Proceedings of the Australian Academy of Business and Social Sciences Conference 2014

(in partnership with The Journal of Developing Areas)

ISBN 978-0-9925622-0-5

CAPITAL STRUCTURE IN ISLAMIC CAPITAL MARKETS:

EVIDENCES FROM BURSA MALAYSIA

Omer Bin Thabet

Universiti Sains Islam Malaysia, Malaysia

Mustafa Mohd Hanefah

Universiti Sains Islam Malaysia, Malaysia

ABSTRACT

Since 1958, numerous attempts have been made to address the issue of capital structure choice. However, none of these attempts studied

the capital structure of Shariah-compliant markets. The objective is to develop a model that accounts for the capital structure choice of

263 Shariah-compliant firms listed on Bursa Malaysia over the period 2006-2011. The evidence suggests that the capital structure

choice of Shariah-compliant firms is always influenced by factors such as liquidity and risks and sometimes influenced by profitability,

zakah, and tax. However, in the presence of managerial ownership as moderating variable, only profitability and tax are found to be

significant to capital structure choice.

Corresponding Author’s Email Address: obt250@gmail.com

1. INTRODUCTION It is documented that the value of firm with high debt ratio in their capital structure is much better compared to those

having low debt ratio. Ju et al. (2005) found that the value of firms maintaining low debt ratio is lower than those

maintaining higher debt ratio. However, this financial instrument (debt) is one of controversial issues in Islamic finance. In

other words, Islamic firms are not free to choose the level of debt they want in their capital structure due to unfair return

associated with debt financing (Zaher and Hassan, 2001). Therefore, Islamic regulatory bodies have issued regulations that

restrict the use of debt financing. The purpose of these regulations is to verify that all activities of firms listed in Islamic

capital markets do not contradict with Shariah. For example, Accounting and Audit Organization for Islamic Financial

Institutions (AAOIFI) Shariah standard No. 21 states that Islamic institutions are allowed debt financing up to 30% of their

total capital (AAOIFI, 2010). Similarly, Dow Jones Islamic market and Financial Times Stock Exchange requires that the

debt to equity ratio must be equal to or less than 33 %, and interest-related income shall not exceed 9% of firm’s total

income (Abdul Rahman et al 2010). Likewise, Bursa Malaysia requires Shariah-compliant firms must have proper debt

ratios, meaning that firms with high debt ratios compared to their assets are unacceptable. Besides, the interest-related

income shall not exceed 10 percent of firm’s total income (Bursa Malaysia, 2012)1.

These regulations have impact on the capital structure choice of Shariah-compliant firms. For example, the

prohibition of interest-related income motivates Shariah-compliant firms to use idle internal funds for financial purposes

(instead of investing it in interest-related activities), which may reduce the need for external fund (debt) as suggested by

pecking order theory (Myers and Majluf, 1984). Harris and Raviv (1991) suggests that empirical studies are required to

investigate the determinants of capital structure in various contexts, and due to the lack of consensus found in the literature

about the determinants of capital structure and pressures imposed by Shariah of using debt and investing in interest-related

activities, it’s difficult to claim that these determinants have same direction and strength with Islamic firms’ capital

structures.

2. LITERATURE REVIEW

Due to the country and firm factors, the determinants of capital structure vary from one market to another (Booth et al

2001; and Psillaki and Daskalakis 2009). Therefore, the evidences of recent empirical studies across countries are not in

line with each other, which sometimes are in a great conflict. For example, among others, Booth et al. (2001) and La

Rocca et al (2009) found that there is a negative relationship between leverage and profitability. However, Fraser et al

(2006) and Al-Ajmi et al (2009) found positive association between these variables. Interestingly, the third group of

studies found mixed relationship between leverage and profitability (Bhaduri, 2002; Chang et al. 2009; Kouki and Ben

1Bursa Malaysia .2012.Shari'ah Compliant Listed Equities. http://www.bursamalaysia.com/market/islamic-

markets/products/islamic-capital-market/shariah-compliant-listed-equities

Proceedings of the Australian Academy of Business and Social Sciences Conference 2014

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Said, 2012). The major difference between these studies is due to differences of taxes (trade-off theory), information

asymmetry (pecking order theory), and agency problems (agency theory) across countries (Myers, 2001).

