Determinants of

Determinants of corporate capital corporate capital

structure: evidence from structure
an emerging economy
25
Tarek I. Eldomiaty
Department of Economics and Finance, College of Business and Economics,
United Arab Emirates University, Al Ain, United Arab Emirates

Abstract
Purpose – This research paper aims at examining the determinants of corporate leverage in Egypt
according to the assumptions of three theories of capital structure: tradeoff, pecking order, and free
cash flow.
Design/methodology/approach – The methodology utilizes the benefits of the partial adjustment
autoregressive model to measure the speed of adjusting long-term and short-term debts to a target
level.
Findings – The results indicate that companies use both long-term and short-term debt to adjust the
leverage with a relative dependence on long-term debt; the tradeoff-related determinants of capital
structure are taxes, debt/equity ratio and bankruptcy risk; the pecking order-related determinants of
capital structure are growth and profitability; borrowing decisions are not affected by the assumptions
of free cash flow. Overall, the explanatory powers of the three regression equations are high and
significant which indicate that the model construction is quite indicative.
Originality/value – The paper contributes to the literature in that it shows that the determinants of
capital structure conform to those reported by other related studies in emerging markets as well as
developed markets which supports the general conclusion that the determinants of capital structure in
emerging and developed markets are converging.
Keywords Cash flow, Counter trade, Emerging markets, Egypt
Paper type Research paper

1. Introduction
The literature on determinants of capital structure is well-known of the existence of
three theories: trade-off, pecking order and free cash flow (or managerial agency costs).
Each theory presents a different explanation of corporate financing. The trade-off
theory is concerned with the trade-off between debt tax shields (or tax saving) and
bankruptcy costs, according to which an optimal capital structure is assumed to exist.
The pecking order theory assumes hierarchal financing decisions where firms depend
first on internal sources of financing and, if these are less than the investment
requirements, the firm seeks external financing from debt as a second source, then
equity as the last resort. The free cash flow theory assumes that debt presents fixed
obligations (debt interests and principals to pay) that have to be met by the firm. These
obligations are assumed to take over the firm’s free cash flow (if exists), therefore
prevents managers from over consuming the firm’s financial resources. International Journal of Commerce
and Management
Vol. 17 No. 1/2, 2007
The author is especially grateful to an anonymous referee who provided insightful comments pp. 25-43
q Emerald Group Publishing Limited
and suggestions that substantially contributed to the value of the paper. He also appreciates the 1056-9219
editorial efforts and consideration of the IJCOMA Editor. DOI 10.1108/10569210710774730
IJCOMA It was recognized that the three theories are “conditional” in a sense that each works
17,1/2 out under its own assumptions and propositions (Myers, 2001). That is, none of the
three theories can give a complete picture of the practice of capital structure. This
means that firms can pursue capital structure strategies that are conditional as well.
That means that when the business conditions change, the financing decisions and
strategies may change, moving from one theory to another. This is the main reason
26 that the literature does not include one theory (or one explanation) on the determinants
of capital structure. In fact, an interrelationship can be observed between and among
the three theories of capital structure. For example, the tradeoff theory assumes a
higher use of debt as long as it (debt) is associated with positive tax shields and less
bankruptcy costs. This does not mean that the firm can reach the maximum debt ratio
if, under the assumptions of the pecking order theory, the firm is profitable enough to
replace debt with internal financing using the accumulated retained earnings (which is
considered as a part of an equity financing). According to the free cash flow theory, the
two previous likely conclusions are affected by the severity of the agency costs
associated with debt (or equity) financing. In fact, the agency theory presents another
explanation of debt financing. That is, as long as the agency problem arises from the
presence of information asymmetry, Ross (1977), Myers and Majluf (1984) and John
(1987) have shown that under asymmetric information, firms may prefer debt to equity
financing. In other cases, the asymmetric information may leave corporate insiders
with a degree of residual uncertainty leading to the pecking order effect, i.e. the relative
preference of equity financing (Noe, 1988). Therefore, the interrelationships between
and among the three theories of capital structure call for further examination.
It was also found out that studies on the determinants of capital structure include
selected determinants in a regression equation. The results in many cases turned out to
be mixed. This is what Fama and French (2002) referred to as the two theories of
capital structure (trade-off and pecking order) share many common predictions about
the determinants of leverage, turning out results to be inconclusive (Prasad et al., 2001).
This paper follows another approach which is to examine each theory independently.
The argument here follows what is stated by Myers (2001) that each theory works out
under its own assumptions. This requires an examination of each theory independently
to avoid the highly likely overlap between results. Generally, the explanatory power
and significance of each theory (represented by an independent regression equation)
will show the extent to which the explanatory variables of each theory explain
variations in corporate leverage. Therefore, the objective of this paper is to examine the
extent to which capital structure decisions are affected by the three common theories:
trade-off, pecking order and free cash flow. The leverage ratio is used as a proxy for
firm’s capital structure. The type of industry (firm-specific characteristic) is used as a
control variable that may have effects on changes of capital structure.

