This chapter gives a brief overview of the oil and gas sector in Pakistan; its construction and composition, performance and productivity and the historic evolution of the KSE. Further the chapter discuses the nationalization and privatization along with the issues and concerns regarding the oil and gas sector in Pakistan.
1.1 An overview of the oil & gas sector; construction and composition in Pakistan:
The importance of oil and gas sector can be derived from the fact that it attracts the highest amount of foreign direct investment in our country, which ultimately translates into increasing the government's tax revenue. According to (Mumtaz, 2010), it is stated that primary energy consumption in Pakistan totals to around 60.25 MTOE, of which 79% of the demand is met by the oil and gas sector. The oil and gas industry sector profile of Pakistan can be broadly divided into four main areas: Extraction of Crude Petroleum, Natural Gas Liquid Extraction, Oil Refining, Petroleum and Petroleum Products Wholesalers. There are around twenty six Petroleum Exploration & Production companies operating in Pakistan, out of which sixteen are foreign owned. Pakistan also has a reasonably well developed gas sector, with two publicly owned companies responsible for the distribution of gas. The sectoral share of electricity and gas distribution for the year 2010 in Gross Domestic Product (GDP) is 1.8%; as stated in the State Bank of Pakistan's handbook of statistics.
The three primary sources of energy used in Pakistan are oil, natural gas and hydro power. Constrained by the limited reserves of oil and gas present in our country, the import of oil and petroleum related products from Middle East and mainly Saudi Arabia approximates to 80 percent and are of foremost importance (EIA,2006), ( World Bank Report). As shown by the statistics stated in the Pakistan energy year book, the share of natural gas in country's energy use is approximately 50 percent out of the total energy consumption. Figure 1 in Appendix A shows the energy mix of Pakistan. It shows that out of the entire energy sources used in Pakistan, around 47.5 percent share if of natural gas, which is followed by oil.
Production, productivity and sustainability of performance of oil and gas sector:
The economy of Pakistan is growing at a steady pace. The growth requires a greater energy usage, and the pressure is consequently built on the country's economy. To fulfill the energy requirements, Pakistan depends on its oil and gas resources. The indigenous oil and gas resources are not sufficient to quench the thirst of the growing energy demand, as a result, Pakistan has to import huge quantities of oil and petroleum based products from the Middle East countries.
Natural gas plays a vital role in the power sector. At present, in Pakistan, there are some local as well as international oil upstream and downstream companies who together with the government of Pakistan are devising investor friendly policies to attract more international investors. The high degree of uncertainty along with the deteriorating political condition poses significant challenges in attracting the investments.
Despite the global economic downturn, Pakistan's Oil and Gas sector has been able to attract the highest amount of FDI (Foreign Direct Investment). Pakistan' annual energy demand is expected to grow around (4.4% to 6.1%), in the next fifteen years; as cited by (Mumtaz, 2010). Around 80% of the energy demand is met by imports which imposes a huge burden on the foreign exchange reserves of Pakistan. This reason for this sharp rise in the investment in this sector is due to the power crisis face in this country. Pakistan is going through a turmoil, since the common consumer and the industry is being adversely affected by this crisis. To keep the economy moving, bringing in foreign investment is the need of the hour.
The Government of Pakistan is looking for numerous options to meet the growing energy demand by considering various transnational pipeline projects. The upstream companies are regulated by the Ministry of Petroleum and Natural Resources where as OGRA (Oil & gas regularity authority is responsible to administer the midstream and the downstream companies.
The ratio of reserves to production is falling, meaning that the usage exceeds the reserves. According to (Ahmad and Jha, 2007), it is estimated that the oil and gas reserves will deplete within 14 and 21 years respectively. Figure 2 in Appendix A shows that the reserve to production ratio is highest for coal then followed by natural gas; while hydro has already been realized.
