1% and 5% significance except
growth estimate. The findings support the capital structure theories and
early findings. The signs of estimates suggest that both the pecking
order and tradeoff theories are at work in explaining capital structure of
Nepalese firms.
 7
8

- The analysis of macroeconomic influences on capital structure shows

that economic growth, inflation and capital market are macroeconomic
determinants of firms' capital structures. The economic growth rate and
inflation rate negatively influence on total debt ratio and short-term debt
ratio, but positively influence on long-term debt ratio. The development
of capital market has positive influence on all three debt ratios.

- The analysis of opinions of respondents on various aspects of capital

structure shows that in Nepalese context, managers prefer moderate to
high or around 60% level of debt, which is regarded as optimal capital
structure by them. During the survey, it was however revealed that there
is nothing like capital structure policy in Nepalese enterprises. The
retained earning followed by bank loan is the most preferred financing
alternative. Tax, product market or industry class, assets structure,
profitability, size, growth, risk and liquidity are perceived by managers
as the major firm specific attributes influencing leverage.

From above, it can be concluded that Nepalese firms are highly levered and
rely more on short-term debt. The trend of debt ratio (total and short-term) is
increasing over the period. It might be the consequences of the regressive
(recession) economic scenario, which results in to lower profitability and
higher leverage (Booth et al., 2001). Similarly, the decreasing or negative
profitability increases the payables, which ultimately increases the short-term
debt. It would be the cause to increase the short-term debt ratio of the firm
since 1999. The high debt ratio could not result into profitability because the
marginal analysis for debt function is concave. The optimal level of debt-equity
combination results in profitability and optimal value of the firm. Both the firm
specific and macroeconomic factors also play important in firms' capital
structure decisions. The retained earning and the bank loads are the most
preferred sources of financing among Nepalese practitioners.

2. Recommendation
 7
9

It is observed that majority of the firms in sample have debt ratio more than
60% of total assets. It is also observed that moderate level (range of 40-60%) of
debt ratio yielded optimal profitability. Therefore, the firms can be benefited by
employing moderate level of debt rather than low or extremely high. The heavy
reliance on short-term debt may not be the positive signal for the profitability
and liquidity, which may result into bankruptcy because of default.

The recommendations of this study are as follows:

Before designing capital structure of any company, a careful attention

should be paid on appropriate features of capital structure and various
determinants of capital structure. It is observed that more executives or
practitioners do not pay attention to their capital structure.

Capital structure of the firm should be compared to similar other firms

or with industry debt. HMG should come up with the policy of industry
data or debt ratios. It will enable the firm to compare with industry data.

One can increase the sample size to obtain more reliable and valid
conclusions. Also, a study extending the survey regarding optimal
capital structure is anticipated.

A study similar to this should be conducted from time to time. The long-
term stability of results needs to be reviewed from time to time. Also,
the determinants of capital structure may vary from one period to
another period, from one firm to another firm and from one industry to
another industry. Hence, a study of capital structure determinants in
individual firm, particular industry should be conducted.

Since the study is based on panel data, estimation techniques for such
data could be somewhat different from OLS and GLS. For panel data,
Arellano-Bond dynamic panel data estimation technique is suggested
which is regarded as better estimation technique of panel data. It also
 8
0

gives the consistent and efficient long-run adjustment on target capital

structure as suggested by tradeoff theory (Arellano and Bond, 1991).

There are different measures of leverage; one can use those different
alternative measures of leverage to test the results.

Cost of capital is another important aspect of capital structure. One can

along study the effect of cost of capital.

The pecking order theory is easier to explain than optimal capital

structure because it is more concerned with behavioral aspect of
management. One can extend research from pecking order theory
perspective too.

A rigorous study of capital structure from macroeconomic perspective is

also expected.

Since the capital structure is one of the most controversial issues in corporate
finance, there is room for study from different perspectives. Even, one can
develop his or her own methodological approach to study various aspects of
capital structure.
 8
1

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APPENDIX A

Secondary Dataset

(not included in this e-version)

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APPENDIX B
Interview Schedule
Name: Position:
Organization: Address:
Date: ..

1. Currently, what type of capital you have employed?

a. Equity Shares
b. Debt and Hybrid Securities
c. Bank Loans
d. Retained Earning
e. Others (If any, specify) ..
2. Roughly, what is your current ratio of debt to total assets?
3. Is there a limit on what you can borrow (debts)?
4. Are you at or very near the limit?
5. What is your preferred leverage ratio?
a. Below 40%
b. 40-60%
c. Above 60%
6. Do you have a formal or written capital structure policy?
a. Yes
b. No
7. What are your preferred financing alternatives (types and sources)? (Please
rank 1 to most preferred and 5 for least preferred).
a. External Equity
b. Debt and Hybrid Securities
c. Bank Loans (Short and Long)
d. Retained Earning
e. Others (if any, specify)
8. Do tax issues have major influence on your financing decision?
a. Yes
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b. No
9. If tax rate increases by 20%, what will be your response?
a. Increase debt
b. Decrease debt
c. No changes
10. In your opinion, how the following firm specific attributes affects on
leverage ratio?
Firm Specific Attributes Positive Influence Negative Influence Don't
Know/Undecided
Non-Debt Tax Shield
Assets Structure
Profitability
Firm Size
Growth
Liquidity
Business Risk

11. Do you think that product market and/or industry class also influence the
leverage ratio?
a. Yes b. No c. Don't Know/Undecided