SECTOR ANALYSIS OF CAPITAL STRUCTURE AND FIRM PERFORMANCE IN NIGERIA 1997-2012

ABSTRACT

The purpose of this study is to empirically analyze the impact of capital structure on firm’s performance in Nigeria; A sector by sector analysis. The annual financial statements of 15 firms listed on the Nigerian Stock Exchange from Four (4) sectors of the Nigerian economy were used for this study which covered the period between  1997-2012. Multiple regression analysis was applied on performance indicators such as Return on Asset (ROA) as well as Short-term debt to Total assets (STDTA), Long term debt to Total assets (LTDTA) and Total debt to Equity (TDE) as capital structure variables. The hypotheses were tested with ordinary least square regression estimation technique and analyzed. Generally, the results showed a negative and  non-significant  impact of capital structure on firm’s performance. The study therefore, concludes  that  statistically,  capital  structure  is  not  a  major  determinant  of  firm  performance.  It recommends that managers of firms should exercise caution while choosing the amount of debt to use in their capital structure as it affects their performance negatively. That firms should try to finance their activities with retained earnings and use debt as a last option as this is consistent with the pecking order theory.  Finally,  the  study strongly recommends  that  firms  should  use  more  of equity  than  debt  in financing their business activities, this is because in spite of the fact that the value of a business can be enhanced with debt capital, it gets to a point that it becomes detrimental (negative) or unfavorable to the business.

CHAPTER ONE

INTRODUCTION

1.1      Background to the Study

Capital structure is one  of the  finance topics among the  studies of researchers and scholars. Its importance derives from the fact that capital structure is closely related to the ability of firms to fulfil the needs of various stakeholders. Capital structure represents the major claims to firm’s assets. This includes the different types of both equities and liabilities. Capital structure of a firm is such a vital factor that it enhances its performance (Uremadu and Efobi, 2012). A firm’s capital structure refers to the mix of its financial liabilities. It has been an important issue from the strategic management standpoint since it is linked with a firm’s ability to meet the demands  of  various  stakeholders.  Capital  structure  is  the  most  significant  discipline  of company’s operations. Capital structure decision is a vital decision with great implication for the firm’s sustainability. The ability of the organization to carry out their stakeholders need is closely related to the capital structure. The determination of a company’s capital structure is a difficult task to achieve. According to Uremadu (2004) capital structure of a firm includes retained earnings, debt and equity. This is in agreement with Pandey (2010) which states that the term capital structure is used to represent the proportionate relationship between debt and equity. Equity includes paid-up share capital, share premium and reserve and surplus (retained earnings).

Capital structure has been a major issue in financial economics ever since Modigliani and Miller  showed  in  1958  that  given  frictionless  markets,  homogeneous expectations;  capital structure decision of the firm is irrelevant. By relaxing the assumptions and analyzing their effects, theories seek to determine whether an optimal capital structure exists or not, and if so what could possibly be its determinants. The relationship between capital structure decisions and firm value has been extensively investigated in the past few decades. Capital structure could have two effects; according to Desai (2007) firms of the same risk class could possibly have higher cost of capital with higher leverage. Also, that capital structure may affect the valuation of the firm, with more leveraged firms, being riskier and consequently valued lower than the less leveraged firms. If the manager of a firm has the shareholders’ wealth maximization as his

objective, then capital structure is an important decision, for it could lead to an optimal financing mix which maximizes the market price per share of the firm.

Every business whether newly born or an ongoing, requires fund to carry out its activities as no success is achievable in the absence of fund. The needed fund may be for daily running of a firm or for business expansion. This tells how important fund is in the life of every business. This fund is referred to as capital. Capital therefore refers to the means of funding a business. Firms that are willing to raise capital for their activities normally source their funds through two major sources. These sources are internal and external sources. The internal source refers to the funds generated from within an enterprise which is mostly retained earnings. It results from success enterprises earn from their activities. Firms may in the same vein look outside to source for their needed funds to enhance their activities. Any fund sourced not from within the earnings of their activities is termed external financing. The external funding may be by increasing the number of co-owners of a  business or outright borrowing  in  form of loan.  Financing and investment are two major decision areas in a firm. In the financing decision the manager is concerned with determining the best financing mix or capital structure for his firm. Capital structure decision is the mix of debt and equity that a company uses to finance its business (Damodaran, 2001). Capital structure theory is an essential reference theory in firm’s performance. The capital structure refers to firms’ mixture of debt and equity financing. To pursue a policy of an optimal capital structure, is one of the most important and complex issues to  resolve  in  an organization. Most  firms’ capital especially during the  beginning of their businesses comes from combinations of various debt and equity proportions. This is gotten from shareholders funds to finance their company’s needs and balance their leverage which signifies good standing of the firm. Debts can be acquired in form of bonds, short and long term credit while equity can  be  acquired through participation of stakeholders or  common stocks and retained earnings. Following the work of Modigliani and Miller (1958), a substantial amount of effort has been put forward in corporate finance theory to determine the factors that influence a firm’s choice of capital structure. The issue of finance has been identified as the major reason for firms failing to start or grow. It is pertinent for firms in Nigeria to make the best choice in financing their activities and grow over time.

