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Corporate Tax And Capital Structure In An Emerging Market : An Empirical Analysis Of Quoted Firms In Nigeria

Corporate Tax and Capital Structure IN AN EMERGING MARKET : An empirical analysis of Quoted firms in Nigeria.

 

 

                                                J.U.J, ONWUMERE. PhD

                                                          OKOYEUZU CHINWE.

 

Abstract: The purpose of this study is to carry out empirical testing using dynamic panel data methodology, to analyse the relationship between corporate taxation and debt. The choice of  Nigeria is that Nigeria  economy is a strong force in Africa. We adapt a standard model of capital choice under corporate taxation. We controlled for other leverage determinants.  Our dataset covers a cross-section of 60  quoted firms from Nigerian stock markets over a ten year period (1996-2005), we find that firm's debt ratio decreases with  corporate tax rate. our results reveal that tax benefit of debt approximately equals 15 percent of firm value. Paradoxically, the regression results presented indicate that the tax rate (ﺡ) is insignificant in the borrowing decisions of firms because our model suggests that the debt ratio is negatively associated with the corporate tax rate.

Further, we predict that the tax induced advantage of debt financing makes more sense in  countries with  well –structured and effective corporate tax practice ,if not  managers will not take serious the tradeoff argument.

   .This work contributes  to the existing body of literature in such a way that empirical result  is provided for trade off model of corporate  capital structure where companies borrow to take advantage of tax benefits of debt. Using data from an emerging market this paper provides an important insight on the international debate on Debt and Taxes.

INTRODUCTION:

Capital structure has aroused intense debate in the financial management areas for a long time. since the seminal work of Modigliani and Miller(1958),the basic question of whether a unique combination of debt and equity capital maximizes the firm value, and if so, what factors could influence a firm's optimal capital structure have been the subject of frequent debate in the capital structure literature.

         

The primary responsibility of the corporate financial manager is to make the investment and financing decisions. The basic corporate profits tax allows companies to deduct interest payments but not dividends in their calculation of taxable income, adding debt to a firm's capital structure lowers its expected tax liability and thereby increase its after-tax cash flow. The argument of corporate taxes assumes that there are no personal taxes, that corporations are taxed but interest payments on debt are tax deductible ,while dividend payments on  equity are not; that there is always  enough profit to make interest  valuable from atax perspective. That is, the taxable profit before interest and tax is always greater than the interest expenses so that the interest leads to a lower tax bill.  if there were only a corporate profit tax and no individual taxes on the returns from corporate securietes, the value of  a debt –financed company would equal that of an identical all-equity firm plus the present value of its interest tax shield. Therefore, this tax effect encourages debt use by the firm, as more debt increases the after tax proceeds go to the owners (Modigliani and miller 1963,miller,1977)

There have been numerous empirical studies of the impact of taxation on corporate financing decisions in the major industrial countries. Some are concerned directly with tax policy .for example Graham (2000) Mackie-Mason(1990)studied the tax effect on corporate financing decisions. The study provided evidence of substantial tax effect on the choice between debt and equity .He concluded that changes in the marginal tax rate for any firm should affect financing decisions when already exhausted (with loss carry forwards)or with a high probability of financing a zero tax rate, a firm with high tax shield is less likely to finance with debt. The reason is that tax shields lower the effective marginal tax rate on interest rate deduction. The empirical question which many researchers investigate borders on whether tax-shield, which constitutes the core basis for the choice of debt financing directly or inversely influence corporate financial leverage decisions. While some results reveal some form of positive relationship, others find instead that the relationship is a negative one. The main objective of this paper therefore is to determine the significance of the marginal corporate tax in explaining observed leverage ratios amongst firms in Nigeria.

To empirically investigate this , we use a cross section of 60firms compiled from  the Nigerian stock market. We regressed the debt ratios on our variable of interest (the statutory corporate tax rate) along with other determinants suggested in the literature.

The rest of this paper is organized as follows, the next section gives a review of related literature .section 3 presents the methodology..section 4 presents the empirical results while we summarized  our main findings in section 5

 

Literature  on capital structure

The capital structure of a firm is actually a specific mixture of debt and equity a firm employs in financing its operation. The capital structure decision is crucial for any business organization. The decision is important because of the need to maximize returns as well as being able to compete with environment. The key division in capital structure is between debt and equity. the proportion debt finding is measured by gearing or leverage .There  are different factors that affect a firm's capital structure, and a firm should attempt to determine what is optimal, or best, mix of financing

Brealey and Myers(2003)contend that the choice of capital structure is fundamentally a marketing problem. They state that the firm can issue dozens of distinct securities in countless combinations, but it attempts to find the particular combination that maximizes market value. In an attempt to set a capital structure that maximizes overall market value, firms do differ with regard to their capital structure. that is why there are various theories to explain the capital structure  of firms. Three main theories currently dominate the capital structure debate namely tradeoff, the pecking order theory and agency theory

The static trade off theory usually regards a firm's optimal debt ratio as determined by a trade off of the costs and benefits of borrowing holding the firm's assets and investment plans constant. The firm is portrayed as balancing the value of interest tax shields against various costs of bankruptcy or financial embaressment.the firm is supposed to substitute debt for equity or equity for debt until the value of the firm is maximized. Thus as noted by Beattie et,al(2004),in the trade off theory, companies are said to operate with a target debt/equity ratio at which the costs and benefits of issuing debt are balanced.

Theories of target leverage also suggest that high profitability could be associated with high target debt ratio. such association may arise for a number of reasons.example,other things equal, higher profitability implies potentially higher tax savings from debt, lower probability of bankruptcy, and potentially higher over investment, all of which imply a higher target debt ratio, if target leverage is important ,then firms with high profitability will issue debt, rather than equity and will have higher observed debt ratios.

