Abstract
Why the financial structure is still believed to be relevant within business firms? A number of
competing theories have been developed for explaining this question. The three theories that
stand out are Pecking order, Trade off and Agency cost. However, the first two are frequently
referred to and contradictory to each other. The ‘trade-off’ theory suggests that corporate
taxes in combination with bankruptcy costs imply that there exists an optimal combination of
debt and equity capital that management should search for in order to maximize shareholder
value. The challenging ‘pecking order’ theory recognizes no such optimum, but instead states
that there is a ranking order in the firms between different types of capital where the issuance
of equity capital is seen only as a last resort. This paper examines the role and importance of
different firm characteristics that explain financial structure as well as the theories that best
fit in Pakistani context and considers concepts like optimal capital structure, risk, financial
hierarchy and asymmetric information. The sample of the study consists of firms extracted
from financial (70 firms) and non-financial (120 firms) sectors listed on the KSE for a period
of 2000-2013. Secondary data is extracted from firm’s annual reports. The sources like SBP
publications; Bloom burgee business week and KSE were used to collect data. The results
indicate that firms in the two sectors prefer funds generated internally for financing their
assets. Moreover debt will be preferred to equity once external funds are required. The
pecking order appears to be a good description of financing behavior for a large sample of
firms over a long time period after accounting for debt capacity. We have also studied agency
theory of the firm however there was little evidence to support the Agency cost theory.
Dr. Fazal Husain, Dr. Sajid Gul. (2015) Testing Trade-off, Agency Cost and Pecking Order Predictions of Capital Structure: Lessons from the Pakistani Experience, Journal of Independent Studies and Research-Management, Social Sciences and Economics, Volume-13, Issue-2.
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