Optimal Capital Structure and Firm Performance in the Textile Sector of Pakistan

Abstract

The study explores the critical role of capital structure decisions in shaping firm performance, with a particular focus on the textile sector of Pakistan. Recognizing the importance of achieving an optimal mix of debt and equity to maximize shareholder wealth and ensure long-term sustainability, the research investigates the threshold effects of leverage on firm value and identifies the optimal debt ratio for textile firms. Employing panel threshold regression analysis, the study examines data spanning from 2007 to 2022, with key control variables including the growth rate of operating sales, firm size, and market value of book value. This comprehensive approach allows for a nuanced understanding of the relationship between leverage and firm value, considering both linear and non-linear effects. The findings reveal that firms in the textile sector of Pakistan can enhance their value by strategically utilizing debt financing, thus supporting the tenets of the trade-off theory. Importantly, the presence of an optimal debt ratio suggests that firms can achieve maximum value by striking a balance between debt and equity financing. Moreover, the study highlights the significance of differentiating between short-term and long-term debt in determining the optimal capital structure. The low target debt ratio observed for short-term debt underscores the textile sector's reliance on short-term loans, potentially due to the industry's cyclical nature and fluctuating capital requirements. Based on these findings, the study offers practical recommendations for textile firms, advising them to maintain their debt ratios within the identified target range. By adhering to the optimal debt ratio, firms can capitalize on the benefits of the interest tax shield while minimizing the risks associated with excessive leverage. This research contributes to the ongoing discourse on capital structure decisions and firm performance, particularly within the context of the textile sector in Pakistan. By providing empirical evidence of the threshold effects of leverage on firm value and identifying optimal debt ratios, the study offers valuable insights for textile firms seeking to enhance their financial sustainability and maximize shareholder wealth in a dynamic and competitive market environment.