 

The pecking order theory of capital structure says that firms do not have a target amount of debt in mind but that the amount of debt financing employed depends on the profitability of the firm. Firms will use funds from the following sources in order, until that source is exhausted or the cost of that source becomes too high.-retained profits, debt financinig,equity financing. This is based on the assumption that managers act in favour of the interest of existing shareholders. As a consequence, they refuse to issue undervalued shares unless the value transfer from old to new shareholders is more than offset by the net present value of the growth opportunity. This leads to the conclusion that new shares will only be issued at a higher price than that imposed by the real market value of the firm.Therfore,investors interpret the issuance of equity by a firm as signal of overpricing. If external financing is unavoidable, the firm will opt for secured debt as opposed to risky debt and firms will only issue common stocks as a Last resort.Myers and majluf(1984),maintain that firms would prefer internal sources to costly external finance .thus according to pecking order hypothesis,firms that are profitable and therefore generate high earnings are expected to use less debt capital than those that do not generate high earnings.

AGENCY COSTS AND CAPITAL STRUCTURE

Any model in which managers have objectives different from those of shareholders is an agency model. More generally, agency theory deals with conflicts between stakeholders especially between bondholders and stockholders The basis of the agency theory is on the advocacy for the need to control management excesses, especially as it concerns the pursuit of personal interests.(Simerly and Li,2000)

The agency cost theory proposes that the higher level of debt increases shareholder's value by transferring risk to creditors and having managers allocate cash for debt payment rather than for suboptimal or excessive investments Jensen and MECKLING(1976).under this theory, there are two kinds of inherited conflicts of interests: managers –shareholder conflict and creditors-shareholder conflict,Jensen and Meckling (1976),maintain that managers also always act in their own economic interests. The managers' interests however, can agree with shareholders interests when managers' compensation is tied to the company's performance. The two stakeholders' interests can usually converge during takeover threats.therfore, the manager-shareholder conflict can be ultimately minimized. When conflicts arise between debt and equity investors, managers have common interests with shareholders as discussed previously; managers will make business decisions for shareholders rather than for creditors.

Agency cost represents important issues in corporate governance in both financial and non financial industries. the separation of ownership and control is a professionally managed firm-one source of agency conflicts-may result in managers exerting insufficient work effort ,indulging in prequisities,choosing inputs that suit their own preferences or otherwise failing to maximize firm value. In effect, the agency costs of outside ownership equal the lost value from professional managers maximizing their own utility, rather than the value of the firm. Theory suggests that the choice of capital structure may help mitigate these agency costs .under the agency costs hypothesis, high leverage or a low equity/asset ratio reduces the agency costs of outside equity and increases firm value by constraining or encouraging managers to act more in the interests of shareholders.

Greater financial leverage may affect managers and reduce agency costs through the threat of liquidation, which causes personal losses to managers of salaries,reputation,perquisites,etc and through pressure to generate cash flow to pay interest expenses. Higher leverage can mitigate conflicts between shareholders and managers concerning the choice of investment. Myers,(1977),the amount of risk to undertake, the conditions under which the firm is liquidated and dividend policy(Stultz 1990),where as increased leverage may reduce the agency costs of outside equity, the opposite effect may occur for the agency costs of outside debt arising from conflicts between debt holders and shareholders. when leverage becomes relatively high, further increases may generate significant agency costs of outside debt from risk shifting or reduced effort to control risk that result in higher expected costs of financial distress, bankruptcy or liquidation. These agency results in higher interest expenses for firms to compensate debt holders for their expected losses. At low levels of leverage, increases will produce positive incentives for managers and reduce total agency costs by reducing the agency costs of outside equity.

     Michael Jensen and William Meckling (1976) use agency costs to argue that the probability distribution of cash flows provided by the firm is not independent of its ownership structure and that this fact may be used to explain optimal leverage. First, there is an incentive problem associated with the issuance of new debt, an agency cost of debt. Debt holders can protect themselves against expropriation by imposing constraints on the company at time a loan is made. Protective covenants and monitoring devices restrict the stockholders' ability to increase the riskiness of the company and/ or its leverage. Of course, there are costs associated with writing and enforcing such contracts.

The MM argument for the irrelevance of capital structure requires that security holders protect themselves against capital structure changes that work to erode their position. " Me-first" rules ensure that one party cannot gain at the expense of the other. Although stockholders usually gain and old debt holders usually lose, the reverse can occur. Each group ensures that its wealth is not eroded without compensation. To the extent that "me-first" rules are not effective, capital structure decisions may be relevant even in the absence of taxes and bankruptcy costs. It's instructive to note that shareholders bears monitoring costs because debt holders anticipating such costs, charge higher interest rate. The higher the probable monitoring costs, the higher the interest rate and the lower the firm value, all other things the same.

 

 

 

SECTION 111

METHODOLOGY. A cross section of 60 firms was investigated. Data was obtained from annual financial reports and securities and exchange commission over a ten year period (1996-2005) We regressed the debt ratio (defined as the ratio of total debt over total book value of debt plus the market capitalization of equity) on our variable of interest (ie)the statutory corporate tax rate  along with other controls suggested in the literature ;the non-debt tax shelter ratio (r), firm size (s), future growth opportunities (v), profitability (p), capital market conditions (m), tangible assets (c) and earning volatility (σ).  Accordingly, the theoretical model can be written in its general form as: 

          l = f (ﺡ, r, s, v,p, m, c, σ) ……….(3.1)

          This prediction approximates reality only if there has been no structural change in the parameters of the model ,otherwise the regression results would be spurious (Phillips, 1998:2001; Ferson et al, 2003).  Hence, theory and data have to be matched appropriately.  This clearly requires a more elaborate dynamic structure because firms cannot be expected to be in steady state equilibrium at every point in time.

