Optimum Capital Structure

An Empirical Evidence From Emerging Economics

Thesis (M.A.) 2009 53 Pages

Business economics - Economic Policy



Executive Summary

1.1 Scope and Objective of the Study
1.2 Categorization of the Report
1.3 Methodology
1.4 Limitation of the Study

2.1 Financial market
Institutional framework and environment of Bangladeshi firms
2. 3. Corporate Governance Practice in Banks and Financial Institutions
2.4 Problem, Prospects and Challenges of Bangladesh Capital Market

3.1. Defining variables explaining firm 's capital structure
3.1.a. Dependent Variable:
3.1.b. Agency Variables:
3.2.1 Source of Information
3.2.2 Sampling and Population
3.2.3 Statement of Hypotheses
3.2.4 Pattern of the Model
3.2.5 Significant Proxy Variable




Data Appendices

Executive Summary

Capital structure in one of the most converse and vital issues both in the finance literature and practical research. This research deals with the theoretical and empirical aspects of capital structure decision. It is observed that the determination of debt ratio is subtle and sophisticated to determine, and its estimation is still a matter of debate, and yet there is no entirely satisfactory theoretical model for forecasting the optimal debt ratio in the firm's capital structure. There is little consensus on how firms choose their capital structure and how the firm-specific factors influence the shape of the capital structure. This research develops a link between theory and practice of capital structure.

This study has supported a set of sample firms to show the impact of six factors determinants on the financial leverage and how they comply with the findings derived by different previous theories regarding these factors. Least Square method has been used to assess the influence of defined explanatory variables on the capital structure by using the dataset of Bangladeshi manufacturing firms for the period 2000 to 2004. In the analysis, 10 engineering, 15 food, and allied, 3 jute-based companies, 13 textile, 8 pharmaceuticals, 2 paper and printing, 4 cement, 7 miscellaneous companies are used as a sample. This study shows that the independent variables explain around 33% of the variation. Out of Six examined explanatory variables-agency-equity, agency debt, Bankruptcy, profitability are statistically significant determinants of financial leverage., Otherwise growth rate and operating leverage are found to be insignificant. Agency-equity, agency debt, bankruptcy operating leverage, profitability, growth rate, all these are showing a negative relation with the dependent variable.

Among the six determinants agency equity, bankruptcy, profitability, and operating leverage show their expected sign whereas agency debt, bankruptcy, growth shows the opposite sign from the model’s expectation. The most uniqueness of our study that three agency variables: agency equity, agency debt, and bankruptcy are statistically significant determinants of financial leverage.

Also, this paper suggests that the institutional context and macroeconomic events play an essential role in the capital structure decisions of Bangladeshi companies. It would seem appropriate that further research should focus on the role played by the institutional framework, such as the impact of taxation, the practice of good corporate governance, legal and regulatory structure and that of the relative importance of the various sources of credit (securitized debt vs. bank debt).

In this empirical study found that the determinants have a significant role in the companies of the Dhaka Stock Exchange (DSE) based on the agency cost model of capital structure. From an empirical perspective, emphasis should be placed on creating dynamic models that enable to discriminate between the various factors that impact on the target and those that influence the speed of adjustment. The empirical results of this study are consistent with the theoretical expectation.

