THE IMPACT OF DEBT FINANCING ON VALUE OF NIGERIAN FIRMS

ABSTRACT

The issue of value creation for stakeholders of the firm as a result of the composition of its financial mix can be traced to the seminal work of Modigliani and Miller (MM) in 1958. Their argument is the irrelevance of the financing mix of firms on value. Thus, whether the firm uses equity or debt, the value of the firm does not change. There  have been several theories after the works of MM carried out by several scholars either criticizing or supporting the Modigliani  and Miller  Irrelevance  theorem.  The Trade-off  theory of capital  structure suggests that there is an advantage to finance the firm with debt and also a cost of financing with debt.  As a result,  firms  are  assumed  to  trade-off  the tax benefits  of debt  with the bankruptcy  cost  of  debt  when  making  their  financing  decisions.  However,  present  and potential investors need single information which is, the value creating potential of the firm no matter the composition of the firm’s financing mix. Therefore this study had the following objectives; to determine the impact of debt financing on the ability of the firm to make profit; to determine the impact of debt financing on the ability of the firm to maximise the use of its assets; to determine the impact of debt financing on the firm’s earning power on per share basis;  to  determine  the  impact  of  debt  financing  on  the  ability  of  the  firm  to  reward shareholders  on per share basis; to determine  the impact of debt financing  on the firm’s ability to  meet  its’  financial  obligations  as at when  due and  to  determine  whether  debt financing  enhance  the  value  of   Nigerian  firms.  The  ex  post  facto  research  design  was adopted  to enable the researcher  make use of secondary  data and determine  cause-effect relationship  for twenty-eight quoted Nigerian firms for  the period 2004-2008 on a firm by firm as well as on aggregate basis. The Ordinary Least Square (OLS) estimation technique was adopted using SPSS statistical software to  evaluate objectives one to five where ratio values of Total Debt Rate (TDR) was  used as the independent  variable  while Net Profit Margin (NPM), Total Asset Turnover (TAT), Earnings Per Share (EPS), Dividend Per Share (DPS) and Current Ratio (CR) as dependent variables, while adopting a bankruptcy model, the  Multiple Discriminant Analysis Model (MDA) to evaluate objective six using MDA’s Z- score benchmark of 2.675 to determine  value (Rashmi and Sinha, 2004; Xing and Cheng,

2005). The study revealed that on a firm by firm basis there were mix variations of the impact of Total Debt Rate on the firms’ value parameters (NPM, TAT, EPS, DPS and  CR) across firms sampled while on aggregate basis; there was a positive non-significant impact of Total Debt Rate on Net Profit Margin;  there was a negative non-significant impact of Total Debt Rate on Asset Turnover Rate; there was a positive non-significant impact of Total Debt Rate on Earnings per Share; there was a positive non-significant  impact of Total Debt Rate on Dividend per Share and there was a negative non-significant impact of Total Debt Rate on Current Ratio and twenty firms created value as a result of the firms’ use of debt financing representing 71.4% of firms sampled while eight firms representing 28.6% of firms did not create value. From the foregoing therefore, the use of debt financing enhances the value of Nigerian firms, thus could be used to enhance shareholders’ wealth, however further studies could still be carried out as to determine why some firms did not enhance value as a result of the used of debt finance in the financial mix of Nigerian firms .

CHAPTER ONE     

 INTRODUCTION

1.1      BACKGROUND OF THE STUDY

The Modigliani-Miller  theorem is one of the cornerstones of modern corporate finance. At its heart, the theorem is an irrelevance proposition; the Modigliani-Miller  theorem provides conditions under which a firm’s financial mix does not affect its value. No wonder, Modigliani (1980, xiii) explains the theorem as follows:

… with well-functioning market (and neutral taxes) and rational investors, who can undo the corporate financial structure by holding positive or negative amount of debt, the market value of the firm-debt plus equity, depends only on the streams of income generated by its assets. It follows,

in particular, that the value of the firm should not be affected by the share

of debt in its financial structure or by what will be done with the returns paid out as dividend or reinvested (profitably)…

In  fact,  what  is  currently  understood  as  the  Modigliani-Miller  theorem  comprises  three  distinct results from a series of papers (1958, 1961 and 1963). The first proposition establishes that under certain   conditions,   a  firm’s  debt-equity   ratio  does  not  affect  its  market   value.  The  second proposition establishes  that a firm’s leverage has no effect on its weighted average cost of capital (that  is,  the  cost  of  equity  capital  is  a linear  function  of  the  debt-equity  ratio)  while  the  third proposition establishes that the firm’s value is independent of its dividend policy.

