1Dept of Banking And Finance, Abia State University, Uturu, Nigeria, E-mail: [email protected]
2Faculty of Management Sciences, University of Benin, Benin City, Nigeria, E-mail: [email protected]
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Fund Performance, Fund Size, Risk, Expense Ratio, Turnover Ratio, Fund Age
A theme of one on going debate in the world of corporate finance is what determines a firm’s capital structure. Despite significant contributions, research produced so far did not yet provide a sound basis for establishing the empirical validity of different theoretical models. Probably the most eclectic, prevalent and non controversial view with respect to the contention surrounding corporate capital structure theory is Myer’s (1993) argument that it is a PUZZLE, and mirrored by Stiglitz and Weiss (1981) as a DILEMMA.
According to Rajan and Zingales (1995) and Harris and Raviv (1991), more research on capital structure hypothesis is needed to increase the robustness of its determinants. Inspite of extensive research, Myers’ (1984) classic question “how do firms choose their capital structure?” remains unanswered. Also Altman and Subrahmanyam (1985) saw the factors likely to determine corporate capital structure as both extensive and indeterminate. Two landmark contributions: the corporate tax equilibrium models developed by Modigliani and Miller (1963) and the synthesis of personal and corporate tax effect by Miller (1977) represent extremes in the sense that they are equilibrium models built on sets of fairly restrictive assumptions.
Also, their implications represents two opposing “corner solutions” of either gains of increased resort to debt via the corporate tax shields on interest payments, or zero gains in inappropriate circumstances where the personal tax rates on debt and equity are of the relative magnitude required to vitiate any corporate gains from tax shields on interest payments. In between these extremes are numerous papers which suggest that determining an appropriate capital structure might involve a trade-off between positive tax subsidies associated with issuing debts and the various costs which are likely to be associated in an imperfect world with higher leverage (De Angelo and Masulis, 1980; and Modigliani, 1982). This trade-off theory postulates that an appropriate capital structure involves balancing the corporate tax advantages of debt financing against the costs of financial distress that arise from bankruptcy risks (Kraus and Litzenberger, 1982) and agency costs (Jensen and Meckling, 1976). The empirical support for this theory, however, is far from conclusive. For instance, Bradley, Jarrel and Kim (1984) find no clear evidence.. The inclusion of personal taxation (Miller, 1977) and non-debt tax shields (DeAngelo and Masulis, 1980) has made the debate even more complex. Later, in the early 1980s theories based on asymmetric information joined the debate (Myers, 1984).
In a quest for the factors that managers consider in deciding the capital structure of a firm, many studies have examined the role of several firm-specific factors. In a review article, Harris and Raviv (1991) report that leverage is positively related to non-debt tax shields, firm size, asset tangibility, and investment growth opportunities, while it is inversely related to bankruptcy risk, research and development expenditure, advertising expenditure, and firm’s uniqueness. In general, major studies so far have analyzed the role of firm-specific factors that represent taxation, agency costs and information asymmetries.
Also, in a cross-sectional analysis of the determinants of corporate capital structure of companies in the G-7 economies, Rajan and Zingales (1995) expanded the view of Harris and Raviv (1991) by identifying that leverage is positively related to Growth, Size and Tangibility but negatively related to profitability. Bevan and Danbolt (1999) researched this work in 1999 and complemented the work of Rajan and Zingales (1995). In this study, we intend to add to these studies by analyzing the determinants of corporate capital structure in the Federal Republic of Nigeria. The variables of interest (capital structure, size, growth, profitability, tangibility, and age) are defined as follows. Capital structure means the addition of long-term debt and shareholders’ fund. Tangibility is the percentage of fixed tangible assets to total assets (fixed assets plus current assets). Profitability is the percentage of profit before tax to total assets. Age is the age of the firm arrived at by finding the difference between the date this study was conducted and the firm’s incorporation date. Size is the turnover (for other companies) or gross income (for Banks) or gross premium (in case of insurance companies) and growth means the percentage change in turnover/gross income or gross premium for a number of years.
The theoretical literature on the factors that are likely to determine corporate capital structure is both extensive and indeterminate (Altman and Subrahmanyam, 1985). Two landmark contributions are the corporate tax equilibrium model and the synthesis of personal and corporate tax offsets by Miller (1977). These 2 papers have represented extremes, in the sense that they are equilibrium models built on sets of fairly restrictive assumptions and their implications represents 2 opposing ‘corner solutions’ of either gains from increased resort to debt via the corporate tax shield on interest payment or zero gains in inappropriate circumstances, where the personal tax rate on debts and equity are of the relative magnitudes required to vitiate any corporate gains from tax shields on interest payment. In between these 2 extremes are numerous papers, which suggest that an optimum capital structure might involve a trade-off between positive tax subsidies associated with issuing debts and the various cost likely to be associated in an imperfect world with higher leverage (De Angelo and Masulis, 1980; and Modigliani, 1982).
