DETERMINANTS OF FINANCIAL STRUCTURE EVIDENCE FROM NIGERIAN QUOTED FIRMS

ABSTRACT

The study sought to examine the determinants of financial structure of Nigeria quoted firms during the period spanning 1999 – 2014. The 15- year period accommodated several time periods and data points. The study adopted ex-post facto research design. The research work also adopted two theoretical frameworks: Pecking Order and Static Trade – off theories captured in a panel regression model. A sample of 24 firms was  selected  based  on  data  quality and  availability to  address  the requirements of the variables in the model. Five hypotheses were formulated and tested using Pooled Ordinary Least Squares (OLS) multiple regression. Results show that profitability (PRT) had a positive and significant impact on financial structure; tangible fixed asset (TAN) has a positive and significant impact on financial structure of quoted firms; growth opportunities (GRW) had a positive and significant impact on  financial  structure  of  Nigerian  quoted  firms.  Results  of  panel regression also indicate that operating risk (volatility), (OPR) had a positive and statistically significant impact on financial structure of listed firms in Nigeria. Finally, firm size (FST) which is the natural logarithm of total assets had a positive and significant impact on financial structure. Firm size was used to control possible non-linearity and prevent problem of heteroskedasticity. These findings are corroborative of theoretical and empirical predictions. For instance, employing a high proportion of a long term debt in the financial structure results in low profitability because short-term debts are less expensive, but accessible to many firms. On the basis of the entire findings, useful recommendations for optimal financial mix by managers as well as measures to enhance the management of the Nigerian Stock Exchange were made. For instance, reducing floatation costs insider abuses will enable firms to access funds easily and increase investors confidence respectively.

CHAPTER ONE

INTRODUCTION

1.1  Background of the study

In some countries, governments often give financial assistance to business firms to enable them to kick-start and sustain their operations and overcome some teething problems. Such assistance takes pre- eminence during economic recession which is often characterized by low demand for goods and services occasioned by low level of income, falling Gross Domestic Product (GDP), business failure and loss of jobs. The rationale for governments’ action in this direction are legion: to prevent corporate failure and its contagious effects; increase the Gross Domestic Product by producing goods and services for local and international consumption; maintain a desired level of employment and above all, encourage entrepreneurial development.

Financial and economic crises are known to have effects on financial structure decision of firms. For instance, Deesomak, Paudyal and Pescetto (2004) investigated the determinants of capital structure of Asia  Pacific  region  after  the  financial  crisis  that  engulfed Thailand, Malaysia and Singapore. The crisis which originated in Thailand, had a snowball effect on the region’s capital markets severely, with outflows of foreign investments as international investors become concerned with higher risk in the affected countries. Raising capital in these countries became more costly because of high risk premia, compounded by the high level of interest rates needed to support local currencies (Deesomark, et al 2004). Grenville (1999) and Chou and Ho (2002),

reported that the Asian countries were hit in different degrees by the crisis. This prompted researchers to conduct research on determinants of capital structure across the affected countries between the pre and post- crisis period to provide insights into firms’ financial decision making. In the same vein Zoppa and McMahon(2009) compared Pecking Order Theory with the financial structure of manufacturing SMEs in Australia.

Financing decisions have also been identified to have direct impact on financial structure and performance of companies. See for instance, Gupta, Srivastava and Sharma (2010), Chou and lee (2007), Schwarts and Aronsou (1979),  Booth, et al (2001), Pratheepkpanth (2001), Bas, Muradoglu and Phylaktis (2009) and Booth, Alvazian and Demirguc – Kunt (2001).

Economic and financial crises are not alien to Nigeria especially during the period spanning 1990 – 2008. See for instance, Dagogo and Ollor (2009), Olo (1991), Uche (2000), Sanusi (2003) and Soludo (2004). In every economy, the real and financial sectors complement each other in order to maintain a progressive balance (Dagogo and Ollor, 2009).

