Importance of Judicial Efficiency in Capital Structure Decisionsof Small Firms: Evidence from Pakistan

Empirical evidence to identify factors that are responsiblefor the sluggish development of bond and capital markets in Pakistanremains scanty. This paper is a step forward in this direction.Specifically, this paper draws on the recent developments in the area oflaw and finance to formulate several propositions on how judicialefficiency can have a differential impact on corporate capitalstructures of small and large firms. These propositions are tested usingdata of 370 firms listed at the Karachi Stock Exchange (KSE) and 27districts high courts of Pakistan. The results indicate that leverageratio decreases, when judicial efficiency decreases; however, thisrelationship is not statistically significant. This is due to thecomposition effect. Allowing judicial efficiency to interact with theincluded explanatory variables, the results show that worsening judicialefficiency increases leverage ratios of large firms and decreasesleverage ratios of small firms, which is an indication of the fact thatcreditors shift credit away from small firms to large firms in thepresence of inefficient judicial system. Results also indicate that theeffect of inefficient courts is greater on leverage ratios of firms thathave fewer tangible assets as percentage of total assets than onleverage ratios of firms that have more tangible assets. The resultsindicate that under inefficient judicial system creditors reduce theirlending to small firms and firms with little collateral and redistributethe credit to large firms. This is why judicial inefficiency does notchange volume of credit, but changes distribution of the credit. Theseresults highlight the importance of judicial efficiency for small firmsin the determination of their capital structures. JEL Classification:G10, G21, G32 Keywords: Judicial Efficiency, Leverage, KSE, CapitalMarket Development, Law and Finance.