Capital Structure, Profitability and Market Structure: Evidence from Textile Industries in Bangladesh.

Topics: Debt, Economics, Balance sheet Pages: 18 (5784 words) Published: July 5, 2012
Capital Structure, Profitability and Market Structure: Evidence from Textile Industries in Bangladesh.


In corporate finance, the academic contribution of Modigliani and Miller (1958, 1963) about capital structure irrelevance and the tax shield advantage paved the way for the development of alternative theories and a series of empirical research initiatives on capital structure. The alternative theories include the trade-off theory, the pecking order/asymmetric information theory and the agency theory. All these theories have been subjected to extensive empirical testing in the context of developed countries. A few studies report on international comparisons of capital structure determinants and there are some studies that provide evidence on the capital structure determinants from the emerging markets of South-East Asia. The recent focus of corporate finance empirical literature has been to identify some 'stylized' factors that determine capital structure.

With relatively little evidence available on the interaction between capital structure and product market structure, some researchers have recently started investigating this relationship. Brander and Lewis (1986), Maksimovic (1988), Ravid (1988) and Bolton variously offer a theoretical framework for the linkage between capital structure and market structure.

On a broader front, Harris and Raviv (1991) and Phillips (1995) provide surveys of both the theoretical and empirical research on the relationship between capital structure and market structure. In a recent study, Rathinasamy, Krishnaswamy and Mantripragada (2000) Rathinasamy, Krishnaswamy and Mantripragada (2000) from forty-seven countries. All these studies establish a linear relationship, either positive or negative, between capital structure and market structure. Differing from the linear theory, this paper argues that the relationship between capital structure and market structure is cubic. It also shows that the relation of profitability with capital structure is U-shaped. The results of the present empirical work vindicate these predictions. To their knowledge, we have tried to uncover the cubic relationship between capital structure and market structure, and the saucer-shaped relationship between capital structure and profitability. It is also possible that we are the first to carry out the empirical work on the relationship between capital structure and market structure using data from 12 textile companies of Dhaka Stock Exchange.

The remaining sections of the paper are organized as follows. Following a review of the literature, the theoretical framework of the study is presented, after which there is a description of the data and research methodology. The results of the statistical analyses are then reported, and the paper ends with a summary of the main conclusions.

Literature Review

Brander and Lewis (1986) and Maksimovic (1988) provide the theoretical framework that links capital structure and market structure. Contrary to the profit maximization objective postulated in industrial organization literature, these theories are similar to the corporate finance theory in that they assume that the firm's objective is to maximize the wealth of shareholders. Furthermore, market structure is shown to affect capital structure by influencing the competitive behavior and strategies of firms. Firms in an oligopolistic market will follow the strategy of maximizing their output in favorable economic conditions to optimize profitability (Brander & Lewis 1986). The theory also holds in unfavorable economic conditions; firms would take a cut in production and reduce their profitability. Shareholders, though, while enjoying increased wealth in good periods, tend to ignore a decline in profitability in bad times. This is due to the fact that unfavorable consequences are passed onto lenders because of shareholders' limited liability status. Therefore, the oligopolistic...

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 Bolton, P. & Scharfstein, D. 1990, 'A theory of production based agency problems in financial contracting ', American Economic Review, 80(1): 59-581.
 Brander, J.A. & Lewis, T.R. 1986, 'Oligopoly and financial structure: the limited liability effect ', American Economic Review, 76(5): 956-70.
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