          In other words, capital structure decisions are dynamic by nature and should be modelled as such.  The stochastic static equivalent of equation (3.1) can be written as:

Iit  = wzit + Uit                                                                  ……. (3.2) 

 

 

Where w is a 1 x n vector of coefficients and Zit is a n x 1 vector of regressor variables.  Uit represents the error term.  We assume that firms have target leverage ratios.  The proxy for these would be the estimates derived based on regressing observed debt ratios on the exogenous variables (that is, without incorporating the stochastic error term).

                            SECTION IV    RESULTS

 

 

           The  Table  below presents the results of our time-series leverage regression on our eight (8) regressors.

TABLE 1.              RESULTS OF MARKET LEVERAGE REGRESSION USING TIME SERIES DATA

Constant

Marginal tax rate (τ)

Non-debt tax shetter

(r)

Size (s)

Growth

(v)

Capital market (m)

Collateral (c)

Profitability

(π)

Earnings volatility (σ)

Std. error of estimate

R2

Adjusted R2

Durbin Watson

N

0.14

-0.01

0.75

0.09

-0.00

-0.00

-0.24

-0.03

-0.00

0.18

0.59

0.58

2.12

600

(3.05)

(-0.91)

(3.44)

(4.75)

(-1.36)

(-0.47)

(-15.42)

(-4.33

(-0.33)

 

 

 

 

 

 

TABLE 4.1b:        RESULTS OF BOOK LEVERAGE REGRESSION USING TIME SERIES DATA

Constant

Marginal tax rate (τ)

Non-debt tax shetter

(r)

Size (s)

Growth

(v)

Capital market (m)

Collateral (c)

Profitability

(π)

Earnings volatility (σ)

Std. error of estimate

R2

Adjusted R2

Durbin Watson

N

Constant

Marginal tax rate (τ)

Non-debt tax shetter

(r)

Size (s)

Growth

(v)

Capital market (m)

Collateral (c)

Profitability

(π)

Earnings volatility (σ)

Std. error of estimate

R2

Adjusted R2

Durbin Watson

N

0.27

-0.01

0.03

0.07

-0.00

-0.00

-0.21

-0.03

-0.00

0.23

0.43

0.42

1.88

600

(4.96)

(-1.53)

(0.13)

(3.07)

(-1.21)

(-0.11)

(-10.82)

(-3.59)

(-0.62)

 

 

 

 

 

 

 

A comparison of the R2 in the tables above shows that the market leverage regression is better than the book leverage regression.

The coefficients of the marginal tax rate as well as the non-debt tax shelter ratio contrasts with theoretical expectation. , marginal tax rates, seem to be insignificant in the determination of debt ratios of the sixty (60) quoted firms in our sample.

 

 

 

         

     i.        There is an inverse relationship between leverage and the marginal tax rate for the years 1996-2005 and statistically significant at ten percent (0.10) level or better for 1998-2003 and then 2005. This result contradicts the notion that firms' leverage is an increasing function of their respective tax positions. This result might suggest that the substitution effect, brought about by the existence of tax shelter substitutes, is greater than the income effect of increasing debt in order to reduce the corporate tax liability.

    ii.         

The nature of the relationship between leverage and the non-debt tax shelter ratio (r) is mixed. For 1996-1997 and 2003-2005, our results show an inverse relation in line with the De-Angelo and Masulis hypothesis. This inverse relation is consistent with the theory that firms with large non-debt tax shields have a lower incentive to use debt from a tax shield point of view, and thus consistent with our leverage – marginal tax relation in (i) above.

 

TABLE 4.2: INTERCO-RELATION MATRIX OF THE RELATION BETWEEN

MARKET LEVERAGE (ML) AND THE EIGHT REGRESSORS

 

 

ML

Τ

R

S

V

M

c

Π

Σ

 

 

 

 

 

 

 

 

 

 

 

 

ML

1.00

 

 

 

 

 

 

 

 

 

τ

-0.09

1.00

 

 

 

 

 

 

 

 

r

0.08

-0.04

1.00

 

 

 

 

 

 

 

s

-0.33

-0.06

0.32

1.00

 

 

 

 

 

 

v

-0.10

0.01

-0.05

0.02

1.00

 

 

 

 

 

m

-0.06

0.00

-0.03

-0.06

0.00

1.00

 

 

 

 

c

-0.69

0.03

0.18

0.72

0.05

0.03

1.00

 

 

 

π

-0.13

-0.01

0.05

0.13

-0.01

-0.04

0.00

1.00

 

 

σ

-0.08

-0.06

0.23

0.47

-0.09

-0.05

0.26

0.05

1.00

Sig

(1-tailed)

ML

τ

r

s

v

m

c

π

σ

 

.09

.11

.00

.06

.17

.00

.02

.12

 

 

.26

.18

.47

.48

.34

.47

.19

 

 

 

.00

.21

.30

.00

.23

.00

 

 

 

 

.40

.17

.00

.02

.00

 

 

 

 

 

.48

.23

.45

.08

 

 

 

 

 

 

.35

.26

.24

 

 

 

 

 

 

 

.49

.00

 

 

 

 

 

 

 

 

.23

 

Table 2 above indicates that the explanatory variables are not highly multi-collinear. Thus, the regression estimates in Table 1 are quite reliable.

