IMPACT OF EXTERNAL FINANCING ON FIRM PERFORMANCE: EVIDENCE FROM NIGERIA QUOTED MANUFACTURING FIRMS
ABSTRACT
The use of external financing can be
described as a balancing act between higher returns for shareholders
versus higher risk to shareholders. Though external financing can boost
stock performance of firms, it is still inconclusive as to its impact on
performance of firms in developing economies like Nigeria. It is,
therefore, against this background that this study investigated the
impact of external financing on earnings per share; pay-out ratio;
dividend per share; return on assets and return on equity of Nigerian
manufacturing firms. The study adopted the ex-post facto research
design. Panel data were collated from the Annual financial Statement of
Quoted manufacturing firms as well as from the Nigerian Stock Exchange
Fact book for the period 1999 – 2012. Five (5) hypotheses which state
that External Financing does not have positive and significant impact on
earnings per share; payout ratio; dividend per share; return on assets
and return on equity of Nigerian manufacturing firms were tested using
the Ordinary LeastSquare (OLS) regression technique. The independent
variable was External Finance while the dependent variables were
earnings per share (EPS), payout ratio (PR), dividend per share (DPS),
return on assets (ROA) and return on equity (ROE). The result of this
study revealed that External Financing had negative and non-significant
impact on earnings per share, payout ratio, dividend per share and
return on equity while its impact on return on assets was found to be
positive and significant. The implications of the finding reveal that in
Nigeria, External Financing does not magnify earnings attributable to
shareholders in terms of the book value measures. However, it increases
the asset structure of these firms. This study therefore recommends,
among others, that Nigerian manufacturing firms should utilize more
External Financing in their capital structure up to the optimal level to
leverage on the magnifying effect of external financing on
shareholder’s wealth.
CHAPTER ONE
1.0 INTRODUCTION
1.1 Background to the study
In most developing economies like
Nigeria, the financing policies of firms may become relevant because
managers in a company invest in new plants and equipments to generate
additional revenue and income. While the revenue belongs to the owners
of the company and can be distributed as either dividend paid to owners
or retained in the firm as retained earnings, the retained earnings
could be used for a new investment or capitalized by using it to issue
bonus shares. But where the retained earnings are not enough to support
all profitable investment opportunities, the company may forgo the
investment or raise additional capital, thus altering the financial
structure of firms (Olugbenga, 2012).
According to Pandey (2005) the financial
structure of a firm is a long term plan, set up as tradeoff among
conflicting interests and identified as the major function of a
corporate manager. They determine the appropriate combination or mix of
equity and debt in order to maximize firm value. This major function of
corporate managers has generated so much debate along the following
line; the relationship between leverage and profitability; the optimal
mix between equity and debt and the determinants of corporate financial
structure. The underlining assumption of these debates is to effectively
understand the factors that influence the financing behaviour of firms.
In order to explain and/or understand the
financing behaviour of corporate managers, so many theories have
emerged. The earliest is the neoclassical view of finance dominated by
the Miller Modigliani theorem, also known as the capital structure
irrelevance theory (Miller and Modigliani 1958), according to the
theorem, given the assumption that “firms and investors have the same
financial opportunities, under conditions of perfectly competitive
financial markets, no asymmetries of information between different
agents and the same tax treatment of different forms of finance, the
corporate financial policy is irrelevant. The theory establishes that,
the stock market valuation of a firm is based exclusively on the earning
prospects of the firm and not on its finance structure. In effect,
internal and external finance are viewed as substitutes and2 firms could
use external finance to smoothen investment when internal finance
fluctuates (Yartey, 2006).
Another strand of literature on the
financing structure of firms is based on the managerial theory of
investment also known as the modified M-M theorem. Proponents of this
theory argue that the fundamental determinant of investment is the
availability of internal finance. Therefore, managers tend to push
investment programmmes to a point that the marginal rate of return is
below the level which would have maximized shareholder’s welfare. The
manager pursues overinvestment policies using internal finance which
help them bypass the capital market. This is usually in the managers’
desires for growth. The bypass of the capital market has the effect of
managers not being subjected to the discipline of the stock market, thus
the level of cash flow is irrelevant for the firm’s investment
decisions in neoclassical theory, but rather what matters is the cost of
capital” (Yartey, 2006).
