Page 1 of 17

Journal for Studies in Management and Planning

Available at http://edupediapublications.org/journals/index.php/JSMaP/

e-ISSN: 2395-0463

Volume 02 Issue 2

February 2016

Available online: http://edupediapublications.org/journals/index.php/JSMaP/ P a g e | 308

Impact of Capital Structure and Dividend Policy on Firm

Value

Obaid Ur Rehman1

1

Institute of Business and Management Sciences, The Agriculture University, Peshawar, Pakistan

Bluechip1122@gmail.com

Abstract

The study aimed to investigate the impact of capital

structure and dividend policy on firm value of KSE

non financial listed firms using cross sectional time

series regression analysis for the period 2006-2013

in Pakistan. The study uses fixed effect Model to

measure the disparities of intercepts for each group

considering fixed coefficient for independent

variables and fixed variance among groups of the

panel data. The results of the study reporting

number of variables of capital structure and

dividend policy has significant impact on

dependent variable (tobin’s Q). Three independent

variables (TDTA as leverage ratio, SG as profit

sustainability ratio and EQ as shareholders equity)

of capital structure, while one independent variable

(EPS as profitability ratio) of dividend policy has

significant impact on dependent variable (tobin’s

Q). The left behind two variables (FATO as

performance ratio of capital structure and DPO as

cash flow indicator ratio of dividend policy) are not

significant with depended variable (tobin’s Q).

Elaborately; EPS approve the prophecy of signaling

theory while EQ, TDTA and SG statistically

confirm assumptions of trade off theory and

pecking order theory. Furthermore FATO fail to

support the trade off hypothesis while DPO fail to

favor the signaling theory postulations.

Consequently our research analysis approves the

hypothesis of pecking order theory and trade off

theory in case of capital structure and signaling

theory in case of dividend policy.

Keywords: Capital Structure, Dividend Policy,

Firm Value

1. Introduction

1.1 Background

The capital structure of the company is the blend of

current and long term debt, owner equity and other

sources of endowments to funds its long term assets.

Aligning the capital structure and dividend policy with the

company’s strategy is crucial task and need critical

analysis. Shah and Khan (2010) contending that decision

of capital structure is core of many other decision in

corporate finance. Most of the theories emphasize on the

balance between debt and equity which is then known

optimized capital structure. Graham (2001) proposed that

optimum capital structure is acquired by balancing its

marginal cost and marginal benefits. If debt portion is

increased, tax advantage can be achieved but it also can

boost risk of financial distress and moving control to the

investors. Therefore pronouncement making in the capital

structure engineering and dividend policy conjointly

called financial policy is extremely risky matter to all

firms due to its direct effect on the firm value. Literature

shows that firms uses practical approach in designing

capital structure and try to align it with the strategy which

is flexible and responding to the changing circumstances

in the market.

Another factor which is the interesting area for the

investors is the dividend payment behavior of the firm.

Dividend payout ratio can affect firm value positively or

adversely (Elfakhani, 1995). There are bunch of factors

that can affect the company’s dividend policy like

constraints on dividend payment, investment

opportunities, alternative sources of capital (Fida et al.,

2012). Faulkender, et al., (2006) concluded that decision

regarding financial policy is based conjointly upon capital

structure designing and setting dividend policy. In one

extreme, if firm uses high leverage and low equity, most

of the control is in the hand of investors. On the other

hand, if firm uses low leverage and high equity, less

dividend should be paid and more control in the hands of

managers. All over the discussion, the utmost aim of the

firm should be to increase the shareholders capital or to

extend the returns of the investors. So selection of optimal

capital structure and dividend policy both or one by one

can affect firm value positively or negatively.

The Modigliani and Miller provide base work for

capital structure in 1958 and 1963. Their work postulates

that in the symmetric world, firm leverage and no relation

with its respective value but only in the case of tax

consideration. However this theory is criticized by many

because it work only in the idealistic world, but in reality

firm value is manipulated by many factors like agency

problem, information asymmetry, bankruptcy cost, tax

Page 2 of 17

Journal for Studies in Management and Planning

Available at http://edupediapublications.org/journals/index.php/JSMaP/

e-ISSN: 2395-0463

Volume 02 Issue 2

February 2016

Available online: http://edupediapublications.org/journals/index.php/JSMaP/ P a g e | 309

considerations and further industry digressions. Optimal

capital structure can only be achieved if the fore stated

factors are taken in consideration for measuring the value

of the firm.

