Macroeconomic Factors Influencing Firm’s Capital Structure: Evidences from Pakistan and India

Abstract

Capital structure is concerned with the long term financing of the firm and is recognized as an important managerial decision because of its influence on the value and riskiness of the firm. The theory of capital structure came into prominence after the landmark study of Modigliani and Miller in 1958. Since then numerous researches have been carried out to find out whether capital structure matters or not. During this time a number of factors have been identified which could influence firm financing decisions. These factors are categorized into internal factors and external factors. Initially most of the researches have focused on internal factors whereas in recent times we have witnessed the shift in focus from internal factors to external factors. During the last few decades, the macroeconomic environment has change considerably around the globe thus presenting numerous challenges for managers to run businesses successfully. Changes like integration in international financial markets, deregulation, trade liberalization, increased mobility of capital across countries have made national economies vulnerable to real and monetary shocks occurring in the global markets. Changes in macroeconomic environment are a major concern for modern managers because firm’s corporate performance is strongly affected by it. Therefore, the purpose of this study is to measure the effect of macroeconomic factors on the capital structure of non-financial firms in India and Pakistan. Panel data regression (fixed effects model) was used to measure the effect of macroeconomic factors on capital structure. Data from 2004-2013 for 929 firms was collected from World Bank database, State Bank of Pakistan database and Money control database. The findings of the study revealed that macroeconomic factors significantly influence capital structure decisions of the firm. The effect of corporate taxes, real interest rates, GDP growth rates on economic leverage is positive whereas exchange rates, public debt and stock market development show a negative effect on with economic leverage. These findings are attributed to the challenging environments of Pakistan and India. Both countries are in the development phase where financial markets are not fully developed and governments’ inclination to financing budget deficits through local borrowing leaves very little for the private sector borrowing. Real interest rate, corporate taxes and GDP growth rate viii positively influences economic leverage thus showing firm preference for exploiting tax shield advantages. Furthermore, in comparative analysis of Pakistani and Indian firms, it was found that corporate taxes, GDP growth rates and exchange rates are significantly affect economic leverage in Pakistan whereas in India only corporate taxes is significantly influencing capital structures of listed firms. Hence, if governments in both countries provide better and stable monetary and fiscal policies, improve law and order and provide a friendly business environment then firms will greatly benefit by taking long-term financing decisions that will be influential in the growth of firms as well as overall economy. In future similar studies can be conducted involving financial firms as well as other external factors like political, technological factors etc. to measure their impact on firm leverage.