A deficiency in one sector hampers growth and development in the other. For instance, Sharpe, Alexander and Bailey (1995) argued that there exists a strong relationship between highly developed financial sector and real sector investment. In Nigeria, however, evidence shows that both sectors are not so symbiotic such that the financial sector milk

– dries the real sector. Thus, funds meant for real sector development

are channeled to non-productive sectors. Soludo (2004) and Sanusi

(2003) observed that banks declare huge profits even as factories close down, simply because Nigeria banks were less responsible to long-term financing than they were to short–term trade financing and foreign on exchange deals.

Dagogo and Ollor (2009), have observed that the failure of previous financial policies of government to achieve desirable economic growth was  a  concern that demands restructuring of  the  Nigerian system, especially in the glare of an ailing economy. Thus, the introduction of the Structural Adjustment Programme (SAP) in 1986 and the privatisation programme in 1989 were in response to failed institutional measures to promote growth in the industrial sector. Uche (2000) is of the view that SAP was designed to achieve balance of payment viability by altering and restructuring the production and consumption patterns of the economy, eliminating price distortions, reducing the heavy dependence on consumer goods, imports and crude oil exports, enhancing the non-oil export base, rationalising the role of the public sector,  accelerating the  growth  potential  of  the  private  sector and achieving sustainable growth. To achieve these objectives, the main strategies of the programme were the adoption of a market exchange rate for the Naira, the deregulation of external trade and balance of payment  arrangements,  reduction  in  the  price  and  administrative control and more reliance on market forces as a major determinant of economic activity. In the same vein, Ojo (1991) pointed out that government’s reasons for deregulation of the economy were legion: stagnant growth, rising inflation, unemployment, food shortage and mounting external debt.

The corporate sector remains the engine room of growth and development of all economies. Abor (2008) observed that corporate sector growth is vital to economic development.

While acknowledging the role of small and medium scale enterprises in the Nigerian economy, Yerima and Danjuma (2007) pointed out that these enterprises have been identified as the means through which rapid industrialization, job creation, poverty alleviation, and other developmental goals are realized. Again, Abor (2008) asserts that it is imperative for firms in developing countries to be able to finance their activities and grow overtime if they are ever to play an increasing and predominant role in providing employment as well as income in terms of profits, dividends and wages to households. Firms earn economic gains or rents from strategic assets which are financed by debt or equality. Kochhar (1997) affirms that strategic assets provide a firm with a source of steady stream of rents so that it gains a sustained competitive advantage over its rivals. Thus, it is the stock of strategic assets that is important in determining a firm’s profitability level.

Increasingly, business people are seeking to manage companies in a strategic manner. The strategic model of the firm argues that improved firm performance occurs when the firm’s managers select strategic goals and all of the activities of the firm are directed towards meeting those goals. Therefore, the financial strategy of the firm should be consistent with the firm’s strategic objectives (Prasad, et al,1997).

Again, Kochhar (1997) asserts that the nature of the firm’s assets predicts efficient ways of organising transactions. Varying characteristics

of assets imply different levels of optimal capital mix of debt and equity. If the transactions with suppliers of finance are not organised as per these predictions, the ability of firms to obtain a competitive advantage over their rivals maybe impaired (Hennart, 1994).

It suggests, therefore that the capabilities in managing financial policies are important if a firm is to realise gains from its specialized resources; poor capital structure decisions lead to a possible reduction/loss in the value derived from strategic assets (Kochhar, 1997).

In the presence of uncertainty, bounded rationality and opportunism, contracts that completely safeguard an investment cannot be designed. This leads to organising costs for the firm, as is the case for other economic activities. These organising costs are a function of the institutional and environmental constraints (Williamson, 1991). It  is important to note that different countries have different institutional arrangements, mainly with respect to their tax and bankruptcy codes, the  existing market for corporate control  and the  roles  banks and securities markets play (Pratheepkpanth, 2011).

