By SULEIMAN, Hamisu Kargi PhD/ADMIN/11934/2008-2009 capital structure: a test of the pecking order theory IN LISTED CONGLOMERATE COMPANIES IN NIGERIA By SULEIMAN, Hamisu Kargi PhD/ADMIN/11934/2008-2009

Background Successful firms usually achieve growth through increase in sales which requires the support of increased investments. To achieve expected growth a firm has to raise funds through various sources and the financial manager should decide when, where and how to acquire such funds to meet investment need. Decisions must be made about the use of internal or external funds, the use of debts or equity and the use of short-term or long- term financing and/or their combination.

Capital structure represents the mix of the various debt and equity used in financing firm’s operation. A firm can choose among many alternative capital structures. It can either issue a large amount of debt or it can issue very little debt. However, the optimal capital structure is the set of proportions that maximizes the total value of the firm. Therefore, decisions concerning the proportion of debt and equity are quite challenging for the management of a firm because a wrong decision may lead to financial distress and eventually to bankruptcy.

A number of theories have been advanced in explaining the capital structure of firm. The theory of capital structure was earlier developed by Modigliani and Miller (1958). They argue that in the absence of corporate taxes and other market imperfections, the total value of the firm and its cost of capital are independent of capital structure. Since the seminal Modigliani and Miller (1958) irrelevance propositions, financial economists have developed a number of theories in which the capital structure choice becomes relevant.

The pecking order theory developed by Myers and Majluf (1984) and Myers (1984) does not predict an optimal capital structure. The theory predicts a strict preference of corporate financing, in which investments are financed by internal funds first, then by low- risk debt and hybrid securities such as convertibles, and equities as the last resort.

The trade-off theory, based on research on taxes (Modigliani and Miller, 1963) and bankruptcy and financial distress costs (Warner, 1977) and the insights from the agency literature (Jensen and Meckling, 1976), suggests that firms have a unique optimal capital structure that balances between the tax advantage of debt financing (i.e. debt tax shields), the costs of financial distress and the agency benefits and costs of debt (Bradley et al., 1984, Leary and Roberts, 2005 and Strebulaev, 2007).

Market timing is another theory of capital structure brought up by Baker and Wurgler (2002). As claimed by its proponents in the United States between 1968 and 1999, Baker and Wurgler find out that firms prefer external equity when the cost of equity is low, and prefer debt vice versa.

In Nigeria Adesola (2009) tested the static trade off theory against pecking order theory and establish the presence of pecking order theory. However, the result is inconclusive about which of the two theories exerts the most dominant effect on the capital structure of Nigerian quoted firms during the period of the study. This might be because the study is testing one theory against the other and is cross sectional in nature.

Despite these theoretical appeals to capital structure, academicians and researchers have not yet agreed on specific method that corporate managers can use in order to attain an optimal capital structure. This may be because of the fact that theories of capital structure differ in their relative emphases. For example, the trade-off theory emphasizes taxes and the pecking order theory emphasizes information asymmetry. How successful are these theories in explaining the time-series patterns of financing activities?

The lack of footing for predicting the long run effect of a specific financing mix makes the financial decision more difficult in many ways than both the investment and dividend decisions. Does the pecking order theory explain the capital structure of Nigerian corporations? Which financing option best explain the capital structure decisions in Nigeria?

The purpose of the study is to examine the evidence of the pecking order hypothesis. The study primarily addresses the issue of how robust the pecking order hypothesis is in explaining capital structure of conglomerate firms in Nigeria. It was hypothesised that pecking order theory has no significant impact in explaining the capital structure of conglomerate firms in Nigeria.

Some studies have examined how well the pecking order hypothesis actually fit. Baskin (1989) and Shyam-Sunder and Myers (1999) tested a number of predictions of the pecking order hypothesis and argued that their results were consistent with the theory. Moreover, the findings of Adesola (2009), Sheikh and Wang (2010) and Chang et al (2010) are in support of the theory.