One of the more notable recent contributions in this area is a paper by Bradley, Jarrel and Kim (1984) which has the dual merits of; first, constructing a comparative single static model of a company’s capital structure determinants, which captures tax advantage and bankruptcy costs trade-off along the lines suggested by Kraus and Litzenberger (1982) and the agency cost of debt argument of Jensen and Meckling (1976). It was further argued that, it also reflects the potential loss of non-debt tax shields in states of non default as suggested by De Angelo and Masulis (1980), and the previously mentioned work on personal and corporate tax rates by Miller (1977), and extensions of this by Kim (1978) and Modigliani (1982). Secondly, it features an attempt to verify empirically, the models predictions via a cross-sectional regression analysis of data relating to 851 American corporations over the period 1962-1981.
A theoretical consideration of the previously mentioned literature suggests a number of factors which are likely to have an impact on a company’s capital structure decision. Modigliani and Miller (1963) argue that due to the tax deductibility of interest payments, companies may prefer debt to equity. This would suggest that highly profitable firms would choose to have high level of debts in order to obtain attractive tax shields. However, others such as Miller (1977) highlighted the limitations of his and Modigliani’s 1963 arguments, by additionally considering the effects of personal taxation. If Millers 1977 approach is adopted, then disparities in the personal tax treatment of returns from equity to debt could ‘wash out’ any corporate tax advantages of tax shield on interest payments. There is a large literature linking increased leverage with increased probability of incurring bankruptcy costs, but the evidence on the scale of bankruptcy cost is meager (Warner, 1977). This has led many to suggest an inverse relationship between riskiness (variously defined) and corporate debt levels, a theme echoed by Bradley, Jarrel and Kim (1984). Furthermore, interest tax shields are not the only methods of reducing corporate tax burdens. Indeed there are various non debt tax shields, such as accelerated depreciation and investment tax credits which De Angelo and Masulis (1980), amongst others, have suggested can act as substitutes for the former. Thus, other things being equal, we might expect an inverse relationship between company debt levels and the availability of non-debt tax shield.
A further dimension to the issue is provided by the agency literature. This suggests that the various agency cost associated with increased resort to debt issues in the form of restrictive bond covenants for example, mean that after a certain point, issuing further debt becomes counter productive (Jensen and Meckling, 1976). The difficulties lie in defining the type of company that is particularly likely to encounter heavy agency costs. Jensen and Meckling (1976) defined the issue in terms of ownership structure and management participation in this, but more recently, Myers (1977) and Myers and Majluf (1984) have extended the issue to include the value of the assets in place vis-à-vis intangible assets and value tied up in ‘option to invest’. Thus, other things being equal, it might be expected that a company with large expenditure on research and development, or advertising or both would have a greater portion of its value made up in intangible forms and, therefore to incur higher agency costs in a debt issue than a company whose value is predominantly made up of tangible assets.
Work on asymmetric information (again by Myers and Majluf, 1984) suggests that companies may have a pecking order and prefer internal finance, then debt, and finally equity. Bradley, Jarrel and Kim (1984) made no elicit reference in their study to the likely impact of increased profitability and debt ratios, yet work by Kester (1986) in a cross-sectional study of debt ratios in the USA and Japan indicates that profitability has a negative influence on debt ratios. The authors therefore decided to include a variable to proxy for this.
Furthermore, empirical work by Kester (1986) suggests that profitability is likely to be a major determining factor. Kester’s work also features Growth variable which obviously could not be incorporated in Bradley, Jarrel and Kim’s (1984) one-period model. The authors decided to include such a variable and a further one to represent the dividend payout ratio. This was because the ‘Me-first’ and the agency literature suggests that a large dividend payout can reduce the security of the bondholders and in practice, debt covenant of many western corporations explicitly set limits on the freedom of the companies to increase their ratios beyond certain limits (Smith and Warner, 1979). The hypothesis would be that, debt ratios would be negatively related to dividend payout ratios and positively related to growth since growth as measured by asset value would enhance the company’s ability to borrow further.
Rajan and Zingales (1995) examine the extent to which, at the level of the individual firm, capital structure determinants may be explained by four key factors, namely, the level of growth opportunities, profitability, and tangibility. In this study, the intension is to extend their analysis to large firms operating in Nigeria, in a cross-sectional analysis; taking into consideration the key likely determinants – firm size, growth opportunities, profitability, tangibility and age.