As stated by the Oil and Gas Journal (OGJ), Pakistan had 300 million of barrels of proven oil reserves as of January 2006. The majority of reserves are located in the southern half of the country, from where a significant amount of oil comes from. The three largest oil producing fields are located in the Southern Indus Basin (EIA, 2006). Pakistan was able to produce an average of 58,000bbl/d of crude oil in 2006; however, it aimed to achieve an output of 100,000 bbl/d by 2010. Pakistan consumes all of its natural gas production, but in future, Pakistan will become an importer of natural gas if the production does not increase. Baluchistan, which is the most prospective area for exploring the gas reserves, has its own problems due to the tribal system and political rivalries.
Assessing performance of oil and gas sector in KSE; historic evolution:
The oil sector of Pakistan is regulated by the Ministry of Petroleum and natural resources, which was created in 1977. There are around four companies which make up this sector, namely POL, PPL, OGDCL and PSO. All these are partnerships or joint ventures with either international or domestic firms. The oil and gas sector reported handsome return of 45 percent in the fiscal year 2010, when the performance of the companies out weighted the KSE by 19 percent (The News, 2010). This was due to the rising foreign interest and earnings growth. The E & P and the OMC'S both outperformed the KSE. Out of the E & P, Mari Gas reported negative returns. In the OMC's, three listed companies underperformed primarily due to higher turnover tax. The weight of oil and gas sector has increased substantially from 29.6 percent to 34.8 percent in 2010. Oil and gas now, in 2011, makes up a 36 percent of KSE's total market capitalization. Oil and gas being one of the outperforming sectors contributes a major chunk to the economic growth of Pakistan.
1.4: Nationalization, denationalization and deregulation of the oil and gas sector:
A milestone which gave full legal protection to investors was the advent of the 1992 Economic Reforms, which carried out the privatization process. Subsequently, a number of new regulatory authorities like OGRA were created with the Privatization Act of 2000. Before the privatization reforms took place, decisions made by the government were more politically influenced than economically influenced. This situation has changed dramatically over the past years, and now Pakistan leads in the South Asian Reforms. Privatization being the key economic reform, the upstream and the downstream gas production and distribution is a combination of private and public sector entities, and the major focus was on the privatization of Pakistan State Oil (PSO), OGDCL and Pakistan Petroleum Limited (PPL) which are all on the Government's privatization list.
The focus of the government has been on promoting upstream private investments and deregulating the market for the petroleum products. The government has been working on the establishment of regulatory agencies for the gas sector; moreover, the government has introduced price caps. The improvement has been to the extent that the board of governors of public limited companies, in the petroleum sector have been given complete autonomy to make decisions. These reforms have led to more transparency, and has enabled to measure the performance of the macroeconomic management. Even at present, the government has a major role to play in terms of deciding the tariffs and the allocation of gas to the each sector as long as the shortage persists. The government still pays huge amounts of subsidies on the gas to consumers which distort the market mechanism. For a sustainable environment, a competitive and a privately owned and run oil and gas sector can deliver efficient supplies and contribute more generously to the economy as a whole.
1.5: Oil and Gas sector performance in KSE; issues and concerns:
The presence of institutional and structural disconnections in Pakistan's energy sector creates a dire need for management efficiency and a unified sustainable long term policy making. This research has a few objectives: the prime focus of these studies has been to identify and analyze the determinants of leverage and since the past studies have at times used too simplistic or inappropriate modeling technique, which makes it an area of research. (Walliulah and Nishat,2008) have recently done work to address the dynamics of capital structure but the study is sort of flawed in terms of the econometric model which they have used.
Hence the results are biased and not consistent. They have confined there study to 2005 moreover. To determine the optimal capital structure of a company; for long and short term and also to ensure that the funds are available on the time they are needed to finance the company. Moreover, a corporation needs to know the amount they need to borrow and from whom and when to borrow. Repayment schedule and ensuring that how the loan would be repaid. Also to help identify that which sector employs the greatest portion of loan.
1.6: Keywords and Definitions:
Keywords: Capital structure; Leverage; Oil and Gas, Firm Specific Variables.