 

4.2     THE TAX BENEFITS OF DEBT

          Surveys of the theory of optimal capital structure always start with the Modigliani and Miller (1958) proof that financing doesn't matter in perfect capital markets. The MM (1963) tax-corrected version of the capital structure theory seems to indicate debt ratio arising from tax-shield benefit of debt. Miller, (1977) argues that the corporate tax advantage of debt is counter balanced with the marginal personal tax disadvantage of debt, thereby implying leverage irrelevancy to any given firm. Miller's path-breaking contribution in this line relates to a world of differential personal taxes. In the absence of differential personal tax treatment of interest income and return on equity, the Miller formular on the gain from leverage reduces to the present value of interest tax shields when it is assumed that debt is fixed and permanent. In other words, the firm commits to maintain its current debt level and to make annual interest payments for the indefinite future.

To derive a proxy for the tax benefits of debt in the Nigerian Corporate Environment, we use  τCb.  τc represents the corporate tax rate while b represents average debt issues for the selected firms and for the ten-year period.

Mathematically

VL=Vu+ τCB

 

 

 

 

Table 3        Average market values of Outstanding Debt and Net Assets of Sample Firms (1996 – 2005)

s/n

Name of company

Average outstanding debt (bi)

Net assets (NAi)

1

2

3

4

5

6

7

8

9

10

11

12

13

14

15

16

17

18

19

20

21

22

23

24

25

26

27

28

29

30

31

32

33

34

35

36

37

38

39

40

41

42

43

44

45

46

47

48

49

50

51

52

53

54

55

56

57

58

59

60

Dunlop

R.T. Briscoe

Guinness

Nigerian Breweries

Ashaka Cement

WAPCO

First Bank (FBN)

UBA Plc

Union Bank (UBN)

CAP Plc

John Holt

Unilever

PZ Industries

UAC

7-UP Bottling Company

Cadbury

Flour Mills

Nigerian Bottling Company

May and Baker

Neimeth

Vita Foam

Mobil

Oando

Total Plc

Longman

Nestle

Texaco

Berger Paints

CFAO

First Aluminum

Julius Berger

Trans Nationwide Express

Nigerian Enamel Ware

Lennards Nigeria

Vono Products

Academy Press

Cement Co. of N/Nigeria

Poly Products Nigeria

SCOA Nigeria

Triple Gee

AVON

CAPPA AND D'ALBERTO

Northern Nig. Flour Mills

International Breweries

Alumaco Plc

Nigerian Wires and Cable

Nigerian German Chemical Plc

Glaxosmithcline Consumer

Okumo Oil

Afriprint

United Textile

Evans Medical

Morison

IPWA

Capital Oil Plc

Thomas Wyatt Plc

NCR

Presco

Costain

B.O.C. Gases

1, 231,032

845,763

2,019,007

10,241,765

2,664

10,659,102

160,646,842

105,065,122

169,523,200

244,895

1,748,200

1,750,364

1,021,851

4,244,709

1,397,129

2,740,938

5,565,057

2,603,398

230,862

476,971

364,256

2,850,103

8,619,471

232,842

119,565

159,646,835

104,765,124

1,335,030

741,763

302,640

169,222,834

444,899

1,758,602

1,550,360

1,611,853

4,234,307

10,049,100

9,881,765

2,219,057

433,963

464,236

1,297,129

5,265,007

2,640,738

2,703,598

2,650

432,871

576,942

8,419,451

319,585

464,276

10,376,951

9,252,939

10,659,502

232,842

10,119,165

10,244,895

2,845,662

38,220,488

105,065,122

3,470,421

1,514,570

46,826,773

126,111,065

13,753,664

34,470,938

207,084,034

120,951,322

220,222,800

905,555

3,297,000

33,273,409

18,931,344

10,640,361

4,876,588

27,084,404

13,911,759

36,685,639

810,816

967,944

1,854,545

29,268,428

27,793,913

27,282,966

489,430

207,084,034

120,951,322

3,670,451

1,714,177

14,955,600

219,020,864

937,509

4,295,050

32,271,309

18,903,440

11,540,341

33,570,958

124,100,060

48,837,778

810,816

1,754,044

4,977,086

15,901,750

27,063,400

34,695,648

29,268,428

27,482,966

988,948

27,993,943

489,137

1,954,551

31,967,944

25,710,810

32,297,000

26,482,966

21,489,137

26,905,585

9,514,570

109,877,881

118,951,322

 

Average outstanding debt was computed for each firm thus:

 

bi       =        n=10

                   S

                   t=1     bit

                      n                                           ……………….                 (4.1)

Average market value of net assets was computed for each firm thus:

NAi    =        n=10

                                        S               NAit      ……………………………  (4.2)

                                      t=1                       

                                                 n

 

These computations are consistent with

Realdon (2006)

Given the results in Table 3 and the fact that the corporate tax rate equals

30 percent for the study period (1996 – 2005), we derive the tax benefits of debt (TD) as follows:

TD      =        τcB                       (4.3)

=        30% x N1,186,668,259

=        N356,000,477.7

In absolute terms, the tax benefits of debt for the sample firms are over Three Hundred and Fifty Six Billion Naira.

          The percentage of these benefits that is captured in net assets can also be derived:

PTD    =        356000477.7

                   2430910613

          =        14.6%

Given that the values of net assets are equivalent to aggregate market valuation of firms; our results reveal that tax benefit of debt approximately equals 15 percent of firm value.

          V     SUMMARY AND CONCLUSIONS

The Nigerian Government taxes corporate income, but interest is tax-deductible expense. A taxpaying firm that pays an extra naira amount of interest receives a partially off setting "interest tax shield" in the form of lower taxes paid. Financing with debt instead of equity increases the total after-tax return to debt and equity investors, and should increase firm value. The present value of interest tax shields could be a very big number. Using a convenient proxy for this variable, we estimate about Three Hundred and Fifty Six Billion Naira as the tax shield advantage for our sample firms over the study period. This amount represents about 14.6 percent of the average market value of sample firms. This calculation hinges on the assumptions that debt is fixed and permanent, that corporate income is taxed at 30 percent statutory rate and that firms remain profitable to have enough income to shield from taxes. These calculations may be seen as remote upper bounds if the underlying assumptions do not hold. First, the firm may not always be profitable, so the average effective future tax rate is less than the statutory rate. Second, debt is not fixed and permanent. The literature on debt maturity structure is well recognized in empirical research (especially in alleviating manager-shareholder agency conflicts). Refer to Datta et al (2005).