The choice between two governance structures depends on the comparative costs for organising a particular transaction, for instance, financing a particular investment (Kochhar, 1997). As Williamson (1991) argued, it is the characteristics of assets under consideration that affect costs under alternative governance structures. Alternative governance structures are referred to debt and equity. The variation in the benefits of the two instruments and their ability to monitor and evaluate managerial actions according to Berglof (1990) and Williamson (1988)

imply that debt and equity can be considered as alternative governance structures. A firm has the option to choose either one when financing a new investment. The debt-to-equality ratio, therefore is the result of transactions with potential debt-holders and equality holders. These transactions come about with the formation of explicit or implicit contracts that  delineate the  benefits and  resource available to  the suppliers of finance (Jensen and Meckling, 1976). The benefits available represent  the  property  rights  due  to  their  claims  over  the  return streams (from the assets). This recourse available is in the form of their control rights over management actions (Kochhar, 1997).

There are two basic concepts involved in financing firms’ assets – capital structure and financial structure. Capital structure is most applicable to developed economies because the financial markets are efficient and near perfection. Whereas financial structure is applicable to less developed financial markets typical of developing economies.

Firms have choices to raise their capital by various means including internally generated funds equity issues and various types of debts. The decision to select sources of finances is referred to as financial structure decision. Financial structure decision is very critical decision with great implications for the firm’s performance. Theories proposed by the researchers to explain the financing decisions have been subject of considerable debate (Amjed, 2010). Internal funds allow companies to utilize gained profit for financing. It means that instead of dividends distribution, they use profit for the company’s operation in order to have higher return. In contrast, external financing companies use debt and issue securities (Titman and Gronblati, 1998).

A process which leads to final decision of combining equity and debt (short and long – term) is called financial structure determining method. Methods of determining financial structure should be chosen with particular attention to the main features of securities influenced by internal factors within the  firm  or other external  factors (Esfaheni,

2006).

Financial managers chose policies related to the financial structure of firms for increasing stockholders’ wealth; they also consider solutions such as debtor equity increase for financing their projects (Asghari

2009).

The aim of determining financial structure is to distinguish structure of financial fund in order to minimize shareholders’ wealth (Akparpour and Aghabeygzadeh, 2011).

The more bonds a firm issues, the higher will be its breakdown point and leverage. Otherwise, the profit per share will decline, therefore, financial managers measure different impacts on different financial structures on shareholders’ wealth (Reynor, 2006.

According to William (1991), the financing structures of debt and equity can be compared with respect to the characteristics of control and property rights. The debt instrument carries with it fixed rules and covenants that usually monitor the lending process. The repayment schedule of the principal loan amount and the interest payment are

stipulated in the contract, with debt holders having primary claim over the firm’s cash flows from the assets. The firm is often required to meet liquidity tests to ensure that lender’s investment is not jeopardized. Equity owners, on the other hand, have a residual claimant status over the cash flows from asset earnings and assets liquidation. That is, they obtain the cash flows from asset earnings and assets liquidation. That is, they obtain the cash flows that are left after paying off more senior claims such as debt. Thus, equity holders have weaker property rights, similar to hierarchical control (Williamson, 1991).

Therefore, debt increases creditors’ claims and equity increases owners’

claims on the organisation. The owners’ claim increase when a firm issues shares to raise capital or pay dividends in form of bonus shares. On the other hand, the creditors’ claims increase when a firm borrows on both short and long-terms.

Hovakimian, Opler and Titman (2001) tested the hypothesis that firms tend to a target ratio when they either raise new capital or retire or repurchase existing capital. They argued that firms should use relatively more debt to finance assets in place and relatively equity to finance growth opportunities. Booth, Alvanzian, Demirguc-Kurt and Maksimovic (2001) noted, in general, highly profitable slow-growing firm should generate more cash, but less profitable fast-growing firms will need significant external financing. They averred that there maybe link with the agency cost argument if the existence of strong investment opportunities is correlated with current levels of profitability.