Definitions:
Sr.
Dependent Variable
Operational Definition
Source
Leverage[1]
(Hajazi and Shah, 2004)
One way to measure leverage is the Debt to Equity ratio.
Total Debt/ Total Assets
Financial statements
Independent Variables:
Operational Definition
1.
Size
(Hajazi and Shah, 2004)
Size is measured by taking the Natural LOG of Sales.
Financial statements
2.
Growth
(Hajazi and Shah, 2004)
Annual percentage increase in the Total Assets of the firm.
Financial statements
3.
Tangibility
(Hajazi and Shah, 2004)
Measure tangibility by taking the ratio of Fixed Assets to Total Assets.
Financial statements
4.
Profitability
(Shah and Khan, 2007)
Profitability can be measured by:
Net Income After Tax/ Total Sales
Financial statements
5.
Non-debt tax shields
(Shah and Khan, 2007)
Non debt tax shields:
Annual Depreciation/Total Assets
Financial statements
6.
Earning Volatility
(Shah and Khan, 2007)
We use the value of the deviations from the mean of net profit divided by the total number of years for each firm in the given year as the proxy of earning volatility.
Financial statements
7.
Return on Assets
(Butt and Hasan, 2009)
Calculated by : Net Income/ Total Assets
Financial statements
8.
GDP growth rate
(Kabir and Nguyen, 2005)
The rate of growth in the GDP from one year to another.
SBP(State Bank Of Pakistan) yearly reports
9.
Risk
(Kabir and Nguyen, 2005)
Standard deviation of the EBITDA.
Financial statements
10.
Tax
(Kabir and Nguyen, 2005)
Taken as the average tax rate in that country in that year.
Financial statements
11.
Liquidity
(Kabir and Nguyen, 2005)
Can be calculated by:
Total Current Assets/ Total Current Liabilities
Financial statements
1.7: Study Objectives:
Hypothesis 1: Size;
There is a positive relationship between size and leverage.
Hypothesis 2: Growth;
Growth rate is negatively related to leverage.
Hypothesis 3: Tangibility;
The higher the percentage of fixed assets, the higher will be the leverage.
Hypothesis 4: Profitability;
Firms with higher profitability will have lower leverage.
Hypothesis 5: Non debt tax shields (NDTS);
NDTS is inversely related to leverage.
Hypothesis 6: Earning volatility;
Earning volatility has a negative relation with leverage.
Hypothesis 7: Return on Assets (ROA);
ROA has a negative relation with leverage.
Hypothesis 8: GDP growth rate;
GDP growth is positively related to the firms leverage.
Hypothesis 9: Risk;
There is a negative relation between risk and leverage.
Hypothesis 10: Tax;
Tax and leverage are positively related.
Hypothesis 11: Liquidity;
The higher the liquidity, the lesser will be the leverage of the firm.
Chapter No. 2: Literature Review
This chapter gives an overview of the past studies conducted on the determinants of the capital structure of the non financial companies, pertaining to the firm specific variables also incorporating the role of corporate governance, asymmetric information, term structure of interest rates, privatization and deregulation, followed by the financial globalization and financial market distortions.
2.1: An over view of the non-financial sector performance in capital markets: A cross country evidence:
The debate on capital structure took its origin from the publication of the "Irrelevance Theory", which was proposed by (Modigliani and Miller, 1958). The theory supports the fact that capital structure choice is independent of a firm's value under certain assumptions. In order to maximize the value of the firm, it is of grave importance to determine the optimal mix of debt and equity. Hence, equity and debt tend to be the perfect substitutes.