1.1 Why capital structure in an emerging market?

Research on the determinants of capital structure in emerging/developing markets has
emerged as an extended new line of research for certain reasons. These reasons can be
outlined as follows:
(1) Capital and stock markets in emerging markets are relatively less efficient and
incomplete than their developed counterparts. This causes financing decisions
to be incomplete and subject to a considerable degree of irregularity.
 Companies in emerging markets may not be able to rationalize the financing Determinants of
decisions to follow a clear theoretical approach. This requires a thorough corporate capital
examination of the real determinants of capital structure in an emerging market
and the results are to be compared with those reached in developed markets. structure
(2) Information asymmetry in emerging stock markets is considerably higher than
the developed markets. This renders emerging stock markets not readily
markets for raising financing which leads to none optimal financing decisions 27
in terms of the theoretical assumptions of capital structure theories.
(3) The literature on the determinants of capital structure has already been
developed in developed markets that have different institutional financing
arrangements from those in emerging markets. This requires a thorough
examination of the predictors of capital structure in an emerging market.

According to the three reasons above-mentioned, this paper tests the hypothesis that
“in an emerging market, determinants of capital structure include mixed predictors
from three theories: tradeoff, pecking order and free cash flow.”
The contribution of this paper is twofold:
(1) This paper is the first attempt (to the best of the author’s knowledge) in
emerging markets in general, and Egypt in particular, that examines
empirically the predictors of capital structure according to the three common
capital structure theories.
(2) This paper is also the first attempt to include as comprehensive numbers of
predictors of capital structure as possible which include all predictors assumed
by the three theories and those previously examined in related studies in
developed as well as emerging markets. This aims at providing a relatively as
complete picture as possible of the determinants of capital structure in an
emerging market.

The paper is organized as follows. Section 2 discusses comprehensive number of

determinants of capital structure. The determinants cover the basic assumptions of
tradeoff theory, pecking order theory and free cash flow theory. Section 3 describes the
variables and describes the data and the methodology of the study. Section 4 discusses
the results of the study. Section 5 concludes.

2. Determinants of capital structure: theoretical background

Since, the famous work of Modigliani and Miller (1958) appeared, researchers started to
examine the MM propositions providing the literature, number of factors that affect
corporate financing decision using debt and/or equity. These factors cover not only
those related to tax shields and bankruptcy costs, but also many other factors that
affect corporate financing decisions. Other distinct approaches have been proposed to
explain the rational of financing decisions. Those approaches were developed later on
to other theories of capital structure such as the pecking order theory and the free cash
flow theory. Therefore, the determinants of capital structure were expanding trying to
provide evidence on each theory, hence on the practice of corporate financing. This
vast literature is summarized in Table I which summarizes the capital structure
determinants examined in this study, the ratio(s) or proxy for each determinant,
 28
17,1/2

Table I.
IJCOMA

List of the factors

examined in the study
Determinants of Expected Variables
Theory of capital structure capital structure relationship (ratio/proxy) Definition

Trade-off theory Target debt (þ) DEtþ 1 Debt-equity ratio in a next period
ratioa
Modigliani and Miller (1963), Gupta (1969), Schmidt DDR*t An indicator to the relationship
(1976), Schwarz and Aronson (1967), White and Turnbull between actual and optimal (target)
(1974), Scott (1976), Warner (1977), Smith and Warner capital structure
(1979), Ferri and Jones (1979), DeAngelo and Masulis Average (þ) DDRAVG An indicator to the average leverage
(1980), Marsh (1982), Castanias (1983), Bradley et al. industry level of other firms in the same
(1984), Auerbach (1985), Moore (1986), Kim and Sorensen leverage industry
(1986), Titman and Wessels (1988), Fischer et al. (1989), Structure of (2) Short-term debt FATAt Ratio of fixed assets/total assets. An
Harris and Artur (1991), Homaifar et al. (1994), Rajan and tangible assets indicator to the structure of tangible
Zingales (1995), Lasfer (1995), Andrade and Kaplan assets
(1998), Shyam-Sunder and Myers (1999), (þ ) Long-term debt
Wiwattanakatang (1999), Chirinko and Singha (2000), Relative tax (þ) DNDTAXt The ratio of depreciation to total
Nuri (2000), Ghosh et al. (2000), Bevan and Danbolt (2000, effects assets. A proxy for non-debt tax
2002), Hovakimian et al. (2001), Booth et al. (2001), Ozkan shields
(2001), Antoniou et al. (2002) and Tong and Green (2004) DNDTAt A direct estimate of non-debt tax
shields over total assets (Titman and
Wessels, 1988)b
(þ) ECTRt The effective corporate tax rate
(Lasfer, 1995)c. A proxy for debt tax
shields
Bankruptcy risk (2) BRt A direct measure of bankruptcy risk,
which is taken as a proxy for the
bankruptcy costs (White and
Turnbull, 1974)d
DCRt Debt coverage ratio; a proxy for
firm’s failure
Pecking order theory Growth (þ ) Short-term debt, CETAt Proxies for firm’s future growth rate,
(2) long-term debt which include:
(continued)
 Determinants of Expected Variables
Theory of capital structure capital structure relationship (ratio/proxy) Definition