Prasad, et al (2001) argued that growing SMEs will contribute in expanding the size of the direct productive sector in the economy;

generating tax revenue for the government; and in facilitating poverty reduction through fiscal transfers and income from employment   and firm ownership.

Firms must accumulate capital for growth and survival. To understand how  firms  in  developing  countries  such  as  Nigeria  finance  their activities, it is necessary to examine the composition of their capital, hence the focus on financial structure in this study.

The capital of any business firm is the foundation upon which the business operates. Capital absorbs losses, multiplies fixed assets, and in all, enhances growth through mergers and acquisitions.

The decision to combine equity, long-term and short-term debts as the capital mix is called financial structure. When financing their activities, firms, especially those with limited liabilities, combine debt and equity. Equity capital includes common and preference shares while debt includes such instruments as long-term loan stock, mortgage and debenture bonds. The combination of long-term interest bearing obligations and equity is referred to as capital structure. This work is not centered on capital structure decision. However, attempts have been made to explain the concept – capital structure. It refers to the mix of long-term sources of funds, such as debentures, long-term debts, preference share capital and equity share capital including reserves and surpluses (i.e. retained earnings) (Pandey, 2000). Teker, et al (2009) explained that the capital structure of a company consists of a particular combination of debt and equity issues to relieve potential pressures on its long-term financing. To examine such issues, many theories have

been developed in the literature and they generally focus upon what determinants are likely to influence the so-called leverage decisions of the firms. Among these, the Modigliani and Miller (MM) theory, trade-off theory, pecking order theory or signally theory have been said to mainly play a crucial role in identifying and testing the various properties of the leverage decisions (Teker, et al 2009).

Dagogo and Ollor (2009) explained that the capital structure of a firm involves  decisions  about  debt  and/or  equity  financing,  and  the implication that higher leverage increases value seems to be more applicable to large corporations than to fledglings. Usually, at the early stage preference is given to survival and sustainability, in which case the first rule is to employ the structure that does not expose the enterprise to overbearing financial obligation during period of low cash flow and low return on assets. They argued that debt financing is cheaper only with mature businesses or businesses with high initial cash inflow.

Longenecker, Moore and Petty (1997) argued that financial structure decision depends on the type of business, the firm’s financial strength, and the current economic environment. It also involves tradeoffs about potential profitability, financial risk and voting control. Debt financing involves fixed interest bearing instruments or obligations, the payment of which takes precedence over other financial claims to the enterprise. See for instance, Price and Allen (1998) and Hiscrich and Peters (1998).

Financial structure decision is a very strategic managerial decision. This is because it influences the shareholders’ risk and return, consequently the market value of the firm. Inability to plan firms’ financial structure develops as a result of the financial decisions taken by the financial managers.  Such  companies  with  unplanned  capital  structure  may flourish in the short run, but ultimately they may encounter severe financial crises. The adage, “he who fails to plan, plans to fail” is a pointer to this argument. Failing to plan implies that these companies may not be able to utilise the accounting principle of conservatism in the management of their funds. Pandey (2000) argued that it is being increasingly realized that a company should plan its capital structure to minimise the use of the funds in order to adapt more easily to the changing macroeconomic conditions surrounding businesses.