Miller (1991:217) succinctly explains the intuition for the theorem with a simple analogy, he says;

…think of the firm as a gigantic tub of whole milk. The farmer can sell the whole milk as it is, or he can separate out the cream and sell it at a considerably higher price than the whole milk would bring…

He continues

…the Modigliani-Miller proposition say that if there were no costs of separation (and of course, no government dairy support program), the cream plus the skim milk would bring the same price as the whole milk…

The essence of Miller’s argument is that, increasing the amount of debt (cream) lowers the ratio of outstanding equity (skim milk) – selling off safe cash flows to debtholders which leaves the firm with more valued  equity thus keeping  the total value of the firm unchanged.  Put  differently,  any gain from using more of what might be seem to be a cheaper debt is offset by the higher cost of riskier

equity.  Hence,  given  a fixed amount  of total  capital,  the allocation  of capital  between  debt  and equity is irrelevant because the weighted average of the two costs of capital to the firm is the same for all possible combinations of the two.

Spurred by Modigliani and Miller’s (1958, 1961 and 1963) arguments, that in an ideal world without taxes a firm’s value is independent of its debt-equity mix, economists have sought conditions under which the financial structure of the firm would matter. Economic and financial theories suggest that several factors influence the debt-equity mix such as differential  taxation of income from different sources,  informational  asymmetries,  bankruptcy  cost/risks,  issues  of  control  and dilution  and the agency problem (see Hart, 2001).

Thus, in line with the above,  the question  now is? Do corporate  financing  decisions  affect  firm’s value? How much do they add and what factor(s) contribute to this effect? An enormous research effort, both theoretical and empirical has been devoted towards sensible answers to these questions since the works of Modigliani and Miller (1953, 1961, and 1963). Several foreign and local scholars have theoretically and empirically studied the impact of the firm’s financial mix on the value of the firm from different  perspective  (see,  Jensen and  Meckling,  1976;  Jensen,  1986; Fama and Miller, 1972; Myers, 1977; Miller and Scholes, 1978; Elton and Gruber, 1970; among others).

In fact, Elton and Gruber (1970) studied the link between taxes, financing decisions and firm value and found that personal taxes make dividend less valuable that capital gain and stock prices fall by less than the full amount of the dividend on ex-dividend days. Fama and Miller’s (1972) study on the financial  structure  of the firm was  on leverage  and  they argue  that  leverage  (debt  finance)  can increase  the  incentive  of  the  stockholders   to  make  risky  investment   that  shift  wealth  from bondholders  but  do  not  maximize  the  combined  wealth  of  security  holders,    thus,  value  is  not created.    Jensen  and Meckling  (1976)  evaluating  financial  structure  from  the agency  cost  model submit  that  higher  leverage  allow  managers  to  hold  a  larger  part  of  its common  stock  thereby reducing agency problem by closely aligning the interest of the managers  and other stockholders, thus asserting  that since the  interest  of stockholders  are protected,  value is created.  In another paper by Jensen (1986), he said leverage (debt finance) used by the firm enhances value by forcing the firm to pay out resources that might otherwise be wasted on bad investment by managers.

Myers (1977) argues that leverage (debt finance) can make firms to under invest because the gains from investment are shared with the existing risky bonds of the firm. In effect, the agency effect of financing   decision   work   through   profitability   and  can  make  firms   to  take   better   or  worse investments  and  to  use  assets  more  or  less  efficiently.  Miller  (1977)  re-evaluating  earlier  MM theories on financial structure argues that if common stock is priced as tax free but personal tax rate built  into the pricing  of the stock,  corporate  interest  payment  is then  the corporation  tax  rate. Hence, the tax shield at the corporate level is offset by taxes on interest at the personal level thus debt  does not affect firm value.  He  therefore  submit  that if there are two firms  with the same earnings, before interest and taxes, the more levered firm’s higher after-tax earnings are just offset by the higher personal taxes paid by its bondholders.   Therefore, given pre-tax earnings, there is no relationship between debt and value.