2.1 Tangibility

According to capital structure theories, assets structure or tangibility is considered one of leading factors that determine the

level of firm’s leverage (Titman and Wessels, 1988). Capital structure theories and prior studies tried to address the

relationships between assets structure and leverage. However, there are two contradicting results regarding the relationships

between these two variables. First, Agency theory predicted negative relationships between tangibility and leverage. This

prediction is in line with the findings of many recent studies (i.e. Chang et al, 2009; Psillaki and Daskalakis, 2009; and

Sbeiti, 2010). Second, the trade-off theory assumed positive relationships between them due to using such assets as

collateral to get loans. Several studies supported this claim, among others, Rajan and Zingales (1995) and Huang and Song

(2006) found positive relationships between tangibility and firms’ leverage. Islamic firms are considered tangible firms

because they are not allowed to maintain intangible and receivable assets more than certain percentage otherwise the trade

in their stocks will be similar to sale of debt which is highly prohibited in Islam (Yusof et al. 2009). Therefore, this study

assumes a positive relationship between tangibility and leverage. This study uses the ratio of fixed assets to total asset as

proxy for tangibility.

2.2 Profitability

Profitability received extensive theoretical and empirical intentions as a determinant of firm’s leverage. This is because

profit is the main source of internal fund available for firms to reinvest without any financial burden. Therefore, pecking

order theory reported that profitable firms are not willing to use external fund and less profitable firms are keen to use

external fund in the form of debt, if not possible they use equity as last resort (Myers and Majluf, 1984). In other words,

there is a negative relationship between firm’s leverage and profitability. Almost all studies conducted in developed and

emerging markets found negative association between these variables (Booth et al. 2001: Psillaki and Daskalakis, 2009:

and Sbeiti 2010).

However, another theoretical viewpoint assumed that there is a positive relationship between firm leverage and

profitability. This is because higher debt firms get more tax deduction and higher profit accordingly. Also, profitable firms

get chance to use debt due to their ability to meet the payment of interest. In line with this statement, Fraser et al (2006) and

Al-Ajmi et al (2009) found that profitability is positively related to Malaysian and Saudi firm’s leverage. The study uses the

ratio of earnings before interest and tax to total assets as a proxy of return of assets to capture the influence of profitability

on firms’ leverage.

2.3 Liquidity

Liquidity has various impacts on firm’s level of leverage. Trade-of theory assumes that the higher liquid firms are qualified

to borrow more debt due to their ability to meet their debt. In line with this theory, few studies found positive relationship

between liquidity and leverage (i.e. Stonehill, et all 1975; and Al-Najjar and Taylor (2008). The rational is that the high

liquid firms attracting lenders due to their ability to pay back the debt obligations in the future. However, this relationship

could be negative for two reasons. First, liquidity represents one of the main sources of internal funds; this type of fund is

attractive to use due to its costless compared to external sources of fund. Therefore, pecking order theory assumed that the

firms with high liquid assets less rely on debt financing. Second, it’s well known that there is a motivation for managers of

liquid firms to invest the idle fund to maximize their interest, for such investment there is a possibility of unsound

investment activities, which may lead to default risk. Therefore, agency theory assumed there is a negative relationship

between firms leverage and liquidity. Consistent with these theories, several studies in both developed and emerging

markets found negative relationship between liquidity and leverage (i.e. Ozkan (2001) de Jong et al, 2008: Lipton and

Mortal, 2009: Suto, 2003: Al-Ajmi et al, 2009; and Sheikh and Wang, 2011). This study, therefore, uses the current ratio as

proxy to investigate the influence of liquidity on firms leverage measured by the ratio of current assets to current liabilities.

2.4 Business Risk

There are two different theoretical predictions about the impact of business risks on firm’s leverage. It is well known that

there is a high probability of bankruptcy costs for firms with high volatile earnings due to their inability to meet their future

obligations. Therefore, trade-off theory predicts that firms with high bankruptcy costs and financial distress, as a result of

earning volatility, have less chance to use debt financing (Booth et al, 2001). Consistent with this theory, majority of

developed emerging markets studies found a negative relationship between risks and firms leverage (i.e. Taub 1975; Jensen

et al. 1992; Barakat and Roa 2004; and Jagdish 2011). Agency theory, however, suggests that the using of debt reduces the

involvement in negative or risky projects. Therefore, a positive relationship is expected between risks and leverage.

Literature provides few evidences that support this assumption (i.e. Marsh 1982 and Suto 2003). This study uses the

standard deviation of earnings before income and taxes to total assets as a proxy of business risk.