Most empirical studies on the determinants of capital structure have been based on data from developed economies. For instance, Devan and Danbolt (2000 and 2002) utilized data from the UK. Similarly, Antoniou, Guney and Paudyal (2002) analysed data from the UK, Germany and France while Hall, Hutchinson and Michaelas (2004) obtained data from European SMEs. There are a few studies which have provided evidence from developing economies. In this category are, Booth, Aivazian, Demirguc-Kunt and Maksimovic (2001) who utilised data from ten developing countries, viz: Brazil, Mexico, India, South Korea, Jordan, Malaysia, Pakistan, Thailand, Turkey and Zimbabwe; Abor (2008) combined data from Ghanaian quoted firms and SMEs; Pandey (2001) used data from Malaysia, Chen (2004) utilised data from China;  Al-Sakran  (2001)  analysed  data  from  Saudi  Arabia  while Buferna, Bangassa and Hodgkinson (2005) concentrated on data obtained from Libya. The present study is restricted to the Nigerian business environment which is typical of a developing economy. Booth,

Aivazian,  Demirguc-Kunt  and  Maksimovic  (2001)  identified  unique factors  that  affect  leverage  ratios  in  developed  and  developing countries, thus; In general, debt ratios in developing countries seem to be affected in the same way and by the same types of variables that are significant in developed countries. However, there are systematic differences in the way these ratios are affected by country factors, such as GDP growth rates, inflation rates, and development of capital markets.

In  the  developing  economies  such  as  Nigeria,  financial  structure decisions are taken based on the level of development of the domestic markets. Amjed (2008) observed that financial markets are complete almost perfect in developed counties. Therefore, parameters for making financial structure decisions are mainly the cost benefits of a particular source of financing these countries. Whereas in developing countries, financial markets are not fully capable of meeting the financial needs of the corporate sector. Non conventional securities particularly debt securities are not warmly welcomed by the markets. Therefore, firms rely on the commercial bank loans and lease financing as source of debt. With this challenge, the firms in developing economies have to balance their capital structure in such a way that short term sources of financing are inclusive.

In Nigeria, there is little or no empirical work on the determinants of financial structure among quoted firms. Available empirical works are on the determinants of capital structure. However, Odedokun (1995) showed the influence of dividend policy and investment spending on

financing decisions of non-financial firms in Nigeria. In the same vein, Adesola (2009) tested static trade-off theory against Pecking order models of capital structure among quoted firms in Nigeria. See also for example, Olatundun (2002), Abel (2010) and Abel and Okafor (2011). In each case, the researchers utilised familiar determinants such as firm size, non-debt tax shield, growth opportunities, profitability (return on assets) and tangibility of assets.

Additionally, Olowoniyi, Akinleye and Afolabi (2012), and Owolabi(2012) attempted an analysis of the determinants of capital structure  of listed Nigerian firms. Although, capital structure describes the appropriate relationship between debt and equity. Equity includes paid-up-share capital, share premium and reserves and surplus (retained earnings) while long-term debts include debenture, fixed income securities, mortgage and debenture bonds.

Because  of  absence  of  long-term  debts  in  financial  markets  of developing economies, some authors and scholars alike  attempt to include short-term debts in their analysis of capital structure. If this is the case, it is better to analyze the determinants of financial structure. Therefore, this work will include short-term debts or liabilities hence, the title financial structure.

1.2  Statement of the Problem

Financial structure decisions are one of the most contentious areas in corporate finance. The issue in contention revolves around the optimal financial mix. There are two schools of thought in this regard. One school of thought called the traditional theory advocates for optimal

financial structure and the other opposes it.  The former school argues that judicious use of debt and equity capital can maximise the value of the firm. The latter school of thought led by Modigliani and Miller (1958) contended that financing decision does not affect the value of the firm because the value of the firm depends on the underlying profitability and  investment  risk.  That  is,  under  the  perfect  capital  market assumption of no bankruptcy cost and frictionless capital markets; if no taxes, the firm’s value is independent of the financial structure.

In developing countries such as Nigeria, financing decisions are taken based on the level of development of the domestic markets. Firms in developing countries rely on commercial bank loans and lease financing as major sources of debt. It behoves on researchers in such countries to analyse the determinant of financial structure of firms instead of capital structure because of the limitations of the domestic markets. In view of the peculiarity of the Nigerian financial market and the necessity to split the financial mix of debt and equity in order to support a company’s operations, hence to maximise its market value, What are the critical factors  determining  the  financial  structure  of  a  given  company  in Nigeria? Therefore, what is the impact of profitability, tangibility, volatility, growth opportunities and firm size on the financial structure of listed firms in Nigeria?

