Determining Optimal Capital Structure: Case of Corporate Taxes in Pakistan

Abstract

Leverage has a strong influence on decision about optimal capital structure that must be chosen by firm to enhance its profitability as well as to maximize the shareholder’s wealth. A key question in this respect is that whether only the fixed expenses the reason of leverage? Corporate taxes have no influence on profitability and goal of wealth maximization? To address this question, current study is aimed to explore impact of the corporate taxes on decision of capital structure choices in business scenario of Pakistan. In this aim, sample of 50 companies is taken that are listed on PSEX 100 index out of which 35 are taxpaying firms and 15 are non-tax paying firms. Firm specific variables (firm size, profitability, liquidity) and macroeconomic variables (GDP, inflation) along with stock market variables are taken into this study to analyze the impact on leverage and capital structure. Results of the study clearly show all variables have a significant effect on capital structure decision except stock market capitalization, inflation and firm size. These three exceptional variables do not have any significant influence on capital structure decision. This study has practical implications for CFO’s/COOs in determining an optimal capital structure of a firm. Taxation Policy makers like Federal Board of Revenue (FBR) in Pakistan can get useful insight from this study in formulation of the effective corporate tax policies to trigger business activity in the country.