RESEARCH PAPER ON CAPITAL STRUCTURE AND PROFITABILITY A case study of oil and gas sector of Pakistan.

Submitted To Mr.Sikandar

Submitted By Usman khan khalil M.Com: (2 years,4th Semester) Roll No: (83)

Quaid-e-Azam College of Commerce, University of Peshawar

ABSTRACT
The purpose of this study is to examine the effect of Capital Structure on the profitability of firms listed on Karachi Stock Exchange. In this regard I have selected a sample of 13 oil and gas sector companies for a period of two years of 2009 and 2010. The data is collected from the financial statements (Annual Reports) of these 13 companies. For analysis purpose linear regression model is used in the estimation of a function relating to the Profitability(RoA) with the independent variables including Debt Ratio(DR), Long Term Debt to Liabilities(LTDTL), Shareholders Equity to total Liabilities(SHETL) and LIQ(liquidity) and Firm Size (LOS). The results indicate that DR and LTDTL have negative while SHETL, LIQUITY and Firm Size (LOS) have positive relations with profitability. Thus capital structure of the oil and gas sector companies listed on Karachi Stock Exchange has a significant effect on the profitability. If these firm want to increase their profitability, they will have to give due consideration to the financing mix, otherwise it may suffer from losses.

TABLE OF CONTENTS
Chapter No. Title Page No. Chapter-1 Introduction. 1.1 Objective Of the Study... Chapter-2 Literature Review Chapter-3 Data Description and Methodology. 3.1 Sample Size 3.2 Data Sources. 3.3 Variables. 3.3.1 Dependent Variable 3.3.2 Independent Variables 3.4 Measurement of Variables 3.5 Model.. Chapter-4 Data Analysis 4.1 Regression and correlation Analysis. Chapter-5 Conclusion References.

Chapte No-1 Introduction

Capital Structure refers to the various financing options of the assets by a firm. A business concern can go for different levels of the mixtures of equity, debt or other financial facilities. This may be lease financing, term financing, debentures, direct loans from bank etc with equity having the emphasis on maximizing the firms value. Not all the firms use standardized capital structure they differ in their financial decisions in various terms. It is a difficult decision for the firms to determine the capital structure in which risk and cost is minimum and can give high profits, and therefore can increase the value of shareholders. This difference of choices about the financing decisions gives rise to the various capital structure theories. The capital structure theories have been comparing the effects of sources of finance, tax advantages associated to leverages, and the investors required rate of return on the overall cost of capital and the resultant returns to investors. Most of the researches conducted on capital structure concluded that there is an optimal capital structure that is affected by a variety of internal and external factors. This study takes Oil and Gas sector of Pakistan from KSE to determine the factors affecting the capital structure decisions of the companies taken into consideration. The study intends to analyze the effect of profitability (ROA) on independent variables (DR, SHETL, LTDTL, LIQ, and LOS) on capital structure of the listed companies of Oil and Gas sector in Karachi Stock Exchange. The companies include Pakistan State Oil, Shell Pakistan, Attack Petroleum, Sui Northern Gas, Sui Southern Gas, National Refinery Limited, Byco Petroleum Pakistan Limited, Mari Gas Company limited, Pakistan petroleum limited, Pakistan Oilfield limited, Shell gas LPG limited, Oil and Gas Development Company limited and Pakistan Refinery Limited.

1.1 Objective of Study

The objective of this study is to investigate the impact of the determinants of capital structure of listed oil and gas company in Pakistan during the period 2009 2010.The objectives are, 1. 2. 3. 4. 5. To examine Long term debts to total liabilities impact on Profitability To examine Share holders Equity impact on Profitability To examine liquidity impact on Profitability To examine size of firm impact on Profitability To examine Debt ratio impact on Profitability

