THE CHOICE BETWEEN EQUITY AND DEBT IN NIGERIAN QUOTED COMPANIES SOME EMPIRICAL TESTS OF THE CAPITAL STRUCTURE THEORY

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.

Firms  in developing economies face  far  much financial difficulties arising from regulatory institutional rigidities, stock market imperfection, and inefficient banking systems.

The analysis will be conducted using quoted companies data in Nigeria to determine the relative importance of the different theories and, to identify those aspects of financial policy that each theory is most helpful in explaining.

An attempt was made to test the trade-off theory as well as the pecking order theory to ascertain whether their theoretical predictions do describe the observed phenomenon in Nigeria.   As scholars hold, the acceptability of any theory is to be judged by its ability to predict and understand phenomena. The theory of capital structure is an interesting and one of the most contentious issues in finance. There is no universal theory of capital structure and perhaps no reason to expect one but the logic of the MM paper has come to be widely accepted. It is along this framework (with its various extensions) that this study followed and sought to explore the determinants of the debt–to–equity mix of companies in Nigeria.

1.2    STATEMENT OF RESEARCH PROBLEM

The theory of capital structure is one of the most contentious issues in corporate finance. After fifty years of the Modigliani Miller break through, there are still some grey areas on the theory especially with respect to its portability across various environments.   The analysis of how companies chose their financing mix has been primarily an empirical question and has largely concentrated on industrialized countries, while evidence from the emerging markets remains scanty. As we know, good management decisions could cause a turn around in the performance of an otherwise unprofitable firm. Conversely poor management decisions could prevent a firm from exploiting its opportunities and hence lead to a fall in its growth rate and market share. Sound decisions are decisions based on tested principles and realities on ground. Due to lack of empirical  studies,  corporate  decisions  are  continuously  being  based  more  on  theoretical arguments or, at best, on foreign empirical evidences. This in turn has affected corporate growth and performance in Nigeria.  Many companies suffer low capacity utilization.  This has made the companies to contract rather than expand.

One of the limitations of Modigliani-Miller insights, though discovered about three decades ago, is the discarding (or denial) of theories for determination of capital structure.  Along this line, theories have emerged in the finance literature to explain observed leverage ratios incorporating signaling opportunities (Ross, 1997; Myers, 1986; Hart and Maore, 1995; Jung et. al, 1996; Novaes, 2003; and so) and tax benefits of debt such as( Graham ,1996, 1999, 2000) and( Graham and Harvey ,2001).

Further, an interesting element of this evolution is the prediction of each of these  modern theories of capital structure.   There exists similar predictions in respect of some variables of interests and there exists, as well, contrary predictions.  The nature and direction of relationship between leverage and any of the explanatory variables determine the theories at work and could provide the basis for the practitioner to apply the validated theory.

The need for further testing of the (modern) capital structure theory was the motivation for this work.   The gap, created by insufficient empirical attempts at explaining observed capital structures of quoted firms in Nigeria, was what this research attempted to fill.

1.3    OBJECTIVES OF THE STUDY

In view of the above, our objective of study include

i.      To determine the significance of the tax benefits in explaining observed leverage ratios amongst firms in Nigeria.

ii.      To ascertain the validity of the asymmetry of Information idea in explaining the security issue choice of firms in Nigeria.

iii.      To investigate the linkage (if any) between capital market conditions and firms financial structure.

iv.      To specify the ‘key’ variables that explain firm’s capital structure and relate the obtained results to the insights gleaned from existing literature; that is, the theoretical plausibility of the exogenous variables.

v.    An attempt to trace the adjustment process (if any) of structure from short-run contemporaneous relationships to long-run steady state equilibrium estimates.

1.4 RESEARCH QUESTIONS

Our research questions for this study were as follows:

1.  How significant is the tax benefit of debt in explaining observed leverage in Nigeria?

2.  To what extent does the asymmetry of information idea (or information costs) influence corporate choice between debt and equity?

3.  To what extent do capital market conditions influence firm’s choice of debt in financing?

4.  What is the nature and extent of the relationship between leverage and conventional determinants of capital structure such as size, growth, profitability, collaterals and financial distress?

5.  Is there any adjustment process or path from short-run contemporaneous relationships to a long run steady state equilibrium estimates?

1.5      RESEARCH HYPOTHESES

The following hypotheses were tested in this study:

1.         Tax  benefit  does  not  have  a  significant  positive  impact  on  leverage  or  capital structure.

2.        The pecking order theory does not explain observed capital structure in Nigeria

3.         The financing deficit does not dominate other conventional determinants of leverage in observed capital structures.

4.        Stock market conditions do not influence debt ratio dynamics.

5.         There is no adjustment from short-run contemporaneous relationships to long-run state estimates of debt ratio parameters.

1.6    SIGNIFICANCE OF THE STUDY

The  significance  of this  study  can  be  viewed  from two  major  standpoints-  academic  and practical.

a. Practical significance: On the practical side, the study attempted to point managers and practitioners to critical variables that should influence their choice of debt-to-equity mix. Knowledge of the various parameters in the choice of financing might save managers of sometime/effort that they spend in the rigorous decision process. In particular, the study detected time path of adjustment in the debt-to-equity mix, the rationale for such corporate action was suggested. This should help managers to gradually tailor the existing structure to whatever target ratio they have established in line with their strategic objectives.

b. Academic significance: In the academic arena, this study proves to be significant in the following ways:

1.  It is expected to contribute to the enrichment of the literature on the capital structure theory as it extends the sample to Nigeria.

2.  The outcome of this work is expected to raise issues in the field of corporate finance.  The provision of empirical evidence either in support of known theories or in contradiction was a major contribution of this work.

