Key Determinants of Capital Structure in Iran

1.1 Background

Capital structure choice is one of the important financial decisions that can affect firm’s value. Capital structure has been studied by many scholars during past five decades, which in turn generated some theories and various finding in this area of corporate finance. Definitely, Modigliani and Miler (1958, 1961) theorem of capital structure had a significant contribution on developing capital structure literatures .They proposed two approaches of capital structure under certain assumptions, based on Modigliani and Miler (1958), there is no differences between debt and equity financing under perfect market assumptions, and so capital structure decision is irrelevance. While Modigliani and Miler (1961) considered corporate tax and proposed debt financing will increase value of the firm.

Since then by the end of 1990, many researchers studied potential determinant of capital structure (in addition to taxes) and introduced new theories of capital such as trade of theory and pecking order theory based on different models including, agency cost model (Jensen and Meckling (1976), Chang (1987), Stulz(1990), Harris and Raviv (1990)), asymmetric information model (Ross (1977), Myers and Majluf (1984), Brennan and Kraus (1986) ), product / input markets interaction model (Titman (1984), Brander and Lewis (1986), Saring (1988)), and corporate control model (Harris and Raviv (1988), Stulz (1988), Stulz (1988)). They concluded that in addition to debt tax shield other factors including earning volatility, bankruptcy probability, fixed assets, non-debt tax shield, research and development expenditures, profitability, growth opportunity, free cash flow and uniqueness may effect firms capital structure . The capital structure literatures have been evolved by endeavourer of researchers for empirically testing new theories of capital structure.

Majority of main capital structure findings are based on data from developed countries such as United kingdom, Germany, France, Italy, Canada, United States and Japan ( Titman and Wessel (1988), Rjan and zingales (1995), Myers (1999), Bevan and Danbolt (2000), Antoniou, Guney, and Paudyal (2002).

There are few outstanding studies that use data from developing countries, for instance Booth, Maksimovic, and Demirguc-Kunt (2001) studied capital structure by employing data from Brazil, Jordan, India, South Korea, Pakistan, Malaysia, Mexico, Turkey, Zimbabwe and Thailand, Deesomsak, Paudyal and Pescetto (2004) utilized data from Asia Pacific Region, Tong and Green (2005) analyzed data from China, Chakraborty (2010) used data from India.

1.2 Financial resources for Iranian companies

There are mainly two financial resources namely internal and external resources, for any company, everywhere in the world .The internal sources of fund is almost the same for all companies apart from geographical locations, while the availability of external fund depends on level of capital market development and structure of banking system in each countries. As far as Iranian companies are concerned, the available financial resources for them is consist of stock market, bond market and bank loan.

1.2.1 Iran stock market

Tehran stock exchange (TSE) incorporated in 1967 with 6 listed companies and experienced three different period of time as following.

1967-1978: the number of listed companies increased from 6 to 105 companies and TSE experienced a good period of time and attracted both companies and investors.

1978-1988: In this period of time, TSE severely affected by two major events, the Islamic revolution and Iraq’s war, and the value and number of exiting companies reduced dramatically.

1988 -2009: This period is full of up and down for TSE, for example during 2001 to 2004 return on investment in TSE increased and reached to 134 % in 2003, while it experienced very tough situation in 2007. The numbers of listed companies increase from 88 in 1988 to 417 in 2006 and then reduced to 337 in 2009.TSE consists of main and secondary market with own listing requirements and regulations.

1.2.2 Iran bond market

Bond market in Iran is at an early stage of development, and in fact there is no considerable corporate bond market. The listed companies on TSE were allowed to issue corporate bond in 2003, these bonds, which called participation paper, are short tem bond between 1 to 3 years .fixed income instrument and shariah complaint.

1.3 Problem Statement

Capital structure mainly studied in developed countries and still there is a lack of study for developing countries especially Iran. Capital structure of Iranian companies influenced at least by three main different factors from firm capital structure in developed countries .Firstly Iranian companies rising fund based on Islamic Financial Systems which has own regulation in banking and financial market .Secondly financial market especially bond market are less developed in Iran compare to developed countries which limit debt financing mostly to bank loan. Thirdly most economic activity directly or indirectly controlled by government which may affect firm capital structure in Iran.