(Hijazi and Shah, 2004) in their paper attempted to examine the determinants of capital structure of the non financial companies listed on KSE 100 index. The paper examined the manufacturing sector taking into account the data from 1980 to 1987 and came up with explicitly explaining the variables that influence the mix of debt to equity. He took leverage as a proxy for the dependent variable and then took tangibility, size, growth and profitability as the independent variables. Another research conducted by (Shah and Khan, 2007) who too included the independent variables namely: profitability, earning volatility, size, tangibility and growth to determine a firm's leverage. Further these variables have been replicated by almost every author who has conducted study on the determinants of capital structure. (Shah and Khan, 2007), (Khalid, 2011), (Mazhar and Nasr, n.d), (Butt and Hasan, 2009), (Lipson and Mortal, 2009) and (Kabir and Nguyen, 2005) did include most of variables from growth, size, tangibility and profitability in their analysis.
2.2: Firm Specific Models of Capital Structure:
Jong, Kabir and Naguyen (2007), in their research regarding the roles of firm specific and country specific determinants of capital structure; they analyzed the importance of firm and country specific factors affecting the leverage decisions of the firms across different countries. The study proves that the firm specific factors vary across countries, despite the fact that the previous studies considered these factors to have an equal impact for all countries. A research conducted by Rajan and Zingales (1995), also states the importance of firm specific variables across countries and also emphasis the role of country specific determinants. Booth et al. (2001) states that for both, the developed and the developing countries, the firm specific determinants are the same, although, the country specific variables like capital market development and GDP growth rate, do differ in determining the leverage of a country. Although these studies acknowledge the fact that the firm specific determinants do differ in magnitudes, signs and the significance. Jong, Kabir and Naguyen (2007), conducted a detailed analysis of the firm specific variables, which include factors like firm size, tangibility, risk, profitability and growth opportunities and concluded these factors to be strongly consistent across countries with regard to the capital structure theories. They took developed and developing countries data from year 1997 to 2001. The firm specific variables included were: Tangibility, risk, growth, size, profitability, liquidity, and tax. Tangibility, size and tax were hypothesized to have positive relation with firm's leverage, whereas the rest were inversely related to firms leverage. The basic theories that explain the variables specific to a firm are based on the tradeoff theory, asymmetric information and the agency cost theory (Booth et al., 2001). A .de Jong et. Al (2007) reaches the conclusion that the firm specific variables are consistent and significant with the finance theories for most of the countries.
Deesomsak, Paudyal, Pescetto (2004), in their paper, the determinants of capital structure: evidence from Asia Pacific region, took four countries and included the firm specific variables. The result showed that the capital structure decisions of countries are influenced by a country's environment in which they operate. That is, the legal, institutional and financial environment. Countries with differing institutional, legal and financial environment have different cost of taking debt and so the risk premium charged would vary accordingly. This provides us with the evidence that the mix of debt and equity will vary accordingly. Also the fact that the state linked organizations have various advantages in terms of financing decisions, which means that a few firm specific variables like tangibility, firm size and earnings volatility play a less important role in determining the leverage of such firms.
R. Deesomsak et al. (2004) incorporates the firm specific variables as tangibility, non-debt-tax shields, growth, size, profitability, earnings volatility, liquidity and share price performance. The author expects a positive relation of tangibility, firm size with firm's leverage. The others variables are expected to have a negative relation with leverage, though a few variables can have a positive and a negative relation with leverage depending upon which finance theory are we basing our hypothesis upon. The agency theory suggests that firms tend to under invest who have a high leverage, so that the wealth is transferred from debtholders to shareholders. This means more collateral is required to secure the debt and the firm becomes more liquid as it decreases the proportion of tangible assets. So firms with fewer tangible assets will have to pay more interest and so they'll issue more equity; this justifies the positive relation between tangibility and leverage.