The complexities of today’s business
require firms to source funds through internal and external financing
for its operations. External financing options involve financing
activities through public offerings of equity (Ritter, 1991; Loughran
and Ritter, 1995; Spiess and Affleck-Graves, 1995), private placement of
equity, (Hertzel, et..al 2002), public debt offerings (Spies and Affleck-Graves,1999) and bank loans, (Billett, et al,
2001). These options that are available for the financing pattern of
firms, though with their disadvantages enable firms to fully tap
opportunities and strengths which maximize shareholder’s wealth as well
as ensure future stock returns.
Another school of thought, generally
referred to as the traditional school opine that capital structure
matters and this brought out other financial theories on the issue.
These theories consider various effects of corporate taxation on
leverage, capital structure and financial distress; agency effects,
theory of dividend payments, signaling effects and preference of firms
for internal sourcing of funds rather than external (Fabozzi, 2012). The
static trade-off hypothesis views debt to equity ratio as being
determined by a trade-off between the cost and benefit of borrowing.
According to Shyran and Myers, (1999), in finding optimum debt ratio, it
requires a trade-off so that the benefit of tax shield is weighed
against the backdrop of financial distress.
This will ensure that the firm maintains a
healthy debt ratio. Therefore, the static theory of optimal capital
structure predicts a point in the activity of the firm at which there is
a positive correlation between debts and return on assets before
interest and taxes. At this point, the firms have more income that will
shield them from cost of financial distress. The pecking-order theory
has also tried to explain the financing behavior of firms. According to
Myers and Majluf (1984), the theory states that companies prioritize
their sources of financing.
Firstly, firms prefer to use internal
financing, secondly, they resort to borrowing when internal financing is
not available and lastly to issuing of equity when both internal and
external finances and debt servicing are not available. The reason for
this order according to Beasley et.al (2007) is the issue of
information asymmetries as managers known more about the firm’s
performance and prospects than outsiders. This view holds that managers
are likely to issue company shares when they believe shares are
undervalued but will be more inclined to issues when they believe that
shares are overvalued. As such, the assumption is that shareholders are
aware of this likely managerial behavior and thus regard equity issues
with suspicion (Beasley et.al, 2007).
The contribution of the pecking order
theory in explaining the behaviour of firms can be observed on why the
most profitable firms generally borrow less. According to Berzkalne
(2012) it is not because they have low target debt ratios but because
they don’t need outside money.
However, less profitable firms issue debt
because they do not have sufficient internal funds for their capital
investment programme and because debt is first in the pecking order for
external finance. The pecking order theory does not deny that taxes and
financial distress can be important factors in the choice of capital
structure. However, the theory says that these factors are less
important than managers’ preference for internal over external funds and
for debt financing over new issues of common stock (Berzkalne, 2012).
Conversely, the dynamic model counteracts
the static trade–off hypothesis by arguing that capital structure is
not static but changes through time as firms face new developments and
new information about market conditions (Fabozzi et al, 2012).
The agency theory states that there is conflict of interest among
shareholders, debt holders and manager, because there arise agency cost
to the firm. These costs in the form of monitoring and restrictive
covenants embodied to protect the interests of shareholders and
debt-holders against the agency cost, incurred when managers of firms
raise and invest funds so that the wealth of firm is maximized (Pandey,
2005).
In between the dynamic model and agency
theory is the dynamic trade – off theory which stipulates that the
business conditions of the firm is not static, but that the firm’s
leverage changes, that is, it is dynamics. In such a situation, firms
try to utilize or maximize the conditions to foster growth
opportunities, not holding to the utilization of tax shield. Thus, when
these growth opportunities are envisaged, the agency cost theory comes
into play and achieves the motivation behind the dynamic hypothesis of
the trade-off hypothesis.
These theories are based on the findings
from developed economies with developed and robust debt and equity
markets. In developing economies such as Nigeria, the debt market is not
developed, and the debt and equity are not alternative sources of
funding to a firm. For instance, equity trading constitutes about 80% of
all market activities in the new issue and stock market (see the
Nigerian Stock Exchange Factbook (various years). Also, the government
development stock constitutes more than 95% of total debt traded on the
exchange. Such financing constraint will not give Nigerian firms the
latitude to combine equity and debt in line with the above theories.