In the case of Iran by the time of writing this thesis, seven papers (published on international journal) about determinant of capital structure have been found, which have own limitations and problems, such as employing limited number of variables, using little number of firms, choosing short horizon of time study, and even some statistical problems in running regression models. Hence, there is still a room for studying capital structure of Iranian companies by testing more independent variables in longer period of time with accurate and sophisticated model.

1.4 Research questions and objectives

This study aims to, firstly clarify determinant of capital structure for Iranian companies and secondly study importance of each factors on capital structure choice, and thirdly determine which capital structure theory, trade off or pecking order, better explain capital structure choice of Iranian companies.

1.4.1 Research questions

In order to achieve these goals the following question marked in this study.

  • Which factors determine capital structure of Iranian companies?
  • What is the importance of each factor on Iranian firm capital structure?
  • Do firms’ capital structure choices in Iran follow trade off or pecking order theory?

1.4.2 Research objectives

In order to answer the study’s questions the following objectives determined:

  • To find relationship between liquidity and debt ratio
  • To find relationship between profitability and debt ratio
  • To find relationship between tangibility and debt ratio
  • To find relationship between growth opportunity and debt ratio
  • To find relationship between business risk and debt ratio

1.5 Research hypothesis

There is two set of hypothesis based on capital structure theories. First group is based on trade off theory and second one is based on pecking order theory.

1- Trade off theory and determinant of capital structure

Trade off theory considered optimal capital structure based on balance between advantage and disadvantage of debt financing, so firms has own optimal capital structure that maximize its value. Based on this theory profitable, highly liquid and firm with more tangible assets should have higher level of debt, while companies with more growth and higher earnings volatility have lower amount of debt.

H1: There is a positive correlation between liquidity and debt ratio

H2: There is a positive correlation between profitability and debt ratio

H3: There is a positive correlation between tangibility and debt ratio

H4: There is a negative correlation between growth and debt ratio

H5: There is a negative correlation between business risk and debt ratio

2-pecking order theory and determinant of capital structure

Pecking order theory doesn’t hold optimal capital structure and proposed firms should finance with internal over external fund and debt over equity whenever external financing is unavoidable. According to this theory firm with more tangible assets and growth opportunity should have higher amount of debt while profitable and highly liquid firm have lower amount of debt, also firm with higher bossiness risk should have lower amount of debt.

H6: There is a negative correlation between liquidity and debt ratio

H7: There is a negative correlation between profitability and debt ratio

H8: There is a positive correlation between tangibility and debt ratio

H9: There is a positive correlation between growth opportunity and debt

H10: There is a negative correlation between business risk and debt ratio

Table 1.Summary of predicted sign between independent variables and debt ratio

Trade off Theory

Pecking order theory













Business Risk



1.6 Research instrument

The study mainly use secondary information, in forms of annual financial information of Iranian companies listed on Tehran stock Exchange consist of balance sheet and income statement available online at www.codal.Ir official web site of Tehran stock exchange for company’s announcements and financial information.

1.7 Research approach and methodology

The research approach is based on quantitative approach, since the study deal with numbers in form of financial ratio. Research methodology is based on OLS regression model with five independent variables and one dummy as following:

Yit=α +β1LIQit + β2PROit + β3 TANit + β4GROit + β5BUSRit+ β6DUM+e

Y =Total debt over total asset

LIQ=Current asset divided by current liability

PRO=Earnings before interest and tax divided by total asses

TAN= Fixed asset divided by total assets

GRO=Percentage change in total earnings

BUSR= Absolute difference between the annual percentage change in earnings before interest and taxes and the average of this change over the sample period

1.8 Justification of study

The importance of capital structure and firm’s value widely accepted by both scholars and financial managers, since capital structure affect cost of capital or expected earnings, however there is still debate about how companies rising fund. In recent years, the number of listed companies on Tehran stock exchange increase and the issue of capital structure choice became important for both firm’s owner and investors. As there is lack of study about capital structure of Iranian companies, this study tries to clarify firm’s capital structure in Iran and expand frontier of knowledge in this area, furthermore it provides some insight for financial and executive managers.