   There is a near-consensus, among both  practitioners and economists, that there is a  significant tax incentive for corporate borrowing. Therefore, we should observe corporations borrowing to exploit interest tax shields. If there were no offsetting costs, they would attempt to shield as much taxable income as possible

 

The weakness and complexities in the Nigerian tax practice has been reported by (CITN 2002:14). They urge that both personal and corporate tax administration in Nigeria today does not measure up to appropriate standards. The traditional tax arguments for debt financing makes more sense in countries with well – structured and functional corporate tax practice. The practice is beseeched by gross in efficiency which poses less incentive for corporate decision despite the fact that we report the tax benefit of debt to be as high as 14.6 percent of firm value.

          Our result might suggest that the substitution effect, brought about by the existence of tax shelter substitutes, is greater than the income effect of increasing debt in order to reduce the corporate tax liability. Capital allowance, rather than depreciation, is recognized as a tax – deductible expense in Nigeria also constitutes one of the key reasons for the identified corporate capital structure behavior among quoted firms.

         

 

 

 

 

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Corporate Tax and Capital Structure IN AN EMERGING MARKET : An empirical analysis of Quoted firms in Nigeria.

 

 

                                                J.U.J, ONWUMERE. PhD

                                                          OKOYEUZU CHINWE.

 

Abstract: The purpose of this study is to carry out empirical testing using dynamic panel data methodology, to analyse the relationship between corporate taxation and debt. The choice of  Nigeria is that Nigeria  economy is a strong force in Africa. We adapt a standard model of capital choice under corporate taxation. We controlled for other leverage determinants.  Our dataset covers a cross-section of 60  quoted firms from Nigerian stock markets over a ten year period (1996-2005), we find that firm's debt ratio decreases with  corporate tax rate. our results reveal that tax benefit of debt approximately equals 15 percent of firm value. Paradoxically, the regression results presented indicate that the tax rate (ﺡ) is insignificant in the borrowing decisions of firms because our model suggests that the debt ratio is negatively associated with the corporate tax rate.

Further, we predict that the tax induced advantage of debt financing makes more sense in  countries with  well –structured and effective corporate tax practice ,if not  managers will not take serious the tradeoff argument.

   .This work contributes  to the existing body of literature in such a way that empirical result  is provided for trade off model of corporate  capital structure where companies borrow to take advantage of tax benefits of debt. Using data from an emerging market this paper provides an important insight on the international debate on Debt and Taxes.

INTRODUCTION:

Capital structure has aroused intense debate in the financial management areas for a long time. since the seminal work of Modigliani and Miller(1958),the basic question of whether a unique combination of debt and equity capital maximizes the firm value, and if so, what factors could influence a firm's optimal capital structure have been the subject of frequent debate in the capital structure literature.

         

The primary responsibility of the corporate financial manager is to make the investment and financing decisions. The basic corporate profits tax allows companies to deduct interest payments but not dividends in their calculation of taxable income, adding debt to a firm's capital structure lowers its expected tax liability and thereby increase its after-tax cash flow. The argument of corporate taxes assumes that there are no personal taxes, that corporations are taxed but interest payments on debt are tax deductible ,while dividend payments on  equity are not; that there is always  enough profit to make interest  valuable from atax perspective. That is, the taxable profit before interest and tax is always greater than the interest expenses so that the interest leads to a lower tax bill.  if there were only a corporate profit tax and no individual taxes on the returns from corporate securietes, the value of  a debt –financed company would equal that of an identical all-equity firm plus the present value of its interest tax shield. Therefore, this tax effect encourages debt use by the firm, as more debt increases the after tax proceeds go to the owners (Modigliani and miller 1963,miller,1977)

There have been numerous empirical studies of the impact of taxation on corporate financing decisions in the major industrial countries. Some are concerned directly with tax policy .for example Graham (2000) Mackie-Mason(1990)studied the tax effect on corporate financing decisions. The study provided evidence of substantial tax effect on the choice between debt and equity .He concluded that changes in the marginal tax rate for any firm should affect financing decisions when already exhausted (with loss carry forwards)or with a high probability of financing a zero tax rate, a firm with high tax shield is less likely to finance with debt. The reason is that tax shields lower the effective marginal tax rate on interest rate deduction. The empirical question which many researchers investigate borders on whether tax-shield, which constitutes the core basis for the choice of debt financing directly or inversely influence corporate financial leverage decisions. While some results reveal some form of positive relationship, others find instead that the relationship is a negative one. The main objective of this paper therefore is to determine the significance of the marginal corporate tax in explaining observed leverage ratios amongst firms in Nigeria.

To empirically investigate this , we use a cross section of 60firms compiled from  the Nigerian stock market. We regressed the debt ratios on our variable of interest (the statutory corporate tax rate) along with other determinants suggested in the literature.