Chapter No-02 Literature Review

B.Prahalathan et.al conducted a study in Sri Lanka to determine the relationship between leverage, profitability, size of firm and tangibility of Assets. This study use multiple regression analysis, and concluded that long term debts has weak positive no significant relationship with capital intensity, non-significant and positive impact with tangibility and size of firm, and having strong negative significant with profitability and non-debt tax shield. This study considers 19 manufacturing companies for the period of 2003-2007. Yuanxin Liu et al (2009) conducted a study in China to determine the relationship between profitability, Tangibility, Liquidity, Profit Growth Rate and growth opportunity and leverage. This study use linear regression model and concluded that size of the companies are positively related to leverage, while growth, Profitability, Liquidity, Profit growth rate and Growth opportunity are negatively associated with leverage. This study considers 90 Chinese listed companies for the period of 2004 to 2007. O.Materirano (2007) conducted a study in Zimbabwe to determine the relationship between debt, profitability and taxes. This study uses multiple regression models and concluded that selection of debt as a source of capital finance should be done with line with the cost and benefits of its use. If ROA is higher than before-tax interest business result of using debt financing. Thus if a firm earning profit may use debt financing, otherwise equity financing but it depends on management decisions. B Nimalathasan (2010) conducted a study in Sri Lanka to determine the relationship between debts and profitability. The study uses regression and correlation model and concluded that debts to equity ratio (D/E) are positively and strongly associated to all profitability ratios. The data is selected from secondary sources in the manufacturing companies during 2003-2007. Jose Edson Lara et al () conducted a study in Brazil to determine the relationship between capital structure and profitability. This study uses Ordinary least square

method and concluded that the return rates presents a positive correlation with short-term debts and equity, and inverse correlation with long-term debts, i.e. the larger the debts the lower the profitability.This study considers 70 companies collected in past seven years (1995-2001). R Fereti (2012) conducted a study in Macedonian to determine the relationship between the return on Equity (ROE) with the index in short run debts and also with total owner Equity. This study uses ordinary least square method and concluded that return rates present positive correlation with short term debts and owner equity negative correlation with long-term debts.The study considers 150 respective firms collected in last 10 years. Abdul Raheman et al (2007) conducted a study in Pakistan to determine the relationship between profitability, size and leverage of firm. The study uses Pearsons Correlation and regression model and concluded that the capital structure of non-financial firms listed on ISE has a significant effect on profitability. If these firms want to increase profitability, they will have to use mix of debts and equity financing otherwise may suffer from losses.The study considers 94 non-financial firms for a period of 6 years (1999-2004). MavishSabir et al (2012) conducted a study in Pakistan to determine the relationship between Profitability, Tangibility, Size and Liquidity on capital structure decision. The study uses pooled least square model and concluded that Profitability is the only variable that shows negative relationship against the dependent variable leverage, whereas the other three variables liquidity, size and tangibility have positive relationship with leverage.This study considers 05 firms for the period of 2005-2010. Dr.Aurangzeb et al (2012) conducted this study in Pakistan to determine the relationship between dependent variable (leverage) and Independent variables (Firm Size, Tangibility of Assets, Profitability and Sales Growth). The study use multiple regression and concluded that Firm Size, Tangibility of Assets and Profitability have positive relationship and have significant impact of the balance of leverage while Sales Growth has negative relationship with leverage.The study uses data for the period of 2004-2009.

Ayesha Mazhar et al (2007) conducted a study in Pakistan to determine the relationship between Tangibility, Size Growth Rate, Tax provision, ROA, Profitability and leverage. The study uses Spearmans correlation and regression model and concluded that Assets tangibility, Profitability, and ROA is negatively correlated with leverage while Size, Growth rate and Tax rate is positive related with leverage.The study considers 91 companies for the period of 1999-2006. C. S.Mishral (2011) conducted a study to determine the relationship between profitability, tax, asset structure and leverage. The study uses Multiple regressions model and concluded that growth (define as growth in Total Assets) is positively related to leverage, and Assets structure and Profitability is negatively related to leverage. Firms with less effective Tax rate have gone for more debts.The study considers a sample of 48 profit making manufacturing PSUs is considered for the time period 2006 to 2010. A.M.I Lakshan et al, conducted a study in Srilanaka to determine the relationship between the companies working capital, cost structure and there profitability. The study uses Correlation and regression analysis and concluded that those Managers can increase corporate profitability by reducing no of inventory days, increasing creditors payable days and minimizing the length of working capital cycle. Increase in creditors payable days would give opportunity to the company for further investment.The study uses 65 companies listed on Colombo Stock Exchange for a period of 2003-2007. Naveed Ahmad et al (2010) conducted a study in Pakistan to determine the relationship between Profitability, Size, Growth, Age, Risk, Tangibility of Assets, liquidity and Leaverage. The study uses Ordinary Least Square Regression Model and concluded that leverage has negative relationship with Profitability, Liquidity, and Age while positive relationship with Size. The result also indicates that leverage has insignificant relationship with Grown and Tangibility of Assets.The study uses 05 insurance companies for a period of 2001-2007. MahiraRafique (2011) conducted a study in Pakistan to determine the relationship between Profitability and Financial Leverage. The study uses Regression model and concluded that the Profitability of the firms and financial leverage has an insignificant impact on the capital structure of the studied firms during the