The pecking order theory states that managers will first avail the retained earnings to finance the operations or growth, due to information asymmetry among managers and investors. So, firms will use retained earnings, followed by external debt and the last resort is equity financing so to avoid dilution of ownership. Thus postulating a negative relation between leverage and profitability. The positive relation between leverage and firm size can be based upon the tradeoff theory, since larger firms will face less bankruptcy risk, and a lower cost, so they'll be highly leveraged. Moreover, larger firms have lower monitoring costs, smaller agency costs of debt, easy access to credit markets, relatively certain cashflows and take more debt to benefit from the non debt tax shields (R. Deesomsak et al., 2004). Growth opportunities make a firm likely to invest in riskier projects and so the cost of borrowing will rise and this postulates an inverse relation between leverage and firm growth. The major attraction of using more debt is to save on the corporate tax. Non debt tax shields like depreciation can lead to a decrease in the tax charged. The potential tax benefit of debt is hence reduced when depreciation increases, so this drafts a negative relation between leverage and non debt tax shields. Liquidity is inversely related to leverage, as firms having more liquidity will take on less debt. If a firm has greater volatility in earnings, they will choose less debt, since their ability to service debt decreases as earnings are not certain (R. Deesomsak et al., 2004). They conclude that he non debt tax shields, share price premium and liquidity are significant in influencing the leverage across all countries. Further the results of research also signify the fact that the results can vary across countries due to institutional, governance and legal differences.
2.3: Asymmetric Information, Risk and Risk Management Initiatives
Agency theory and transaction cost economics are the two theories by which the market imperfections can be explained. These theories give a contradictory view point regarding the mix of debt and equity (Kochhar, 1996). Although the evidence suggests that mainly the views of transaction cost theory are supported in the empirical evidence. As stated by (Barton and Gordon, 1987, 1988), that the firm's capital structure is influenced by the risk taking propensity of a firm and which is further influenced by the corporate governance of the institutions. Modigliani and Miller (1958), in their irrelevance theory stated that the capital structure decision is independent of the firm's value under certain assumptions. One of the assumptions includes the transaction costs in capital markets and the other states that there is no information asymmetry between market players. As in the real world, imperfections are present, so this validates the theories which are based on imperfections rather than the ones based on perfections (Miller, 1989).
The agency theory has a greater impact on the management while a few researchers stated the harmful implications for firms using the agency theory in terms of taking on excessive debt. The similarity between transaction cost theory and the agency theory is the notion of opportunism and self interest (Kochhar, 1996). The divergence of the roles between the debt holders and the equity holders is the behavioral feature. The agency theory is based on the conflict of the principal and agent. Principal being the shareholders and agents being the managers leads the managers to pursue such policies in which they can maximize their personal self interest and the money of shareholders i.e. the shareholders are at stake. According to the agency theory, debt acts as a governance tool to reduce the conflict between the two parties by reducing the amount of the free cashflows available to the managers. This means that the managers will have to pay the interest payments and so if they spend on wasteful expenditures, their ability to service debt reduces substantially and they will face bankruptcy costs and may have to quit their jobs. This creates an incentive for the managers to better utilize the assets (Jensen, 1986).
The transaction cost perspective on capital structure states that the cost of financing firm specific assets is more expensive and so there will be less debt. For assets which cannot be used in other businesses, equity financing will be utilized. The research of Titman and Wessels (1988) stated that the leverage is inversely related to product uniqueness. The transaction theory relies on the notion of market failure, due to bounded rationality, so the transaction cost of debt will be very high if the asset is firm specific. Agency theory on the other side, assumes market efficiency, so it suggests more debt. Information asymmetry is an important aspect according to Kochhar (1996) between the two parties. Information asymmetry can be reduced in the agency cost theory by my spending on monitoring devices, but it cannot be lessened in the transaction cost theory and hence results in the market failure. The debtholders and the shareholders both have governance abilities; hence the debt to equity will affect the firm's performance by altering the governance costs.