The rest of this paper is organized as follows, the next section gives a review of related literature .section 3 presents the methodology..section 4 presents the empirical results while we summarized  our main findings in section 5

 

Literature  on capital structure

The capital structure of a firm is actually a specific mixture of debt and equity a firm employs in financing its operation. The capital structure decision is crucial for any business organization. The decision is important because of the need to maximize returns as well as being able to compete with environment. The key division in capital structure is between debt and equity. the proportion debt finding is measured by gearing or leverage .There  are different factors that affect a firm's capital structure, and a firm should attempt to determine what is optimal, or best, mix of financing

Brealey and Myers(2003)contend that the choice of capital structure is fundamentally a marketing problem. They state that the firm can issue dozens of distinct securities in countless combinations, but it attempts to find the particular combination that maximizes market value. In an attempt to set a capital structure that maximizes overall market value, firms do differ with regard to their capital structure. that is why there are various theories to explain the capital structure  of firms. Three main theories currently dominate the capital structure debate namely tradeoff, the pecking order theory and agency theory

The static trade off theory usually regards a firm's optimal debt ratio as determined by a trade off of the costs and benefits of borrowing holding the firm's assets and investment plans constant. The firm is portrayed as balancing the value of interest tax shields against various costs of bankruptcy or financial embaressment.the firm is supposed to substitute debt for equity or equity for debt until the value of the firm is maximized. Thus as noted by Beattie et,al(2004),in the trade off theory, companies are said to operate with a target debt/equity ratio at which the costs and benefits of issuing debt are balanced.

Theories of target leverage also suggest that high profitability could be associated with high target debt ratio. such association may arise for a number of reasons.example,other things equal, higher profitability implies potentially higher tax savings from debt, lower probability of bankruptcy, and potentially higher over investment, all of which imply a higher target debt ratio, if target leverage is important ,then firms with high profitability will issue debt, rather than equity and will have higher observed debt ratios.

 

The pecking order theory of capital structure says that firms do not have a target amount of debt in mind but that the amount of debt financing employed depends on the profitability of the firm. Firms will use funds from the following sources in order, until that source is exhausted or the cost of that source becomes too high.-retained profits, debt financinig,equity financing. This is based on the assumption that managers act in favour of the interest of existing shareholders. As a consequence, they refuse to issue undervalued shares unless the value transfer from old to new shareholders is more than offset by the net present value of the growth opportunity. This leads to the conclusion that new shares will only be issued at a higher price than that imposed by the real market value of the firm.Therfore,investors interpret the issuance of equity by a firm as signal of overpricing. If external financing is unavoidable, the firm will opt for secured debt as opposed to risky debt and firms will only issue common stocks as a Last resort.Myers and majluf(1984),maintain that firms would prefer internal sources to costly external finance .thus according to pecking order hypothesis,firms that are profitable and therefore generate high earnings are expected to use less debt capital than those that do not generate high earnings.

AGENCY COSTS AND CAPITAL STRUCTURE

Any model in which managers have objectives different from those of shareholders is an agency model. More generally, agency theory deals with conflicts between stakeholders especially between bondholders and stockholders The basis of the agency theory is on the advocacy for the need to control management excesses, especially as it concerns the pursuit of personal interests.(Simerly and Li,2000)

The agency cost theory proposes that the higher level of debt increases shareholder's value by transferring risk to creditors and having managers allocate cash for debt payment rather than for suboptimal or excessive investments Jensen and MECKLING(1976).under this theory, there are two kinds of inherited conflicts of interests: managers –shareholder conflict and creditors-shareholder conflict,Jensen and Meckling (1976),maintain that managers also always act in their own economic interests. The managers' interests however, can agree with shareholders interests when managers' compensation is tied to the company's performance. The two stakeholders' interests can usually converge during takeover threats.therfore, the manager-shareholder conflict can be ultimately minimized. When conflicts arise between debt and equity investors, managers have common interests with shareholders as discussed previously; managers will make business decisions for shareholders rather than for creditors.

Agency cost represents important issues in corporate governance in both financial and non financial industries. the separation of ownership and control is a professionally managed firm-one source of agency conflicts-may result in managers exerting insufficient work effort ,indulging in prequisities,choosing inputs that suit their own preferences or otherwise failing to maximize firm value. In effect, the agency costs of outside ownership equal the lost value from professional managers maximizing their own utility, rather than the value of the firm. Theory suggests that the choice of capital structure may help mitigate these agency costs .under the agency costs hypothesis, high leverage or a low equity/asset ratio reduces the agency costs of outside equity and increases firm value by constraining or encouraging managers to act more in the interests of shareholders.

Greater financial leverage may affect managers and reduce agency costs through the threat of liquidation, which causes personal losses to managers of salaries,reputation,perquisites,etc and through pressure to generate cash flow to pay interest expenses. Higher leverage can mitigate conflicts between shareholders and managers concerning the choice of investment. Myers,(1977),the amount of risk to undertake, the conditions under which the firm is liquidated and dividend policy(Stultz 1990),where as increased leverage may reduce the agency costs of outside equity, the opposite effect may occur for the agency costs of outside debt arising from conflicts between debt holders and shareholders. when leverage becomes relatively high, further increases may generate significant agency costs of outside debt from risk shifting or reduced effort to control risk that result in higher expected costs of financial distress, bankruptcy or liquidation. These agency results in higher interest expenses for firms to compensate debt holders for their expected losses. At low levels of leverage, increases will produce positive incentives for managers and reduce total agency costs by reducing the agency costs of outside equity.

     Michael Jensen and William Meckling (1976) use agency costs to argue that the probability distribution of cash flows provided by the firm is not independent of its ownership structure and that this fact may be used to explain optimal leverage. First, there is an incentive problem associated with the issuance of new debt, an agency cost of debt. Debt holders can protect themselves against expropriation by imposing constraints on the company at time a loan is made. Protective covenants and monitoring devices restrict the stockholders' ability to increase the riskiness of the company and/ or its leverage. Of course, there are costs associated with writing and enforcing such contracts.