Literature postulates that whenever any firms make

financial decision, it has two major choices. First is the

setting dividend policy and the second one is the capital

structure engineering. Faulkender, et al., (2006) presents a

theory in their research work which posits that capital

structure and dividend policy mutually verify inherent

governance mechanism to organize over project choice.

Ronny Manos (2002) concluded that if more amounts is

set back as retention, less external source of finance is

needed and vice versa. So in the choice of financial policy,

capital structure and dividend policy has vital role. Firm

having more debt finance and less equity, tend to be more

influenced by the investors in its corporate governance

(Faulkender, et al., 2006). From such various perspectives

of the various researchers, the management of any firm or

company should well understood their call concerning

dividend payouts and capital structure, for the explanation

that these policies together or one by one impact lots on

the worth of a firm (Jensen and Meckling. 1976). By using

more debt, firm will move average below from the

industry and market will positively respond in that

scenario (Masulis, 1983).

One rationale of the study is that prior literatures only

consider capital structure design impact on firm value or

dividend policy influence on firm value. It looks like that

both (capital structure design and dividend policy) factor

impact on measuring the firm value in Pakistan is not yet

discussed. For example capital structure design like

leverage ratio, performance ratio, profit sustainability

ratio, shareholders equity and dividend policy like

profitability and dividend payout ratio in determining the

firm’s worth.

Simultaneous equation is used to distinguish the

positive or negative relation among dependent and

independent variables. The major findings this paper

support some of the empirical studies in literature like

shah and khan (2007), C. Anup and P.C. Suman (2010),

Samuel Antwi (2012) while contradicting with C. Anup

and P.C. Suman (2010), Shah & Hijazi (2004). The study

is beneficial for measuring the optimum value of the firm.

1.2 Problem Statement

The study investigates impact of capital structure

design and dividend policy on firm value under the

Pakistani setting. Their combined impact is not discussed

before. Moreover the study takes recent and longer time

period (8 years from 2006 to 2013) and more variable in

order to extend the idea of how the design of capital

structure and choice of dividend policy affect the firm’s

value individually and conjointly.

1.3 Research Question

The study attempt to identify that the capital structure

design and dividend policy both or one by one has impact

on firm value or not.

1.4 Objective of Research

The intent of the research work is to propose a new

integrated theory of capital structure and dividend policy

decision which empirically predict their affect on value of

the firm. The analysis is based on the existing capital

structure of the sample firm during 2006-2013. The sub

objectives of the study consist of:

1. Identify the impact of capital structure design on firm

value

2. To investigate the impact of dividend policy on firm

value

The above phenomenon contended that firms take two

key decisions during business course, which are design

decision of capital structure and the policy regarding

dividend. These two decisions conjointly or one by one

have positive or inverse impact upon value of the firm. By

efficiently designing the capital structure and establishing

a well desired dividend policy in developing countries like

Pakistan, a firm can avail opportunities coping the risk and

mould with the divergent perspectives of the investors and

ultimately create firm’s worth.

1.5 Hypothesis

H0A = Capital Structure has no significant effect on firm’s

value

H1A = Capital Structure has significant effect

on firm’s value.

H0B = Dividend Policy has no significant effect on firm’s

value

H1B = Dividend Policy has significant effect on firm’s

value.

1.6 Significance of the study

The current research study will bring to light the

diverse levels of debts uphold by the firm and how this

dissimilar level has impact on firm value. In Pakistani

market the firms typically employ more debts and this

straight to boost in the success of the firm. This boosted

profit also has impact on firm value and it will attract the

investors to spend in the specific firm.