Proceedings of the Australian Academy of Business and Social Sciences Conference 2014

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2.5 Zakah

There are two different opinions about the paying of zakah on debt. First, zakah payer will deduct debt from his zakatable

wealth and pay zakah on that amount. According to this view, there is a motivation for firms to use debt over equity. In

other words, firms with high debt financing are subjected to low amount of zakah. Another opinion is that the current due

debt is deducted, but if it is deferred, only payment due for that year is deducted. Based on this, firms still get debt zakah

shields but less than first ones (Abu Ghuddah, 2008). Empirically, Omet and Mashharawe (2003) investigated the capital

structure choice for tax and non-tax middles eastern countries (Jordan, Kuwaiti, Oman and Saudi Arabia). They found that

the firms in all four countries are more toward equity financing. The result reveals that there is no impact of corporate tax

on capital structure choice in these countries. However, Barakat and Roa (2004) investigated the relationship between the choice of capital structure and

corporate tax. They used sample from Bahrain, Kuwait, Oman, United Arab Emirates, Qatar, Saudi Arabia, Jordan,

Palestine, Lebanon, Egypt, Tunisia and Morocco. They found that taxed countries use more debt than non-tax countries.

The result reveals that there is a positive relationship between leverage and corporate tax. They further argued that in the

non-tax countries, firms do not differentiate between the uses of equity and debt due to the absence of tax advantage of

equity for the investor (non-tax debt shield) or tax advantages of debt for the corporation (debt tax shield). Therefore, the

results of Barakat and Roa (2004) implicitly indicate that zakat systems may encourage firms in taxed countries to use debt

financing. These claims are based on the fact that the calculation of the zakah excludes debt from zakatable wealth (Abu

Ghuddah 2008). Therefore, firms with high debt financing are expected to pay less zakah. This study uses zakah as dummy

variable, value of one (1) if the firm pays zakah; and zero (0) otherwise.

2.6 Tax

Modigliani and Miller (1963) argue that firms with high tax liabilities are expected to utilize greater amounts of debt to take

advantage of the deductibility of interest payments. Moreover, tax benefits of interest deductibility are considered as the

cornerstone of the trade-off theory of capital structure. Therefore, the major motivation of using debt over equity is the

saving of corporate tax. Higher debt tax shields increase the potential tax benefits of debt; hence a positive link is expected

between tax shields and leverage. In line with this, Amidu (2007) found a positive relationship between leverage and

corporate tax for Ghanaian firms. This study uses the ratio of tax expense to earnings before taxes as a proxy of corporate

tax.

Table 1 summarizes the theoretical relationships between capital structure and its determinant. The table shows

that there are conflicting views regarding these relationships. The last column shows the hypothesized relationships

between the leverage of Shariah-compliant firms in Malaysia and its determinants.

Table 1: THEORIES AND EXPECTED RELATIONS BETWEEN LEVERAGE AND IT'S

DETERMINANTS

Determinants Trade-off Pecking order Agency Expected

Tangibility + - +

Profitability + - + -

Liquidity + - - -

Risks - - + -

Tax + +

Zakah + +

3. METHODOLOGY AND MODELS

Proceedings of the Australian Academy of Business and Social Sciences Conference 2014

(in partnership with The Journal of Developing Areas)

ISBN 978-0-9925622-0-5

3.1 Sample

At the end of 2011, there were 946 firms listed on Bursa Malaysia, among them, 839 are Shariah-compliant divided into

nine sectors. Financial sector was excluded from the sample due to their unique business activities, and have different

regulatory requirements (Yatim et al., 2006). Moreover, the study excluded those firms with any missing observations for

any variable in the model during the period 2006–2011. As a result, the final sample set consists of a balanced panel of 263

firms over a period of 6 years.

3.2 Models

Main model

The basic or the main model of the study involves determinants suggested by capital structure theories namely; Tangibility,

Profitability, Liquidity, Risk, and Tax. Furthermore, the study adds new variable to the model, which is Zakah (ZAK). The

study assumes there is impact of this factor on capital structure for two reasons. First, the amount of paid zakah reduces the

amount of retained earnings and firms’ capital accordingly. Therefore, firm has to find external fund to overcome this

shortage. Second, to calculate the amount of zakah (zakatable wealth), debt must be excluded (Abu Ghuddah 2008). The

rational justification of this, zakah is levying on the payer’s property (wajib or self-obligation) not on others' properties

such as debt. Therefore, firms with high debt financing are subjected to pay less zakah. Finally, the study adds to the model

two control variables: firm size and firm age. Therefore, the main model of this study is as follows:

L = TAN + PRO + LIQ +RSK+ ZAK+ TAX + OS + SZE + AGE

Moderating Model

As mentioned above, there is a disagreement about the sign of relationship between capital structure and its determinants.

