CHAPTER ONE

INTRODUCTION

1.1 Background to the Study

Investors and potential investors will be obliged to invest their hard-earned savings in a company that promised to make a return that will change their wealth position at a particular point in time. However, capital structure can simply be defined as a firms’ financial framework, which comprise of a firm retain earnings, debt financing and equity financing in order to maintain the business entity in financing its assets. The essence of capital structure decision is to ensure the right combination of financing resources that will yield maximum return without necessarily strangling the interest of stakeholders. Capital structure refers to the different options used by a firm in financing its’ assets (Bhaduri, 2002). Generally, firm can go for different levels of debt, equity or other financial management. The capital structure of a firm consists of various sources, which are presented in the equity and liability side of the balance sheet. A firm’s leverage refers to the mix of its financial liabilities. As financial capital is an uncertain but critical resource for all firms, suppliers of finance are able to exert control over firms (Xavier & Holger, 2015). 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 correspondingly, have greater control over decisions.

Questions related to the choice of an appropriate financing means (debt versus equity) have increasingly gained importance in management research. Traditionally examined in the discipline of finance, these issues have gained relevance in the past few years, with researchers examining linkages to strategy and strategic outcomes. The financial management functions of a firm including its capital structure decision deals with the management of the sources and uses of finances.

Zietlow, Hankin and Seidner (2007) notes that debt is one of the important items in the capital structure of companies and it provides a medium for corporate financing as firms borrow money in order to obtain the capital they require for capital expenditure. It represents any agreement between a lender and a borrower: notes, certificates, bonds, debentures, mortgages and leases. Debt can either be short-term or long-term. Short-term debt represents funds needed to finance the daily operations of the firm, such as trade receivables, short-term loans and inventory financing. These types of funds' repayment schedules take place in less than one year. Long-term financing is usually acquired when firms purchase assets such as buildings, machinery. The scheduled repayments for these funds extend over periods longer than one year (Zietlow, Hankin, & Seidner 2007).

Equity enables the firm to obtain funds without incurring debt (Sibilkov,2009). This means that the fund obtained through equity do not have to be repaid at a particular time. The investors who purchase shares in the firm hope to reclaim their investment out of future profits. The shareholders have the privilege to share in the profits of the firm in the form of dividends or future capital gains. However, if the firm suffers a loss, the shareholders have limited liability, which means that the only loss they face is the amount that they had invested in the firm (Sibilkov 2009).

Theory of capital structure is an important theory in finance. It addresses sources of finance available to business organizations wishing to raise funds to finance their operations. These include equity sales, retained earnings, bonds, bank loans, accounts payable and line of credit (McMenamin, 1999; Ross, Westerfield & Jaffe, 2005) and possibly few other interest bearing debts. The capital structure theory originated from the famous work of (Modigliani & Miller 1958). They argued that, under certain conditions, the choice between debt and equity does not affect a firm value and hence, the capital structure decision is irrelevant, but in a world with tax-deductible interest payment, firm value and capital structure are positively related. Miller and Modigliani (1958) pointed out the direction that capital structure must take by showing under what conditions the capital structure is irrelevant. Titman (2001) lists some fundamental conditions that make the M&M proposition hold as: no taxes, no transaction cost, no bankruptcy cost, perfect contracting assumptions and complete and perfect market assumption. Some academicians received Modigliani and Miller work as been controversial and state that, in real world situation, the main assumptions never hold and hence, ‘capital structure irrelevance’ is nothing but a fiction. Moreover, they stated that in a ‘non-perfect’ world, there are factors influencing capital structure decision of a firm. In their seminal paper Jensen and Meckling (1976) emphasized the importance of the agency costs of equity incorporate finance arising from the separation of ownership and control of firms whereby managers tend to maximize their own utility rather than the value of the firm. Agency costs can also exist from conflicts between debt and equity investors. These conflicts arise when there is a risk of default. The risk of default may create what Myers (1977) referred to as an “underinvestment” or “debt overhang” problem. In this case, debt will have a negative effect on the value of the firm. But firm performance may also affect the choice of capital structure.

Since the publication of M&M’s irrelevance propositions raise the issues on the contrary to norms in respect of the capital structure, hundreds of Scholars have contributed in the discussion to establish whether their theory is obtainable, thereby resolving basic financing decision problems regarding optimal capital structure for individual firm, the effect of an appropriate financing means or mix on firm performance and what condition is the choice of capital structure relevant once or more of the key conditions are relaxed. Miller (1997) added personal taxes to his analysis and demonstrated that optimal debt usage occurs on a macro-level but does not exist at the firm level and that interest deductibility at firm level is offset at the investor level.

