ABSTRACT
The study of capital structure attempts to explain the mix of securities and financing sources used by corporations to finance real investment. Most of the researches are on industrialized economies and evidence on developing countries like Nigeria remain scanty. This study, which attempts to fill the void or contribute to filling it, investigates and empirically analyses the application of the capital structure theory to the Nigerian situation. capital structure models, such as the pecking order and trade-off theories, were specifically applied using data from annual financial reports of sixty quoted firms over a ten-year period, 1996 to 2005, as well as the Nigerian Stock Exchange (NSE) publications. The study utilized correlation and regression analyses as well as an autoregressive distributive lag (ADL) model to test for capital structure adjustment and other related issues. The study showed that market leverage is a decreasing function of marginal tax rate, growth options, capital market conditions, collateral, profitability and earnings volatility; and an increasing function of size and profitability attained Statistical significance with meaningful theoretical explanation. The cross-sectional behaviour of most of the explanatory variables was unstable over time. Overall, the empirical evidence obtained confirms the theoretical predictions of the pecking order and trade-off models though more evidence exists to validate the former theory. Further, we find that the tax benefits of debt are about 14.6 per cent of firm value. The implications of these results are discussed. In particular, managers of firms seem to be concerned about the value of tangible assets, firm size and profitability in their financing decisions. Finally, our results confirmed the targets-adjustment hypothesis of capital structure: Nigerian quoted firms engage in dynamic rebalancing of capital structure toward their target debt ratios. The major contribution of this study is the applications of our theory, a modified version of the standard pecking model. We recommend among others that profitable firms in greater tax brackets should borrow more to maximize the tax shield benefit. This thesis therefore sends some signals on the need for both the lending institutions and the financial system regulators to review the corporate financing operations. it also recommends, among others that further studies should investigate the issue of adjustment costs on capital structure.
CHAPTER ONE
1.0 INTRODUCTION
1.1 BACKGROUND OF THE STUDY
The modern theory of capital structure began with the celebrated paper of Modigliani and Miller (1958). They propose that all mixes of capital structure produce the same financial result in a perfect capital market. In other words, the optimal capital structure is irrelevant to creating shareholders’ wealth. After the 1958 paper of Modigliani, and Miller (MM) concluded irrelevance under stringent assumptions, subsequent works have added many potential explanations for capital structure policies in firms. Much emphasis has been placed on relating the assumptions made and in particular taking into account taxes (the importance of which MM themselves recognized. (MM, 1963).
Capital structure has generated great interest among financial researchers (Harris and Raviv, 1991; Myers, 2003). With respect to the theoretical studies, three main theories currently dominate the capital structure debate namely; trade off theory, pecking order theory and agency theory. According to static trade off theory, the optimal capital structure does exist. A firm is regarded as setting a target debt level and gradually moving towards it. The firm’s optimal capital structure will involve the trade off among the effects of corporate and personal taxes. Firms maximize their value when the marginal benefits that stem from debt (The tax shield, the disciplinary role of debt, and cheaper information costs) equal the marginal costs of debt (bankruptcy costs and agency costs between shareholders and bondholders). However, this theory is immediately challenged by the fact that many profitable companies such as Microsoft, with low cost to borrow, still operate at low debt ratios. (Myers ,2001)On the other hand, the pecking order theory, first suggested by (Myers and Majluf ,1984) states that there is no well defined target debt ratio. The pecking order is a consequence of information asymmetries existing between managers of firms and outside investors (i.e. the capital market). The theory leads managers to adapt their financing policy to minimize the associated costs. More specifically, it predicts that firms prefer internal financing to external financing, and risky debt to equity because of the lower information costs associated with debt issues. Companies issue equity only as a last resort, when their debt capacity has been exhausted. Unlike the trade off theory, attraction of interest tax shield advantage of debt is considered a second order effect in the pecking order of financing. The pecking order stresses the importance of financial slack. Without financial slack, the firm may be caught at the bottom of the pecking order and be forced to choose between issuing under valued shares, borrowing and risking financial distress or passing up valuable investment opportunities. The pecking order theory would thus suggest that companies with few investment opportunities and substantial free cash flow will have low debt ratios and that growth firms with lower operating cash flows will have high debt ratios.
