CAPITAL STRUCTURE AND PROFITABILITY: EVIDENCE FROM LISTED DEPOSIT MONEY BANKS (DMB's) IN NIGERIA

CAPITAL STRUCTURE AND PROFITABILITY: EVIDENCE FROM LISTED DEPOSIT MONEY BANKS (DMB's) IN NIGERIA

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                                           SECTION ONE: INTRODUCTION

1.1 BACKGROUND OF THE STUDY

1. Introduction

Capital structure simply means the way a firm finance itself through debts, equity or hybrid securities. It is the combination of debt and equity that is needed for a firm to finance its assets. According to Brealey, Myers and Marcus (2001) capital simply refers to the firm’s sources of long term financing which is the manager’s duty to pay for investments in real assets. Specifically, the study focus on the ability of a firm to finance its asset through debt or equity. Emphasis has been made on capital structure mix of a firm,as it often determines the return on asset (ROA). Capital structure decision is very important since the performance of a firm is directly affected by such decision.Return on assets is a key profitability ratio which measures the amount of profit made by a firm per naira of its assets. Returns on asset examines how efficiently management uses firm’s assets to generate profit.

The key issue of this study is that firms can finance from a mix of financing sources, which can be either internal or external financing sources. And this has direct effect on the firm’s ability to generate profit as being described in the literature. Traditional trade-off theory of capital structure refers to the idea that a firm selects how much debt finance and how much equity finance to use by balancing the costs and benefits. Pecking order theory starts with asymmetric information as managers know more about their firm’s prospects, risks and value than outside investors. Asymmetric information affects the choice between internal and external financing and between the issue of debt or equity. Firms prefer internal financing which is the pecking order theory.

The goal of the capital structure decision is to determine the financial leverage that maximizes the value of the firm or minimizes the weighted average cost of capital. In the Modigliani and Miller theory developed without taxes, capital structure is irrelevant and has no effect on firm’s value. Modigliani and Miller (1958) explained that the value of a firm is viewed as a function of financial leverage while dividend and retained earnings are not deductible for tax purposes, interest on debt is a tax deductible expense.

Another vital imperfection affecting capital structure decision is the presence of bankruptcy cost. When a firm is unable to meet its obligation it results in financial distress that can lead to bankruptcy because a major contributor to financial distress is debt. Jensen & Meckling, (1976) put forward the concept of agency cost which recognises that the interest of managers and shareholders my conflict and managers may make major financial policy decision such as the choice of capital structure. Myers (1977) mentioned another type of agency cost of debt which arises from under investment problem.

 One of the major objectives of a firm is to maximize the wealth of owners or shareholders of the firm. The wealth of shareholders’ in turn is defined as the current price of the firm’s outstanding shares. In order to achieve this objective firm’s management should take rational financing decisions regarding optimal capital structure which in turn would minimize its cost of capital Goyal (2013) capital structure refers to several alternatives that could be adopted by a firm to get the necessary funds for its investing activities in a way that is consistent with its priorities. Most of the effort of the financial decision making process is centered on the determination of the optimal capital structure; where the cost of capital is minimized and firms value is maximized. Capital structure theory suggests that firms determine what is often referred to as a target debt ratio; which is based on various trade-off between the costs and benefits of debt versus equity. The theory of capital structure was first established by Modigliani and Miller in 1958.  Following the seminal work of Modigliani and Miller (1958), a vast theoretical literature developed, which led to the formulation of alternative theories, such as the static trade off theory, pecking order theory.

Financial performance of a firm is a subjective measure of how well a firm can use its’ assets to generate revenues. Erasmus (2008) noted that financial performance measures like profitability and liquidity among others provided a valuable tool to stakeholders to evaluate the past financial performance and the current position of a firm. Brigham and Gapenski (1996) argued that in theory, the Modigliani and Miller model was valid however in practice, bankruptcy costs did exist and that these costs were directly proportional to the debt levels in a firm. This conclusion implied a direct relationship between capital structure and financial performance of a firm. Therefore, given the unique features of banks’ financial structure and the environment in which they operate, there are strong grounds for a separate study on the impact of capital structure on profitability of banks in Nigeria  with due focus on the profitability of core business operations of commercial banks.