Capital structure and company size
Rajan and Zingales (1995: 1451) opines that, “the effect of size on leverage is more ambiguous. Larger firms tend to be more diversified and fail less often, so size (net sales) may be an inverse proxy for the probability of bankruptcy in developed countries”. In addition, larger companies are more likely to have a credit rating and thus have access to non-bank debt financing, which is usually unavailable to smaller companies (Bevan and Danbolt, 1999). The principal-agency controversy between equity holders and lenders make credit rating of small companies very low, thereby making lenders to shorten the length of maturity for loans to small companies. However, the empirical evidence is inconclusive; Barclay, Smith and Watts (1995) find a positive relationship between size and gearing. Stohs and Mauer (1996) find no size effect. Therefore in this study, it is hypothesized that:
There is no positive relationship between gearing (CAPSTR) and company size.
Capital Structure and Growth Options
According to Bevan and Danbolt (1999), the market-to-book ratio is used by Rajan and Zingales (1995) as a proxy for the level of growth opportunities available to the company. This is in common with most studies which tend to apply proxies, rather than valuation models to estimate growth opportunities. Myers (1977) argues that, due to information asymmetries, companies with high gearing would have a tendency to pass up positive net present value investment opportunities. Myers therefore argued that companies with large amounts of investment opportunities (also known as growth options) would tend to have low gearing ratios. However, as discussed by Myers (1977), Barnea, Haugen, and Senbet (1980), Stohs and Mauer (1996), and Michaelas, Chittenden and Poutziouris (1999), the relationship between growth opportunities and capital structure may be different for short and long-term forms of debt. Therefore, it is hypothesized that:
There is no positive relationship between gearing (CAPSTR) and a company’s growth options.
Capital Structure and Profitability
As earlier stated the pecking order theory of capital structure implies that, most profitable firms use source of internal funding and low profitable firms use debt financing due to insufficient internal funds. Unlike MM’s theory, POT weighted less to tax shield in capital structure. Profitable firms with limited investment opportunities work down to low debt ratios. Bevan and Danbolt (1999) in their study on ‘dynamics in the determinants of capital structure in the UK’ tend to support the POT; they found that profitable firms are less geared. This appears to be driven by a monotonic positive shift in the correlation between profitability and short term bank debt.
Modigliani and Miller (1963) argue that, due to the tax deductibility of interest payments, companies may prefer debt to equity. This means, most profitable firms will prefer to be highly levered than less profitable firms, in order to obtain tax shields. However, with the introduction of personal taxation by Miller (1977), M & M’s (1963) argument seems to loose weight. Moreover, De Angelo and Masulis (1980) submit that, interest tax shields may be unimportant to companies with other tax shields, such as depreciation. Consequently, Myers and Majluf (1984) and Myers (1984) pecking-order theory predict that, firms will prefer internal to external capital sources. Therefore, it is hypothesized that:
There is no positive relationship between gearing (CAPSTR) and profitability of a company.
Capital Structure and Tangibility
According to Jensen and Mekling (1976) the conflict of interest between debt providers and equity holders, generates adverse selection possibilities among decision makers in the organization. This therefore exposes those holding debt instruments to high level of risk, which results in their demand for higher returns. Bradley et al. (1984) opines that, there is a positive relationship between tangibility and gearing. Consistent with this finding of Bradley et al. (1984), Rajan and Zingales (1995) study of capital structure in the G-7 economies produces evidence to suggest a positive relation between tangibility (which is seen as the ratio of fixed to total assets) and debt. Chittenden, Hall and Hutchinson (1996) observed that, the relationship between tangibility and gearing is a function of debt applied. While there is a positive relationship between tangibility and long term debt, and negative for short-term debt. The submissions of Bradley et al. (1984) and Chittenden et al (1996) provide some reasonably strong priors with which it is hypothesized that there is a positive relationship between capital structure and tangibility:
There is no positive relationship between gearing (CAPSTR) and a company’s tangibility.
