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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