A study of Risk Management Implications for Capital Structure and the Cost of Capital in Pakistani Listed Companies

Abstract

The present research explores the presence of a simultaneous relationship between the management of risk exposures, capital costs, and capital structures in Pakistan. It highlights the management of risk exposures and its effect on distinctive parts of an organization, for example, the cost of financing and its financial structure. MM’s traditional theory have been tested in various locations worldwide, with a few studies focusing on risk management (RM). However, in Pakistan, lack of evidence is available for the management of risk exposures as a critical parameter in finding the optimal capital structure and reducing costs. Overall, the data of 117 companies (consisting of 92 nonfinancial and 25 financial companies) listed on the Karachi Stock Exchange (KSE) from year 2010 to 2014 were analyzed using statistical and econometrics methodologies such as the generalized method of moments (GMM). To test the validity of the GMM model, Hausman, Breusch- Pagan, and Durbin-Wu-Hausman diagnostic tests were applied. In the panel data model, the bivariate analysis results were found to be consistent with simultaneous equations. Using three linear regression equations, the research questions are addressed, yielding meaningful results. The research questions explored in this paper involved simultaneous decision settings, the effect of the management of risk exposures, the determinants and the impact of agency cost, the cost of capital and the optimal capital structure of the KSE-listed companies. The results are as follows. The results of equation 1 show that the capital structure, size, costs of capital and liquidity have a significant positive influence on the management of vii risk exposures in the selected firms. The results of equation 2 show that the cost and structure of the capital, tangibility, size, tax savings, and investment opportunities on the cost of capital are significantly positively impacted. The results of equation 3 demonstrate that the cost of capital has significant positive effects on capital structure, firm size, investment opportunity, tax savings, tangibility and profitability. Furthermore, other findings include the optimal level of an organization’s capital structure (59% for nonfinancial firms as compared to 51% for financial firms) and agency costs resulting in a reduction in risk exposures. A financial and non-financial firm’s agency cost have significantly positive influence on the management of risk exposures.