examined period and is unable to establish any significant relationship between profitability and financial leverage.The study considers 11 firms for a period of 2004-2009. Ahmad et al (2011) conducted a study in Pakistan to determine the relationship between profitability, size, growth, tangibility of assets, non-debt tax shield, liquidity and leverage. The study uses Regression model and concluded that size, tangibility of assets, non-debt tax shields, liquidity and payout are statistically significantly related to leverage, and profitability is statistically insignificantly related with leverage. This study considers 336 non-financial firms over the period of 5 years (2005-2009). MEHDI EBEDI et al (2011) conducted a study in Iran to determine the relationship between (liquidity, Tangibility, Profitability, Growth and Business Risk and leverage. The study uses Regression and Correlation model and concluded that Profitability has a direct significant impact on debt ratio; tangibility and Growth have significant positive impact while liquidity and Risk have significant negative relation. The study considers 72 Iranian companies listed on Tehran Stock Exchange from 2003 to 2009. H. Jamal Zubairi (2010), conducted a study in Pakistan to determine the relationship between profitability, operating and financing leverage and size of firm. The study uses regression model and concluded that financial leverage and size of firm have a significant positive impact on profitability, while operating leverage and financial leverage have a negative and statistically significant influence on profitability.The study considers 07 Automobile sector companies quoted on Karachi Stock Exchange for the years 2000 to 2008. E. Caglorgen et al (2010) conducted a study in Turkey to determine the relationship between Tangibility, Profitability, Size, and Market to book and leverage. The study uses regression model and concluded that size and market to Book have positive and statistically significant impact on leverage while Profitability and tangibility have negative and significant impacts on leverage.The study considers 25 deposit Banks in Turkey with in the period of 1992-2007.

A .Shah jehanpour et al (2010) conducted a study in Iron to determine the relationship between Liquidity, profitability, Effective tax rate, payout ratio with short term debt ratio and long term debt ratio. The study uses multiple regression and correlation model and concluded that earning tax rate is positive significant while Profitability, liquidity and payout ratio are negative significant with debts ratio. The study considers 248 firms have been for a period between 2007-2008. Ramachandran Azhagaiah et al (2011) conducted a study in India to determine the relationship between profitability variables and capital structure variables. The study uses regression model and concluded that profitability variables. Return on Assets (ROA) and Return on capital Employed (ROCE) and capital structure has significant influence on profitability and increase on debt fund in capital structure have negative influence on Net profit of IT firms listed in Bombay stock Exchange.The study uses 102 IT firms during 1999-2000 and 2006-2007(08 years).

Chapter-3 Methodology
This section provides information about the source of data, sample size, measurement of the variables, hypotheses formulation and model selection and discussion of different measures of the variables. 3.1 Sample Size As the study focuses the Oil and Gas sector companies on Karachi Stock Exchange (KSE). The 13 companies listed and having financial statement are selected. 3.2 Data Source This study is based on the financial data of sample firms from 2009-2010 and has been taken from Karachi Stock Exchange (KSE) hand book of listed companies. 3.3 Varibles 3.3.1 Dependent Variable Profitability = ROA (Return on Assets) 3.3.2 Independent Variables LTDTL = Long term Debts to Total Liability DR = Debt Ratio SHETL = Shareholder Equity to Total liability LIQ=LIQUIDITY ratio LOS= Firm Size (log of sales)