Page 3 of 17

Journal for Studies in Management and Planning

Available at http://edupediapublications.org/journals/index.php/JSMaP/

e-ISSN: 2395-0463

Volume 02 Issue 2

February 2016

Available online: http://edupediapublications.org/journals/index.php/JSMaP/ P a g e | 310

By employing capital structure and dividend policy

ratios, the profit of the companies has been broadly

exposed by the research works but still there is a need to

present practical confirmations for the association of the

capital structure and dividend policy on the firm value.

The study weighs up the various schools of thoughts

relevant to association and grant pragmatic proof from the

Pakistani financial system.

This study will beneficial for academics that are

interested in getting more knowledge about this topic and

also provide opportunity to other researcher to conduct

further studies in the mentioned area.

In developing countries like Pakistan, the study will

enable the practitioners to better evaluate the designing of

capital structure and setting the dividend policy for

business growth and firm value.

2. Literature Review

2.1 Background

Capital structure and dividend policy are the most

dominant decisions taken by the firm. It allows firms to

minimize the weighted average cost of capital and retain a

specific sum of money for particular purposes. The

connection between capital structure and value of the firm

is a debatable matter both empirically and theoretically.

Literature regarding capital structure engineering and

dividend policy postulates that it has significant impact on

firm’s worth.

2.2 Theoretical Literature

2.2.1 Trade-off theory

Developed by Scott (1977) argue that firm optimal debt

ratio can be figure out by comparing its associated cost

(like insolvency cost) with its associated benefits (like tax

benefit). The study focuses on debt structure by TDTA,

FATO, SG and EQ ratio considering the trade off

postulations and assuming the higher success of firm

anticipated to depreciate its associated cost and permit the

firm to enjoy the tax benefit by hoisting leverage ratio.

Cost and benefit analysis of debt financing to achieve

optimal capital structure is the theory hypothesis (Gaud et

al., 2005). The theory mainly counterbalances the cost of

debt against the benefits of debt (Abdullah, A.K. 2005).

The theory postulate that firm’s are usually finance by

both debt and equity. The firm can balance the marginal

cost and benefit by trade off the equity and debt financing

decision and to achieve so called optimum capital

structure (Titman and Wessels. 1988).

2.2.2 Pecking order theory

Developed by Myers and Majluf (1984) assert that

firm’s financing needs decides the level of leverage. The

theory postulates that typically companies used their retain

earning at first in priority to sponsor their projects.

Secondly company call for external debt and finally the

alternative of issuing new share and generating equity is

exercise to fuel their project engine. The retained earnings

are prioritized at top because it relatively has almost no

cost. Moreover financing from debts or issuing new equity

broadcast signals towards the market. If manager issue

more equity, a rational investor thinks that stock is

overvalued and stock price will probable to plummet in

the near future.

The on hand study assumes the pecking order

hypothesis like Akhtar (2005), Friend and Lang (1988),

Rajan and Zingales (1995), Shah & Khan (2007), Harris

and Raviv (1991), and Akhtar and Oliver (2009) for

capital structure impact on firm value. Drobetz and Fix,

(2003) study investigates that ratio of leverage in the

capital structure is the success story of company’s

management which broadcast information asymmetry to

the rational investor. Furthermore our study assume that if

the company retain earnings in the shape of internal funds

are inadequate to avail any profitable project, firm

prioritize to get finances from external sources but in such

a way that it reduces the marginal cost of informational

asymmetry (Akerlof, G.A. 1970).

2.2.3 Signaling Theory

Develop by Ross (1977) claim that company’s dividend

policy release signals towards investors. According to

Bhattacharya (1979) in his signaling model claims that

high quality firm pay more dividend compare to low

quality firm. If signal increases with the information

discrepancy between investor and manager, organization

with higher information discrepancy should pay higher

dividend. Ross (1977) argued that outside investors don’t

know the exact distribution of the inside company’s

income, but only inside management knows. If the internal

management chooses to gives dividend, it transmits

signals to more cash outflow and uses of more debt.

Conversely if decision of retain earning is taking, less uses

of debts decision is taken. So the issuing of dividend by

the company has relation with the company’s solvency

ratio. Furthermore there is relation between EPS of a

company and its dividend payout (Kuczynski. 2005).

2.3 Empirical Literature