Many cross-country studies related this ambiguity in results to the firm and country factors (e.g. Booth et al, 2001; Psillaki

and Daskalakis, 2009; and Sbeiti, 2010). The ownership expected to be one of these factors because it carries the features

of firm and country factors. It is firm factor because firm determines the fractions of shares for insiders, public, and etc.,

and it is country factor because the protection of owner's right differs from country to another (La Porta et al 1998).

Moreover, agency theory assumed that the use of debt reduces the idle cash flow that may use to serve the

managers’ interest, as a result the owners-managers conflict or agency costs will drop down (Jensen, 1986). In case of

managerial ownership, debt is preferred because it prevents the ownership dilution as a result of issuing new equity, which

reduces the controlling of existing managers (owners). Therefore, the theory assumed there is a positive association

between managerial ownership and leverage. Berger et al. (1997) and Bajaj et al. (1998) reported that the managerial

ownership is positively related with various measures of leverage. However, Friend and Lang (1988) found that the

managerial ownership is negatively related to leverage.

Besides, several studies have found that there is a relationship between managerial ownership and selective

independent variables. For example, Al-Najjar and Taylor (2008) found that managerial ownership is negatively related to

tangibility. The findings between managerial ownership and profitability are not uniformly in agreement, McConnell and

Servaes (1995) found curvilinear relationship between managerial ownership and firms value whereas, Sarin et al. (2000)

reported negative relationship between managerial ownership and liquidity. May (1995) found managerial ownership to be

negatively related to risks. Chaplinsky and Niehaus (1993) found managerial ownership is positive with tax advantages.

Therefore, there is a probability for interaction effect of managerial ownership on the relationship between

leverage and its determinants. Especially, in Islamic capital markets where firms are restricted to use high level of debt and

(Abdul Rahman et al. 2010); maintain large tangible assets (Yusof et al. (2009); maintain low liquidity (Abdul Rahman et

al. 2010); faces more risks (Siddiqui, 2008; Abdullah et al, 2011; Tafri et al. 2011); and where ownership concentration

(managerial ownership) has no impact on decision’s makers (Iqbal and Mirakhor. 2004; Ismail and Tohrin, 2010).

Therefore, the moderating model developed is as follows:

L = TAN + PRO + LIQ + RSK + ZAK + TAX + SZE + AGE + (TAN*OS) + (PRO*OS) + (LIQ*OS) + (RSK*OS) +

(ZAK*OS) + (TAX*OS)

Where;

L = Capital structure or Leverage

TAN = Tangibility

PRO = Profitability

LIQ = Liquidity

RSK = Risk

SZE = Firm size

Proceedings of the Australian Academy of Business and Social Sciences Conference 2014

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ISBN 978-0-9925622-0-5

AGE=Age

TAX = Tax

ZAK=Zakah

OS = Ownership

4. FINDINGS

4.1 Statistical descriptive

Table 2 shows the descriptive statistics of the variables.

Book leverage (BL): on average Shariah-compliant firms use 19.5% debt financing in their capital structure. This finding

indicates that Shariah- compliant firms are less relies on debt which explains the constrains imposed by Shariah of the

using of debt.

Tangibility (TAN): on average 38% of Shariah-compliant firms’ assets are tangible or fixed assets.

Profitability (PRO): it ranges from a minimum of -69% and a maximum of 48% with an average of 5.73%. This reveals

that Shariah-compliant firms listed in Bursa Malaysia generate 5.73 cents for each Ringgit invested in assets.

Liquidity (LIQ): ranges from a minimum of .09 and a maximum of 33.46 with an average of 2.69.This reveals that the

current assets of Malaysian Shariah-compliant firms are 2.69 times more than current liabilities which indicate that these

firms are more capable to payback their future obligations. Therefore, Shariah-compliant firms do not suffer from liquidity

issue though most liquidity instruments are interest-based instruments as reported by (Abdul Majid, 2003).

Risks (RSK): ranges from a minimum of 0% and a maximum of 268% with an average of 5%. However, de Jong et al.