After over half a century of studies on this great topic, economists and financial experts have not reached an agreement on how and to which extent firms’ capital structure impacts on

their performance. However, this study contributes to the empirical studies on how capital structure impact on firm performance in the Nigerian context.

1.2      Statement of the Problem

The actual impact of capital structure on firm performance in Nigeria has been a major problem among researchers that has not been resolved. There is still no conclusive empirical evidence in the literature about how capital structure impacts on firm performance in Nigeria and this formed a knowledge gap that needs to be filled. Therefore, it is on this premise that the researcher  embarked  on  this  study.  Meanwhile,  according  to  Kochar  (1997),  poor  capital structure decisions may lead to a possible reduction/loss in the value derived from strategic assets. Hence, the capability of a firm in managing its financial policies is important, if the firm is to realize gains from its resources. The raising of appropriate fund in an organization will aid the firm in its operation; hence, it is important for firms in Nigeria to know the debt-equity mix that gives effective and efficient performance, after a good analysis of business operations and obligations.

A firm’s capital structure refers to the mix of its financial liabilities. It has long been an important issue from the strategic management standpoint since it is linked with a firm’s ability to meet the demands of various stakeholders (Roy and Minfang, 2000). Debt and equity are the two major classes of liabilities, with debt holders and equity holders representing the two types of investors in the firm. Each of these is associated with different levels of risk, benefits, and control. While debt holders exert lower control, they earn a fixed rate of return and are protected by contractual obligations with respect to their  investment. Equity holders are the residual claimants, bearing most of the risk and have greater control over decisions.

An appropriate capital structure is a critical decision for any business organization. The decision is important not only because of the need to maximize returns to various organizational constituencies, but also because of the impact such a decision have on an organization’s ability to deal with its competitive environment. Following the work of Modigliani and Miller (1958) much research has been carried out in corporate finance to determine the influence of a firm’s choice of capital structure on performance. The difficulty facing companies when structuring their finance is to determine its impact on performance, as the performance of the business is crucial to the value of the firm and consequently, its survival.

Managers have numerous opportunities to exercise their discretion with respect to capital structure decisions. The capital structure employed may not be meant for value maximization of

the firm but for protection of the manager’s interest especially in organizations where corporate decisions are dictated by managers and shares of the company closely held (Dimitris, and Psillaki, 2008). Even where shares are not closely held, owners of equity are generally large in number and an average shareholder controls a minute proportion of the shares of the firm. This gives rise to the tendency for such a shareholder to take less interest in the monitoring of managers who pursue interest different from owners of equity.

Any investment decision taken by a firm’s manager affects the performance of the firm. What will be the appropriate percentage of the capital, debt, and equity so as to maximize profitability of the firm given that each source of finance has a cost and benefit attached to it, makes it a major and difficult decision to be taken by the managers. It is always very difficult for firms to identify or get the right combination of debt and equity (capital structure) which will ultimately satisfies them or brings favourable and profitable results for the firms. However, not all business or firm use a standardized capital structure; hence they differ in their financial decisions under various terms and conditions. It is therefore a difficult situation for these firms to determine the capital structure in which risk and costs are minimum and that can raise the value of shareholders wealth and maximize profit. Decisions as to the right source to obtain funds for investment purposes are often very difficult one. Factors such as the shareholders liability, bankruptcy cost, uncertainty and taxes complicate the decision of capital structure for firms.

Similarly, the difficulty facing firms in Nigeria has to do more with the financing – whether to raise debt or equity capital. The issue of finance is so important that it has been identified as an immediate reason for business failing to start or grow. Thus, it is necessary for firms in Nigeria to be able to finance their activities properly and grow over time, if they want to play an increasing and predominant role in creating value added, as well as income in terms of profits. From the foregoing, it is therefore important to understand how firms financing choices affects their performance.

However, many scholars over time have examined the impact between capital structure and  firm’s  performance.  Some  were  of  the  view  that  capital  structure  has  positive  and significance impact on firm’s performance, others reported negative impact while others were of the view that both positive and negative relationship exist between capital structure and firm’s performance. While some authors work such as Akintoye (2008) lacked empirical analysis a study of this nature should have and the study covered ten years.

With the mixed results of the previous scholars, prompted the researcher to embark on this study in order to examine the impact of capital structure on firm performance.  Thus, the focal point of this study is to evaluate the impact of capital structure on the performance of Nigerian firms using fiftteen (15) firms of which sixteen (16) years was covered.

1.3    Objectives of the Study

The main objective of this study is to examine the impact of capital structure on firm performance in Nigerian.

