Determinants of capital structure: Evidence from Nigerian panel data

The paper examines the determinants of capital of 66 firms listed on the Nigerian stock Exchange during the period 1999-2007 using panel data. The results show that there is a negative relationship between leverage and growth opportunities, leverage and tangibility, but positively related to liquidity as well as size. This negative coefficient shows that growing firms do not use debt financing. Negative relationship of profitability with leverage in the three models confirms the implication of pecking order hypothesis which argues that highly profitable firms prefer to finance new investment with internally available funds than through debt finance. It also shows that size and leverage are positively related. Introduction Modern corporate finance literature is replete with studies on the determinants of capital structure. However, the issue still remains contentious. Asides, the concerns of most studies on capital structure are in developed and industrialized countries that have many institutional similarities than from data from developing and less developed economies that have different institutional structures. This therefore raises the issue of the validity of the conclusions from theoretical and empirical research carried out in developed and industrialized economies for developing and less developed countries. Hence, this work is motivated by three main factors. The first is lack of consensus among researchers on the factors that determine firm’s capital structure. The second is the need to ascertain the validity of the findings on determinants of capital structure in developed economies in developing economies. The last is the dearth of empirical work to understand the factors that influence capital structure of firms in Nigeria. It is expected that the findings of the study will shed light on the determinants of capital structure in African Economic and Business Review Vol. 9, No. 1, Spring 2011 ISSN 1109-5609 © 2011 The African Education and Business Research Institute, Inc. 2 Nigeria, which will be invaluable to corporate managers, and other shareholders in the economy. The rest of the paper is organized as follows: Section 2 provides the review of literature, section 3 looks at some potential determinants of capital structure as identified in both theoretical and empirical studies. Section 4 explains the data and methodology. Section 5 is devoted to empirical results while section 6 provides the conclusion. Literature Review Theories of Capital Structure A number of theories have been advanced in explaining the capital structure of the firm. The first is the traditional view that states that debt capital is cheaper than equity. The implication of this assertion is that the cost of debt plus the increased cost of equity together on a weighted basis will be less than the cost of equity that existed on equity before debt financing (Barges, 1963). However, Modigliani and Miller (MM) 1958 do not agree with the traditional view. Modigliani and Miller (1958) theory, argue that in perfect capital markets without taxes and transaction costs, a firm’s market value and the cost of capital remain invariant to the capital structure changes. This implies that the financial instruments issued by the firm do not affect a firm’s productivity and value. However, because of the unrealistic assumptions in MM irrelevance theory, research on capital structure gave birth to other theories. One of such theories is the trade-off theory which asserts that companies optimize their debt level such that marginal tax advantages of additional borrowing are offset by the increase in the costs of financial distress. In short, since interest payments are tax deductible, raising more debt increases the tax benefits. However, an increase in debt equally increases the probability of default and hence the expected cost of bankruptcy. The next theory is the pecking order theory pioneered by Myers and Majluf (1984) and Myers (1984). This theory is rooted on the notion of asymmetric information that corporate managers know more about their company’s prospects, risk and value than do outside investors. According to the theory, companies prefer to finance their projects African Economic and Business Review Vol. 9, No. 1, Spring 2011 ISSN 1109-5609 © 2011 The African Education and Business Research Institute, Inc. 3 from internally generated cash flows. When this is exhausted, debt will be used and when debt is exhausted, additional equity will be issued. DeAngelo and Masulis (1980) emphasized that each firm has an internal optimal capital structure that maximizes its value. Signaling effect was proposed by Ross (1977) based on asymmetric information. This theory states that investors believe higher levels of debt will imply higher quality and higher future cash flows. This means that lower quality firms with higher expected costs of bankruptcy at any level of debt cannot follow the steps of higher quality