Capital Structure and Age
On the other hand, age of the firm is a standard measure of reputation in capital structure models. As a firm continues longer in business, it establishes itself as an ongoing business and therefore increases its capacity to take on more debt; hence age is positively related to debt (Abor, 2008). Before granting a loan, banks tend to evaluate the creditworthiness of entrepreneurs as these are generally believed to pin high hopes on very risky projects promising high profitability rates. In particular, when it comes to highly indebted companies, they are essentially gambling their creditors’ money. If the investment is profitable, shareholders will collect a significant share of the earnings, but if the project fails, then the creditors have to bear the consequences (Myers, 1977). To overcome problems associated with the evaluation of creditworthiness, Diamond (1989) suggests the use of firm reputation. He takes reputation to mean the good name a firm has built up over the years; the name is recognized by the market, which has observed the firm’s ability to meet its obligations in a timely manner. Directors concerned with a firm’s reputation tend to act more prudently and avoid riskier projects in favour of safer projects, even when the latter have not been approved by shareholders, thus reducing debt agency costs - by reducing the “temptation” to gamble at creditors’ cost.
This perspective has also been seconded within the context of small business. It is important to note the extension of firm risk to the personal area of the business person (given the unlimited liability of entrepreneurs) to be a way of managing the agency costs resulting from cases of more opportunistic behaviour. Given the fragmentation of information, and the high costs of control and evaluation, the firm’s and the entrepreneur’s reputations become a valuable asset in the management of relations between the principal (investor) and the agent (business person). Rajan and Zingales (1995) found that older firms should have higher debt ratios since they should be higher quality firms. Michaels et al (1999) agreed that age is positively related to long-term debt but negatively related to short-term debt. Lemmon et al (2001), however, found that age is negatively related to both long-term and short-term debt. We hereby assume in this study that:
There is no positive relationship between gearing (CAPSTR) and age of a company.
The population of study is made up of the 225 companies listed on the Nigerian Stock Exchange (NSE) as at 31st December, 2008. The cross-sectional survey research design was used in this study. This design was adopted because the selected companies making up the sample for this study are to be observed at a particular point in time. The major source of data for this work is the Secondary source of data which is the Nigerian Stock Exchange (NSE) Fact-book, 2008. The sample size was 124 of the 225 companies listed on the Nigerian Stock Exchange (NSE). The sample size is more than 50% of the population and therefore believed to be representative of the population.
The stratified random sampling and simple random sampling methods were used in this study. The reason for the choice of the stratified random sampling method is to ensure adequate or proportional representation of the different categories of companies that make up the population. Against this background, the research population, that is, all the 225 companies listed on the NSE as at 31st December, 2008, were organized into homogeneous subsets (sectors) with heterogeneity between the subsets. The appropriate number of companies was then selected from each subset, using the simple random sampling method (lottery technique).
The reason for also introducing the simple random sampling method is because, it made every company in each subset (sector) to have an equal and known chance of being selected. However, there was a major methodological weakness in this study. This limitation was the further reduction of the sample size from 114 to 110, which is only about 49% of the population of study. The reason for removing the 14 companies earlier sampled from the analysis was simply because in the course of collecting data, insufficient data were available on them.
The Ordinary Least Square (OLS) correlation method is to be used in estimating and analyzing the regression model stated below. The reason for the choice of the OLS method of data analysis is because; the test in this study is a test of association between capital structure and some independent variables (size, growth, profitability, tangibility and age). Also, the OLS regression is a good estimation technique in this study; given that, any form of violation in its assumptions can be corrected using auto – regression correction methods such as Cochrane – Orcutt iteration method and Newton – Raphson iteration method.
The theory behind this research is that; the Capital Structure of a firm (CAPSTR) is a function of five independent variables namely: firm size (SIZE), growth opportunities (GROWTH), profitability (PROF), tangibility (TANG), and age (AGE). This is presented in a relational form as follows: CAPSTR = f (SIZE, GROWTH, PROF, TANG, AGE) with the linear expression:
CAPSTR = α0 + β1SIZE + β2 GROWTH + β3 PROF + β4 TANG + β5 AGE + Ut
α0, β1, β2, β3, β4 and β5 are parameters to be estimated with the apriori expectation;
β1, β2, β3, β4 and β5 > 0 where: Ut is the error term
A total of one hundred and ten (110) companies’ financial statements were analyzed. In appendix 1, the names of the 110 quoted companies are given along side the summary of figures made up of capital structure, size, profitability, tangibility, growth and age. The computations leading to the arrival of the figures are shown in appendix 2. The Ordinary Least Square (OLS) technique was used to estimate the parameters of the model specified by this study. The initial OLS result showed the presence of autocorrelation, which made correlation inevitable. The Cochrane-Orcutt method was used to correct the serial correlation problem by experimenting with third autoregressive scheme.