List of Tables

Table 1: Ownership Concentration by Top Shareholders and Industry

Table 2: Banking System Structure

Table 3: Industry Representation

Table 4: Variable Definitions

Table 5: Variable Formula

Table 6 : Descriptive Statistics

Table 7: Correlation Matrix of Explanatory Variables

Table 8: Model Summary

Table 9: Determinants of financial leverage Regression results

Table 10: - Model Summary


Capital Structure is a mix of debt and equity capital maintained by a firm. Capital structure is also referred to as the financial structure of a firm. The capital structure of a firm is very important since it related to the ability of the firm to meet the needs of its stakeholders. Capital Structure is a topic that continues to keep researchers pondering. Researchers continue to analyze capital structures and intend to determine whether optimal capital structures exist. An optimal capital structure is usually defined as one that will minimize a firm's cost of capital while maximizing firm value. Hence, capital structure decisions have a great impact on the success of the firm. Exactly how firms choose the amount of debt and equity in their capital structures remains an enigma. Are firms mostly influenced by the traditional capital structures of their industries or are there other reasons behind their actions? The answers to these questions are very important because the actions managers take will affect the performance of the firm, as well as influence how investors will perceive the firm. Lubatkin and Chatterjee (1994) prove that there exists a relationship between capital structure and firm value. In more recent literature, authors have shown that they are less interested in how capital structure affects the firm value. Instead, they lay more emphasis on how capital structure impacts on the ownership/governance structure thereby influencing top management of the firms to make strategic decisions (Hitt, Hockessin and Harrison, 1991). These decisions will in turn impact on the overall performance of the firm (Jensen, 1986). Nowadays, the main issue for the capital structure is how to resolve the conflict on the firms' resources between managers and owners (Jensen, 1989). Many of these theories have also been empirically tested. But little analysis has been made on the ground of capital structure theories and determinants of capital structure in the context of Bangladesh. Only an extensive and resourceful analysis by Chowdhury (2004) shed light on this issue. As a result, the study of capital structure determinants bears significant importance in the context of Bangladesh. Our study attempts to test the influence of various explanatory variables in the capital structure and the association of these variables with the capital structure theories. Unlike Chowdhury (2004) who focus on the capital structure determinants on both Japan-Bangladesh contexts, this study sample, on the other hand, spans 100 Bangladeshi companies. Thus, this report aims to see the sights the determinants of capital structure for Bangladeshi companies. Chowdhury (2004) used some agency variables and some other variables (i.e., bankruptcy risk, growth rate, profitability). In this research paper, I have endeavored to observe the determinants of capital structure in a complete way using some additional variables- agency-equity, agency debt, bankruptcy risk, profitability, growth rate, operating leverage listed to Dhaka Stock Exchange Ltd. as of November 2005. And the research findings will show how much significance the variables are for the capital structure in the context of Bangladeshi companies enlisted in the stock market.

1.1 Scope and Objective of the Study

The most important aspects in shaping the long-term existence and profitability of the company in financial management pronouncements are financing, and investment and the decision of financing, as well as the decision of capital structure, determine the ownership for the contributors of finance and arrangements with the firm's choices of the types of securities to issue. The major concern of contest turns around the determination of optimal capital structure. While deciding the optimal capital structure various factors like ­ equity, agency debt, bankruptcy, profitability, growth rate, operating leverage and various agency problems associated with different securities including costs of adverse selection.etc.

The scope of the study is the determination of the significance of capital structure variables to ensure the optimal capital structure among the firms of the developing countries like Bangladesh.

Thus, this spot envelops a wide-ranging. This research paper effort to focus on those matters as follows:

- To spotlight on the different theoretical development that arises from the capital structure.
- To explain the determinants of the optimal capital structure.
- To find out the determinants of the capital structure of Bangladeshi firms.
- To highlight the financing sketch out of Bangladeshi firms.
- To focus on the organization atmosphere of Bangladeshi firms.
- To find out the significance of determinants on the capital structure of Bangladeshi firm.
- To find out whether the findings of this empirical study sustain or counter the theoretical remark of capital structure theories.

1.2 Categorization of the Report

The structure of the research paper is organized as follows:

In Chapter One, Introduction of research Chapter two is involved with a emphasize on the practical financing pattern and financial environment of Bangladeshi firms.

The research design and the data are accessible in chapter three, while the results from using multiple regression models are discussed in chapter five. Finally. Chapter five brings to a close the study.

1.3 Methodology

The study is based on a model developed by Dodd (1986) to test the determinants of capital structure. The study explains the variation in capital structure among the firms of Dhaka Stock Exchange (DSE) by the six explanatory variables included in the model.

Different methodologies have been used to fulfill the objectives of the study.

- This study is based on secondary data. The main source of data collected from Balance Sheet Analysis of Joint Stock Companies published by Statistics Department of Bangladesh Bank on November 2005 for the required financial statements from period of2000-2004, Dhaka Stock Exchange (DSE).
- Information and data were required on the official website of DSE and available financial statements. Literature Review related to Capital Structure Theories and past studies is extracted from different website financial Journal.
- Multiple regressions were run to evaluate the relationship between the determinants of capital structure and the debt level.