firms by incurring more debt. Another theory is the Agency theory. This theory suggests that there exists an optimal level in capital structure than can minimize the agency costs. In the framework of this theory, there is a strand of literature that studies the impact of debt on sub-optimal managerial decision making. One important perspective here is the free cash flow approach advanced by Jensen (1986). The approach postulates that high leverage leads to increase in firm value, despite the threat to financial distress, when a firm’s operating cash flows exceeds its profitable investment opportunities. To mitigate the agency problems, various methods have been suggested. Jensen and Meckling (1976) suggest either to increase the ownership of the managers in the firm in order to align the interest of managers with that of the owners or increase the use of debt which will reduce the equity base and thus increase the percentage of equity owned by managers. Jensen (1986) suggests that debt would be used as a controlling device to motivate managers to distribute free cash among shareholders instead of wasting it on inefficient activities. Grossman and Hart (1982) suggest that the use of debt increases the chances of bankruptcy and job loss that further motivate managers to use the organizational resources efficiently and reduce their consumption of parkes. In general, many empirical studies have examined the validity of these theories, but no consensus has emerged among researchers as regards the theory that best explains the capital structure choice. As clearly stated by Myers (2001), there are no universal theory of debt-equity choice and no reason to expect one. All the same, there are several African Economic and Business Review Vol. 9, No. 1, Spring 2011 ISSN 1109-5609 © 2011 The African Education and Business Research Institute, Inc. 4 useful conditional theories, each of which helps to understand the financial structure that firm’s choose. Determinants of capital structure In this section, we examine some of the determinants of capital structure that have been identified by existing theories and empirical studies. These factors are namely sales growth, tangibility, liquidity, profitability, size and GDP growth. There are two conflicting viewpoints about the relationship of size and leverage of a firm. The first school of thought believes that large firms do not consider the direct bankruptcy costs as an active variable in deciding the level of leverage because these costs are fixed by constitution and they are a smaller proportion of the total firm’s value (Titman and Wessels, 1988). Empirical studies in support of this view include Akhtar and Oliver(2009), Supanvanij (2006), Aktar (2005), Buferna et al. (2005), Deesomsak et al. (2004), Chkir and Cosset (2001), Agrawal and Nagarajan (1990), Fama and French (2002), Huang and Song (2006), Marsh(1982), Taub (1975), and Zou and Xiao (2006). From this view, it is assumed that size and leverage would have a positive relationship. The second school of thought is that of Rajan and Zingales (1995) who believe a negative relationship exist between size and leverage because there is less asymmetrical information about larger firms which will reduce the chances of undervaluation of the new equity issue and would make the large firms to use equity financing. This view is supported by Chen (2004) and Ezeoha (2008). Size (SIZ) is measured in this study as the natural log of sales. In the case of liquidity and leverage, the trade off theory believes that a positive relationship exist between leverage and liquidity because higher liquidity ratio can support a relatively higher debt ratio due to greater ability of a firm to satisfy short-term contractual obligations on time, but the pecking order theory has a contrary view. This theory believes a negative relationship exist between liquidity and leverage because firms with enough liquidity may use internally available fund to finance investment. Empirical studies in support of this finding include Deesomsak et al. (2004), Mazur (2007) and Viviani (2008). Liquidity (LIQ) is measured as number of days account receivable plus African Economic and Business Review Vol. 9, No. 1, Spring 2011 ISSN 1109-5609 © 2011 The African Education and Business Research Institute, Inc. 5 the number of days of inventory minus the number of days account payable i.e. cash conversion cycle. Another important firm characteristic found in the literature is future growth opportunities. Firms with high future growth opportunities are expected to use more equity financing because a highly leveraged company may forgo profitable investment opportunities when it expects by undertaking new project the value goes to firm’s existing debt holders (Myers 1977). This suggests negative relationship between leverage and growth. This view is supported by Akhtar and Oliver (2009), Supanvanij (2006), Buferna et al. (2005), Barclay and Smith (2005), Lang, Ofex and Stulz (1996), Rajan and Zingales (