(2008) found low business risk for firms listed in conventional (developed) markets, such as Greece 3.3% japan 1.4%, Italy

2.4%. Spain 2.2%. The higher risk in Islamic capital markets is due to additional risks exists in these markets as a result of

the unique nature of Islamic finance (Siddiqui, 2008; and Abdullah et al, 2011).

zakah (ZAK): on average only 16 firms out of 100 Shariah-compliant firms are paying zakah on behalf of their investors,

the remaining are paid by the investors.

Tax (TAX): ranges from a minimum of 1% and a maximum of 97% with an average of 22.5%. This means 22.5% of the

corporate net income is deducted for tax. This ratio varies from country to country and depend on the tax rate for the given

tax year.

Ownership concentration (OS): on average only 11% of sampled firms' equity is owned by managers.

TABLE 2: DESCRIPTIVE STATISTICS

BL TAN PRO LIQ RSK ZAK TAX OS SZE AGE

Mean .19 .38 .05 2.69 .046 .16 .22 0.11 2.63 24.1

Maximum .96 .92 .48 33.46 2.68 1.00 .97 0.74 4.90 101

Minimum .00 .00 -.69 .09 .00 .00 .01 0.00 .41 1.00

Std. Dev. .16 .46 .08 2.88 .13 .36 .13 0.15 .64 16.5

Table 3 represents the outputs of Pearson correlation test for all variables chosen in the study. The table shows the

correlation among variables is between -0.61 and 0.26. The highest correlation reported is between the liquidity (LIQ) with

dependent variable, which is -0.60. Moreover, the higher level of correlation among independent variables is -0.26 between

size and age. This result is better compared to prior studies such as Huang and Song (2006) who found correlation of 0.57

between tangibility and NDTS. In Sum, all correlations between independent variables are below the role of thumb (0.80)

suggested by (Anderson et al. 1995). Thus, it is plausibly to claim that there is no existence of serious collinearity among

regressed variables.

TABLE 3: CORRELATION MATRIX

BL TAN PRO LIQ RSK ZAK TAX OS SZE AGE

BL 1.00

TAN 0.08 1.00

PRO -0.22 -0.08 1.00

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LIQ -0.61 -0.11 0.20 1.00

RSK -0.08 -0.01 -0.05 0.02 1.00

ZAK 0.12 -0.01 0.06 -0.16 0.00 1.00

TAX 0.02 -0.07 0.01 -0.07 -0.08 0.03 1.00

OS 0.06 0.04 -0.07 0.01 0.02 -0.07 -0.01 1.00

SZE 0.22 0.23 0.10 -0.18 -0.08 0.16 0.04 -0.26 1.00

AGE -0.06 0.01 0.05 0.00 0.01 0.07 0.06 -0.16 0.26 1.00

4.2 Results of the main model

This subsection discusses the relationship between book leverage as dependent variables with independent and control

variables. As mentioned above, three regressions (pooled, FE, and RE) are conducted to examine the relationship between

capital structure variable and their determinants. Lagrange multiplier and Hausman tests are used to distinguish between the

results of these three methods. The results of panel are preferred over pooled OLS when the results of Lagrange multiplier

test are statistically significant and vice versa. Similarly, if the result of Hausman test is statistically significant, the results

of fixed effects model is preferred over random effects. In Tables 4 and 5, Lagrange multipliers are statistically significant

(p<0.05) which reject the null hypothesis of zero variance of random effect i.e. firm heterogeneity has a significant effect.

Therefore, the random effect method is more appropriate and better than the pooled method. In addition, the significant

(p<0.05) of Hausman test reveals that the alternative hypothesis of correlation between individual effect and regressors

cannot be rejected i.e. there is correlation between individual effect and regressors. Therefore, the fixed effect method is

more appropriate and better to use than random effect method.