2.4: Corporate governance, capital structure and efficiency
Margaritis and Psillaki (2008) in their research used the DEA (Data Envelopment Analysis) to measure firm's efficiency to examine that whether efficient firms use more or less debt. The research also tests the relation between efficiency and leverage, through the agency cost theory proposed by Jensen and Meckling (1976). There are hypothesis that are being tested in this research; firstly, to assess the impact of leverage on the performance of the firm, secondly, to analyze that does efficiency has an impact on the firm's capital structure or not. Lebibenstein (1966) in his research proved that how the differing principal-agent objectives are sources of inefficiency and are measured by the difference between the firm's potential output and the firm's actual output. The failure to achieve the efficiency is known as the X-inefficiency. If the agency costs were mitigated, so more leverage will be used and so this will lead to improvement in the firm's performance. There are two hypotheses under consideration: the efficiency risk hypothesis and the franchise value hypothesis. The efficiency risk hypotheses assumes that firms will be more leveraged since they are more efficient and so the bankruptcy costs would be lower, but the franchise value hypotheses suggests that leverage will be lesser for more efficient firms since the economic rents need to be protected which arise from efficiency. Margaritis and Psillaki (2008) state that the idea that the interests of the managers and the owners are not in line is highlighted by the agency cost theory. The managers may be using cashflows in risky investments and so the debt levels rise to reduce the free cashflows and so the inefficiencies are reduced. The author states in the hypotheses that: if the firm's leverage increases, the agency cost is likely to decrease and this will lower the inefficiency and hence increase the performance. Equity concentration can lead to positive impact on the firm's performance, in countries where the legal system is weak and the capital markets are less developed (La Porta et al., 2002).
So according to the agency cost theory, leverage and efficiency are positively related; but the relation can alter for higher levels of debt. The author in his research has used a control variable to incorporate all the firm specific variables likes size, profitability, tangibility, intangibility, growth and ownership. The corporate governance as discussed by R.Deesomsak et al (2004) includes the legal, institutional and regulatory surroundings of a country, which then impacts the relation among the stakeholders. The paper focuses mainly on the Asian Pacific Regions. Firms located in a well developed country, have a better access to external financing as compared to the ones located in the underdeveloped or developing nations. When law is such that it protects the investor's rights, then naturally, the outside investors tend to finance the firms more willingly. In countries like Malaysia and Singapore, where equal rights are given to both the shareholders and the bondholders, the leverage or debt to equity is independent of the other provisions. Collateral plays a pivotal role in the countries which have a poor creditor protection. The major aspects used by the author for corporate governance are: financial orientation; meaning that is the economy a market based or mixed economy, the legal origin, meaning that is it governed by common or civil law, law and order, justice, shareholders rights, creditors rights, control of public companies etc. The research of R.Deesomsak et al (2004) summarizes the fact that capital structure mix is dependent upon corporate governance, legal framework and institutional environment and not only the firm specific variables.
Hasan and Butt (2009) researched on the corporate governance and capital structure and focused that the agency theory is one of the determinants of the capital structure. The corporate governance variables that he choose were: board size and stated that firms with more board of directors have a low leverage, whereas the relation between non executive directors and leverage is expected to be negative since the managers are keenly observed by the non executive directors so there is a very low probability that the debt levels be high.
2.5: The Term Structure of Interest Rate and the Interest Rate Risk:
Prisman, (2003), in a research studies the fact that people often consider markets as frictionless and the bonds market to be illiquid and so this leads to the mispricing of the assets and so the accurate values of term structure of interest rates are hard to find. This lead to the arbitrage profits and the term structure of interest rates is very important in formulating the economic policies and also the fact that it is used to discount the cashflows to estimate the prices. Dewachter (2006) researches about the term structure of interest rates and then models it against the expected inflation. The slope will tell about the business cycle and the graph will portray the monetary factor which is independent. The model is such that inculcates the inflation rate, output gap and the term structure simultaneously. The repeated results imply the same that incorporating the inflation into the term structure, is important from a macro economics view point.