1.4 Limitation of the Study

Although this study covered all the relevant concerns, it has some major shortcomings

- Due to the limited access to the data. I have located that companies' conventional information afforded in the research and other documents. This study may not be perfect in completely.
- Another major constraint is timing. Master research program is a short period curriculum to practice a long and comprehensively research analysis.
- A good number of cases to get true market value data. This is sometimes rigid to identify the Capital structure.
- Due to a few former accurate experiences, it is entirely and perfectly may not be explained capital structure theories, determinants of capital structure, multiple regression analysis, and interpretation of the findings.
- The experiential analysis is being efficiently non-dynamics may be incapable of reproducing the character of the dynamic capital structure modification by firms.


A hale and hearty, apparent and dynamically evolving financial system help mobilize savings and allocate resources, ensure safe and efficient payment and settlement arrangements and ease financial crisis management. Financial Institutions are investment intermediaries linking the savers and users of the fund. These intermediaries are interposed between the ultimate borrowers and lenders permitting them the efficient transfer of funds. Individuals having surplus funds can lend them for reasonable return to entrepreneurs who need funds to take advantage of economically and financially viable investment opportunities. The existence of financial market (both money and capital market) and financial -institutions facilitate such exchange of resources.

Thus, these markets and financial institutions have a positive role in financing and investment which is a multidimensional process involving the complexity of many interrelated and interdependent factors of diversified nature. Continuous efforts are made over the years to establish a sound financial system in the country to help them play their role. This chapter shed lights on the contribution by the financial market and institutions to the firms' capitalization.

2.1 Financial market

Financial markets are of two types; the money market, which is divisible, under two sectors: organized and unorganized. The unorganized market is largely made up of informal moneylenders. There are three main components of the unorganized sector of the money markets;

i. Interbank call money market
ii. Bill market and
iii. Bank loan market.

The other financial market is the capital market that can be divided into two sectors: organized and unorganized. The organized area comprises the stock market, banks and development banks.

The unorganized sector is primarily made up of moneylenders.

In the view of practical situation financial market is divided into security and non-­ security market segment. Security market can be broken down into new issue market which refers to the IPO market and secondary market.

The secondary market can be classified into an organized stock exchange like Dhaka Stock Exchange (DSE), Chittagong Stock Exchange (CSE) and the second category is over the counter market, there is no OTC in Bangladesh.

Despite the Bangladesh economy, faced challenges originating from price hike of some essential commodities in the international market coupled with upward adjustment in the domestic fuel prices and supply disruption of domestic front causing fluctuations in the real sector over the last few years, the overall financial market was sound functioning during the year. To establish a healthy, sound, well functioning and dynamically evolving financial system a series of reform measures were initiated.

2.1.a Contribution by Money Market

Over the years, there is continuing effort to establishing a well functioning and stable money market. Effective monetary operation mainly use of shorter-term monetary instruments such as reverse repo and reintroduction of Bangladesh Bank Bills helped keep the money market sound and stable during the financial year 2008. Steps towards the activation of secondary trading in treasury bills/bonds were also continued. As a result, the overall money market situations remained stable and sound over the last year.

2.1.b Contribution by Capital Market

The amount of industrial term loans disbursement by banks and financial institutions stood at Taka 201.5 billion, many-fold higher than the amount of Taka 7.4 billion raised by new capital issues through private placements and public offerings in the capital market in FY08. This indicates the overwhelming preference of bank finance in industrial investment financing. The dominance of term loans in investment financing implies low equity stake and risk exposure of the owners, with a disproportionately high incidence of risk on the lending banks and financial institutions, including liquidity risk arising from the funding of these long-term loans with typically shorter-term deposits.

The share market witnessed robust growth during FY08 aimed at a healthy economic prospect and outlook. As there was the demand of securities having good fundamentals in the capital market, at the time of the rise in order, the prices of securities listed on exchanges showed a significant upward trend that turned the capital market somewhat volatile. On the other hand, major economic indicators showed a positive direction to support the gradual development of the market. The capital market was very active during FY08 because of significant improvements made in protecting investors' interests and boosting the confidence of investors in the capital market, introducing automated trading through electronic registration and transfer of securities, simplifying rules and regulations and notifying guidelines on corporate governance on comply or explain basis. These measures have created an investment-friendly atmosphere in the capital market, and a positive impact has been noticed in both primary and secondary market. Thus, the depth of share market and daily turnover of securities transactions have notably increased. Besides, positive public perception about the Bangladesh Bank supervision of banks and financial institutions in addition to the general Securities and Exchange Commission (SEC) supervision of public companies continued to attract keen investor interest in the new capital issues of banks and financial institutions. This reawakened investor confidence in the capital market should extend to unique aspects of listed companies in other economic sectors with stronger SEC supervision, more demanding audit and financial disclosure standards, and credit rating of issuers by independent rating agencies.