1.2 Statement of the problem

The choice of capital structure is one of the most important strategic financial decisions of firms. However, it has been the subject of substantial debate and investigation. The debate on what drives capital structure decisions and its impact on profitability is still open.The determinants of capital structure and firm value have been contested for many years and still represent one of the most unresolved issues in corporate finance literature. Only a few of the developed theories have been tested by empirical studies and the theories themselves lead to different, not mutually exclusive and sometimes opposed result and conclusion Rajan & Zingales (1995), Morri & Beretta (2008) explained that numerous theoretical studies and much empirical research have addressed those issues, but there is no a fully supported and generally accepted theory; and the debate on the significance of determinant factors of capital structure and profitability/ firm value is still open.  However, understanding the determinants of capital structure and profitability as well as the impact of financing decision or capital structure on profitability is as important for banks as for non-banks firms. According to Amidu (2007) currently, there is no clear understanding on how banks choose their capital structure and what factors influence their corporate financing behavior. Likewise the relationship between capital structure and profitability is one that received considerable attention in the finance literature. However, in the context of banking industry, the subject has received a limited research attention Taani (2013).

Knowledge of the impact of financing decision or capital structure on profitability of banks would help financial managers to predict and mitigate potential problems associated with their financing decision. Particularly, acquiring knowledge of the impact of capital structure on profitability of banks’ core business operations will have significant benefit to manage financing decision in a way that meets the goal of firms; shareholders’ wealth maximization. Therefore, given the unique features of banks’ financial structure and the environment in which they operate, there are strong grounds for a separate study on the impact of capital structure on profitability of commercial banks in Nigeria by emphasizing on banks’ core business operations profitability.

Hence, the aim of this study was to examine the impact of leverage/capital structure on profitability of commercial banks in Nigeria with an emphasis on banks’ core business operations as it was defined as the banks’ operations of deposit mobilization and providing loans to customers. The result intends to equip financial managers with applied knowledge of the potential problems in profitability and capital structure, as well as determining their optimal level of capital structure to achieve optimum level of firm’s profitability so that to meet wealth maximization goal of firms. Furthermore, it intends to serve as a base for policy makers in considering the minimum capital requirement of banks operating in the country.

1.3 Aim and Objectives of the Study

This study attempts to analyse the impact of capital structure on profitability of listed DMB's in Nigeria. Therefore, the main objective of the study is to examine the effect of capital structure on profitability of listed DMB's in Nigeria; while the specific objectives are to:

        i.            To examine the impact of debt to total asset ratio on profitability of listed DMB's in Nigeria.

      ii.            To analyse the effect of debt to equity ratio on profitability of listed DMB's in Nigeria.

1.4 Hypotheses of the Study

Ho1: debt to total asset ratio has no significant impact on profitability of listed DMB's in   Nigeria

      Ho2: debt to equity ratio does not have significant effect on profitability of listed DMB's in Nigeria.

1.5 Significance of the Study

This study have significant role to play in filling gap in understanding of the impact of capital structure decisions on profitability of core business operations of banks in Nigeria applied knowledge of the potential problems in financing decisions/capital structure and profitability, as well as determining their optimal level of capital structure to achieve optimum level of firm’s profitability so that to meet wealth maximization goal of firms. In addition, it will serve as a base for policy makers such as Central bank of Nigeria to look at the appropriate level of capital requirement for banks. And hence will serve as reference for financial managers to equip them with applied knowledge of the potential problems in financing decisions / capital structure and profitability, as well as determining their optimal level of capital structure to achieve optimum level of firm’s profitability so that to meet wealth maximization goal of firms. In addition, it will serve as a base for policy makers such as the Central bank of Nigeria to look at the appropriate level of capital requirement for banks. Besides, it will also serve as a reference for other researchers in the area of corporate finance.

The finding of this research is expected to be helpful to potential investors for predicting firm performance and consequently affect their decision on whether to invest in high, moderate or low levered banks. It will also serve as an additional literature and basis of validating theory. The implication of the finding will be great contribution to regulatory authority (CBN).