1.7   SCOPE OF THE RESEARCH

Previous researchers identified some sets of variables believed to be major determinants of financial leverage. This study employed eight (8) explanatory variables in the analysis of the capital structure in Nigeria.  The variables include the corporate tax rate, the non-debt tax shelter ratio, firm size, future growth opportunities (as proxied natural logarithm of market-to-book values of assets) profitability, and capital market conditions, tangible assets and earnings volatility.   The research covered sixty quoted companies in the Nigerian Stock Market.   The period, 1996-2005 covered the aspect dealing with our data for statistical analysis.

1.8  LIMITATIONS OF THE STUDY

A lot of factors affected this work. A major constrain was fund. The work was capital intensive and required a lot of money due to multiple trips made to Nigerian Stock Exchange to source for meaningful materials.

Annual reports and statement of accounts of the sixty firms selected were needed. To get at these financials were not very easy due to poor habit of data preservation in Nigeria.

While the development of theory on capital structure has evolved rapidly, empirical research lagged behind. Our knowledge of capital structures has mostly been derived from data from developed economies. We found it difficult to lay our hands on substantial local literature on capital structure.

1.9      OPERATIONAL DEFINITIONS OF TERMS

Adjusted Present Value (APV): Net present value of an asset if financed solely by equity plus the present value of any financing side effects. It is the most appropriate approach for evaluating project, which has several financing side effect.

Adverse  Selection:  A  situation  in  which  a  pricing  policy  causes  only  the  less  desirable customers to do business, e.g. a rise in insurance prices that leads only the worst risks to buy insurance.

Agency problem: the possibility of conflict of interest between the owners and management of a firm.

Agency Theory: Theory of the relationship between a principal e.g. a shareholder, and an agent of the principal.

Bankruptcy: A legal proceeding for liquidating or reorganizing a business. Also the transfer of some or all firm’s assets to its creditors.

Beta: A measure of the sensitivity of a security’s return to movements in an underlying factor. It is a measure of systematic risk.

Capital structure: The capital structure of a company is a particular combination of debt, equity and other sources of finance that it uses to find its long-term asset.

CAPM:. Capital asset pricing model. it is a model that provides a framework to determine the required rate of return on an asset and indicates the relationship between return and risk of the asset.

Common stock: Security representing ownership of a corporation. it is the source of permanent capital since they do not have a maturity date. Correlation coefficient: Measure of the closeness of the relationship between two variables.

Cum rights value: The value of an ordinary share when a right issue is declared but not yet excised. It is higher than the normal market price per share because of the interest value of the right.

EBIT: it is an abbreviation for earnings before interest and taxes.

Efficient Portfolio: Portfolio that offers the lowest risk (standard deviation) for its expected return and the highest expected return for its level of risk.

EPS:  It is an abbreviation for earning per share. It is the earnings due to one ordinary share. It is derivable by dividing earnings available to ordinary shareholders by the number of outstanding shares.

Expected  return:  The  rate  of  return  a  firm  expects  to  realize  from  an  investment.  In probabilistic situations it is calculated by multiplying each probability by its related absolute returns and adding the probability adjusted returns to get the expected value return.

Face value: It is the Nominal value of shares. Not the book value or market value.

Financial leverage: (gearing) use of debt to increase the expected return on equity. Financial leverage is measured by the ratio of debt-to-debt plus equity.

Fisher effect:  It is the Relationship between nominal returns, real returns and inflation.

Free cash flow: Cash not required for operations or for reinvestment.

GAAP: An abbreviation for  generally accepted accounting principles.  The  common set  of standards and procedures by which audited financial statements are prepared.

Growth Stock: Common stock of a company that has an opportunity to invest money to earn more than the opportunity cost of capital (income stock).

Home made leverage: The use of personal borrowing to change the overall amount of financial leverage to which an individual is exposed.

Interest tax shield: The tax saving attained by a firm from interest expense. Leveraged Buyout (LBO) Acquisition in which (1) a large part of the purchase price is debt financed and (2) the remaining equity is privately held by a small group of investors.

Liquidating dividend: This is the type of dividend that represents a return of capital. Dividends are returns given to shareholders out of profit after tax. It may be preference dividends (or preference shares) Dividends can either be paid in cash or in form of bonus shares or script.

M & M Proposition I:  This is the Modigliani and Miller first proposition that the value of the firm is independent of its capital structure.

M & M proposition II: The second proposition of Modigliani that a firm’s cost of equity capital is a positive linear function of its capital structure managerial options, Opportunities, which managers can exploit if certain things happen in the future.

Net Present Value Method: A capital budgeting technique in which an investment project is accepted only if the net present value is positive. The net present value is equal to the difference between the present value of future cash inflow, and the present value of the cash outflows. Perpetuity:  A stream of future annuities expected to continue forever. Investment offering a level stream of cash flows in perpetuity.

Profitability index: The present value of cash inflows of a project divided by the present value of the investment outlay. It is an investment evaluation criterion useful in evaluating projects especially in a situation of capital Rationing.

Regression Analysis: A statistical technique for predicting the value of one variable (dependent variable) on the basis of the knowledge about one or more other  variable (independent variables)

R squared (R2) square of the correlation coefficient the proportion of the variability in one series that can be explained by the variability of one or more other series.

Skewed Distribution: Probability distribution in which an unequal number of observations lie below and above the mean.

Spin – off. Distribution of shares  which goes to the company’s shareholders so that they hold shares separately in the two firms.

Static theory of capital structure: Theory that a firm borrows up to the point where the tax benefits from an extra dollar to the debt is exactly equal to the cost that comes from the increased probability of financial distress.

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