1.9 Structure of the Research

The following chapter organized in this thesis as following; Chapter 2 introduce summary of literatures on capital structure theory and determinant of capital structure based on trade off and pecking order theory, furthermore it presents selected article in both developed and developing countries and discussed main articles in Iran. Chapter 3 presents research methodology, data sampling, regression equation and assumptions. In chapter 4 regression assumptions and final result are demonstrated. And finally in chapter 5 main findings and conclusions are discussed.

Chapter 2: Literature Review

2.1 Introduction

Capital structure is one the arguable area of financial research and the mystery of debt and equity equation in firms’ capital structure is not completely clarified. However, the tax shield benefit of debt financing obviously accepted and understood by both financial managers and researchers. There are mainly three approaches of capital structure. At on extreme, net income (NI) approach (Durand, 1952) states that firm can lessen its cost of capital and thus increase its value by debt financing. In contrast, net operating income (NOI) approach, also proposed by Modigliani and Miller (1958) claims that firm’s value and capital structure are independent and debt and equity financing create the same value.

Solomon (1963) introduced intermediate approached of capital structure, also known as traditional approaches, which explains that the firm’s value increase when financial leverage rises and it becomes constant on designated level of debt and finally the firm’s value decrease. In fact this approach holds the concept of optimal capital structure. In other word, the companies should have a target capital structure and follow it in order to increase firms’ value. Various theories of capital structure have been developed during past five decades that mainly tried to illustrate relation between capital structure and firms value, and also find important factors of effect capital structure selection. At the same time, vast amount of empirical studies have tried to test and confirm capital structure theories, however, they have shown various results regarding effectiveness of these theories.

The aim of this chapter is to introduce the primary theoretical themes that have evolved to explain capital structure vagueness. It is also intended to review the main empirical research that have been studied to test correlation between firms characteristics and capital structure to present some of the evidence that have been collected. The structure of this chapter is as follows. Main capital structure theories are explained in section 2.2, in section 2.3 firms’ characteristics and capital structure are discussed, and results of selected empirical studies are reviewed in section 2.4.

2.2 Capital structure theories

Modigliani and Miller (1958) introduced modern theory of capital structure known as MM theory that basically considered as a foundation of modern corporate finance. Modigliani and Miller theorem consist of two distinct propositions under certain assumptions. The two propositions declared under assumption of perfect capital market and in the absence of bankruptcy cost, transaction cost, symmetry information and the world without tax.

MM Proposition I: argue that the firm’ value and capital structure are independent, it means that whatever capital structure selected for the firm the value would be the same. In other word under this proposition, the value of levered firm (VL) is the same as unlevered one (VUL) and managers should not worry about the firm capital structure and they can freely choose whatever composition of debt and equity.


MM Proposition II: claims that cost of equity increase with leverage because risk to equity rise as well, so weighted average cost of capital remain constant as lower cost of debt compensate with higher cost of equity. In other world, cost of equity remains constant with any degree of leverage, and it is a linear function of debt equity ratio.

However, Modigliani and Miller (1963) evolved their propositions under presence of corporate tax rate (t) while keeping other assumptions. They argue that the value of firms increase with rise of financial leverage as they do not pay tax on their interest paid (D) to debt holders. Furthermore, weighted average cost of capital is not constant and result of linear function of debt to equity ratio. Because, firm do not pay tax on interest paid to debt holders, weighted average of cost of capital decreases as financial leverage rises.