2.1.c Contribution by the ICB

The three subsidiaries of state-owned Investment Corporation of Bangladesh (ICB) namely the ICB Capital Management Ltd. (ICML), the ICB Asset Management Company Ltd. (IAMCL) and the ICB Securities Trading Company Ltd. (ISTCL) under ongoing restructuring program of the capital market development program (CMDP) are functioning in the capital market in Bangladesh. The ICB capital management subsidiary ICML acted in the roles of underwriter, issue manager and placement services provider. The net investment against the investors' accounts stood at Taka 2.57 billion in FY08. The net investment and the market prices of the company's portfolio stood at Taka 0.61 billion and Taka 0.58 billion respectively at the end of June 2008. The ICB asset management subsidiary IAMCL floated three closed-ends and two open-end mutual funds in FY08. The net investment in the portfolios of the funds stood at Taka 0.55 billion, and the market prices of net investment rose at Taka 1.85 billion as of end June 2008. Besides, the own financing of IAMCL, the net investment and the market prices of net investment of the mutual funds stood at Taka 0.21 billion and Taka 0.47 billion respectively as of end June 2008. The ICB securities trading subsidiary ISTCL emerged as the largest stockbroker in the country handling total turnover worth Taka 60.58 billion in FY08. The parent ICB itself sold unit certificates amounting Taka 0.21 billion against repurchase of unit certificates amounting Taka 0.30 billion in FY08. In FY08, the ICB received deposits of Taka 0.33 billion and approved loans of Taka 2.1 billion in investment accounts or investors. The volume of securities traded in FY08 of the ICB stood at Taka 43.12 billion against Taka 13.06 billion traded in FY07. Total commitments for investment made by the ICB in FY08 stood at Taka 4.65 billion of which, for pre-IPO placement of share Taka 0.60 billion, pre-IPO placement of debenture Taka 0.46 billion, purchase of preference share Taka 0.45 billion, investment in equity Taka 0.21 billion, purchase of debentures Taka 1.17 billion, investment in bond Taka 0.54 billion and in lease financing Taka 1.22 billion. In FY07 the total amount of commitments was Taka 4.32 billion.

2.1.d Scheduled Bank Investments in Capital Market Securities

Holdings of capital market assets (equities, debentures) by scheduled banks stood at Taka 43.1 billion as of end June 2008 as against Taka 32.9 billion of period June 2007. Outstanding advances of scheduled banks against shares and securities amounted to Taka 6.3 billion at the end of June 2008, which was Taka 2.9 billion as of end June 2007.

2.2 Institutional framework and environment of Bangladeshi firms

Bangladesh is an emerging economy with massive potential of growth, which is precisely one of the reasons on why it is necessary to enforce critical strategies such as sound functioning of capital market at the juncture of the growth stage to promote investors' confidence, improve investor’s perception and macroeconomic stability. Economic reform is stalled in many instances by political infighting and corruption at all levels of government. Progress also has been blocked by the political unrest, high level of bureaucracy, trade unions, and other vested interest groups. For higher GDP growth, investments in both public and private sectors will need to be accelerated. Sound political and economic stability can encourage investment in the private sector. The recent trend of foreign direct investment is very encouraging. The government is committed to the market economy. Bangladesh has been pursuing policies for supporting and encouraging private investment and eliminating unproductive expenditures in the public sector. Several measures have been taken to strengthen the planning system and intensify reforms in the financial industry.

3.2.a Legal and regulatory environment:

Financial workers are regulated under the legal and regulatory framework of a country. These regulations provide a guideline for the participants under which terms and conditions financial assets will be traded. The success of any economic system largely depends on the efficient regulatory and legal environment. Various organizational and institutional settings regulate the capital market of Bangladesh. The primary sector of the capital market is the security market, which is governed by specific rules and regulations.

