The Speed of Adjustment of Capital Structure of Nigerian Quoted Firms

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ABSTRACT: The presence of financing frictions motivates the use of dynamic panel adjustment models to describe the evolution of debt ratios and the adjustment of leverage to optimal target ratios. The purpose of this study is to investigate the pattern of capital structure and speed of adjustment of capital structure from a developing country perspective. Capital structure variation is the norm rather than the exception. Under the classical trade-off theory of capital structure, firms' optimal debt levels occur at the point where the marginal tax benefit of debt equates the marginal cost of bankruptcy but this theoretical corner solution has been challenged by a debt conservatism puzzle in both the theoretical literature (Graham, 2000) and empirical literature in Nigeria (Paseda and Adedeji, 2020; Paseda, 2021). The classic (S, s) model provides a robust framework for allowing debt ratios to drift between two tolerable (upper and lower) limits. Using a sample of 50 non-financial quoted Nigerian firms over the period 1999-2019, debt ratios exhibit strong influences from firm-level variables, confirming trade-off, pecking order and market timing predictions. With respect to macroeconomic variables, the target leverage and lower refinancing thresholds exhibit pro-cyclical behavior while the upper limit is counter-cyclical. The study breaks new grounds by shedding light on the forces driving the behavior of the refinancing spread. The refinancing spread is positively impacted by the age of the firm as well as market timing but inversely by marginal tax rate and dividend payout ratio. The direct implication is that older firms and companies whose securities' prices are more subject to volatility exhibit greater financial flexibility relative to the relatively younger counterparts. Target zone model exhibited by the classic (S, s) methodology, thus, appears a closer description of debt dynamics. An exciting feature of this (S,s) model is that it separates the influences on the target leverage from those factors that influence the upper and lower leverage thresholds such that the target is unobscured by the leverage adjustment mechanism that occurs between refinancing events. This is an advantage over nested traditional regression frameworks which represent simultaneous combination of these forces. Thus, the resulting target zone models are informative in addressing core capital structure issues such as target behavior and refinancing issues. As the empirical results show, studying refinancing limits in addition to target leverage increases the understanding of firms' financing decisions. The study implications can be generalized to markets with similar institutional characteristics such as rule of law, capital market efficiency and development, economic growth and financial depth.