Chudson (1945), Donaldson (1961), Hall and Weiss (1967), (1) Capital expenditures over total
Gupta (1969), Baxter and Cragg (1970), Bosworth (1971), assets
Gale (1972), Toy et al. (1974), Carleton and Silberman GTAt (2) Growth of total
(1977), Nakamura and Nakamura (1982), Myers (1984), assets ¼ percentage change in total
Myers and Majluf (1984), Long and Malitz (1985), Titman assets
and Wessels (1988), Kester (1986), Baskin (1989), Pinegar SGt (3) Sales growth
and Wilbricht (1989), Whited (1992), Chung (1993), Allen ASTURNt (4) Assets turnover
(1993), Shyam-Sunder and Myers (1999), Investment (þ ) Short-term debt, MBt Market-book ratio as a proxy for
Wiwattanakatang (1999), Ghosh et al. (2000), Chirinko growth (2) long-term debt firm’s growth options
and Singha (2000), Um (2001), Frank and Goyal (2003)e, opportunities
Tong and Green (2004) and Chen (2004) Uniqueness (2) SESt Selling expenses over sales. The
relationship between specialized
products and capital structure
Size (þ ) Short-term debt, LnAssetst The effects of firm’s size on the
(þ) long-term debt composition of capital structure
Profitability (þ ) Short-term debt., DEBITDAt Earnings before interest, taxes, and
(2) long-term debt depreciation over total assets
DOISt Operating income over sales
DOIAt Operating income over total assets
DPMt Profit margin
DROIt Return on investment
Financial (2) REAtþ 1 The expected effect of “retained
flexibility earnings ratio” as a proxy for the
retention rate
(continued)
structure
corporate capital

29

Table I.
Determinants of
 30
17,1/2

Table I.
IJCOMA

Determinants of Expected Variables

Theory of capital structure capital structure relationship (ratio/proxy) Definition

DREAt A measure of the cumulative effect

retained earnings, thus the extent of
firm’s financial flexibility
Liquidity (2) DQRt Quick ratio
position DWCRt Working capital ratio
DCashRt Cash ratio
DCRt Current ratio
Timing effect (2) DPEt Price/earnings ratio
Dividend paid (þ) DPRt Dividend payout ratio
out
Free cash flow theory Agency costs (þ) ERt Expense ratio ¼ operating expenses
scaled by annual sales. A measure of
how effectively the firm’s
management controls operating
costs, including excessive
prerequisite consumption, and other
direct agency costsf
(continued)
 Determinants of Expected Variables
Theory of capital structure capital structure relationship (ratio/proxy) Definition

Jensen and Meckling (1976), Myers (1977), Grossman and (2) Short-term debt, AURt Assets utilization ratio ¼ annual
Hart (1982), Easterbrook (1984), Jensen and Meckling (þ) long-term debt sales/total assets. A measure of how
(1986), Stulz (1990), Chung (1993), Maloney et al. (1993), effectively the firm’s management
Parrino and Weisbach (1999) and Ang et al. (2000) deploys its assets
Estimate of free (2) FCFt Direct estimate of firm’s free cash
cash flow flow (operating perspective)
Control, variables (common factors between the three Interest rate (þ ) Short-term debt, IRt Interest rate on bank loans. Bosworth
theories of capital structure) (2) long-term debt (1971), White (1974), Solnik and Grall
(1975) and Taggart (1977)
Industry (2) ICt The industry effects on firm’s capital
classification structure (Scott, 1972; Scott and
Martin, 1975; Schmidt, 1976; Ferri
and Jones, 1979; Titman and Wessels,
1988; Graham and Harvey, 2001)
Time effect (2) Time Time dummies
Notes: The “expected relationship” denotes to the expected sign of the formulated hypothesis. The D is measured as ðtÞ 2 ðt 2 1Þ for all variables except
*
for DDR ¼ ðDR*tþ1 2 DRt Þ; athere are alternative approaches to calculate the target ratios such as (1) the average over certain number of years; (2) by
fitting an autoregressive function; (3) by taking the maximum debt ratio in the past (Marsh, 1982). However, the three approaches result in one estimate for
the target ratio which gives the impression that firms look at only one certain estimate (ratio) and plan their capital structure accordingly. The method
used in this paper is based on the assumption that the firm changes its target ratio generically, then the ratio a firm could achieve is considered as if it was
the target ratio. This point of view takes into account the generic aspects of planning for capital structure changes. According to the literature, floatation
costs, firm’s size, asset structure and the market conditions change over time which necessitate planning for capital structure generically and the target
ratios are changed accordingly. However, we experimented with the three methods plus our suggested one which utilizes the two ratios (DEtþ 1 and
DDR*). The results showed slightly significant increase in the R 2 for our suggested measures; bNDT ¼ OI 2 i 2 T/CTR, where: OI – operating income, i
– interest payments, T – income tax payments, CTR – corporate tax rate; cECTRt ¼ (estimated taxable profits £ corporate tax rate)/(pre-tax profits);
d
bankruptcy risk ¼ (fixed charges 2 earnings before income and tax)/(s of earnings); eFrank and Goyal (2003) reports an exceptional result that contrary
to the pecking order theory, financing deficits were covered by equity rather than debt; fthe expenses ratio is not assumed to measure all agency costs as
discussed in the literature. Nevertheless, and according to the availability of data, this ratio can be considered a first-order estimate and easy-to-measure
indicator of the presence of agency costs at the firm level. The “Expected Relationship” denotes to the expected sign under high systematic risk class and
the vice versa under medium and low systematic risk classes. The D is measured as ðtÞ 2 ðt 2 1Þ for all variables except for DDR * ¼ (DR *tþ 1 2 DRt)
structure
corporate capital