The MM argument for the irrelevance of capital structure requires that security holders protect themselves against capital structure changes that work to erode their position. " Me-first" rules ensure that one party cannot gain at the expense of the other. Although stockholders usually gain and old debt holders usually lose, the reverse can occur. Each group ensures that its wealth is not eroded without compensation. To the extent that "me-first" rules are not effective, capital structure decisions may be relevant even in the absence of taxes and bankruptcy costs. It's instructive to note that shareholders bears monitoring costs because debt holders anticipating such costs, charge higher interest rate. The higher the probable monitoring costs, the higher the interest rate and the lower the firm value, all other things the same.

 

 

 

SECTION 111

METHODOLOGY. A cross section of 60 firms was investigated. Data was obtained from annual financial reports and securities and exchange commission over a ten year period (1996-2005) We regressed the debt ratio (defined as the ratio of total debt over total book value of debt plus the market capitalization of equity) on our variable of interest (ie)the statutory corporate tax rate  along with other controls suggested in the literature ;the non-debt tax shelter ratio (r), firm size (s), future growth opportunities (v), profitability (p), capital market conditions (m), tangible assets (c) and earning volatility (σ).  Accordingly, the theoretical model can be written in its general form as: 

          l = f (ﺡ, r, s, v,p, m, c, σ) ……….(3.1)

          This prediction approximates reality only if there has been no structural change in the parameters of the model ,otherwise the regression results would be spurious (Phillips, 1998:2001; Ferson et al, 2003).  Hence, theory and data have to be matched appropriately.  This clearly requires a more elaborate dynamic structure because firms cannot be expected to be in steady state equilibrium at every point in time.

          In other words, capital structure decisions are dynamic by nature and should be modelled as such.  The stochastic static equivalent of equation (3.1) can be written as:

Iit  = wzit + Uit                                                                  ……. (3.2) 

 

 

Where w is a 1 x n vector of coefficients and Zit is a n x 1 vector of regressor variables.  Uit represents the error term.  We assume that firms have target leverage ratios.  The proxy for these would be the estimates derived based on regressing observed debt ratios on the exogenous variables (that is, without incorporating the stochastic error term).

                            SECTION IV    RESULTS

 

 

           The  Table  below presents the results of our time-series leverage regression on our eight (8) regressors.

TABLE 1.              RESULTS OF MARKET LEVERAGE REGRESSION USING TIME SERIES DATA

Constant

Marginal tax rate (τ)

Non-debt tax shetter

(r)

Size (s)

Growth

(v)

Capital market (m)

Collateral (c)

Profitability

(π)

Earnings volatility (σ)

Std. error of estimate

R2

Adjusted R2

Durbin Watson

N

0.14

-0.01

0.75

0.09

-0.00

-0.00

-0.24

-0.03

-0.00

0.18

0.59

0.58

2.12

600

(3.05)

(-0.91)

(3.44)

(4.75)

(-1.36)

(-0.47)

(-15.42)

(-4.33

(-0.33)

 

 

 

 

 

 

TABLE 4.1b:        RESULTS OF BOOK LEVERAGE REGRESSION USING TIME SERIES DATA

Constant

Marginal tax rate (τ)

Non-debt tax shetter

(r)

Size (s)

Growth

(v)

Capital market (m)

Collateral (c)

Profitability

(π)

Earnings volatility (σ)

Std. error of estimate

R2

Adjusted R2

Durbin Watson

N

Constant

Marginal tax rate (τ)

Non-debt tax shetter

(r)

Size (s)

Growth

(v)

Capital market (m)

Collateral (c)

Profitability

(π)

Earnings volatility (σ)

Std. error of estimate

R2

Adjusted R2

Durbin Watson

N

0.27

-0.01

0.03

0.07

-0.00

-0.00

-0.21

-0.03

-0.00

0.23

0.43

0.42

1.88

600

(4.96)

(-1.53)

(0.13)

(3.07)

(-1.21)

(-0.11)

(-10.82)

(-3.59)

(-0.62)

 

 

 

 

 

 

 

A comparison of the R2 in the tables above shows that the market leverage regression is better than the book leverage regression.

The coefficients of the marginal tax rate as well as the non-debt tax shelter ratio contrasts with theoretical expectation. , marginal tax rates, seem to be insignificant in the determination of debt ratios of the sixty (60) quoted firms in our sample.

 

 

 

         

     i.        There is an inverse relationship between leverage and the marginal tax rate for the years 1996-2005 and statistically significant at ten percent (0.10) level or better for 1998-2003 and then 2005. This result contradicts the notion that firms' leverage is an increasing function of their respective tax positions. This result might suggest that the substitution effect, brought about by the existence of tax shelter substitutes, is greater than the income effect of increasing debt in order to reduce the corporate tax liability.

    ii.         

The nature of the relationship between leverage and the non-debt tax shelter ratio (r) is mixed. For 1996-1997 and 2003-2005, our results show an inverse relation in line with the De-Angelo and Masulis hypothesis. This inverse relation is consistent with the theory that firms with large non-debt tax shields have a lower incentive to use debt from a tax shield point of view, and thus consistent with our leverage – marginal tax relation in (i) above.