In Nigeria, some empirical studies have been done in this area of corporate finance and its effect on the  value  of  the  firm.  Among  such  was  Ezeoha  (2007)  who  examine  the  impact  of  major  firm characteristics on the financial leverage of quoted companies in Nigeria and used panel data from 71 quoted  Nigeria  companies,   for  17  years  period  (1990  –  2006).  The   result  showed  that  the relationship between corporate ownership and financial leverage was positive across the proxies but more  significant  within  the  classes  of  foreign  and  indigenous  firms.  The  relationship  with  asset tangibility was found to be non significant  and negative, using total debt ratio or short term debt ratio  as the dependent  variable.  It was  also seen  from the research  study that the relationship between leverage and profitability was significant and negative (see Ezeoha, 2007)

Also, Adelegan (2007) examine the effect of taxes on business financing decisions and firm value in Nigeria. The study which analyses 85 manufacturing  firm in Nigeria from 1984 to 2004 found that dividend and debt covey information about profitability of the firm. This information  obscures any tax effect of financing decision.   However,  there was evidence that earnings and investment  were key determinants  of the firms’ value in Nigeria.  The study also found positive relationship between dividend and value and negative relationship between debt and value in firms examined.

Though, there have been studies in this area of corporate finance in Nigeria, However, most  have clustered  around  the  estimation   of  corporate  cost  of  capital  (Inanga  1987,  Adelegan,   2001) determinants   of  dividend   decisions   (Inanga,   2001;   Odedekun,   1995),   and   financing   decision (Adelegan, 2007; Ariyo 1999; Ezeoha, 2007). To the best of the researcher’s knowledge, no study has been carried out using firms’ value parameters to study its’ impact on the value of the firm adopting the bankruptcy model.   This is a gap which this study attempts to fill. The essence is to determine from an investors’ or potential investor’s point of view whether value parameters from the financial statements and accounts of quoted firms in Nigeria are affected by the use of debt in the financial mix and the overall impact of debt financing on the value of selected firms taking into account the cost of debt which is bankruptcy.

1.2      STATEMENT OF THE PROBLEM

The issue of value creation for stakeholders of the firm as a result of the composition of the financial mix of the firm may be traced to the seminal works of Modigliani and Miller in

1958. In most of MM’s works, their arguments had always been the irrelevance proposition on the financing choices of firms, thus, whether the firm uses equity or debt, the value of the firm does not change, it must be said that most of their works are based on certain assumption (see MM, 1958; MM, 1961 and MM, 1963).  They have been several theories after the works of MM carried out by several scholars either criticizing or supporting the works of

Modigliani and Miller. These theories postulated by these scholars discusses the composition of the financial structure and it influence on the value of the firm such as the irrelevance or relevance theory (MM, 1958; MM, 1961), the trade-off theory (Kraus and Litzenberger,

1973), the pecking-order theory (Myers and Majluf, 1984), agency theory (Jensen and Meckling, 1976), and the signalling theory (Ross, 1977) are among several theories that have tried to explain the impact of the financing choices of firms on the value of the firm.

The firm’s  financing  structure  as agreed  by these  scholars  consists  of a  mix of debt  and  equity (Okafor, 1983; Pandey, 2005; Damodaran,  2002; Brigham, 2000). It is in line with these works that Brealey, Myers and Marcus (2004), submit that the firm’s basic financial resources are the streams of cash flows produced by its assets and operations and when the firm uses purely equity capital, the cash flows generated by the assets and operations of the firm belongs entirely to the equity holders while when there is a mix of debt and equity,  the cash flows  generated  by the firms’ assets and operations is split into two, a relatively safe steam that goes to the debtholders and a more risky one

that goes to the equity holders.  Therefore, no matter the financing option chosen by the firm, the risky cash  flow streams  that goes  to the equityholders  must be maximized,  thus,  value  must be enhanced for them as the failure of the firm to do so will mean a negative impact on the value of the firm, therefore, the firm as a going concern must continue to exist and at the same time generate a premium which motivates shareholders to continue to invest in these firms. In line with the above, the problem often associated with debt financing includes among others from investors’ or potential investor’s points of view are the following:-

