Stock return volatility and capital structure measures of nonfinancial firms in a dynamic panel model: Evidence from Pakistan

• Date: 01 January 2019
• DOI: http://doi.org/10.1002/ijfe.1682
• Author: Zeeshan Ahmed,Daw Tin Hla
• Published date: 01 January 2019

RESEARCH ARTICLE

Stock return volatility and capital structure measures of

nonfinancial firms in a dynamic panel model: Evidence

from Pakistan

Zeeshan Ahmed | Daw Tin Hla

Department of Accounting and Finance,

Faculty of Economics and Business,

Universiti Malaysia Sarawak (UNIMAS),

Kota Samarahan, Malaysia

Correspondence

Zeeshan Ahmed, Department of

Accounting and Finance, Faculty of

Economics and Business, Universiti

Malaysia Sarawak (UNIMAS), Kota

Samarahan, Malaysia.

Email: zeeshan4282@gmail.com

Abstract

We investigate the impact of stock return volatility on different capital struc-

ture measures of nonfinancial firms in a dynamic panel model. Two‐step sys-

tem generalized method of moment dynamic panel estimator is applied to

nonfinancial sector's data from Pakistan Stock Exchange over the period

2001–2014. The results imply that stock return volatility has a significant neg-

ative impact on book leverage and long‐term market leverage ratios. However,

stock return volatility causes the increase in total market leverage ratios. More-

over, book leverage and long‐term market leverage of firms decrease as a result

of an increase in stock return volatility in different classification of firms. Con-

versely, stock return volatility has a significant positive impact on total market

leverage ratios in those classifications of firms. Capital structure decisions are

more sensitive to stock return volatility as default risk increases. Firms signif-

icantly go for the reduction in their debt financing due to high stock returns

volatility and to avoid from possible consequences of default. The results are

robust to alternative measures such as cash flow volatility and earnings

volatility.

KEYWORDS

capital structure measures, dynamic panel model, nonfinancial firms, stock return volatility, system

GMM

1|INTRODUCTION

Capital structure determinants have been an issue of con-

siderable debate, among which stock return volatility

greatly influences the capital structure. It is one of the

puzzling and striking features of corporate finance that

happens due to the fluctuations in the price of stocks

and consequently changes the financial decisions (Welch,

2004). Not surprisingly, this stock return volatility wit-

nesses a dramatic and shocking effect on corporate capi-

tal structure in both developed and developing

countries. Moreover, the stock returns of firms operating

in developing countries are highly volatile, and firms

are incapable to fulfil the debt obligations (Andrade &

Kaplan, 1998). These firms are unsure about their future

earnings and investments that can be used to pay debt

obligations. Moreover, firms owing high stock return vol-

atility face high cost of external capital, and decreasing

ability in the payment of loans might cause high financial

distress cost. In such a situation, firm prefers the reduc-

tion in debt financing to avoid from possible conse-

quences of default (Dudley & James, 2015). If there is

little or no debt in capital structure, then firm will not

be in danger of default and no potential bankruptcy cost

Received: 13 April 2018 Revised: 1 August 2018 Accepted: 10 September 2018

DOI: 10.1002/ijfe.1682

604 © 2018 John Wiley & Sons, Ltd. Int J Fin Econ. 2019;24:604–628.wileyonlinelibrary.com/journal/ijfe

will be included when security holders value the firm.

Therefore, firm prefers the reduction in leverage (Huang

& Song, 2004).

Since the inception of Modigliani and Miller (1958,

1963), the cost of capital and firm value in an efficient

market is independent of financing decisions. Later on

in 1963, Modigliani and Miller question the validity of

irrelevance theory as most of the assumptions of this

theory were unrealistic under restrictive set of

assumptions. For example, in a frictionless market with

no transaction cost, default risk and taxes of firms are

homogenous in nature. Firms get more tax benefits by

replacing equity with debt and increase the leverage

ratios, which increase the risk related to cost of equity.