TABLE 4: THE REGRESSION OF MAIN MODEL

Variables OLS Fixed Effects Random Effects

Constant -0.258(-2.221)** -2.653(-7.737)*** -0.918(-5.053)***

Tangibility -0.178(-2.259)** -0.055(-0.574) -0.137(-1.595)

Profitability -0.121(-5.415)*** -0.048(-2.411)** -0.056(-3.060)***

Liquidity -1.754(-19.394)*** -1.100(-14.56)*** -1.285(-18.89)**

Risk -0.070(-2.802)*** -0.042(-2.857)*** -0.046(-3.385)***

Zakah 0.075(1.399) - 0.046(0.451)

Tax -0.028(-1.384) -0.010(-0.749) -0.014(-1.072)

Size 0.301(8.561)*** 1.131(9.199)*** 0.504(8.022)***

Age -0.082(-3.691)*** -0.441(-5.720)*** -0.163(-4.437)***

OS 0.603(5.012)*** -0.132(-0.494) 0.346(1.837)*

Adjusted R2 41.89% 85.32% 28.99%

LM 485.04***

Hausman Test 64.77**

Notes: OLS refers to ordinary least square, t-values were placed under the coefficients values in parentheses.

Significant level as *p<0.10, **p<0.05, ***p<0.01. OS refers to ownership concentration or managerial

ownership.

Table 4 reports significant negative relationship between tangibility and book leverage under pooled and random

regressions only. However, the results show that the profitability, liquidity, and risks are negatively associated with book

leverage for three different regressions. Nonetheless, the results reveal that zakah and tax are insignificantly related to book

leverage under the three methods of estimation. Both control variables are significantly related to leverage, whereas

moderate variable is significantly associated with leverage under pooled and random methods only. The insignificant

relationship between ownership and leverage under fixed regression supports the findings of Suto (2003) who found no

significant relationship between managerial ownership and book leverage of Malaysian firms.

4.3 Results of the moderate model

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Table 5 reports the results of moderating model. Like the results of the main model in Table 4, the sigs and the level of

significance of liquidity and risks are same. However, the main differences are the impact of profitability, zakah, and tax on

leverage. Profitability becomes insignificantly related to leverage under panel regressions, whereas zakah becomes

significant positive under pooled model only. Finally, tax and leverage are negatively related in all three models.

TABLE 5: THE REGRESSION OF MODERATING MODEL

N

o

t

e

s

:

O

L

S

r

e

f

e

r

s

t

o

o

rdinary least square, t-values were placed under the coefficients values in parentheses. Significant level as

*p<0.10, **p<0.05, ***p<0.01. OS refers to ownership concentration or managerial ownership.

Moreover, Table 5 reports the influence of interaction effects (managerial ownership) as moderating variable on the

relationship between capital structure variable and its determinants. It shows there are two (2) interaction terms are

statistical significance, which is the multiplicative of ownership concentration (OS) with profitability and tax. First,

the multiplicative of ownership concentration with tax is associated positively with leverage under all regressions. Second,

the ownership concentration moderates negatively the relationship of profitability with leverage. In sum, the moderating

effect of ownership influences positively the relationship between leverage and tax; however, it influences negatively the

relationship of leverage with profitability.

5. DISCUSSION

This section discusses the results of the main and moderating models under fixed effects method only. The choosing of

fixed effects method is suggested by the findings of LM and Hausman tests which indicate that the fixed effect is the best

method of estimation for this study.

5.1 Tangibility

The result shows that there is no relationship of tangibility on leverage. In addition, the results show that there is no

influence of managerial ownership on tangibility-leverage relationship. Therefore, there is no evidence that Shariah-

compliant firms' managers consider the tangibility of the firm when deciding to finance these firms' activities. This finding

could be due to the fact that Islamic firms are tangible by nature; Al-Ajmi et al. (2009) reported that tangible firms prefer to

use equity to finance their activities rather than debt. This result is in line with the findings of Titman and Wessels (1988)

and Ahmed and Hisham (2009) who found no relationships between tangibility and leverage.

5.2 Profitability

The results show that the profitability is negatively associated with leverage under main model and in the presence of

interaction term. In other words, the presence of interaction term (PRO*OS) does not affect profitability-leverage

relationship. This implies that profitable Shariah-compliant firms prefer internal fund to finance their activities. The

Variables OLS Fixed Effects Random Effects

Constant -0.305(-2.701)*** -2.706(-7.871)*** -0.923(-5.194)***

Tangibility -0.346(-4.051)*** -0.065(-0.642) -0.213(-2.363)**

Profitability -0.108(-3.931)*** -0.016(-0.671) -0.034(-1.510)

Liquidity -1.656(-15.571)*** -1.100(-12.543)*** -1.307(-16.634)***

Risk 0.060(-1.961)** -0.042(-2.421)** -0.048(-2.860)***

Zakah 0.175(2.831)*** - 0.093(0.831)