31

Table I.
Determinants of
IJCOMA the previous related studies, and the expected relationship between each determinants
17,1/2 and firms’ short-term and long-term debts.

3. Variables, data and methodology

3.1 Dependent variables
The change in firm’s capital structure is measured by the debt ratio (total debt/total assets).
32 The dependent variable is split into its two main components: long-term debt DLdebtt ¼
ðLdebtt 2 Ldebtt Þt21 and short-term debt DSdebtt ¼ ðSdebtt 2 Sdebtt21 Þ [1]. The
two variables are assumed to measure firm’s adjustment to the debt ratio[2].

3.2 Independent variables

This paper examines as a comprehensive number of determinants of capital structure
as possible which cover the three basic theories of capital structure. Table I
summarizes the capital structure determinants examined in this paper.

3.3 Data
The data used in this paper are obtained from many sources. The data related to firms’
income statement and balance sheet are obtained from the firms’ annual reports and
Kompass Egypt Financial Year Book (Fiani & Partners, 2004). Interest rate data is
published by the IMF: International Financial Statistics 2004 and National Bank of
Egypt. The total number of firms included in the study is 99 firms, which cover
14 non-financial industries (list of the firms is included in the appendix). Firms were
selected based on two criteria. First, the non-financial firms amongst the 100 actively
trading firms in Egypt stock market. Trading activity refers to the number of days the
company’s stock has been trading according to the monthly publications by the stock
market authority in Egypt. Second, the non-financial firms amongst the 100 firms with
the highest market value. The latter is obtained from the monthly publications by the
stock market authority in Egypt. Summary statistics of the variables are reported in
the appendix.

3.4 Methodology
The methodology examines the effects of the assumptions of each capital structure
theory on firms’ leverage (total debt ratio). The leverage is divided to long-term and
short-term debts. The general estimating equation of the partial adjustment
autoregressive models takes the form that follows:

X
n
ytk ¼ ak þ bnk X ntk þ 1tk
i¼1

where t ¼ 1, . . . ,5, k ¼ number of firms in each group.

3.5 Testing for robustness of the methodology

3.5.1 Robustness of the measurement of time. The measurement of the time effects for
each of the variables examined in this paper varies from one variable to another.
According to the literature review, it has been realized that examining the changes (in
the form of DX t ¼ X t 2 X t21 ) in the level of an explanatory variable(s) may address
and/or result in some new insights. This presents one of the usefulness of such studies
to corporate managers when they need to plan for some changes in the capital Determinants of
structure. To test for the robustness of the measurement of time, the author corporate capital
experimented with the same variables twice; with and without considering the time lag
effects. There were some differences realized in the results of both cases, which indicate structure
that the time lag has an effect to be examined thoroughly.
3.5.2 Robustness of the analysis. The paper examines the lag effects of short-term
and long-term debts on the total debt independently. The distinction between both 33
provides a robust analysis for two main reasons. First, most of the studies of
determinants of capital structure use the leverage ratio or debt ratio as a proxy for
firm’s capital structure. Nevertheless, as mentioned above, number of studies in the
literature (Van Horne, 1977; Myers, 1977; Myers et al., 1977; Marsh, 1982) highlights
some distinctive characteristics of short-term and long-term debts to further study.
Second, the practice of borrowing shows that firms may use short-term debt as a
long-term financing if they could get short-term loans renewed for longer periods. For
both reasons, there is a need to explore the real significant determinants of firm’s
borrowing decisions and preferences.

