the effect of capital structure on firms value in Nigeria

the effect of  capital structure on firms value in Nigeria

CHAPTER ONE

INTRODUCTION

1.1     BACKGROUND OF THE STUDY

Financing is one of the crucial areas in a firm. A financing manager is concerned with the determination of the best financing mix and combination of debts and equity for his firm. Capital structure decision is the mix of debt and equity that a company uses to finance its business (Damodaran, 2001).

One of the importance of capital structure is that it is tightly related to the ability of firms to fulfil the needs of various stakeholders. Capital structure represents the major claims to a corporation’s assets which includes the different types of both equities and liabilities (Riahi-Belkaonui, 1999). There are various alternatives of debt-equity ratio, these includes; 100% equity: 0% debt, 0% equity: 100% debt and X% equity: Y% debt (Dare & Sola 2010). From these three alternatives, option one is that of the unlevered firm, that is, the firm that shuns the advantage of leverage (if any). Option two is that of a firm that has no equity capital. This option may not actually be realistic or possible in the real life economic situation, because no provider of funds will invest his money in a firm without equity capital. This partially explains the term “trading on equity”, that is, it is the equity element that is present in the firm’s capital structure that encourages the debt providers to give their scarce resources to the business. Option three is the most realistic one in that, it combines both a certain percentage of debt and equity in the capital structure and thus, the advantages of leverage (if any) is exploited. This mix of debt and equity has long been the subject of debate concerning its determination, evaluation and accounting.

After the Modigliani-Miller (1958 & 1963) paradigms on firms’ capital structure and their market values, there have been considerable debates, both in theoretical and empirical researches on the nature of relationship that exists between a firm’s choice of capital structure and its market value. Debates have centered on whether there is an optimal capital structure for an individual firm or whether the proportion of debt usage is relevant to the individual firm's value (Baxter, 1967). Although, there have been substantial research efforts devoted by different scholars in determining what seems to be an optimal capital structure for firms, yet there is no universally accepted theory throughout the literature explaining the debt-equity choice of firms. But in the last decades, several theories have emerged explaining firms’ capital structure and the resultant effects on their market values. These theories include the pecking order theory by Donaldson, (1961), the capital structure relevance theory by Modigliani and Miller (1963), the agency costs theory and the trade-off theory (Bokpin & Isshaq, 2008).

Financial constraints have been a major factor affecting corporate firms’ performance in developing countries especially Nigeria. The basis for the determination of optimal capital structure of corporate sectors in Nigeria is the widening and deepening of various financial markets. Mainly, the corporate sector is characterized by a large number of firms operating in a largely deregulated and increasingly competitive environment.

Pandey (1999) differentiated between capital structure and financial structure by affirming that the various means used to raise funds represent the firm’s financial structure, while the capital structure represents the proportionate relationship between long-term debt and equity capital. Therefore, a firm’s capital structure simply refers to the combination of long-term debt and equity financing.

1.2     STATEMENT OF THE PROBLEM

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 and 1963), 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 managers 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 left to themselves pursue interest different from owners of equity.

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 in the first place or to progress. Thus it is necessary for firms in Nigeria to be able to finance their activities and grow over time, if they are ever 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 firm financing choice affects their performance.

It is evidently clear that both internal (firm specific) factors and external (macroeconomic) factors could be very important in explaining the performance of firms in an economy. Thus, the central point of this study is to assess the impact of capital structure on firm’s performance in Nigeria.

1.3     OBJECTIVE OF THE STUDY

The main objective of the study is to critically examine the effect of capital structure on the performance of firms in Nigeria. The specific objectives are to:

1.     Evaluate linkage between the value of the total debt and returns on assets and investment

2.     Determine the association between financial leverage and returns on assets

3.     Evaluate the capital structure and firms’ performance in Nigeria

1.4     RESEARCH QUESTIONS

The research in the bid to achieved the goals and objectives of the research is guided by the following questions:

1.     Does the debt-equity ratio affect firms’ performance in Nigeria?

2.     Is there any significant relationship between the long term debt to capital employed ratio and firms’ performance n Nigeria?

3.     In what way does the total debt ratio of a firm affect its performance?

4.     How does the age of a firm affect the firms’ performance in Nigeria?

1.5     STATEMENT OF HYPOTHESIS

The following are the hypotheses formulated;

H₀: There is a significant relationship between firm performance and capital structure.

H₁: There is a significant impact of capital structure on firm’s performance.

1.6     SIGNIFICANCE OF THE STUDY

This study is utmost importance to both researchers and business analysts as it looks into the realm of capital financing. This study adds to existing literatures to verify the claim of traditional theory of capital structure.

1.7     SCOPE OF THE STUDY

The scope of this research is limited to the effect of  capital structure on firms value in Nigeria as Capital structure is about putting in place the structure, processes and mechanism that ensure that the firm is being directed and managed in a way that enhances long term shareholder value through accountability of managers and enhancing organizational performance.

1.8     DEFINITION OF TERMS

CAPITAL STRUCTURE: Capital structure refers to a set of rules and incentives by which the management of a company is directed and controlled.

PERFORMANCE: The accomplishment of a given task measured against present known standards of accuracy, completeness, cost, and speed. In a contrast, performance is deemed to be the fulfilment of an obligation, in a manner that releases the performer from all liabilities under the contract.

STAKEHOLDERS: A stakeholder is anybody who can affect or is affected by an organisation, strategy or project. They can be internal or external and they can be at senior or junior levels. Some definitions suggest that stakeholders are those who have the power to impact an organization or project in some way.

Organization: Organization is an entity, such as an institution or an association, that has a collective goal and is linked to an external environment.

CHAPTER TWO

LITERATURE REVIEW

2.1     INTRODUCTION

This section of the research is centered on reviewing related literatures on the effect of capital structure on the firms value in Nigeria. Contributions of other researchers and authors on the effect Capital structure on a firm’s value will be fully reviewed.

2.2     CONCEPTUAL FRAMEWORK

The term capital structure according to Kennon (2010) refers to the percentage of capital (money) at work in a business by type. There are two forms of capital: equity capital and debt capital. Alfred (2007) stated that a firm’s capital structure implies the proportion of debt and equity in the total capital structure of the firm. Pandey (1999) differentiated between capital structure and financial structure of a firm by affirming that the various means used to raise funds represent the firm’s financial structure, while the capital structure represents the proportionate relationship between long-term debt and equity. The capital structure of a firm as discussed by Inanga and Ajayi (1999) does not include short-term credit, but means the composite of a firm’s long-term funds obtained from various sources. Therefore, a firm’s capital structure is described as the capital mix of both equity and debt capital in financing its assets. However, whether or not an optimal capital structure exists is one of the most important and complex issues in corporate finance.

Capital structure, preferred stock and common equity are mostly used by firms to raise needed funds, capital structure policy seeks a trade-off between risk and expected return. The firm must consider its business risk, tax positions, financial flexibility and managerial conservatism or aggressiveness, while these factors are crucial in determining the target capital structure, operating conditions may cause the actual capital structure to differ from the optimal capital structure.

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