There are many issues related to the study topic, however not all issues will be touched. The thesis will only focus on the issues raised in the research questions. The limitations are therefore listed below. The analysis did not touch on other performance indicators such as growth opportunities, maturity, sustainability, shareholders‟ wealth maximization and profitability. The analysis is restricted only to the accounting performance such as return on asset, return on equity and market performance (Tobin‟s Q).2.This study did not tackle the instantaneous effect on corporate performance of any changes in corporate governance structure, but rather concentrates on the relation between capital structure and profitability of DMB's in Nigeria. The study is within the tradeoff and pecking order view of capital structure given the increased support for these theories in literature. Hence, no other perspectives of interpreting the interrelationships among corporate variables were considered. However, all the frameworks (theories) are reviewed. The effects of the geographical location of the firms and ongoing global economic downturn on the capital structure decisions and profitability of Nigerian firms is not studied as this on its own deserves a separate study as 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 has on an organization’s ability to deal with its competitive environment. A company can finance investment decision by debt and/or equity. This is known as financing decision which could affect the debt-equity mix of firms. The debt-equity mix has an overall implication for the shareholders earnings and risk which will in turn affect the cost of capital and market value of the company. It is therefore imperative for financial managers of firms to determine the proportion of equity capital and debt capital (capital structure) to obtain the debt financing mix that will optimize the value of the firm, that is, an optimal capital structure. The prediction of the Modigliani and Miller Model that in a perfect capital market the value of the firm is independent of its capital structure, and hence debt and equity are perfect substitutes for each other, is widely accepted. However, once the assumption of perfect capital markets is relaxed, the choice of capital structure becomes an important value-determining factor. This paved the way for the development of alternative theories of capital structure decision and their empirical analysis. Although it is now recognized that the choice between debt and equity depends on firm-specific characteristics, the empirical evidence is mixed and often difficult to interpret. Moreover, still very little is still understood about the determinants of firms‟ financing mix outside the US and other major developed markets with only a few papers analyzing international data from developing countries Inter-country comparative studies highlighting differences in capital  structure started to appear only during the last two decades i.e. 1990 to 2010. An early investigation of seven advanced industrialized countries (G7) was performed by Rajan and Zingales (1995) where they argued that although common firm-specific factors significantly influence the capital structure of firms across the countries, several country-specific factors also play an important role. This led to further studies on developing versus developed economies. Dirmirguc-Kunt and Maksimovic (1999) compared capital structure of firms from 19 developed countries and 11 developing countries. They observed that institutional differences between developed and developing countries explained a large portion of the variation in the use of long term debt. They also discovered that some institutional factors such as the stock market size, the financing structure etc.in developing countries influence the leverage of large and small firms differently. In an analysis of ten developing countries, Boooth, Aivaziam, Demirguc-Kunt and Maksimovic, (2001) found that capital structure decisions of firms in these countries were affected by the same firm-specific factors as in developed countries. They examined whether existing capital structure theories applied across countries with different structures in firms in ten developing countries and the G7 countries between 1980 and1991 and found consistent relations in both the pooled data results between firms profitability, asset, tangibility, growth option and leverage.

However, they found out that there are differences in the way leverage is affected by country-specific factors such as GDP growth and capital market development. They therefore concluded that more research needs to be done to understand the impact of institutional factors on firms‟ capital structure choices in different countries.

This study therefore, will have contributed to the literature by examining firm-specific factors that influence the performance of Nigerian firms from the view point of their capital structure choices. This has will help us to understand the impact of institutional factors on Nigerian firm's capital structure choices and how it affects their performance. It has will also helped us to establish that if the western capital structure models exhibit robustness for companies in the Nigerian market to a large extent. This study also differs from other studies conducted so far in the country based on the fact that the study will employs a larger number of quoted firms (a total of 101 quoted firms yielding 505 observation); employed Tobin‟s Q as a market performance measure in the study of capital structure and performance of Nigerian firms increased the number of estimation parameters/measurement variables based on the theories of capital structure and Employed five year averages in the analysis to avoid problems of short term measurement instability and to reduce estimation bias and noises. Therefore, the study is also contributing to methodological discourse as the study employed both pooled, cross-section and time series data in a panel data framework. In effect, this study has improved on previous studies in terms of techniques used in the analysis of the data of Nigerian firms, by employing the use of panel data estimation model. Consequently, the results obtained from the study has helped in the recommendation of some policies and guidelines that will help in decision making and directions of the capital structure of firms in Nigeria in order to improve their performance. Hence, scholars, CEOs of firms and finance managers in Nigeria would find the output of this study a useful database and resource

Olweny & Shipo (2011) the first objective of this study was to evaluate the effects of bank-specific factors; Capital adequacy, Asset quality, liquidity, operational cost efficiency and income diversification on the profitability of commercial banks in Kenya. The second objective was to determine the effects of market structure factors; foreign ownership and market concentration, on the profitability of commercial banks in Kenya. This study adopted an explanatory approach by using panel data research design to fulfill the above objectives. Annual financial statements of 38 Kenyan commercial banks from 2002 to 2008 were obtained from the CBK and Banking Survey 2009. The data was analyzed using multiple linear regressions method. The analysis showed that all the bank specific factors had a statistically significant impact on profitability, while none of the market factors had a significant impact. Based on the findings the study recommends policies that would encourage revenue diversification, reduce operational costs, minimize credit risk and encourage banks to minimize their liquidity holdings. Further research on factors influencing the liquidity of commercials banks in the country could add value to the profitability of banks and academic literature.

