Impact of Observable Determinants and Unobservable Effect on Capital Structure: Evidence from Quoted Public Manufacturing Companies in Sri Lanka

Abstract

The determinants of capital structure has been a widely discussed notion in finance studies and it leads to investigate the factors affecting the firm's capital structure. However, the recent empirical studies question the validity of such studies due to the absence of unobservable effect in models and the explanatory power of the determinants of capital structure. Importantly, these contradictories are subject to the argument of unobservable effect affecting to the capital structure explains a high proportion of the variation of leverage than the observable determinants of capital structure. Hence, the study tested the impact from unobservable effect on capital structure of Sri Lankan firms. To attempt this research problem, three objectives were formulated as; explore the importance of unobservable effect in the capital structure,   identify the determinants of capital structure and to measure the variance decomposition of capital structure pattern. In order to achieve these objectives the study analyzed the selected variables of quoted public manufacturing companies within the time period of 2004 to 2013.. The study revealed that there is an unobservable effect affecting the capital structure in Sri Lankan firms and after accounting unobservable effect into the model the study found profitability, size and liquidity as determinants of book leverage and growth, profitability, size, earnings volatility and stock return as determinants of market leverage. Further, after employing Analysis of Covariance (ANCOVA), the study found a robust result that the unobservable effect explains most of the cross sectional variation in leverage, and the power of usual determinants to explain such variation is fairly limited.