Friend and Lang (1988) states that there is a negative relation between profitability and Debt which is inconsistent with MM theory as the more profitable firm should use more debt in order to increase tax shield benefit of debt. Modigliani and Miller propositions are difficult to test directly (Myers, 2001).Furthermore, Fosberg and Paterson (2010) points out MM theory have been rarely tested by researchers in an exact form described by MM; however there has been some testing of application of theses propositions. Fosberg and Paterson (2010) tested MM equation in the exact form specified by MM and concluded that:

“…neither the MM tax nor the no-tax valuation equations are accurate predictors of firm value. Specifically, the value of the unlevered firm accounts for much less of firm value than predicted and the sign of the coefficient of the interest tax shield variable is negative, instead of positive as MM predict.”

However, MM theory is not applicable in real world with transaction and bankruptcy cost.

2.2.1 Pecking order theory

The pecking order theory (Myers and Majluf, 1984) is a capital structure model based on asymmetry of information between insiders and outsiders that first introduced by Donaldson (1961). The main idea of this theory is that managers have private information about firm’s performance, projects and prospective which are not available for outsider investors, so the selection of firm’s capital structure shed light on outside investors about information of insiders. Consequently, investors will perceive investment decision without issuing securities as a positive signal, while they considered issuing share as negative sign that reduce share price which they willing to pay. The information asymmetry may bring about manager give up positive NPV projects in order to avoid share price falling, since they assume to act in interested of shareholders. To eliminate this underinvestment problem, managers try to finance new projects in a way that is not undervalued by market.

According to this theory (Meyer, 1984), there is no specific target capital structure for the firms. It states that in pecking order model firms adopt hierarchical order of financing, which means that managers prefer internal financing over external financing and debt over equity whenever external funding is unavoidable; also mangers prioritize short debt over long term debt. Internal funds compel no floatation cost and need no disclosure of financial information and firm prospects including firm’s potential gain and investment opportunities. The pecking order theory envisages that amount of debt goes up when investment exceeds internal funds and decrease when amount of investment is fewer than internal financing resources. So as long as firm‘s cash inflow exceed firm’s capital expenditure, there is no need for external financing.

Since introducing pecking order theory in 1984, some empirical studies have been conducted to test this theory, Shyam-Sunder and Myers (1999) studied small sample of firms from 1971 to 1989 and find supporting result for pecking order model. Frank and Goyal (2003) used a large sample of the firm and find less supportive result for pecking order theory .However, they point out that larger firms show better pecking order model performance than smaller firms which is in line with to pecking order theory. Since smaller firms have higher potential for information asymmetry than larger firms, which is main deriver of pecking order theory. De Jong et al (2010) studied US firm over 1971-2005 and find that small firms do not behave according to pecking order theory that support notion of asymmetry information in pecking order model.

Vidal and UGED (2005) describe limitation for Myers and Majluf (1984) model of pecking order theory. Firstly, they claim that Myers and Majluf model refers to American market which firms offered their share mostly through firm commitment underwriting and not right issue .Hence, when the share price is undervalued, the wealth shift form current share holder to new share holders, while in right offering current share holder can benefit from priority of buying share which reduce probability of wealth transfer. Secondly, they argue that this theory mainly describes listed companies and relinquishes non listed companies. Basically small –medium enterprise (SME) have limited access to capital market (Holmes and Kent, 1991) and financing choice for them is restricted to retain earning and loan.

Fama and French (2005) challenged pecking order theory as they find companies issue equity frequently and issue equity even when the internal funding is available or they can issue debt.

2.2.2 Trade off theory

This theory holds (DeAngelo and Masulis, 1980) an optimal capital structure based on balance between advantage and disadvantage of debt financing. In other word the optimal capital structure is a debt equity ratio that benefits of debt compensate with financial distress arising from marginal debt.

Advantage of debt financing: Debt financing reduce amount of tax revenue as a portion of interest paid to creditors (Modigliani and Miller, 1963), moreover it lessen agency cost between shareholders and mangers. This kind of agency problem refers to interest conflict between owners of firms and managers (Jensen and Meckling, 1976). This theory state that corporate manager, agents, will follow their own interest, they looking for high salary, job security, prerequisites, better facility and may even assets and cash flows of the companies. Furthermore, managers tend to increase investment and develop the size of the company even if there is no benefit for the shareholders. This behavior of manager is known as empire building. However investors can control agent by methods of monitoring and controlling, but these methods are more costly and subject to decreasing return. Based on Free cash flow theory(Jensen, 1986) debt can reduce this kind of agency cost, in a way that company must pay interest to creditors which reduce available cash flow to the managers. So, instead of inefficient use of money by managers part of cash flow is given to creditors.