Tailab (2014) this paper empirically aims to analyze the effect of capital structure on financial performance. Two main sets of variables were used: For profitability, return on assets (ROA) as the ratio of net income to total assets, and return on equity (ROE) as the ratio of net income to total shareholders’ equity were adopted as a proxy for financial performance; and to indicate capital structure, short-term debt, long-term debt, total debt, debt to equity ratio, and firm’s size were used. A sample of 30 Energy American firms for a period of nine years from 2005 –2013 was considered. Secondary data were collected from financial statements which were taken online. The data were analyzed by using Smart PLS (Partial Least Square) version 3.Multiple regressions indicated that 10% of ROE and 34% of ROA were predicted by the independent variables, the findings also presented that the total debt has a significant negative impact on ROE and ROA, while size in terms of sales has significantly negative effect only on ROE of the American firms. However, a short debt significantly has a positive influence on ROE. An insignificant either negative or positive relationship was observed between long term debt, debt to equity and size in terms of total assets and profitability. A generalization of the results is limited because of the small sample size. For future research, the author suggests addressing a longer period of time with a large sample size of firms. It would be more accurate if future studies included more independent variables such as concentration and taxation.

Luper & Isaac (2012) this study examines the impact of corporate governance (CG) and capital structure (CS) on the performance of firms in Nigeria. The annual financial statements of manufacturing companies listed on the  Nigerian Stock Exchange were used for this study which covers a period of five (5) years from 2005-2009. Multiple regression analysis was applied on performance indicators such as Return on Asset (ROA) and Profit Margin (PM) as well as Board Size (BS) and Duality (DL) as CG variables, Short-term debt to Total assets (STDTA), Long term debt to Total assets (LTDTA) and Total debt to Equity (TDE) as CS variables. The results show that there is significant relationship between CG (DL) and CS (STDTA, TDE) on ROA while there is no significant relationship between CG (BS) and CS (LTDTA) on ROA. There is no significant relationship between CG (BS, DL) and CS (STDTA) on PM but there is significant relationship between CS (LTDTA, TDE) on PM. This study recommends among others that firm managers should use a combination of debt and equity to achieve higher ROA. In addition if firms should improve their operational performance through PM, they should use debt financing as this is a cheap source of finance.

Oladipupo & OKafor (2013) Good working capital management is vital to a firm’s profitability and profitability is essential for firm’s ability to pay dividends to stake holders. This study investigates the implications of a firm’s working capital management practice on its profitability and dividend payout ratio. The study focuses on the extent of the effects of working capital management (measured by the net trade cycle, current ratio and debt ratio) on the profitability and dividend payout ratio. Financial data were obtained from twelve manufacturing companies quoted on the Nigeria Stock Exchange over five years period (2002 to 2006). Using both the Pearson product moment correlation technique and ordinary least square (OLS) regression technique, we observed that shorter net trade cycle and debt ratio promote high corporate profitability. While the level of leverage has negative significant impact on corporate profitability, the impacts of working capital management on corporate profitability appear to be statistically insignificant at 5% confidence level. On the other hand, we observed that dividend payout ratio was influenced positively by profitability and net trade cycle but negatively by growth rate in earnings. The impacts of both profitability and working management on the dividend payout ratio appear to be statistically insignificant at 5% confidence level.