1)   Reduction of the firm’s profitability (Florackis, 2008)

2)   Loss of flexibility on the use of it asset (Brigham, 2000)

3)   Reduction of shareholders’ earnings per share (Pandey, 2005)

4)   Non payments of dividends to shareholders (Stulz, 1990)

5)   Increased insolvency risk/ liquidity problem (Damadoran, 2002)

6)   Non enhancement of value as a result of the firms’ use of debt (MM, 1958)

Profitability is an important variable that has an impact on the firm’s financial structure. The primary motive of the firm in using debt is to magnify the shareholders return through increased profitability no matter  the economic  conditions.  The role of debt  financing  in magnifying  the  returns  of the shareholders are based on the assumptions that fixed charges can be obtained at a cost lower than the firm’s rate of return on assets. Thus, when the difference between the earnings generated by it assets  financed  by the fixed  charges  funds  and  the cost of these  funds  is not big enough  to be distributed to shareholders as earnings a problem exists. Thus, when the amount of debt used in the financing  mix of the firm is huge,  it reduces  the  profitability  of the firm as a result of the fixed charges paid to debt holders. The net profit margin is used to determine the proportion of revenue that finds its way into profit  and since debt expenses is a deductible expenses before arriving at the net profit of the firm, a high debt profile of the firm will thus reduces profit.

Most debt financing arrangement entered into by the firm are often linked to the assets of the firm as collaterals. The firm cannot use the assets without notifying the debtholders. This limits the ability of the firm to fully maximize the use of these assets as to enhance shareholders’ value. Thus, the value  which  would  have  been  created  as  a  result  of  the  maximization  of  assets  of  the  firm  is impeded.  Most managers measure the performance of their firm by the assets turnover ratio, the use of debt financing which is linked to assets of the firm creates a problem for the firm because, management may not want to run the risk of having conflicts with debtholders as a result, the value

of shareholders may not be enhanced as restrictive covenants included in debt financing agreements limit the ability of the firm to fully harness the potentials of the firm’s resources.

A  firm’s  earnings  per  share  is  one  of  the  most  widely  used  measure  of  a  firm’s  performance. Investors look at the earnings per share of the firm over time as to determine whether their values as shareholders  have increased.  The existence of debt in a company’s financial structure increases equity’s  return  potential  because  it is a cheaper  financing  source.  However,  debt  also  increases equity risk of loss because interest and principal payments are fixed cost that reduces the amount of cashflows  available  for reinvestment  or  distributed  to equity investors.  In designing  the financial policy of the firm, the impact of the  financing  alternatives  on the distribution  of earnings  among shareholders  and  creditors  should  be  considered.  Shareholders  care  about  the  return  on  their investment and managers of public companies care about the reported results, such as earnings per share  or  return  on equity.  Therefore,  no matter  the  financing  method  adopted  by  the firm.  Its’ impacts on shareholders and other various stakeholders must be considered.

It is argued that investors operate in the world of brokerage fees, taxes and uncertainty; hence it is better  to  view  the  firm  in  the  light  of  those  factors.  Therefore,  without  the  MM  restrictive assumptions,  their argument collapses.  If one removes the assumption  of certainty, it will be seen that most investors  prefer some payment  in the form of cash dividends  currently  to an eventual return  in the form of  capital  gain in the future.  It is the  uncertainty  associated  with the future outcomes of the firm that prompts owners to prefer  some current payments as compensation  for their  invested  capital.  Because  current  dividends  reduce  investor’s  uncertainty,   they  tend  to discount  the firms’  earnings  at a  lower  rate thereby creating  a high value for the firms’ stock. If dividend were not paid, investors uncertainty would increase thereby raising the rate at which the firm’s earning are discounted and lowering the value of the firm’s stocks.