The best results obtained are given as:
The t values are presented in the parenthesis below the coefficients. The R2 values of 0.39, shows that about 39% of the total variations in CAPSTR can be explained by the independent variables, while about 61% cannot be explained. The F value of 7.7 passes its significance test at the 5% level. This shows that there is a significant linear relationship between CAPSTR and the various independent variables used. Furthermore, the DW – Statistics of 2.09 shows the absence of serial correlation. This means that the error term is well behaved. In addition, all the variables except PROF and AGE pass their a priori signs. PROF and AGE take negative signs instead of positive signs. Only SIZE and AGE pass their t-test at their 5% level of significance, with values 4.19 and -2.23 respectively. This is due to the fact that both values are more than critical t-value of more than 2.05 using the two-tailed test. PROF, TANG and GROWTH fail their t-test. Finally, the result of this analysis suggests that AGE and SIZE are the major determining factors that influence the behaviour of CAPSTR. Thus a unit rise in SIZE will result in about 974518.6 units rise in CAPSTR, while a unit rise in AGE will lead to about 67788.8 reductions in CAPSTR.
From the research carried out, it was confirmed that there are strong relationships between Size, Profitability, Tangibility, Growth, Age and Capital structure. It was found out that SIZE has a significant positive relationship with CAPSTR. This result is consistent with the views of Rajan and Zingales (1995) and Bevan and Danbolt (1999). This shows that as SIZE increases, CAPSTR will also increase. It was also found out that PROF does not have any positive relationship with CAPSTR. This also follows the views of Toy et al (1997), Titman and Wessels (1988), Rajan and Zingales (1995), Bevan and Danbolt and also Myers’ (1984) pecking order theory. This means that as PROF increases, CAPSTR reduces.
Other findings in this study include the discovery that TANG does not have any significant impact on CAPSTR though it has a positive relationship with CAPSTR suggesting that as TANG rises, CAPSTR will also rise. This also follows the findings of Bradley et al (1984), Titman and Wessels (1988), Rajan and Zingales (1995), Bevan and Danbolt (1999), Scott (1977), Williamson (1988) and Harris and Raviv. But Chittenden et al found that it depends on the measure of debt applied. It was also found that GROWTH does not have any significant impact on CAPSTR but has a positive relationship with CAPSTR. This finding is contrary to the views expressed by Kester (1986) who submitted that there is a positive relationship between tangibility and capital structure. Smith and Warner (1979) submitted a positive relationship with dividend payout. But others like Rajan and Zingales (1995), Bevan and Danbolt (1999), Jensen and Meckling (1976), Myers (1977), Titman and Wessels (1988), Chung (1993) and Barclay et al (1995), all found a negative relationship between Growth and Capital structure. Thus, from the results of this study, it is obvious that as GROWTH increases, CAPSTR will increase. The finding that AGE has a significant negative relationship with CAPSTR is consistent with the view of Abor (2008). This means that as AGE increases, CAPSTR reduces.
The issue of the determinants of corporate capital structure of a firm remains to date one of the most debated topics in corporate finance theory. Equally elusive has been the answer as to how corporate finance managers determine their capital structure. This study makes an attempt to add to the growing body of literature on the issue of corporate capital structure by empirically examining the relationship within the context of the Nigerian economy. While some of the findings are in line with research conducted elsewhere, others (for example, growth) seem to conflict with existing literature on the issue.
The study selected a rather small sample of 110 firms quoted on the Nigerian Stock Exchange over the period 2000-2005, due to the unavailability of data necessary for the purpose of the research. The findings are however encouraging enough to set forth future research agenda on a larger sample of firms with a disaggregated set of dependent variables to further explore the issue of corporate capital structure. Such research, the authors believe, would throw more light on the controversy and hence form a more comprehensive view of the determinants of corporate capital structure. Thus the importance and significance of corporate capital structure decisions in the context of management of businesses can hardly be mitigated.
The results of this study have delivered some insights on the capital structure of Nigerian companies. The issue of capital structure is an important strategic financing decision that firms have to make. It is therefore recommended that:
1. Following from the findings in this study that, size and age of a firm are significant determinants of its capital structure, it is therefore recommended that, directors of companies in Nigeria should pay more attention on two key capital structure indicators (size and age) so as to be in a good position to manage their capital structure for better performance.
2. There should be policies intended to encourage unquoted firms to gain access to the capital market by, for example, reducing listing requirements and subsidizing flotation costs. This will help them grow in size and invariably impact on their capital structure.
3. Considering that export-oriented firms and limited liability companies have easier access to finance, firms should think about entering the international markets to consider more organized forms of business. This will impact positively on their size, tangibility and growth options.
4. Overall, further research work should be carried out to discover other determinants of corporate capital structure because as Stewart Myers (2001) unambiguously suggests, “there is no universal theory of the debt-equity choice and no reason to expect”.
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