Kagiri&Njeri(2013)Capital structure is a financial tool that helps to  determine how firm's choose their capital structure, a firm's capital structure is then the composition or structure  of its liabilities. The general objective of this study is to determine the effect of capital structure to the company’s financial performance of the listed banking institutions in Nairobi Securities Exchange. The objectives of  the study was to; establish how debt; leverage risk; interest rate; and debt equity combinations affect performance of banking institutions listed in the NSE. The study made use of descriptive research study design and data was collected using questionnaires which were administered to the management of the selected banks under study. Correlation and multiple regression analysis were used for analysis. The results of the study were analyzed to see whether there is any effect of capital structure on financial performance. The study also determined whether capital structure have effect on financial performance of the firm by considering the debt, leverage risk, debt equity ratio and interest rates and how they are related to Return on Equity (ROE), Return on Assets (ROA), Gross Profit Margin and Net Profit Margin (NPM) at determined significant level. The study targeted 35 respondent s but managed to obtain responses from 30 of them thus representing 86% response rate. The findings indicated that debt had a coefficient of 0.747;leverage risk had a coefficient of 0.751,interest rate had a coefficient of 0.781,and debt-equity proportion had a coefficient of 0.791, also the study revealed that majority of the respondents agreed to central bank lending rate affected the decision to finance their firms’ working to a great extent (3.8676),majority of the respondents agreed that the ratio of non-performing assets is high in a majority of the banks under study (3.8971) and that capital was always maintained at levels above regulatory levels in many banks (3.8971).in addition, the study findings revealed that majority of the respondents agreed that The bank found it cheaper using more of equity financing to a great extent (4.4647) and that the leverage risk affected the performance of many banks and that the trend of earnings was properly monitored by the bank to a great extent (3.6765). The research findings indicated that there was a positive relationship(R=0.608) between the variables .The study also revealed that 56.4% of financial performance of commercial banks listed at the NSE could be explained by capital structure aspects under study. The study findings revealed that the combined effect of the four aspects under study on financial Performance of commercial banks listed at the NSE was statistically significant. This was revealed by the ANOVA findings where high F values and log p values were registered at 95% confidence. The study recommends that, The Central Bank of Kenya to Formulate and enact a policy which makes commercial debt cheaper hence reduce cost of operations of banks Management of commercial banks listed at the NSE to reduce interest rates so as to attract investors who will inject more funds into these banks. These Funds can be used for onward lending hence increased interest income and management of commercial banks listed at the NSE to contain insolvency to enhance Credibility among their customers. The study recommended that a broad based study covering both public and private institutions be done to find out the effect of the factor. It is also suggested that future research should focus on the capital structure factors on organizational performance.

Igbinsa (2015) explores the long and short run dynamic relationships between capital structure and firm’s performance variables based on financial statements data of (62) non-banking firms quoted on the Nigerian Stock Exchange. The study reveals that quoted firms use long term debts in the short run to boost profitability and earnings but in the long run, as they become more profitable, they resort to internal source of financing. It further reveals that while the combination of debt and equity capital that optimizes return on assets differ from that which optimizes return on equity, it submits that long term debts contribute positively and significantly to enhancing returns to equity owners. It recommends that a firm should determine the appropriate mix of capital that optimizes its own performance suggesting that the combination of debts and equity that optimizes return to equity owners should represent that optimum structure.

Akeem, Edwin, Kiyanjui &kayoed, (2014) this research examines the effect of capital structure on firm’s performance with a case study of manufacturing companies in Nigeria from 2003 to 2012 with the purpose of providing a critical appraisal of the need and importance of capital structure. Descriptive and regression research technique was employed to consider the impact of some key variables such as Returns on asset (ROA), Returns on equity(ROE), Total debt to total asset(TD), Total debt to equity ratio(DER) on firm performance. Secondary data was employed using data derived from ten (10) manufacturing companies.  From our findings, we observe that capital structure measures (total debt and debt to equity ratio) are negatively related to firm performance. It is hereby recommended that firms should use more of equity than debt in financing their business activities, in as much as the value of a business can be enhanced using debt capital. Hence firms should establish the point at which the weighted average cost of capital is minimal and maintain that gearing ratio so that the company’s value will not be eroded, as the firm’s capital structure is optimal at this point ceteris paribus.

1.6 Scope of the Study

The study investigated the impact of capital structure (proxy by debt to total asset ratio and debt to equity ratio) on profitability (proxy by return on asset) of listed DMB's in Nigeria for the period 2005-2014. The population of the study comprises seventeen (17) DMB's listed on the Nigerian Stock Exchange (NSE) December, 2014. Out of which ten (10) banks constitute the sample of the study. The study adopted both correlation and ex-post facto research design. The data for the study was purely from secondary source obtained from the annual reports of the sampled banks.  The results revealed that debt to total asset ratio has a significant positive impact on profitability of listed DMBs in Nigeria; while the impact of Debt-to-Equity ratio on profitability is found to be negative and statistically significant. Based on these findings the study recommends that banks’ finance managers should identify the optimal capital structure that will help to attain the best financial performance in their various business dealings.                                                 

 


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