Tax -0.067(-2.686)*** -0.033(-1.912)** -0.039(-2.335)**

Size 0.321(9.198)*** 1.130(9.183)*** 0.510(8.191)***

Age -0.092(-4.084)*** -0.454(-5.858)*** -0.171(-4.686)***

Tangibility*OS 2.846(5.450)*** 0.200(0.345) 1.167(2.585)***

Profitability*OS -0.117(-0.870) -0.286(-2.463)** -0.183(-1.678)*

Liquidity*OS -0.893(-2.185)** 0.211(0.598) 0.215(0.671)

Risk*OS -0.022(-0.153) 0.040(0.475) 0.040(0.482)

Zakah*OS -1.106(-3.544)*** 1.499(0.951) -0.433(-0.802)

Tax*OS 0.359(3.243)*** 0.163(1.953)** 0.186(2.300)**

Adjusted R2 43.24% 85.41% 29.06%

LM 440.48***

Hausman Test 76.88***

Proceedings of the Australian Academy of Business and Social Sciences Conference 2014

(in partnership with The Journal of Developing Areas)

ISBN 978-0-9925622-0-5

explanation of this finding lies in the fact that Shariah-compliant firms listed on Bursa Malaysia are not allowed to invest

idle cash in interest-based investments due to the involvement of riba in such investments’ return (SC, 2007). Moreover,

the using of internal fund over external equity helps to avoid ownership dilution and gives signal to investors that the equity

is overvalued in the market. The result consistent with pecking order theory suggestion that the profitable firm choose to

finance new investment, first by internal retained earnings, then by debt, and finally by equity (Myers, 1984). Finally, it is

in line with prior studies conducted in capital structure arena (i.e. Wald 1999; Booth et al. 2001; Sbeiti, 2010; 2007; Al-

Ajmi et al, 2009; and Chakraborty 2010).

5.3 Liquidity

The result shows that the liquidity is negatively associated with leverage under main and moderate models. The explanation

for this lies in fact that Islamic capital market do not allow listed firms to have high liquidity ratio because the trading of

shares that covered by high percentages of liquid assets like trading money for money which highly condemned in Islam

(Abdul Rahman et. al 2010). The result is consistent with order theory prediction that the high liquid firms prefer internal

fund than debt to finance their business (Myers, 1984). Finally, the results lend empirical support to the findings of prior

studies of capital structure especially those used current ratio as a proxy for liquidity. For example, Lipson and Mortal

(2009) found significant negative relationship between liquidity and leverages (book and market). Similarly, Sbeiti (2010)

found same association between liquid and leverage of GCC firms.

However, the liquidity-leverage relationship becomes insignificant in the presence of ownership concentration

(LIQ*OS). This indicates that the liquidity is not related to leverage in Shariah-compliant firms with high managerial

ownership. This could be due to the fact that concentration of ownership decreases the agency conflicts with owners due to

incentives of managers to obtain better performance to maximize their interests as owners and managers (Jensen and

Meckling, 1976). To sum, like the managers of conventional firms, the managers of Shariah-compliant firms perform their

duties in a way that serve their interests.

5.4 Risks

Business risks are found to be negatively associated with leverage. The explanation for this result lies in the fact that

Islamic firms are exposed to additional risks of those exist in conventional markets due to the unique nature of Islamic

financial instruments (Siddiqui, 2008; and Abdullah et al, 2011). For example, benchmark risk (rate of return risk),

withdrawal risk, fiduciary risk, reputation risk, displaced commercial risk, Shariah compliance risk and asset price risk

(Tafri et al, 2011). The using of debt in such risky firms will compound the issue of risk by adding new risk to the list

namely, default risk. The results in line with trade-off theory that the sampled firms got less chance to borrow external fund

due to their inability to pay back these future obligations due to the variability in their earnings. Finally the result is

consistent with the findings of prior studies of capital structure that found a significant negative relationship between

business risks and both book and market leverages (i.e. Taub 1975; Jensen et al. 1992; Wald 1999; Barakat and Roa 2004;

and Jagdish 2011).

However, the presence of interaction term (RSK*OS) does not influence risk-leverage relationship. The result

indicates that the risk is not an important determinant of Shariah-compliant firms’ capital structure in the presence of

managerial ownership. This could be due to fact that the risk is not a crucial issue in firms with high managerial ownership

as proposed by agency theory because these firms are not exposed to manager-agent conflicts. May (1995) found that the

risk is negatively related to managerial ownership. Therefore, the creditors do not take the risks into account when they

decide to finance firms with higher managerial ownership. This result is consistent with the findings of prior studies of

capital structure around the world. For example, Titman and Wessels (1988) and Cassar and Holmes (2003) found there is

no relationship between business risks and leverage.