However, Fama and French (2005) examined many individual financing decisions of firms and find that these decisions are often in conflict with many of the important predictions of the pecking order hypothesis. For example, equity is supposed to be the last financing alternative, yet Fama and French observe that most firms issue some sort of equity every year.

Methodology The study utilises data from secondary sources (Fact Books and annual reports) in respect of six firms quoted as conglomerate on the Nigerian Stock Exchange. The firms selected have sufficient data for the study. Data collected include total asset, equity, debt and preceding year retained earnings of the sampled firms which relate to eight years financial periods from 2002 to 2009.

The study adopts Watson and Wilson (2002) model in analysing the data collected. The model was based on Ordinary Least Square (OLS) method in estimating the parameter of the model. Watson and Wilson (2002) use the model to provide the evidence to support the Pecking Order theory.

The model specify that; TA=f(RE, Debt and Equity) The model is thus; (TAit -TAit-1)/TAit-1 = Σβ + β1(Pit -Divit-1)/TAit-1 + β2(Dit -Dit-1)/TAit-1 + β3(EIit)+vit

If the theory holds, the following relationship should be observe for β, which is β1>β2>β3. This relationship might imply that the source of financing has a priority: first from a firm’s retained earnings, then debt issuance, and equity issuance falling at the bottom.

RESULT The result estimated multiple regression model of total asset growth thus; (TAit -TAit-1)/TAit-1 = -0.162 + 0.378(Pit -Divit-1)/TAit-1 + 0.611(Dit -Dit- 1)/TAit-1 + 1.678(EIit)+vit The observed relationship for β in the result shows that β3>β1>β2. The result shows the coefficient of new equity issuance (EQ) [1.678] is larger than the slope coefficients of retained earnings (RE) [0.378] and debt issuance (D) [0.611].

the coefficient of multiple determination R2 (adjusted R2) of 0.312 (0.266) indicates that about 31.2% or exactly 26.6% variations in the observed behaviour of the total asset growth is jointly explained by all the three explanatory (independent). The DW statistic is 1.967, approximately 2.0 indicates that there is no first order autocorellation, either positive or negative. The result of the estimates is therefore reliable for prediction and need no transformation of the original model.

The calculated F- statistic is greater than the table F- statistic (i The calculated F- statistic is greater than the table F- statistic (i.e 6.664 > 4.31), therefore this shows the regression is significant at 1% level. Base on the findings, the null hypothesis which state that pecking order theory has no significant impact in explaining the capital structure of conglomerate firms in Nigeria is rejected.

The analysis though has overall significance indicate that only equity tracks the firm’s financing deficit better than retained earnings and debt. Equity has the most significant coefficient in the model. The findings contradict the pecking order theory developed by Myers and Majluf (1984) in predicting the capital structure of conglomerate firms in Nigeria.

Discussion The findings of the study did not support the pecking order hypothesis as the primary financing theory for conglomerate firms in Nigeria. Firms in this sector finance their deficit mainly with equity issuance, the opposite of what would be expected under the hypothesis. This choice exposes the firms to certain risk such as dilution of ownership. However, due to information asymmetry Nigerian investors prefer immediate return in form of dividend than having earnings retained to finance future expansion

The study support the position of Fama and French (2005) that most firms issue some sort of equity every year The result of the study contradicts the findings of Shyam-Sunder and Myers (1999), Adesola (2009), Sheikh and Wang (2010) and Chang et al (2010).

Conclusion and Recommendation Base on the findings, it can be concluded that the explanatory variables have good description of financing policies of conglomerate firms in Nigeria and has significant impact to the growth of the firms but not in accordance with the pecking order theory. The findings contradict the theory. In accordance with this conclusion, shareholders should be enlightened on the importance of having earnings retained given that it is the cheapest means of financing and without external scrutiny.

However, proper corporate governance is needed to avoid agency problems as a result of information asymmetry. Capital market in Nigeria should be restructured for channelling debt capital at low cost and, to remove information asymmetries between firm managers, investors and the market. This will eliminate imperfections, improve investors’ confidence and integrity of the system.

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