Under the framework of trade‐off and pecking order

theories, firms with volatile returns face the difficulty in

borrowing because in a bad state of world, they might

generate low returns that are not enough to meet their

obligations of debt (Antoniou, Guney, & Paudyal, 2008).

Firms trade off the financial distress cost with tax

benefits, butfinancial distress cost is highdue to high stock

return volatility. This decreases the optimal level of debt

from capital structure to avoid the possibility of default.

The results quantify the trade‐off and pecking order

theories' predictions that firm reduces its leverage ratios

in response to high stock return volatility to counterbalance

the chances of default (Chen, Wang, & Zhou, 2014).

Despite of this theoretical literature between volatility

of stock returns and use of debt, a little empirical evi-

dence about this phenomenon is available. Frank and

Goyal (2009) examine the 25 independent variables that

are used in previous studies and find only six variables

to explain the capital structure of a firm but volatility

does not robustly explain the capital structure of a firm.

Likewise, Leary and Roberts (2005) find that volatility

does not matter while explaining the capital structure of

the firm. In a cross‐country evidence about capital struc-

ture determinants, Rajan and Zingales (1995) do not

incorporate the volatility as an explanatory variable to

explain the capital structure. Moreover, Kayhan and

Titman (2007) and Leary and Roberts (2014) also do not

assimilate volatility as an explanatory variable.

The variable of interest is volatility of stock returns

and its impact on different measures of capital structure.

We define stock return volatility as a standard deviation

of daily stock return's over 1 year (Chen et al., 2014).

The study formulates three book debt ratios, that is,

short‐term, long‐term, and total debt ratios, and two mar-

ket debt ratios. The results provide the evidence of empir-

ical relationship between stock return volatility and

capital structure decisions of nonfinancial firms listed

on Pakistan stock exchange over the period 2001–2014.

Pakistan being an emerging market is not stable,

sensitive, and highly volatile due to unanticipated shocks

in the market. Not surprisingly, the external financing

options available to nonfinancial firms are limited on

account of unpredictable stock market (Ali, Rehman,

Yilmaz, Khan, & Afzal, 2010). Today, Pakistan capital

market faces multitude challenges in the shape of stock

return volatility that has a great impact on firm's financ-

ing transactions. Volatility significantly and negatively

affects the different measures of corporate debt (Keefe &

Yaghoubi, 2016). The findings suggest that firms reduce

the short‐term debt ratios, long‐term debt ratios, total

debt ratios and long‐term market leverage ratios. In this

way, the problem of uncertainty can be minimized, and

the objective of the shareholders' wealth maximization

can be achieved. Therefore, greater stock return volatility

induces the firm to lower the debt ratios for the purpose

to save them from default or bankruptcy.

This is the first comprehensive study in the examina-

tion of decisions related to different capital structure mea-

sures from the perspective of risk related to stock return

volatility. The study aims to fill the gap in existing litera-

ture and provides the empirical evidence about stock

return volatility and capital structure relationship. It con-

tributes to the existing literature in the following ways;

first, it provides the comprehensive knowledge about cap-

ital structure decisions from the perspective of stock

return volatility. Second, it takes into account the debt

with different measures and the impact of stock return

volatility on those measures that have been ignored in

the previous literature. Third, it examines the extent to

which the firm manages its debt structure based on the

classification of firms such as stock returns, firm size,

and profitability effect on how firm responds to the vola-

tilities in stock returns. Fourth, this study considers non-

financial sector in emerging market such as Pakistan as

literature is limited and a few studies address this topic

as well as limited in scope. Lastly, the study uses the more

superior estimation technique of two‐step system general-

ized method of moment (GMM) as previous literature

concentrates on fixed effect, random effect, and general-

ized linear models.

2|LITERATURE REVIEW

A great attention has been given to capital structure

issues by scholars over the last few decades. Capital struc-

ture is the main area of corporate finance and is insuffi-

ciently known in transitional economies and emerging

countries (Omran & Pointon, 2009). The financing deci-

sions are very crucial for the success of a firm and from

earnings point of view (Bancel & Mittoo, 2004). Firms

face serious financial risk due to different kinds of firm‐

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