More specifically this study is undertaken to:

1.  Examine short-term debt ratio to total assets impact on Return on Asset (ROA).

2.  Examine long-term debt ratio to total assets impact on Return on Asset (ROA).

3.  Examine total debt ratio to equity impact on Return on Asset (ROA).

1.4      Research Questions

In striving to achieve the objectives of this study the following pertinent questions need to be answered:

1.  How does short-term debt ratio to total assets impacts on Return on Asset (ROA)?

2.  How far has long-term debt ratio to total assets impacts on Return on Asset (ROA)?

3.  To what extent has total debt ratio to equity impacts on Return on Asset (ROA)?

1.5     Research Hypotheses

The following research hypotheses have been formulated for this study:

Ho1:  Short-term debt ratio to total assets has no positive and significant impact on Return on

Asset (ROA).

Ho2:  Long-term debt ratio to total asset has no positive and significant impact on Return on

Asset (ROA).

Ho3: Total debt ratio to equity has no positive and significant impact on Return on Asset (ROA).

1.6    Scope of the Study

This study covers fifteen (15) firms in Nigeria from four (4) sectors of the economy. Their annual reports for the period ‘between’ 1997 to 2012, sixteen (16) years, was examined to evaluate the impact of capital structure on the selected firm’s performance. It is important at this point to note that, these firms we selected are Nigerian firms listed on the Nigerian Stock Exchange. Hence, we consider them as good representatives of all firms in Nigeria.

1.7       Significance of the study

The significance of this study lies in its usefulness. This study is expected to be useful to a number of persons and institutions as follows:

1.  Policy makers:

This study will be useful to various stakeholders such as the government and Nigerian firms’ board of directors who involve in policy making. It will be beneficial to the policy makers in their effort to fashion out dynamic and reliable policy measures that will serve as important information for emerging economy, such as knowing the best mix of equity to debt in financing their organizations and its activities.

2.  Researchers:

This study will be important to both researchers and business analysts as it looks into the realm of capital structure. There are two broad views on the impact of capital structure on the  performance of  firms,  while  one  asserts  the  significance  of capital  structure  in determining  firm’s  performance; the  other  says  capital  structure  does  not  play  any significant role in determining the performance of firms. This study has reviewed various theories and empirical studies on capital structure and firm performance, which will be useful material to researchers who may like to do further study on this area.

1.8   Definition of terms

The following terms are defined to aid the understanding of this study:

1.  Capital Structure: Capital structure according to Nwude (2003) can be defined as the mixture  of  long-term  financing  sources  such  as  debt,  preference  shares  and  equity interests which constitute the permanent capital used to finance an organization. It shows the proportion of permanent capital of an organization mobilized from the various long- term sources of finance. The long term sources could be debt, preference stock, equity interests such as share capital, share premium, reserves of various names, which may include statutory reserves, capital reserves, revenues reserves, and retained earnings.

2. Financial Structure: Financial structure shows the various means of financing an enterprise, which include current liabilities and long-term liabilities. This implies that financial structure is made up of the current liabilities and long-term liabilities used to finance an enterprise (Nwude, 2003).

3. Gearing: Gearing is the term used to describe the relationship between ordinary shareholders’ capital plus reserves and either prior charge capital or borrowings or both. Prior charge capital  is  capital that  has a right  to  payment of interest or preference dividend before there can be any earnings for ordinary shareholders. It also has a prior claim on the company’s assets in the event of a winding up. Prior charge capital is usually regarded as consisting of any preference share capital plus interest bearing debt. A company that is financed mainly by equity capital is said to be low geared. The higher the proportion of prior charge capital, the higher the gearing. A high-geared company is one which equity capital plus reserves is less than prior charge capital (Nwude, 2003).

4.  Risk: risk can be defined as the chance of failure or loss. It  is the possibility that something bad, unpleasant, or dangerous may happen (Nwude, 2003). In finance risk is a word used to describe a situation where actual return on an investment might turn out a failure. In fact risk is the possibility that the actual return from holding an asset will deviate from the expected return. The greater the magnitude of deviation and probability of its occurrence, the greater is said to be the risk of the asset. Risk occurs where the various possible future outcomes and their attached probabilities can be predicted with some degree of confidence from the knowledge of past or existing events. That is, a situation where the probability distribution of the cash flows of an investment proposal is known. If the possible future outcomes and the probabilities cannot be predicted with any degree  of  confidence  from  the  knowledge  of  past  or  existing  events  it  is  called uncertainty (Nwude, 2003).

5.  Financial Risk: financial risk is the additional risk brought about by debt financing. This implies that financial risk is associated with debt financing. Financial risk is borne by share holders in a geared company. It arises out of the fact that because debt interest has to be paid out in full before equity dividends can be paid, then shareholders are at risk that the company may have insufficient cash flow to pay dividends because it has all gone out in interest payment.

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