The implication therefore, is that firms
will rely heavily on external financing in the form of external or
internal equity and less on bank loans depending on their collateral
value. This might also explain the financial mix or structure of
Nigerian firms, which is dominated by short-term debt. Unlike developed
economies where the financial structure of firms compose of equity and
debt, the financing structure of firms in most developing economies is
mainly equity based and where debt component is involved, it is usually
from deposit money banks or other such financial institutions (Fodio,
2009). Thus, the payment of dividend becomes relevant to investors as
reflected in stock prices. This could be explained through the dividend
signaling hypothesis (Bhattacharya, 1979; Miller and Rock, 1985). They
explained that change in dividend payment is to be interpreted as a
signal to shareholders and investors about the future earning prospects
of the firm. Generally a rise in dividend payment is viewed as a
positive signal, conveying positive information about a firm’s future
earning prospects resulting in an increase in share price. Conversely a
reduction in dividend payment is viewed as negative signal about future
earning prospects, resulting in a decrease in share price.
Also consistent with bird-in-hand theory
argument as developed by Linter (1962) and Gordon (1963) shareholders
are risk-averse and prefer to receive dividend payments rather than
future capital gains. Shareholders consider dividend payments to be more
certain than future capital gains thus a bird in the hand is worth more
than two in the bush. Gordon (op cit.) contended that the payment of
current dividends resolves investor uncertainty. Investors have a
preference for a certain level of income now rather than the prospect of
a higher, but less certain, income at some time in the future. The key
implication as argued by Linter (1962) and Gordon (op cit.) is that
because of the less risky nature of dividends, shareholders and
investors will discount the firm’s dividend stream at a lower rate of
return, thus increasing the value of the firm’s shares.
The effect of external financing on stock
returns could also explain the residual effect of dividend. As argued
by the “dividend as a residual” theory, the pay-out ratio of firms is a
function of its financing decision. The investment opportunities should
be financed by retained earnings. Thus internal accrual forms the first
line of financing growth and investment. If any surplus balance is left
after meeting the financing needs, such amount may be distributed to the
shareholders in the form of dividends. Thus, dividend policy is in the
nature of passive residual.
In case the firm has no investment
opportunities during a particular time period, the dividend pay-out
should be one hundred percent. A firm may smooth out the fluctuations in
the payment of dividends over a period of time. The firm can establish
dividend payments at a level at which the cumulative distribution over a
period of time corresponds to cumulative residual funds over the same
period. This policy smoothens out the fluctuations of dividend pay-out
due to fluctuations in investment opportunities (Fuei, 2010).
The pricing of securities after the
announcement of firms’ external sources of funding tend to be followed
by periods of abnormally low returns, whereas corporate announcements
associated with internal financing tend to be followed by periods of
abnormally high returns (Myers and Majluf, 1984; Myers, 1984). This is
especially true in Nigeria where the use of external financing is viewed
by investors as sign of inefficiency in the firms’ operations. Finding
the right financing structure encompasses numerous considerations such
as growth rate of sales, management risk, liquidity of assets, etc.
Thus, without an appropriate financial structure the growth in sales
will decline, management risk increase, illiquidity of the firms’
assets, loss of control position of the company which will hinder stock
performance of firms.
The use of external financing increases
return on equity up to a certain level of operating income not only in a
developing economy like Nigeria but also firms in developed economies
As the firms grow, higher levels of external financing are needed to
cover for investment opportunities available. In a perfect world,
management would favor more external financing whenever return on
capital exceeds the cost of internal financing (Kraus and Litzenberger,
1973). However, higher returns also result in higher risk to the
business (risk return tradeoff). Therefore, the use of external
financing is a balancing act between higher returns for shareholders
versus higher risk to shareholders.