2.6: Privatization, Globalization, Financial innovation and the Management of change:
Leverage decisions are significantly affected by the deregulation. The tradeoff theory also supports the fact that the firms after deregulation quickly adjust to the optimal leverage (Ovtchinnikov, 2008). This paper published by (Ovtchinnikov, 2008) analyses the impact of deregulation on the capital structure of the firms. Deregulation is a shock to the working environment and since the work practices change following deregulation, it is important to analyze the impact on the firms leverage. The paper defines deregulation as deregulation of entry, exit, quantity and price. Hence, competition is enhanced through deregulation. Evidence from the research suggests that the productivity increased while a fall in the operating costs was seen. The author states in his research that there has been a significant decline in the leverage of the firms following deregulation; around 10 percent decline in a firms leverage, though this is accompanied by decrease in firm's profitability and tangibility while growth opportunities do increase. (Ovtchinnikov, 2008) in his research states that in each industry that is included in the data, the leverage falls by approximately 30 percent in the year in which deregulation takes place. The author took a sample of all the non financial firms in the deregulated industry, with the data ranging from 1966 to 2006. The author in this research has taken five industries that are deregulated, and petroleum and natural gas sector is a part of the research. The research concludes stating that deregulation has a considerable affect on the work environment, and these changes come about due to the alteration in the decision making power and also due to the changing industrial composition followed by deregulation. Deregulation being an exogenous shock, does leads to a change in the capital structure of a firm but it is ambiguous that whether it results in increased returns to shareholders or not.
A research conducted by Rhonda K. Reger, I.M. (1992) studies the performance of the banking sector after the regulation and deregulation takes place. The results state that deregulation has direct effect on the firm's performance and its risk return portfolio. The organization theory hypothesizes the fact that, the governmental regulation has a significant effect on the performance and options of a firm. These aspects are of much more concern due to globalization and deregulation, which brings more competition to the market and the benefits can be passed on to the consumers. The most crucial task is of devising appropriate strategies which are of true match to the changing environment. The paper states that there can be two types of regulations; social and economic. Both will affect the industry in different ways. Milne(1992), in his research states that the last 10 years, privatization has been carried out rigorously, so to create a more competitive environment and reduce the load of government debt. The paper stresses on the fact that leaders with the aim of accumulating wealth, will negate privatization or else they'll lose their valuable assets, since privatization means that the surplus cannot go to the politicians solely.
2.6: Financial globalization, financial innovation and the management of change:
According to O'brien (2003), the firm's choice of financing can be influenced by the choice of investment decisions. The capital structure with in an industry, for all the firms should vary; this can be explained by the capital structure puzzle. The paper mentions that the innovator in the industry will influence the capital structure decisions. Previous researches have highlighted the fact that leverage is relatively lower for the industries who focus more on research and development, since an investment in research and development creates an intangible asset, which cannot be used as a collateral. Kochhar (1996) in his paper stated that the leveraged buyouts (LBO's) take place more in the industries which possess non-unique assets, i.e. common assets which can easily be used across industries. This is due to lower investment opportunities which results in lower governance costs. Simerly and Li (2000) based their view on the transaction cost theory stating that due to environmental dynamisms, a firm's capital structure shall be such that it accommodates its environment. Furthermore, since mostly the lenders are risk averse, the more uncertain the environment, the lesser will be a firm's leverage. Some recent studies have shed light on innovation as a determinant of leverage. Porter's(1980) supported the fact that strategy that had innovation in focus, will be with a lower leverage, as compared to the cost leadership strategy, which takes on more debt. Hence, this postulates a negative relation between debt and expenditure on research and development. The important conclusions of the paper written by O'brien (2003), states that the capital structure is not just a function of industry, market and firm specific factors, but innovation plays a strategic role in influencing a firms capital structure.
2.8: Financial Market Distortions and Monetary Authorities:
Santoro (2008) in his paper studies the relation between the capital market distortions and the implementation of monetary policy. The banking sector, which is a subset of the financial sector, plays a pivotal role in determining the monetary policy, and to determine the impact of monetary policy on the firm's profitability. According to the new Keynesian framework, the marginal cost of the firm is the rate of interest that it has to pay (Santoro 2008).
This paper studies closely the rationale for financial globalization and also the fact that it leads to financial instability which is related closely to financial openness. Financial globalization and economic development seem to go hand in hand, infact it is the same as if we apply it to the cross border capital trade in which one can earn highest rewards.
