Dynamics of Financial Structure Adjustments and Firms' Financial Performance

Abstract

This longitudinal study is an empirical investigation into the financial policy of Pakistan's non-financial corporate sector over a thirteen year period starting from 1999 to 2011 by using panel data methodologies. Most significant capital structure theories can be grouped into two broader categories, namely Pecking Order Theory and Tradeoff Theory. The Pecking order theorists believe that firms follow an order of preference for one source of finance over other sources. Tradeoff theory predicts that firms adjust their capital structure on the basis of underlying costs and benefits of the debt and equity capital. Firms optimize their capital structure by balancing marginal cost with the marginal benefit of the debt. Panel data regressions were applied in a systematic way to test the impact of speed of adjustment on financial performance. The empirical results indicate that the size of the firm, profitability, collateral value of assets, firm specific interest rate, non-debt tax shield, spontaneous finance and short term solvency are the significant determinants of the target capital structure. The Size of the firm, the collateral value of asset and short term solvency have a positive relationship with the target capital structure. On the other hand, profitability firm specific interest rate, non-debt tax shield and spontaneous finance has negative relationship. Growth opportunities have positive but statistically insignificant relationship with contractual debt to asset target ratio and positive and significant relationship with Long term debt to asset and total debt to asset target ratios. The results show that the adjustment speed towards target capital varies across industry and over time. The speed of adjustment is affected by the macroeconomic and firm specific factors. Results also indicate that volatile inflation and higher interest rates impedes the adjustment speed. Banking sector performance, GDP growth rate and distance to target capital structure accelerates the speed of adjustment. It is also found that closer the firms are to their target capital structure by speedy adjustments better the financial performance. Speed of adjustment has a significant effect on the financial performance of Pakistan's corporate sector. The results are consistent with the other international studies with ignorable differences.