4. Results and discussion

The results of the OLS estimates are reported in Tables II-IV. As pointed out earlier,
the literature on theories of capital structure.
Table II reports the determinants of leverage according to the assumptions of the
tradeoff theory. The results show that the coefficient of long-term debt is positive and
significant. This means that corporate leverage adjusts positively according to the
changes in the long-term debt. The positive and significant coefficient of debt/equity
ratio carries the same implication. The positive and significant coefficient of the
effective corporate tax rate fits the assumptions of tradeoff theory that firms may
increase debt to benefit from tax savings. Contrary to the assumptions of the tradeoff
theory, the results also shows that corporate debt ratio is not neither adjusted
according to a target debt ratio nor that fixed assets are used as collateral for higher
borrowing. On the other hand, the negative and significant coefficient of the
bankruptcy risk shows clearly that companies decrease the leverage to avoid higher
degrees of bankruptcy risk. Regarding the effects of type of industry, the results show
that the tradeoff assumptions are significant in two industries (mills and textile) and
one industry (utilities) shows debt financing behavior that is contrary to the tradeoff
theory. The overall results show that more than one of the assumptions of tradeoff
theory (effective corporate tax rate, debt/equity ratio, bankruptcy risk) do influence the
debt financing behavior. In addition, the overall results in Table II show that
the explanatory power of the regression equation is high and significant which indicate
that the model construction is quite indicative.
Table III reports the determinants of leverage according to the assumptions of the
pecking order theory. As in the case of the tradeoff-related determinants of leverage,
the results in Table III show that the coefficient of long-term debt is positive and
significant. This means that corporate leverage adjusts positively according to the
changes in the long-term debt. The negative and significant coefficient of growth of
total assets fits the assumptions of the pecking order theory while the positive and
significant coefficient of sales growth does not meet the assumption of the theory.
The positive and significant coefficient of capital expenditure/assets indicates that
IJCOMA
Variables Coefficients t-statistics Sig. t VIF
17,1/2
Constant 0.0138
Long term debt – DLdebtt 0.1428 65.2435 0.0000 1.843
Effective corporate tax rate – ECTRt 0.0040 2.0200 0.0440 1.253
Fixed assets/total assets – FATA 2 0.0644 24.0243 0.0001 1.322
34 Target debt/equity – DEtþ 1 0.0005 1.6604 0.0975 1.100
Target debt ratio – DDR*t 2 0.0194 22.6041 0.0095 1.940
Non-debt tax shields – DNDTAXt 0.00000002 0.7654 0.4444 1.074
Bankruptcy risk – BRt 2 0.00000072 26.0424 0.0000 1.105
Interest rate – IRt 2 0.2166 20.6283 0.5301 1.055
Mills and storages 0.0208 2.1519 0.0319 1.358
Textiles, garments and consumers goods 0.0352 1.9752 0.0489 1.268
Chemicals and fertilizers 2 0.0223 21.5672 0.1178 1.361
Engineering industries and electrical
equipments 2 0.0206 2 1.1905 0.2345 1.323
Housing and real estate 2 0.0180 21.3861 0.1664 1.360
Utilities and other services 2 0.0417 21.8668 0.0626 1.160
N ¼ 455 F ¼ 522.67 Sig.F ¼ 0.00 DW ¼ 1.98 R
2 ¼ 0:9414
Notes: Regression coefficients (backward) for the trade-off theory. The dependent variables is total
debt ratio. The regression equation is free from multicollinearity (VIF , 5). The time dummy variable
was excluded due to its high multicollinearity with the interest rate (IR). The latter, therefore, carries
that same implications as the time effect. Outliers are detected and excluded accordingly. The
heteroskedastic effects are corrected using the White’s Heteroskedaticity-Corrected Standard Errors
(HCSE), which improves the significance of the OLS estimates. D-W test significant at 2 percent
two-sided level of significance – the significance of the heteroskedasticity affects the predictive power
Table II. of regression models. The rational is that the conventional OLS coefficient standard errors are
Regression coefficients of incorrect, and therefore, the conventional test statistics based on them are invalid. This is the very
the estimators for the reason of using the HCSE methods for correcting the estimated standard error, thus the significance of
tradeoff theory the estimates. For more details, see Johnston and DiNardo (1997)

