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 1 Bursa Malaysia .2012.Shari'ah Compliant Listed Equities. http://www.bursamalaysia.com/market/islamic- markets/products/islamic-capital-market/shariah-compliant-listed-equities