Disadvantage of debt financing :The disadvantage of financial leverage comprise of bankruptcy cost and agency cost occurring between shareholders and debt holders (Jensen and Meckling, 1976) .This sort of agency cost arising from interest conflicts between share holders, or their agents, and debt holders. If investors perceive this kind of risk, they demand higher return for their investment which consequently increase cost of debt financing.

There are three types of conflicts happen between bond holders and share holders. The first conflict is asset substitution problem (Jensen and Meckling, 1976) .in which manger has incentive to take riskier projects when amount of debt increase. it is simply because if project succeed, share holders obtain benefits and, if project fail debt holder get disadvantage since shareholders have limited liability. The second conflict is wealth transfer from debt holder to shareholders (Smith and Warner, 1979) in a way that board of directors, as representative of shareholders, increase amount of dividend as expense of debt holders. Third conflict between shareholders and debt holder is underinvestment problem (Myers, 1977) that mainly occur under financial distress .Since under this situation gains from new projects is taken by bond holders, shareholders have less incentive to undertake these projects even with positive present value.

According to trade off theory profitable firms should use interest tax shield as they have more taxable income (Myers, 2001). In other word, trade off theory doesn’t support negative relation between profitability and debt. Moreover this theory is consistent with some clear fact, for instance, the companies with moderately safe, tangible assets tend to use more debt than companies with variable and intangible assets.

Figure 1

2.3 Determinant of capital structure

There are different factors that can affect firm’s capital structure. These factors can be classified in two groups as external and internal factors (Antoniou et al, 2002). The external factors arising from firm’s environment and basically could not be controlled by firm’s mangers such as country’s economical, institutional factors. Rajan and Zingales (1995) find that institutional factors including tax code, bankruptcy law, and development of capital market affect firm capital structures. Holmstrom and Tirole’s (1997) argue that small firms have tougher constrain than larger firms for external financing, and so, macroeconomic and institutional factors have higher impact on their leverage .

Demirg and Maksimovic (1995) investigate relationship between domestic capital market development and firm leverage and find significant negative relation between domestic market development and leverage. Schmukler and Vesperoni (2001) studied relation between counry’s financial liberalizations and leverage .They find that financial librization do not change leverage ratio, but it change debt structure and rises portion of short term debt. Deesomsak et all (2004) studied determinant of capital structure among Asian pacific countries and find that capital structure is affected by firm environment. They show that 1997 Asian economic crisis have had a significant effect on firm’s capital structure . .Voulgaris et all (2004) studied determinant of capital structure of Greek companies and find that strict monetary and fiscal regulation have more impact on small firms than large firms. De Jong et al (2008) studied determinant of firm capital structure across the world and demonstrate that specific determinant of capital structure vary across the counties and also shows country’s specific factors have indirect effect on firm specific determinant of capital structure.

Internal factors are those attribute that can be controlled, may not completely, by firm’s managers such as firm’s characteristics. This study focus on important factor of capital structure in both developed (Rajan and Zingales, 1995) and developing (Booth et al, . 2001) countries including asset structure, profitability, growth opportunity, liquidity, and business risk.

2.3.1 Growth

According to pecking order theory growth and leverage have positive relationship. The main idea behind this relationship is that growth firms need more fund than lower growth firms, and hence, they probably require external financial recourses, and preferably debt financing, for new projects ( De Jong, 1999). Jung et al. (1996) argue that firm with growth opportunity should use equity financing in order to reduce agency cost between managers and shareholders. Whereas companies with less growth opportunity should use debt financing (Stulz, 1990).