expansion (or growth) is financed relatively by debt. In addition, the negative and
significant coefficients of operating income/sales and return on investments fit the
assumption of the pecking order theory. A contradicting and confusing result is
presented by the positive and significant coefficient of the PE ratio. This shows an
irregular financing behavior that companies increase leverage (instead of issuing
equity) when the PE is increasing. Regarding the effects of type of industry, the results
show that five industries have a significant reverse financing behavior to the pecking
order assumptions. These industries are agriculture and fisheries, food and beverages,
chemicals and fertilizers, engineering industries and electrical equipments, and
utilities. The overall results show that more than one of the assumptions of pecking
order theory (growth of total assets, capital expenditure, and operating income/sales
and return on investments) do influence the debt financing behavior. In addition, the
overall results in Table III also show that the explanatory power of the regression
equation is significant and higher than that of the tradeoff equation which indicates
that the model construction is quite indicative.
Table IV reports the determinants of leverage according to the assumptions of
the free cash flow. The results show that the coefficient of short-term debt is positive
and significant. This means that corporate leverage adjusts positively according to the
 Determinants of
Variables Coefficients t-statistics Sig.t VIF
corporate capital
Constant 20.0039 structure
Long term debt – DLdebtt 0.1705 154.0377 0.0000 1.133
Retained earnings ratio – DREAt 0.0133 0.9493 0.3431 1.888
Growth of total assets – GTAt 20.6347 2141.7391 0.0000 1.086
Capital expenditure/total assets – CETAt 0.0056 3.1575 0.0017 1.269 35
Sales growth – SGt 0.0072 1.9474 0.0522 1.945
Operating income/sales – DOISt 20.0202 27.4558 0.0000 1.512
Return on investments – DROIt 20.7047 212.4615 0.0000 1.546
Current ratio – DCRt 20.0094 21.0075 0.3143 2.797
Quick ratio – DQRt 0.0027 0.2914 0.7709 2.844
Price/earnings ratio – DPEt 0.0000 3.9641 0.0001 1.044
Large investment opportunity – MBt 20.0132 21.2961 0.1957 1.191
Agriculture and fisheries 20.0503 23.2804 0.0011 1.263
Food and beverages 20.0216 22.3163 0.0211 1.654
Mills and storages 20.0098 20.8052 0.4212 1.661
Paper, packaging and plastics 20.0134 21.2039 0.2294 1.431
Chemicals and fertilizers 20.0191 21.9855 0.0478 1.393
Engineering industries and electrical
equipments 2 0.0169 2 1.9240 0.0551 1.400
Utilities and other services 20.0556 23.2037 0.0015 1.246
N ¼ 413 F ¼ 2,145.65 Sig.F ¼ 0.00 DW ¼ 1.94 R
2 ¼ 0.989
Notes: Regression coefficients (backward) for the pecking order theory. The dependent variable is
total debt ratio. The regression equation is free from multicollinearity (VIF , 5). The time dummy
variable was excluded due to its high multicollinearity with the interest rate (IR). The latter, therefore, Table III.
carries that same implications as the time effect. Outliers are detected and excluded accordingly. The Regression coefficients of
heteroskedastic effects are corrected using the White’s HCSE, which improves the significance of the the estimators for the
OLS estimates. D-W test significant at 2 percent two-sided level of significance pecking order theory

Variables Coefficients t-statistics Sig.t VIF

C 0.0643
Short term debt – DSdebtt 0.1544 299.2528 0.0000 1.059
Interest rate – IRt 20.4945 2 1.9149 0.0562 1.023
Food and beverages 20.0136 2 0.8678 0.3860 1.320
Textiles, garments and consumers goods 0.0281 1.7510 0.0806 1.213
Chemicals and fertilizers 20.0132 2 0.7762 0.4380 1.275
Pharmaceuticals and health care 20.0156 2 1.5516 0.1215 1.399
Engineering industries and electrical
equipments 20.0356 21.9946 0.0467 1.245
Housing and real estate 20.0167 2 1.4914 0.1366 1.337
Utilities and other services 20.0492 2 2.2532 0.0247 1.117
N ¼ 454 F ¼ 1,145.21 Sig.F ¼ 0.00 DW ¼ 2.03 R
2 ¼ 0:9578
Notes: Regression coefficients (backward) for the free cash flow theory. The dependent variable is
total debt ratio. The regression equation is free from multicollinearity (VIF , 5). The time dummy
variable was excluded due to its high multicollinearity with the interest rate (IR). The latter, therefore, Table IV.
carries that same implications as the time effect. Outliers are detected and excluded accordingly. The Regression coefficients of
heteroskedastic effects are corrected using the White’s HCSE, which improves the significance of the the estimators for the free
OLS estimates. D-W test significant at 2 percent two-sided level of significance cash flow theory
IJCOMA changes in the short-term debt. The negative and significant coefficient of interest rates
17,1/2 indicates that companies do time the borrowing decisions. That is borrowing occur
when the interest rates is low. Surprisingly, none of the three cash flow-related
variables are present in the model. This means that the assumption of the free cash
flow theory do not have any effect on the borrowing decisions. The coefficients of the
type of industries show that the short-term debt and interest rates do not have that
36 effect on two industries (engineering industries and electrical equipments and utilities),
but have the indicated effect on one industry (textile). The overall results in Table IV
show that the explanatory power of the regression equation is significant and high
which indicate that the model construction is quite indicative as well.