There are Security and Exchange Commission (SEC) Register of Joint Stock Companies (RJSC), Dhaka Stock Exchange (DSC) and Chittagong Stock Exchange (CSE). Among them, SEC is under the Ministry of Finance, and RJSC is under the ministry of Commerce. DSE and CSE are a corporate body under the company Act. They are self has listing rules; in many cases corporate listing with DSE and CSE are influenced by the requirement of the regulatory authorities or the financial institutions, which impose listing requirement as a condition of getting credit attaching lesser importance to the other benefits of stock listing. This regulatory framework possesses some weaknesses regarding its methods of trading, protection of shareholders and conduct of members. Their listing rules are generally outdated and lack objectivity and detailed provisions for administration of listed stocks. DSE and CSE do not ensure disclosure of information on listed companies to protect investors' interest. They do not enforce disciplinary regulations, so that violation of rules and regulations is minimized. In this view Investment Corporation of Bangladesh (ICB) was established to develop a well-functioning capital market, which ultimately has aggravated the optimists. However, SEC of Bangladesh, which is responsible for overseeing the market, is taking initiatives to mitigate agency conflict among different parties through ensuring transparency and defining the code of conduct of the participants.

2.2.b Ownership structure:

The ownership structure is an important determinant of capital structure choice because the distribution of claim has significant influence over the determination of capital structure. For family groups inclined to within themselves. There were found that most of the family owned enterprises wanted to confine their holdings amongst their family members and relatives. It was also reported that even when the company is listed on the stock exchange, few shares are available for trading as the majority remain held by the original sponsors. They often buy additional shares from the market to raise their holdings to as 70 percent or 80 percent though shares are floated in the primary market on 50:50 basis (Chowdhury, 2004) In Bangladesh households are the largest shareholders group although stocks as a percentage of overall household wealth has always been small in the portfolio composition of stock investors, not to speak of the general public. The distributions of stockholding in Bangladesh are skewed ownership structure of Bangladeshi companies as a fundamental issue, of late, the authorities have adopted several policies intended to broaden the base of share ownership as follows:

- The government has withdrawn all restrictions on foreign investment, permitting them to invest directly in the primary and secondary market. The restriction on the sale of shares at a premium has been withdrawn
- No permission is now required to issue Right or bonus shares within some limit.
- 55 percent of IPOs have been reserved for the minimum lot of Tk. 5000.

However, the change in the ownership structure cannot necessarily be explained from the side of individual investors' behaviour only. Corporate behaviour has also it's bearing on it.

The following table ownership concentration by top shareholders' different industry wise in the highest and lowest position.

Table 1: Ownership Concentration by Top Shareholders and Industry

Abbildung in dieser Leseprobe nicht enthalten

Source: Imam and Mallik (2007, pg.92)

2.2.c Banking Sector Performance

The banking sector of Bangladesh comprises of four categories of scheduled banks. These are State-owned Commercial Banks (SCBs), State-owned Development Finance Institutions (DFis), Private Commercial Banks (PCBs) and Foreign Commercial Banks (FCBs). The number of banks remained unchanged at 48 in 2007. These banks had a total number of 6717 branches as of December 2007. The number of bank branches increased from 6562 to 6717 owing to the opening of new branches by the PCBs during the year.

Structure of the banking sector with a breakdown by type of banks is shown in Table 2.

Table 2: Banking System Structure

Abbildung in dieser Leseprobe nicht enthalten

Source: Author’s work

2.3. Corporate Governance Practice in Banks and Financial Institutions

Corporate governance is the system of internal controls and procedures used to define and protect the rights and responsibilities of various stakeholders The Anglo-American type of governance system is practiced in Bangladesh which is characterized by shareholder's interest through corporate market control, the board of directors and direct intervention by large stockholders. In Bangladesh bank-firm relationship is not so intimate. Due to regulatory arrangements, Bangladeshi Financial Institutions are not allowed to participate in stock investment i.e. holding of debt and equity. Banks and Financial Institutions in Bangladesh do not monitor the loan and investment or provide any support to concerned firms. The corporate sector in Bangladesh is hoped to be capable enough to provide a setup for good corporate governance institutionally.



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optimum capital structure empirical evidence from emerging economics




Title: Optimum Capital Structure