1.1 Background

Capital structure choice is one of the important financial decisions that can affect firm’s value. Capital structure has been studied by many scholars during past five decades, which in turn generated some theories and various finding in this area of corporate finance. Definitely, Modigliani and Miler (1958, 1961) theorem of capital structure had a significant contribution on developing capital structure literatures .They proposed two approaches of capital structure under certain assumptions, based on Modigliani and Miler (1958), there is no differences between debt and equity financing under perfect market assumptions, and so capital structure decision is irrelevance. While Modigliani and Miler (1961) considered corporate tax and proposed debt financing will increase value of the firm.

Since then by the end of 1990, many researchers studied potential determinant of capital structure (in addition to taxes) and introduced new theories of capital such as trade of theory and pecking order theory based on different models including, agency cost model (Jensen and Meckling (1976), Chang (1987), Stulz(1990), Harris and Raviv (1990)), asymmetric information model (Ross (1977), Myers and Majluf (1984), Brennan and Kraus (1986) ), product / input markets interaction model (Titman (1984), Brander and Lewis (1986), Saring (1988)), and corporate control model (Harris and Raviv (1988), Stulz (1988), Stulz (1988)). They concluded that in addition to debt tax shield other factors including earning volatility, bankruptcy probability, fixed assets, non-debt tax shield, research and development expenditures, profitability, growth opportunity, free cash flow and uniqueness may effect firms capital structure . The capital structure literatures have been evolved by endeavourer of researchers for empirically testing new theories of capital structure.

Majority of main capital structure findings are based on data from developed countries such as United kingdom, Germany, France, Italy, Canada, United States and Japan ( Titman and Wessel (1988), Rjan and zingales (1995), Myers (1999), Bevan and Danbolt (2000), Antoniou, Guney, and Paudyal (2002).

There are few outstanding studies that use data from developing countries, for instance Booth, Maksimovic, and Demirguc-Kunt (2001) studied capital structure by employing data from Brazil, Jordan, India, South Korea, Pakistan, Malaysia, Mexico, Turkey, Zimbabwe and Thailand, Deesomsak, Paudyal and Pescetto (2004) utilized data from Asia Pacific Region, Tong and Green (2005) analyzed data from China, Chakraborty (2010) used data from India.

1.2 Financial resources for Iranian companies

There are mainly two financial resources namely internal and external resources, for any company, everywhere in the world .The internal sources of fund is almost the same for all companies apart from geographical locations, while the availability of external fund depends on level of capital market development and structure of banking system in each countries. As far as Iranian companies are concerned, the available financial resources for them is consist of stock market, bond market and bank loan.

1.2.1 Iran stock market

Tehran stock exchange (TSE) incorporated in 1967 with 6 listed companies and experienced three different period of time as following.

1967-1978: the number of listed companies increased from 6 to 105 companies and TSE experienced a good period of time and attracted both companies and investors.

1978-1988: In this period of time, TSE severely affected by two major events, the Islamic revolution and Iraq’s war, and the value and number of exiting companies reduced dramatically.

1988 -2009: This period is full of up and down for TSE, for example during 2001 to 2004 return on investment in TSE increased and reached to 134 % in 2003, while it experienced very tough situation in 2007. The numbers of listed companies increase from 88 in 1988 to 417 in 2006 and then reduced to 337 in 2009.TSE consists of main and secondary market with own listing requirements and regulations.

1.2.2 Iran bond market

Bond market in Iran is at an early stage of development, and in fact there is no considerable corporate bond market. The listed companies on TSE were allowed to issue corporate bond in 2003, these bonds, which called participation paper, are short tem bond between 1 to 3 years .fixed income instrument and shariah complaint.

1.3 Problem Statement

Capital structure mainly studied in developed countries and still there is a lack of study for developing countries especially Iran. Capital structure of Iranian companies influenced at least by three main different factors from firm capital structure in developed countries .Firstly Iranian companies rising fund based on Islamic Financial Systems which has own regulation in banking and financial market .Secondly financial market especially bond market are less developed in Iran compare to developed countries which limit debt financing mostly to bank loan. Thirdly most economic activity directly or indirectly controlled by government which may affect firm capital structure in Iran.

In the case of Iran by the time of writing this thesis, seven papers (published on international journal) about determinant of capital structure have been found, which have own limitations and problems, such as employing limited number of variables, using little number of firms, choosing short horizon of time study, and even some statistical problems in running regression models. Hence, there is still a room for studying capital structure of Iranian companies by testing more independent variables in longer period of time with accurate and sophisticated model.

1.4 Research questions and objectives

This study aims to, firstly clarify determinant of capital structure for Iranian companies and secondly study importance of each factors on capital structure choice, and thirdly determine which capital structure theory, trade off or pecking order, better explain capital structure choice of Iranian companies.

1.4.1 Research questions

In order to achieve these goals the following question marked in this study.

• Which factors determine capital structure of Iranian companies?
• What is the importance of each factor on Iranian firm capital structure?
• Do firms’ capital structure choices in Iran follow trade off or pecking order theory?

1.4.2 Resear