5. Conclusion
This paper examines the effects of the assumptions of three theories of capital
structure (tradeoff, pecking order and free cash flow) on the firm’s decision to
change its leverage. In general, the results show that the explanatory power of the
models is relatively high and significant which indicates that the construct validity
of the models is acceptable. When the lagged long-term and short-term debts are
add to the equations, the results showed that companies used both types of debt to
adjust the leverage with the use of long-term debt is relatively higher. Table V
shows the determinants of leverage according to the assumptions of each theory
independently.
The results are interesting and informative in many aspects. First, the results
show that the capital structure decisions are affected to a large extent by two
theories (or approaches): tradeoff and pecking order. This means that searching for
an optimal capital structure is not one-way to go. As Myers (2001) stated that each
capital structure theory works out under its own assumptions and, moreover, does
not offer a complete explanation of the financing decisions. That is why the
explanatory power of each regression equation (representing each capital structure
theory independently) is quite high and significant. Second, as long as corporate
capital structure decisions follow more than one theory, further research is
warranted in the conditions under which each capital structure theory dominates
relatively. These conditions represent firm’s characteristics such as size, growth,
business risk, etc. Third, previous studies on the determinants of capital structure
in developing and emerging markets show a considerable high-degree of
convergence. That is, common determinants of capital structure do exist in
developed as well as developing/emerging economies. This provides a support to
the call for searching for the conditions under which a firm moves from a theory
to another.

Theory of capital structure Determinants of capital structure

Table V.
Determinants of capital Trade-off theory Taxes, debt/equity ratio, bankruptcy risk
structure: independent Pecking order theory Growth, profitability
theory approach Free cash flow None
Notes Determinants of
1. The debt ratio is measured in book rather than market value. Two studies have presented corporate capital
theoretical and empirical justification for the use of book value. Myers (1977) argues that the
debt book value is related to the value of assets in place. Taggart (1977) finds that there is structure
very little to choose between the book and market value formulations.
2. The literature provides reasoning to that split. First, Marsh (1982) argues that small firms
may rely on bank loans rather than long-term debt because of floatation costs and problems 37
of access to capital market. Second, Van Horne (1977) and Myers (1977) give justification that
firms tend to match the maturity of their assets and liabilities. This means that long-term
debt must be associated with fixed assets and short-term debt must be associated with
current assets. Third, Myers et al. (1977) argue that if firms are not certain about future
inflation rates, they tend to rely on short-term interest rate debt.