5.5 Zakah

Zakat is found to be positively related to leverage of sampled firms under moderating model. This indicates that the zakah

payer use debt financing more than non-zakah payer firms. This relationship explains the benefit that the zakat payers can

get form using debt financing (Abu Ghuddah 2008). The result is in line with trade-off theory that assumed firms will

utilize debt when there is an advantage of using debt such as deducting interest form taxable income (Modigliani and Miller

(1963). Finally the result is consistent with Barakat and Roa (2004) who argued that the zakat systems in taxed countries

may encourage firms to use debt financing. Conversely, albeit of zakah benefit (deducting debt from zakatable wealth) that

firm can get from using debt financing, the result in the presence of interaction term (ZAK*OS) shows insignificant

relationship between zakah and leverage. The result could be explained by the projection of agency theory that the

managerial ownership reduces the agency costs; hence, it is worth nothing to use debt to reduce such conflicts (Berger et

al.1997). To sum, the relationship between zakah and leverage in Shariah-compliant firm is explained by agency theory.

5.6 Tax

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The result shows that the tax has negative impact on leverage under moderating model and has no influence under main

model. The negative relationship could be due to the tax advantages that Shariah-compliant firms may get form using

Islamic equity instruments (i.e. sukuk), this advantages in form of deducting the expenditures on issuance of Islamic

securities2. The result is in line with the findings of capital structure studies in emerging markets. For example, Booth et al

(2001) and Huang and Song (2006) found corporate tax is negatively associated with leverage across emerging market.

However, the result shows that there is a positive influence of ownership interaction (TAX*OS) on tax-leverage

relationship. This indicates that Shariah-compliant firms with higher managerial ownership prefer to use debt financing

because the using of debt maximize the wealth of these firms' managers. Agency theory postulated that the owner preferred

to use debt financing because it reduces agency costs Berger et al. (1997), whereas trade-off theory assumed that firms will

utilize debt when there is an advantage of using debt such as deducting the interest form taxable income (Modigliani and

Miller, 1963). The result consistent with the findings of prior studies of capital structure of firms listed on emerging market.

For example, Barakat and Roa (2004); Amidu (2007); and Udomsirikul et al. (2011) found a positive relationship between

debt tax shield and firms leverage.

5. CONCLUSION

The study aims to investigate the relationship between leverage and it’s determinates. Moreover, it tries to determine the

effect of managerial ownership on capital structure choice of Shariah-compliant firms. The study develops two models to

achieve these aims namely: main model and moderating model. Theoretically, the significant relationships between

leverage with profitability, liquidity, and risks, zakah, and tax are consistent with certain theories of capital structure and

inconsistent with others. For example, profitability, liquidity, and risk have inverse impact on Sharah-compliant firms’

decision on issuance of new debt as predicted by pecking order and agency theories. Therefore, the study concludes that the

pecking order theory and agency theory are predominant in firms' financing behavior in Islamic capital market. However,

except zakah, none of trade-off theory suggestion has been supported in the study, hence; the trade-off hypothesis can be

rejected in Islamic markets context.

In the presence of managerial ownership as interaction term, only profitability and tax found to have impact on

firms leverage. This implies that the percentage of managerial ownership affects the capital structure choice of Sharah-

compliant firms which indicate that the agency theory explains the financing behavior in Islamic capital market. Therefore,

the study does not support the claim of Iqbal and Mirakhor (2004) that the managers must serve the interests of whole

stakeholders.

Although this study can be considered the first study of the capital structure of Shariah-compliant firms, the

findings have presented a numeral of areas which might be further explored in future research. For example, further

research is recommended to investigate the relationship between capital structure and it’s determinants for financial

institutions on Bursa Malaysia. Another study is suggested to compare the capital structure of Shariah and non-Shariah-

compliant firms within Bursa Malaysia. Also, it is recommended to study this topic in different Islamic capital market

separately or across these markets. Finally, further study is required to use different proxies of leverage. For example,

short-term debt is highly recommended due to the fact that the liquidity issue in Islamic capital markets is one of the critical

issues faces Islamic firms.

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