Liquidity is generally defined as the ability of a financial  firm to meet its debt obligations  without incurring unacceptably large losses. Liquidity risk is the risk that a firm will not be able to meet its current  and  future  cashflows   and  collateral   needs,   both  expected   and   unexpected,   without materially  affecting  its daily  operations  or overall  financial  condition.  An  investor  that wishes  to access the value of the firm will generally consider whether over time the firm has been able to meet its financial obligations as at when due. Also, lenders in evaluating the health of firms apply various

credit  assessment  methods  to  determine  the  credit  worthiness  of  these  firms  as  to  determine whether  to lend or not. Therefore,  the ability of the firm to meet up its financial  obligations  is a prerequisite  to obtaining  loans and thus increases  in the value of the firm.  When such funds are obtained be it for a short term or long term the value of the firm from an investor’s perspective is increased, otherwise no value as illiquidity reduces the value of the firm.

Present and potential investors for their investment decisions need single information,  which is the value  creating  potential  of  a  firm  and  what  endeavour  currently  are  taken  and  proposed  by management  for enhancing  such  value  creating  potential  along with their  financial  impacts,  This information  helps present and potential  investors  to estimate  the value of the firm which in turn enables them to take investment decisions. Thus when the firm does not create value for owners and potential owners, resentment may occur which will reflect in the market prices of the firm.

1.3      RESEARCH OBJECTIVES

The specific objectives of this study are:-

(1)         To determine how debt financing impacts on the firm’s ability to make profit.

(2)           To determine how debt financing impacts on the ability of the firm to maximize the use of its assets.

(3)         To determine the impact of debt financing on the firm’s earnings power on per-share basis. (4)         To determine the impact of debt financing on shareholders’ return on per share basis

(5)           To  determine  the  impact  of  debt  financing  on  the  firm’s  ability  to  meet  its  financial obligations as at when due and finally

(6)         To determine whether debt financing enhance the value of Nigerian firms.

1.4       RESEARCH QUESTIONS

In view of the objectives of this study, the following pertinent questions are asked, these are:- (1)       What impact does total debt rate has on the net profit margin of Nigeria firms?

(2)         What impact does total debt Rate has on the asset turnover ratio of Nigerian firms? (3)       What impact does total debt date has on the earnings per share of Nigerian firms?

(4)        What impact does total debt rate has on the dividend per share of Nigerian firms? (5)        What impact does total debt rate has on the current ratio of Nigeria firms?

(6)       To what extent does the use of debt finance enhance the value of Nigerian Firms?

1.5        HYPOTHESES OF THE STUDY

These are:-

i.       There are no positive significant relationships between total debt rate and net profit margin of Nigerian firms

ii.        There are no positive significant relationships between total debt rate and the asset turnover ratio of Nigerian firms.

iii.       There are no positive significant relationships between the total debt rate and earnings per share and of Nigerian firms.

iv.       There are no positive significant relationships between total debt rate and the dividend per share of Nigerian firms.

v.       There are no positive significant relationship between total debt rate and the current ratio of Nigerian firms.

vi.       Debt financing does not enhance the value of Nigerian firms.

1.6      SCOPE OF THE STUDY

The Nigerian Stock Exchange is presently made up of 36 Industrial classifications (Cashcraft,

2010). These include both the managed fund subsectors and the manufacturing subsectors; however this study covers 28 actively quoted companies in Nigeria between 1999- 2008 which are listed in the first-tier market of the Nigerian Stock Exchange industrial classification excluding foreign listings, Banks, Insurance and other financial subsectors. The exclusion of the insurance, banking, services and foreign listings is based on the nature of services rendered and the desire of the researcher to localize the research. The managed fund subsectors primarily deals with depositors funds thus highly leveraged and as such

determining the impact of debt financing in their financial structure on the firms’ value will be skewed. Also, they represent the lending spectrum of any economy, thus responsible for the supply of fund to the productive subsectors of the Nigerian economy. The exclusion of the foreign listings is based on our focus to consider only Nigerian incorporated firms.