Theoretically, it has been established
that firms which depend majorly on external financing must promote their
market value through efficient utilization of resources and favourable
dividend policy. For instance, it is argued that in an economy where
there is non-availability or under-development of long-term end of the
debt market, firms in such economy will rely only on the equity market
for long-term funding. However, the ability of the firm to raise the
needed fund from this segment of the market will depend on the market
perception of the profitability of the firm, the firm’s reputation and
collateral value, the performance of their shares in the secondary
market and past dividend policy.
However, as opine by Yartey (2006), there
is no consensus in literature on how such dependence on external
funding could impact on the market value of the firm. For, instance, it
is argued that given the high cost of equity, firms will prefer to
finance their activities first with internal fund, and will resort to
equity only when the internal sources are insufficient. If this theory
holds true, the implication is that such firms will declare next to
nothing as dividend which could impact negatively on the pricing of the
company’s shares in the secondary market. On the other hand, another
school argues that such scenario will put pressure on corporate managers
to perform thereby promoting firm performance.
While the theoretical and empirical
standpoints on the above issues have been laid down, few literatures are
available to reconcile these theories with realities in developing
economies. This study strived to contribute to literature by examining
the impact of external financing on performance of quoted manufacturing
firms in Nigeria.
1.2 Statement of Problem
The Nigerian capital market is skewed
towards equity funding which is associated with higher cost of capital
and imposes serious financing constraint on corporate managers. Such
skewness could influence the financing behaviour of corporate managers
and the overall performance of the firm. For instance, the
under-development of the long-term end of the debt market could put so
much pressure on corporate managers to perform. Such pressure could
enhance performance or promote short-termism and stymie or hinder
long-term investment that promotes performance on the long-run. The
under-development of the debt market could also compel firms to rely so
much on internal funds, thereby restraining their ability to pay
dividend.
To empirically ascertain the influence of
external funding on stock returns has become imperative given the level
of corporate failure and moribund firms in Nigeria. The Nigerian
capital market which was established in 1960, but started operation in
1961 had 9 government stock. However, in 1980 following the enterprise
promotion decree of 1972, the market witnessed increased activities as
the total number of equity stood at 23 and government development stock
stood at 59. The privatisation exercise which was as a result of
Nigerian government decision to adopt the Structural Adjustment
Programme (SAP) in 1986 accelerated capital market activities within the
period. For instance, the value of equity stock which was N92.4 million
in 1973 rose to N348 billion in 1987 and stood at N2, 086.294.59
trillion in 2007. The value of government development stock also rose
from N91.1billion to N307.9mmillion in 1987 and stood at N1.665.4
million in 2006 (CBN, 2012).
Important event that promoted capital
market activities in Nigeria was the 2004 banking consolidation. It will
be recalled that in July 6th, 2004, all commercial banks in Nigeria
were mandated to shore-up their share capital to N25b by December 31,
2005 or have their licenses revoked (Donwa and Odia, 2010). Banks in
order to comply with this directive used the capital market option. This
singular episode astronomically increased capital market activities.
For instance, the total market capitalization stood at N132.95 billion
as at 2007 (CBN. 2012; Ogboru, 2000).
From the above analysis, it is evident
that the Nigerian capital market is dominated by equity and government
development stock. The market for corporate bond is not developed and
this has important financing implication for corporate managers in
Nigeria. Thus, Nigerian firms will depend more on equity for permanent
source of fund and loans from banks for debt component of their funding
mix. This also explains the absence of long-term debt in financial
structure of Nigerian firms (Ikazoboh, 2011).
According to the trade-off hypothesis, in
an environment where a firm is predominantly externally financed and
the market for long-term debt is under-developed, corporate managers are
under pressure to enhance market performance. This is to ensure secure
access to the new issue market according to Baker and Wurgler (2000).
Scholars are divided on the influence of such pressure on firm
performance. One school argued that such financing pressure could be the
needed incentive for managers to maximize shareholders’ wealth thus
improving firm performance (Pandey, 2005). Another school, however,
argued that such financing pressure could make corporate managers pursue
short term goal (shorter-termism) which could stymie corporate
performance as a result of under-investment in long-term projects
(Ujunwa, et al, 2011).