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Appendix Determinants of
corporate capital
structure
Abou Kir Chipsy Food Industries General Silos & Orascom Projects &
Fertilizers Storage Tourist Development
Acrow Misr Delta Construction Giza General Oriental Weavers
Contracting 41
AIC construction Delta Industries Heliopolis Housing Paints & Chemicals
Industries
Al Ahram Development & Engineering Helwan Portland Paper Middle East
Beverages Consultants Cement
Alexandria Cement East Delta Flour Mills Kafr El Zayat Pfizer Egypt
Pesticides
Alexandria Flour Eastern Tobacco Mahmodia Rakta Paper
Mills Contracting & Manufacturing
Investment
Alexandria Iron & Egypt Aluminum Medical Union Samcrete Egypt
Steel Pharmaceuticals
Alexandria Egypt Medical Trade Medinet Nasr Savola Sime Egypt
Pharmaceuticals Housing
Alexandria Real Egyptian Arab Engineering Memphis Semiramis Hotels
Estate Real Estate & Investment Pharmaceuticals
Alex. Spinning & Egyptian Chemical Industries Mena Real Estate Sheeni
Weaving Investment
Ameriyah Cement Egyptian Contracting Middle & West Delta South Cairo & Giza
Flour Mills Mills & Bakeries
Amreyah Egyptian Electrical Cables Misr Chemical Suez Bags
Pharmaceuticals Industries
Arab Ceramics Egyptian Financial & Misr Conditioning Suez Cement
Industrial
Arab Cotton Egyptian International Misr Duty Free Shops T3 A Pharmaceutical
Ginning Pharmaceuticals Group
Arab Egyptian Starch & Glucose Misr Gulf Oil Technopak
Pharmaceuticals Processing
Arabia Housing Egyptian Transport Misr Hotels Telemisr
Assiut Cement El Ezz Porcelain Misr Oils & Soap Torah Cement
Aventis El Kahera Housing Nasr Company for United Arab Bolivara
Pharma-Hochest Civil Works Spinning
Bisco Misr El Nasr Dried Agricultural Nasr for Clothing & United Arab Shipping
Products Textiles
Cairo El Nasr Transformers National Cement United Housing &
Pharmaceuticals Development
Cairo Poultry El Nobareyah Agricultural Natural Gas & Universal
Engineering Mining Project
Cairo Precision El Shams Housing & Nile Cotton Ginning Upper Egypt
Industries Urbanization Contracting
Canal Shipping El Shorouk Press Nile Matches Upper Egypt Flour Mills
Agencies
Central Egypt Engineering Industries Nile Pharmaceuticals Wadi for Exporting
Flour Mills Agricultural Products
Chemical Export Development North Cairo Mills Table AI.
Industries Trading Co. List of the companies
Development included in the study
IJCOMA
Variables Ratio/proxy Mean Median SD Min Max
17,1/2
Total debt ratio DTDt 20.03 2 0.01 0.58 2 7.54 6.13
(Long-term debt DLdebtt21 20.15 0 2.30 2 50.63 0.40
ratio)t2 1
(Short-term debt DSdebtt21 20.12 0 2.24 2 48.62 6.02
42 ratio)t2 1
Target debt ratio DEtþ 1 5.36 1.06 11.98 0 123.3
DDR*t 0.17 0.04 1.07 2 6.13 15.06
Average DDRAVGt 0.08 0.02 0.92 2 0.96 8.58
industry
leverage
Structure of FATAt 0.01 0 0.25 2 4.37 0.78
tangible assets
Relative tax DNDTAXt 25,846.1 21,091.8 2,111.5 2 3,692 1,641.1
effects
DNDTAt 26.17 1.97 139.17 2 0.83 2,110.5
ECTRt 2.17 1.43 2.46 0 15.99
Growth CETAt 0.73 0.12 2.90 0 32.76
GTAt 0.03 0 0.48 2 0.90 10.10
SGt 0.62 0.45 0.83 2 0.80 13.52
ASTURNt 0.11 0 0.94 2 12.2 12.2
Investment High growth 0.05 0 0.22 0 1.00
growth opportunities
opportunities
Medium growth 0.27 0 0.45 0 1.00
opportunities
Low growth 0.68 1.00 0.47 0 1.00
opportunities
Bankruptcy risk BRt 2260.5 0.05 159.04 2 3,052 1,848.7
DCRt 53.48 0 11.11 2 8.81 25.5
Agency costs ERt 0.02 0.01 0.28 2 3.37 3.44
AURt 0.11 0 0.94 2 12.24 12.24
Uniqueness SESt 0.01 0.01 0.26 2 3.12 2.31
Industry Agriculture and fisheries 0.03 0 0.17 0 1.00
classification
Gas, oil and mining 0.01 0 0.10 0 1.00
Food and beverages 0.09 0 0.29 0 1.00
Mills and storages 0.08 0 0.27 0 1.00
Textiles, garments and 0.06 0 0.24 0 1.00
consumers goods
Paper, packaging and 0.06 0 0.24 0 1.00
plastics
Chemicals and fertilizers 0.07 0 0.26 0 1.00
Pharmaceuticals and 0.12 0 0.33 0 1.00
health care
Building materials, 0.21 0 0.41 0 1.00
cement and contracting
Table AII. Engineering industries 0.07 0 0.26 0 1.00
Summary statistics of and electrical equipments
variables used for Housing and real estate 0.10 0 0.30 0 1.00
examining theories of Tourism and leisure 0.03 0 0.17 0 1.00
capital structure (continued)
Variables Ratio/proxy Mean Median SD Min Max
Determinants of
corporate capital
Utilities and other 0.03 0 0.17 0 1.00
services
structure
Information technology 0.03 0 0.17 0 1.00
and communications
Size Large size 0.30 0 0.46 0 1.00
Medium size 0.34 0 0.48 0 1.00
43
Small size 0.35 0 0.48 0 1.00
Profitability DEBITDAt 1.98 0 41.91 2 1.50 932.5
DOISt 20.01 0 0.80 2 12.43 12.43
DOIAt 20.03 2 0.01 0.80 2 12.26 12.26
DPMt 0.18 0.14 0.25 2 0.60 4.13
DROIt 20.01 0.01 0.28 2 3.73 3.72
Financial REAtþ 1 0.02 2 0.01 0.16 2 0.54 0.98
flexibility DREAt 0.21 0.16 0.30 2 0.88 5.33
Liquidity DQRt 20.04 0.02 1.00 2 18.38 2.33
position DWCRt 0.29 0.02 3.40 2 35.22 43.46
DCashRt 20.31 0 6.21 2 137.9 1.98
DCRt 20.01 0.02 1.00 2 18.09 6.13
Interest rate IRt 0.14 0.14 0.01 0.13 0.16
Timing effect DPEt 6.86 0.02 108 2 415.1 205.9
Transaction DPRt 0.94 0.35 11.31 0 251.66
costs
Free cash flow FCFt 22,118.6 27,713 2,167 2 1,294 17,026
Time dummies T 3 3 1.42 1 5
Observations 495 495 495 495 495
Notes: The dependent variable is the total debt ratio DTDt and the other variables are the
independents. The D is measured as (t) 2 (t 2 1) for all variables except for DDR*t ¼ ðDRtþ1 2 DRt Þ:
The data covers the years from 1998-2004 Table AII.

Corresponding author
Tarek I. Eldomiaty can be contacted at: T.Eldomiaty@uaeu.ac.ae

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