1.7      SIGNIFICANCE OF THE STUDY

A number of researchers have provided insights, theoretical as well as empirical on the debt financing policies of the firm. However, everyone agrees that the issue is important. This was confirmed by Brealey, Myers, and Marcus (2004:692) when they said that the financial structure theories is one of the seven (7) unsolved problem in finance not for want of argument on the subject but an accepted, coherent theory of financial structure.  However, this research will be particularly significant to the following groups:

1)        MANAGEMENT

In large firms, there is a divorce between management and ownership. The decision taking authority  in a  company  lies  in the  hands  of managers.    Shareholders  as  owners  of  the company are the principals  and managers are their agents.   Thus, there  is principal-agent relationship between shareholders and managers therefore managers should and must act in the  best  interest  of  shareholders  as  consistent  with  shareholders’  wealth  maximization objectives of the firm. Therefore, this research will enable management to understand what must be done in order to act in the best interest of shareholders in choosing financing options which  will  help  the  firm  achieve  an  optimal  financial  structure  that  will  maximize shareholders’ value.

2)        INVESTORS AND POTENTIAL INVESTORS

The  major  beneficiaries  of  an  enhanced  value  created  firms  are  investors  and  potential investors.   Their contribution in monetary terms in the promotion,  incorporation, continual existence to the growth of the firm must be rewarded with a premium above their risk free rate, thus, acting as a compensation for time and risk inherent in these firms. The choice of a financing  mix  in the  financial  structure  of the  firm  ultimately  determines  whether  these objectives are met as internal and external factors may lead to insolvency and subsequent

bankruptcy of their firms which come with it a cost.  Therefore, this research will contribute along  with  other  similar  literatures  available  in  this  area  of  finance  in  enhancing  the maximization of investors and potential investors’ objectives as concern the value of firms.

3)        ACADEMIC

Essentially,  this  research  intends  to  contribute  significantly  to  the  volume  of  literature available in this area of finance.  In academics, the unknown is never exhausted, as the list of what we do not know could go on forever.   Therefore, as a contribution to this area, hints, recommendations  about  debt  financing  and  its  impacts on the  value  of  firms in Nigeria adopting the bankruptcy model in determining whether value have been enhanced or not is our    major  focus.  Localizing  the  research  to  the  Nigerian  settings  and  environment  is particularly important in this research.

1.8      LIMITATION OF THE STUDY

The first major limitation of this study was funding. The locations of the Nigeria Stock Exchange which are scattered all over the country required huge capital outlay for transportation and other logistics.

The second  limitation  was associated  with data generation.   Getting statistical  data from  various financial  statements  and accounts  of the 28 firms  under  study was a huge problem.  In fact, the intention  of the researcher  was  to undertake  a 10 year  time frame for the  study,  however,  we encountered  problem in generating sufficient data to cover the 10 year  period thus, necessitating the study  of 5 years.  This could  be attributed  to Nigerians  at the  moment  having  poor attitude towards data documentation and preservation and where available sentiments do not allow those in charge to release such data even for academic purposes.

Again, the limited availability of local literature on financial structure posed a problem.  Though, the intention is to localize the research however, it was difficult to garner quality local literatures in this area. The implication is that foreign theoretical and empirical studies constitute the volume of data used in the review of literature

1.9        DEFINITION OF TERMS

The following terms are defined in this research, these are:

VALUE                                    

   The value of a firm is the value of its business  as  a going concern. (Miller, 1991)

DEBT FINANCING                   

The use of external sources of funds in the  financing mix of firms (Tim, Michael and Sheridan, 1997)

BANKRUPTCY                     

    Legally declared inability of the firm to pay it creditors or    stakeholders    (Encyclopaedia    Britannia,    2008) emphasis is researcher’s inclusion.

NET PROFIT MARGIN       

The net profit margin is used to determine the proportion of revenue that finds its way into profit (Pandey, 2005)

TOTAL ASSET TURNOVER 

 Asset   turnover   is   a   financial   ratio   that   measures   the efficiency of a company’s use of its assets in generating sales revenue  or sales income to the company (Zane,  Kane, and Marcus, 2004).

EARNINGS PER SHARE 

 Earnings per share is the reward of an investor for  making his  investment  from  the  book  value  figures  of  the  firm (Patra, 2005)

DIVIDEND PER SHARE 

 This  is  the  sum  of  declared  dividends  for  every  ordinary share issued (Brigham, 2005)

CURRENT RATIO                                    A diagnostic tool that measures whether or not the firm has enough  resources  to pay its liabilities  over a given  period (Ward, 2009)

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