The two conflicting schools are based on
the assumption that investors are not myopic and could effectively
monitor managers. This raises an important question on what happens in
an economy that is characterized with investors’ myopia. How do
corporate managers’ manipulate market indicators to promote access to
the new issue market? This study strived to clear our understanding of
the financing behaviour of corporate managers in Nigeria, a country that
is characterized by the under-development of long-term debt market and
myopic investors.
The Nigerian capital market is skewed
towards equity funding which is associated with higher cost of capital
and imposes serious financing constraint on corporate managers. Such
skewness could influence the financing behavior of corporate managers
and the overall performance of the firm. The under development of the
long-term end of the debt market could put so much pressure on corporate
managers to perform. Such pressure could enhance performance or promote
short-termism and stymie or hinder long term investment that promotes
performance on the long run. The under-development of the debt market
could also compel firms to rely so much on internal funds, thereby
restraining their ability to pay dividend. The constraints the
developing economy firms face in sourcing external resources through
issuing of equity shares in their stock market; will bring out the
dividend policy decisions of firms.
1.3 Objectives of the Study
The primary objective of this study is to
assess the impact of external financing on performance of Nigerian
manufacturing firms. However, this objective was achieved through the
following specific objectives which are:
- To ascertain the impact of External Financing on Earnings per Share.
- To determine the impact of External Financing on Payout Ratio.
- To ascertain the impact of External Financing on Dividend per Share.
- To ascertain the impact of External Financing on Return on Assets and
- To determine the impact of External Financing on Return on Equity.
1.4 Research Questions
The study strived to provide answers to the following questions:
- How far does External Financing have impact on Earnings per Share of Nigerian manufacturing firms?
- To what extent does External Financing have positive and significant impact on Payout Ratio of Nigerian manufacturing firms?
- To what extent does External Financing have positive and significant impact on Dividend per Share of Nigerian manufacturing firms?
- To what extent does External Financing have positive and significant impact on Return on Assets of Nigerian manufacturing firms?
- To what extent does External Financing have positive and significant impact on Return on Equity of Nigerian manufacturing firms?
1.5 Research Hypotheses
In line with the research question raised above, the hypotheses for this study were:
- External Financing does not have positive and significant impact on Earnings per Share of Nigerian manufacturing firms.
- External Financing does not have positive and significant impact on Payout Ratio of Nigerian manufacturing firms.
- External Financing does not have positive and significant impact on Dividend per Share of Nigerian manufacturing firms.
- External Financing does not have positive and significant impact on Return on Assets of Nigerian manufacturing firms.
- External Financing does not have positive and significant impact on Return on Equity of Nigerian manufacturing firms?
1.6 Scope of the Study
This study will cover the period 1999 to
2012. The choice of 1999 is that it heralded the beginning of
uninterrupted democratic rule in Nigeria; therefore, it is assumed that
the impact of democratic rule will open the financial system thereby
allowing manufacturing firms to have access to finance. To accommodate
this, the study collected data from 1999 and covered all selected quoted
manufacturing firms on the Nigerian Stock Exchange from 1999-2012
excluding banked and other financial institutions because of the nature
of their funding which is highly leveraged.
1.7 Significance of the Study
This study is expected to be significant to the following groups. These are:
- Academia
There have been lots of studies on the
theory of capital structures and their determinants worldwide. In
Nigeria, studies have also been concentrated on the same issue and have
often failed to explore the relationship between the financing pattern
and stock returns. This study is peculiar because it would deal with the
impact of the financing pattern on Nigeria firms.
- Management of Nigerian Firms
The financing pattern of Nigerian firms
was shown to be skewed towards equity holdings. This study will be
significant since financial managers would be able to know the way out
of their dilemma in solving investments policy to pursue.
- Policy Makers
The study will help researchers to open
new line and on related topics while local and foreign investors will
benefit as it will expose the effect of external funding on the values
of their shares. The policy makers both in Nigerian and other countries
will benefit from the effective policy guide on market department,
breadth and sophistication of the capital market, towards enhancing the
debt/fixed income capital market and transparency and accountability in
the capital market, and above all implement clear structures for policy
co-ordination across financial service industry regulators. It will also
help in checking the decline in share prices by establishing a capital
market stabilization fund and the liquidity situation in the economy.
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