Organizational life stage theory is another explanation for growth opportunity and debt financing. In fact organizational life stage theory design for strategic management field, but there is a rational link between this theory and capital structure . The simple premise of organizational life stage theory is that firms, the same as living creature, have different life phases and pass through startup, growth, maturity and decline stage (Black, 1998). It states that business risk reduce over firm life stage as firm become more stable and it allow financial risk rises (Bender and ward, 1993). In other word there is a negative relation between business risk and financial risk which is mainly concluded from trade off theory of capital structure. Hence, based on organizational life stage theory, firms should finance with equity in earlier stage and use more debt as they develop. Chang et all (2009) studied determinant of capital structure and find that growth is the most important determinant of firm’s capital structure.

Relationship between growth opportunity and debt has been studied by many researchers. Long and Malitz(1985), Titman and( Wessels 1988) Chung (1993), Rajan and Zingales (1995), Barclay and smith (1999) find that there is a negative relation between firm growth opportunity and leverage. While Hall et al. (2000) demonstrate that growth opportunity is positively related to short debt ratio and negatively related to long term debt ratio.

2.3.2 Asset structure

Asset structure is another determinant of capital structure. There are mainly two groups of asset, tangible and intangible, and each group of assets has own effects on firm capital structures. As tangible asset can be used as collateral, companies with more tangible assets can use debt as financial resources with lower cost . Furthermore, tangible assets reduce moral hazard risks, because tangible assets convey a positive signal to creditors in case of firms default and selling of firms assets. According to trade off theory, when tangible assets use as collateral, reduce bankruptcy cost which turn increase credibility and accessibility to debt market . Also based on pecking order theory tangibility reduce asymmetry information between insider and outsider. Pecking order theory predicts positive relation between tangibility and debt financing. However, Berger and Udel (1994) ague that firms who have close relationship with creditors need less collateral, because they convey more information to creditors and reduce asymmetry information risk.

While majority of studies show positive relation between tangibility and leverage ( Rajan and Zingales, 1995; Frank and Goyal, 2003;Niu.2008;Liu et al 2009), some studies demonstrate negative relation between tangibility and leverage (Booth et al, 2001; Huang and Song, 2002). It is state that relationship between tangibility and leverage affected by type of debt. Hall et all (2004) studied determinant of capital structure among European companies and find that tangibility negatively related to short term debt while positively correlated to long term debt. Also, Sogorb-Mira (2005) find supportive result for negative relation between tangibility and short term debt, and argue that negative relation between tangibility and short term debt may explain with maturity matching principle, where firms try to finance fixed assets with long term debt and working capital needs with short term debt.

2.3.3 Profitability

Profitability can effects debt financing in two directions .Based on pecking order theory there is a negative relation between profitability and debt financing. Since, profitable companies generated enough cash which turn can be used as source of internal financing. Shyam-Sunder and Myers (1999) argue that avers relation between profitability and leverage is consistent with pecking order theory. On the other hand trade off theory predicted positive relation between profitability and leverage. As profitable company generates more available cash for management opportunities for using cash inefficiency and unnecessarily manners that increase agency cost between managers and shareholders. So, Debt financing is the best remedy for overcoming this problem (Jenson, 1986).

Effect of profitability on leverage has been studied by many researchers . Morri and Cristanziani (2009) studied capital structure of UK Property companies and assert that profitability is the most important determinant of capital structure for UK property companies, and it aversely related to leverage.Many studies (Titman and Wessels 1988; Rajan and Zingals, 1995;Fama and French 2002;Hovakimian et al 2004) find negative relation between profitability and debt level . Whereas some researchers argue there is positive relation between profitability and leverage. MacKay and Phillips (2001) state that leverage positively correlated with profitability. Gaud et all (2007) studied debt equity choice among European firms and find that ROA, as proxy of profitability, positively correlated with “debt issue versus Equity issue”. They argue that for European profitable firms, debt financing use as a disciplinary device for controlling mangers performance.

2.3.4 Liquidity

Liquidity is another determinant of capital structure which has been described in many capital structure literatures. Based on pecking order theor

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