1.3  Research Objectives

The broad objective of the work was to analyze the determinants of financial structure of listed firms in Nigeria.

The specific objectives of the research were:

1. To examine the impact of profitability on the financial structure of quoted firms in Nigeria.

2. To assess the effect of tangible fixed assets (tangibility) on the financial structure of quoted firms in Nigeria.

3. To examine the impact of growth opportunities on the financial structure of quoted firms in Nigeria.

4. To evaluate the impact of operating risk (volatility) of Nigerian quoted firms on financial structure.

5. To appraise the effect of firm size on the financial structure of quoted firms in Nigeria.

1.4  Research Questions

In line with the specific objectives, the following questions were raised:

1. To what extent does profitability impact on the financial structure of Nigerian quoted firms?

2. To what extent do tangible fixed assets impact on the financial

structure of Nigerian quoted firms?

3. How far do growth opportunities influence the financial structure of Nigerian quoted firms?

4. To  what  extent  does  operating  risk  impact  on  the  financial structure of quoted firms in Nigeria?

5. To what extent does firm size impact on the financial structure of quoted firms in Nigeria?

1.5  Research Hypotheses

To reaffirm or refute the relationship between variables in the previous researches, the following null hypotheses were formulated to guide the study;

1. Ho:  profitability  of  quoted  firms  in  Nigeria  has  no  significant positive effect on financial structure.

2. Ho: Tangible fixed assets (tangibility) of quoted firms in Nigeria have no significant positive impact on firms’ financial structure.

3. Ho: Financial structure is not positively and significantly influenced by growth opportunities of Nigerian quoted firms.

4. Ho: Operating risk (volatility) does not have a significant positive impact on the financial structure of Nigerian quoted firms.

5. Ho: Firm size does not have a significant positive impact on the financial structure of Nigerian quoted firms

1.6  Scope of Research

In terms of scope, this study will adopt a single-country survey as evident in Turkey, Ghana, Australia, Sweden and Greece etc. The study focuses on the period spanning 1999 – 2014. This period is significant in respect of the government multiple economic reforms and programmes. The study collated and analyzed data from quoted firms on the Nigerian Stock Exchange (NSE).

1.7  Significance of the Study

Firms, whether small, medium or large, contribute immensely to economic  growth  and  development.  Considering  the  strategic  role

played by these manufacturing firms, this work is significant in many respects. The work will have impact on the following stakeholders:

    Scholars, researchers and students: basically, the work provides

empirical evidence to support popular capital structure theories propounded by scholars and researchers alike. This is because the work is a test of the workability of existing theories such as Pecking Order and  Static  Trade-off  theories.  It  would form  a  basis for further research because there exists knowledge gap in every piece of research.  Since  the  research  will  conform  to  the  standard procedure called research methodology, it would enable other research students to evaluate their works or researches.

      Academics: it would contribute to the endless academic debate on the determinants of capital structure, hence optimal capital mix  of  debt  and  equity.  This  is  the  most  critical  area  in corporate financial management.

      Managers of business firms:  the work would become a working paper for managers who seek solution to their leverage decisions and the factors that should influence such decisions.

      Monetary policy and development agents of the government: it would aid the government in the formulation of policies and programmes that will enable firms to accumulate capital and sustain their operations. The national economic management team will also benefit from this work as it will contribute to the actualisation of government macroeconomic objectives of economic  growth,  price  stability  and  employment  creation.

Guided  by  the  recommendations, corporate  failure  and  its attendant consequences on the economy will be prevented.

      Professionals:     these     include     economists,     bankers, accountants, stockbrokers and lawyers. This work will enable them to guide their clients who beseech them daily on financial management issues.

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