 

TABLE 4.2: INTERCO-RELATION MATRIX OF THE RELATION BETWEEN

MARKET LEVERAGE (ML) AND THE EIGHT REGRESSORS

 

 

ML

Τ

R

S

V

M

c

Π

Σ

 

 

 

 

 

 

 

 

 

 

 

 

ML

1.00

 

 

 

 

 

 

 

 

 

τ

-0.09

1.00

 

 

 

 

 

 

 

 

r

0.08

-0.04

1.00

 

 

 

 

 

 

 

s

-0.33

-0.06

0.32

1.00

 

 

 

 

 

 

v

-0.10

0.01

-0.05

0.02

1.00

 

 

 

 

 

m

-0.06

0.00

-0.03

-0.06

0.00

1.00

 

 

 

 

c

-0.69

0.03

0.18

0.72

0.05

0.03

1.00

 

 

 

π

-0.13

-0.01

0.05

0.13

-0.01

-0.04

0.00

1.00

 

 

σ

-0.08

-0.06

0.23

0.47

-0.09

-0.05

0.26

0.05

1.00

Sig

(1-tailed)

ML

τ

r

s

v

m

c

π

σ

 

.09

.11

.00

.06

.17

.00

.02

.12

 

 

.26

.18

.47

.48

.34

.47

.19

 

 

 

.00

.21

.30

.00

.23

.00

 

 

 

 

.40

.17

.00

.02

.00

 

 

 

 

 

.48

.23

.45

.08

 

 

 

 

 

 

.35

.26

.24

 

 

 

 

 

 

 

.49

.00

 

 

 

 

 

 

 

 

.23

 

Table 2 above indicates that the explanatory variables are not highly multi-collinear. Thus, the regression estimates in Table 1 are quite reliable.

 

4.2     THE TAX BENEFITS OF DEBT

          Surveys of the theory of optimal capital structure always start with the Modigliani and Miller (1958) proof that financing doesn't matter in perfect capital markets. The MM (1963) tax-corrected version of the capital structure theory seems to indicate debt ratio arising from tax-shield benefit of debt. Miller, (1977) argues that the corporate tax advantage of debt is counter balanced with the marginal personal tax disadvantage of debt, thereby implying leverage irrelevancy to any given firm. Miller's path-breaking contribution in this line relates to a world of differential personal taxes. In the absence of differential personal tax treatment of interest income and return on equity, the Miller formular on the gain from leverage reduces to the present value of interest tax shields when it is assumed that debt is fixed and permanent. In other words, the firm commits to maintain its current debt level and to make annual interest payments for the indefinite future.

To derive a proxy for the tax benefits of debt in the Nigerian Corporate Environment, we use  τCb.  τc represents the corporate tax rate while b represents average debt issues for the selected firms and for the ten-year period.

Mathematically

VL=Vu+ τCB

 

 

 

 

Table 3        Average market values of Outstanding Debt and Net Assets of Sample Firms (1996 – 2005)

s/n

Name of company

Average outstanding debt (bi)

Net assets (NAi)

1

2

3

4

5

6

7

8

9

10

11

12

13

14

15

16

17

18

19

20

21

22

23

24

25

26

27

28

29

30

31

32

33

34

35

36

37

38

39

40

41

42

43

44

45

46

47

48

49

50

51

52

53

54

55

56

57

58

59

60

Dunlop

R.T. Briscoe

Guinness

Nigerian Breweries

Ashaka Cement

WAPCO

First Bank (FBN)

UBA Plc

Union Bank (UBN)

CAP Plc

John Holt

Unilever

PZ Industries

UAC

7-UP Bottling Company

Cadbury

Flour Mills

Nigerian Bottling Company

May and Baker

Neimeth

Vita Foam

Mobil

Oando

Total Plc

Longman

Nestle

Texaco

Berger Paints

CFAO

First Aluminum

Julius Berger

Trans Nationwide Express

Nigerian Enamel Ware

Lennards Nigeria

Vono Products

Academy Press

Cement Co. of N/Nigeria

Poly Products Nigeria

SCOA Nigeria

Triple Gee

AVON

CAPPA AND D'ALBERTO

Northern Nig. Flour Mills

International Breweries

Alumaco Plc

Nigerian Wires and Cable

Nigerian German Chemical Plc

Glaxosmithcline Consumer

Okumo Oil

Afriprint

United Textile

Evans Medical

Morison

IPWA

Capital Oil Plc

Thomas Wyatt Plc

NCR

Presco

Costain

B.O.C. Gases

1, 231,032

845,763

2,019,007

10,241,765

2,664

10,659,102

160,646,842

105,065,122

169,523,200

244,895

1,748,200

1,750,364

1,021,851

4,244,709

1,397,129

2,740,938

5,565,057

2,603,398

230,862

476,971

364,256

2,850,103

8,619,471

232,842

119,565

159,646,835

104,765,124

1,335,030

741,763

302,640

169,222,834

444,899

1,758,602

1,550,360

1,611,853

4,234,307

10,049,100

9,881,765

2,219,057

433,963

464,236

1,297,129

5,265,007

2,640,738

2,703,598

2,650

432,871

576,942

8,419,451

319,585

464,276

10,376,951

9,252,939

10,659,502

232,842

10,119,165

10,244,895

2,845,662

38,220,488

105,065,122

3,470,421

1,514,570

46,826,773

126,111,065

13,753,664

34,470,938

207,084,034

120,951,322

220,222,800

905,555

3,297,000

33,273,409

18,931,344

10,640,361

4,876,588

27,084,404

13,911,759

36,685,639

810,816

967,944

1,854,545

29,268,428

27,793,913

27,282,966

489,430

207,084,034

120,951,322

3,670,451

1,714,177

14,955,600

219,020,864

937,509

4,295,050

32,271,309

18,903,440

11,540,341

33,570,958

124,100,060

48,837,778

810,816

1,754,044

4,977,086

15,901,750

27,063,400

34,695,648

29,268,428

27,482,966

988,948

27,993,943

489,137

1,954,551

31,967,944

25,710,810

32,297,000

26,482,966

21,489,137

26,905,585

9,514,570

109,877,881

118,951,322

 

Average outstanding debt was computed for each firm thus:

 

bi       =        n=10

                   S

                   t=1     bit

                      n                                         

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