There is however a dark side to financial slack. As (Jensen ,1986) argued in his important article; managers in mature businesses with substantial cash flow have a tendency to destroy value by ploughing too much capital back into those businesses or making ill-advised acquisitions in unrelated businesses, often at inflated prices. Free cash flow represents funds available in the firm that managers may choose to hold as idle cash, return to shareholders, or invest in projects with returns below the firm’s cost of capital. The free cash flow problem tends to be most prevalent in mature companies generating large cash flows with limited opportunities for positive NPV investments. ( Dwight ,et .al.2000)More theoretical treatments can be found in (Hart and Moore, 1995);(Zwiebel, 1996),{ Garvey and Hanka ,1999) and (Novaes,2003). Furthermore, the attention of researchers has been directed at testing the forgoing theories using developed countries data e.g.( Rajan and Zingales ,1995), (Chen, 2004),( Ozkan ,2007),( Chun, et. al. 2007), (Guihai Huang ,2006),( Dirk, et .al. 2006).
These researchers find similar levels of leverage across countries, thus refuting the idea that firms in bank oriented countries are more leveraged than those in market – oriented countries. However, they recognize that this distinction is useful in analyzing the various sources of financing. (Rajan and Zingales,1995) have discovered that the capital structures of Chinese listed firms are consistent with the static trade – off model.
Fama and French (2002) argue that the consistency or otherwise of the theories of capital structure across countries, depends much on the level of financial market development in each country. This is evidence in the case of pecking – order theory which though is consistent among firms in more developed economies with organized and efficient financial markets, is not commonly observed by firms in developing economies with less –efficient financial markets. (Harris and Raviv ,1991) contend that the theoretical rationale for financing strategies has been well defined, but the circumstances under which they are likely to be employed is not clearly understood. (Jung, et. al.,1996) report evidence in support of the agency model and find that firms often depart from the pecking order because of agency considerations. In particular, (Jung, et. al.1996) finds that firms issuing equity are of two types.
1) firms with valuable investment opportunities that seek financing to grow profitably and
2) Firms that do not have valuable investment opportunities and have debt capacity without agency costs of managerial discretion, one would not expect the latter firms to issue equity. The agency model predicts that equity issues by such firms are bad news for shareholders, since they enhance managerial discretion when managers’ objectives differ from shareholders’ objectives. Similar results in support of the agency model of managerial behaviour are provided in (Blanchard, et. al.1994).
A theory of the corporate security issues choice should explain
1) why firms choose to issue a particular security
2) how the market reacts to that choice, and
3) The actions of the firm after the issue. The pecking order theory is well articulated
and addresses each of these questions.
Financial managers are faced with two broad financing decisions (Brealey and Myers, 2003:395)
1. What proportion of profits should the corporation reinvest in the business rather than distribute as dividends to its shareholders?
2. What proportion of the deficit should be financed by borrowing rather than by an issue of equity?
The answer to the first question reflects the firm’s dividend policy and the answer to the second depends on its debt policy. Traditionally, common stock holders own the corporation. They are therefore entitled to whatever earnings are left over after all the firm’s debts are paid. Stockholders also have the ultimate control about how the firm’s debts are paid. They have the ultimate control about how the firm’s assets are used. They exercise this control by voting on important matters, such as membership of the board of directors.
The second source of finance is preferred stock. Preferred is like debt in that it promises a fixed dividend, but preferred dividends are within the discretion of the board of directors. The firm must pay any dividends on the preferred before it is allowed to pay a dividend on common stock. Lawyers and tax experts treat preferred dividends as not tax – deductible. That is one reason that preferred is less popular than debt.
The third important source of finance is debt. Debt holders are entitled to a regular payment of interest and the final repayment of principal. If the company cannot make these payments, it can file for bankruptcy. The usual result is that the debt holders then take over and either sell the company’s assets or continue to operate them under new management.
(Kapoor and Pope ,1997:13) in their comparative analysis whether to use debt or equity financing (or both) argue that this constitutes one of the first and fore most decisions to be made regarding corporate finance. This decision, according to (Sakar and Zapatero ,2005), is among the most important financing decision managers face in corporations. Such an important financing decision need just not theoretical framework but empirical research as well. The need for empirical analysis could be appreciated from the work of (Ayla Kayhan, et. al. 2005); that there are wide discrepancies between the developed and developing economies. They opine that the discrepancies impact on the capital markets of both economies, which determine corporate funds, flows. There are wide differences in the macroeconomic and operating environments of firms in the developed relative to those in the developing economies. Reasons for considering macroeconomic differences when considering debt/equity combination include financial, legal, interest rates and capital market frictions. (Bect et .al, 2005). The variations in capital structure among firms operating in different countries have also been attributed to fiscal policy differentials in these countries (Flam; 2005). The main empirical question, therefore borders on whether tax shield, which constitutes the core basis for the choice of debt financing directly or inversely influence corporate financial leverage decision. While some results reveal some form of positive relationship (Green, 2002) others find instead, that the relationship is a negative one.....
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