3.4 Measurement of Variables The variables are measured through following formulas ROA= Net income/total Assets LTDTL= Long term Debts/ total liability SHETL= Shareholders Equity/total liability DR= Total Debts/Total Asset Liquidity= Current Assets/Current Liabilities LOS= Taking log of the Sales for the period ended. 3.5 Model The study examines the determinants of capital structure of Oil and Gas sector companies in Pakistan. Multiple Regression model is used in the study, uses different measures of capitals structure, based on book value. They are Return on Assets (ROA) with the independent variables used in this study include Debt Ratio (DR), Long term debts to total liability (LTDTL), Shareholders Equity to total Liability (SHETL), firm size (SIZE), and Liquidity. Based on the dependent variable and five independent variables multiple regression model has been used to estimate the determinants of capital structure. The models are as follows. ROA = 0 + 1DR+ 2LIQ + 3LTDTL + 4SHETL + 5LOS+ (log-multiple regression model) Where B0 is constant, B1,B2,B3,B4, and B5 are coefficient of variables and u is residual term.

Chapeter-4 Data Analysis

Linear Regression analysis is used which enables the researcher to consider the effects of such data to estimate the results. For this purpose data from Karachi Stock Exchange has been taken and posted in Microsoft Excel Sheet. The variables (Dependant and Independent) of the data were selected and then analyze financial data. Log of sales data has been taken to smooth the data. The model used single dependent variable and multiple independent variables. The following model is thus developed for testing. ROA = 0 + 1DR+ 2LIQ + 3LTDTL + 4SHETL + 5LOS+u (log-linear model)

The results given in Tables below provide us with useful insights regarding the theoretical model and can be expressed as:
ROA = 0.241 - 0.286DR - 1.121LTDTL + 0.186SHETL + 0.008LIQ + 0.001LOS S.R (0.83) (0.054) (0.937) (0.122) (0.020) (0.011) (R2=0.825)

The value of F-statistic is significant thus it shows reliability of the model. Adjusted R2 shows that the independent variables explain the 0.825 of the leverage. R2 shows overall model perfectness and remaining variation is owing to the unknown variables. 4.1 Regression and Correlation analysis In our analysis we used correlation as a tool of statistics to see the relationship between capital Structure and profitability. The results of Correlation analyses are discussed in model.

The correlation for debt ratio with profitability is -.286 which reveals that the two variables are negatively correlated with each other, meaning by increasing 1 unit in debt ratio profitability of firm decreases up to .286 and is statistically significant.

Long term debt to total liability tells us that by increasing its 1 unit the profitability will decrease up to 1.121. Its P-value shows us that it is statistically insignificant. The correlation among the shareholders equity to total liability is .186, which tells us that if shareholders equity to total liablility (SHETL) increases 1 unit the increase change will occur in profitability. liquidity and log of sales are positive correlation with profitability and which reveals that with the increase of these variables profitability of the firm increases. Hence by increasing 1 unit in LIQ and LOS there will be .008 and .001 increase in profitability. The adjusted R2, also called the coefficient of multiple determinations, is the percent of the variance in the dependent explained uniquely or jointly by the independent variables and is .860. The C is the constant, where the regression line intercepts the y axis, representing the amount the dependent y will be when all the independent variables are 0. The F statistic is used to test the significance of R. Overall; the model is significant as F-statistics is 24.649.

Chapater-5 Conclusion
We conclude that there is negative relationship between the long term debt to total liability (LTDTL) and profitability verifying that long term debt is less profitable. This can be attributed to the interest cost bear by the company for a long term debt financing, which increase the fixed costs of the product and resultantly decrease the profitability. Secondly shows negative relationship between Debt Ratio and profitability verifying that more debts are less profitability. Thirdly the relationship of profitability with shareholder equity to total liability (SHETL) is positive as increases equity financing ratio the firm increases profitability.

Fourthly liquidity if increases the profitability increases and the same with increase of log of sales the profitability of oil and gas companies listed on Karachi Stock Exchange increases. There is more work to be done on capital structure for firms listed on Karachi Stock Exchange. Future researches can be done on the determinant effects of capital structure on ratings of Pakistani firms and how to balance the capital structure of Pakistani firms.

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