Other researchers have added imperfections such as bankruptcy cost, agency costs and gains from leverage-induced tax shields to M&M analysis and have maintained that an optimal capital structure may exist but yet, this academic literature has not been very helpful to provide clear guidance on practical issues. Most important, with only few exceptions, most existing empirical evidence from capital structure studies to date, are based on data from developed countries with only few studies proving evidence from developing countries.

For the purpose of this study, performance is measured by the three proxies namely; return on assets (ROA), return on equity(ROE) and return on investment(ROI). It is however important to note that, in evaluating the performance of a firm, the personal wealth of a firm may influence the level of risk a company investor and managers may be willing to assume as well as determine the resources available to support the business. As a result of ownership and wealth incentive, it is important to investors and others to understand its effects on firm performance as they evaluate a firm because capital structure decision on financing the assets (such as personnel, machinery and buildings) of an organization by debt or by equity will leave relationship with the final result for any given period since capital structure influence the returns and risks of shareholders and this consequently affects the market value of the shares.

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 linked with a firm’s ability to meet the demands of various stakeholders (Roy & 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 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. The vital issue confronting managers today is how to choose the mix of debt and equity to achieve optimum capital structure that would minimize the firm’s cost of capital and improves return to owners of the business. Financial managers make efforts to ascertain a particular combination that will maximize profitability and the firm’s market value. According to Gitman (2003), it is generally believing that the value of a firm is maximized when its cost of capital is minimized. The kind of combination of debt and equity that will minimize the firms cost of capital and hence maximizes the firm’s profitability and market value is the optimal capital structure.

However, financial managers do not have a well-defined formula that for taking decision on optimal capital structure.  A number of theories have been advance to explain the capital structure of firms. However, there is lack of consensus among researchers of financial management about the optimal capital structure. The variations in the various theories further make capital structure decisions crucial. Thus, capital structure decision is very critical, particularly in relation to performance of a firm in terms of profitability and value of the equity. Following the work of Modigliani and Miller (1958) much research has been carried out in corporate finance to determine the influence of a firm’s choice of capital structure on performance. The difficulty facing companies when structuring their finance is to determine its impact on performance, as the performance of the business is crucial to the value of the firm and consequently, its survival. Managers have numerous opportunities to exercise their discretion with respect to capital structure decisions. The capital structure employed may not be meant for value maximization of the firm but for protection of the manager’s interest especially in organizations where company decision is dictated by managers and shares of the company closely held (Dimitris & Psillaki, 2008). Even where shares are not closely hold, 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 themselves pursue interest different from owners of equity. The difficulty-facing firms in Nigeria have to do more with the financing – whether to raise debt or equity capital. The issue of finance is so important that it has been identify as an immediate reason for business failing to start in the first place or to progress. From the foregoing, it is therefore important to understand how firm’s 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. In Nigeria, investors and stakeholders appear not to look in detail the effect of capital structure in measuring their firm’s performance as they may assume that attributions of capital structure are not related to their firms value. Indeed, a well attribution of capital structure will lead to the success of firms. Hence, the issues of capital structure, which may influence the corporate performance of Nigerian firms, have to be resolved. In addition, the capital structure choice of a firm can lead to bankruptcy and have an adverse effect on the performance of the firm if not properly utilized. The research problem therefore is to determine the effects of leverage on firms performance in Nigeria using some selected industrial firms.

Therefore, applying these limit resources should be in the way that creates an appropriate share of value for providers and users of resources because without capital the firm would be unable to run, grow and expand their business. However, other studies present different opinion about what type of fund and the optimum capital structure that will improve a firm performance. Acemoglue (1998); Brounen & Eitchholtz (2001) and Landier (2002) considered debt financing as a more appropriate form of financing the operation of high risk firms because of the advantage of tax shield available on interest payment, while Myers & McConnell (2001) sees equity financing as more appropriate means of financing high risk firms with a lower success probability and higher cash flow. Other researchers such as Berkovitch and Israel (1996) and Habib & Johnsen (2000), see the use of both debt and equity as a more appropriate means of financing a firms operation. Based on these contending views and the resultant conspicuous gap in empirical research on capital structure of manufacturing firms in Nigeria and the appropriate financing means of firm’s operations, corporate managers are faced with a problem of which means of finance and at what level in terms of magnitude will bring about the efficient performance of a firm.

However, the central point of this study is to assess the effect of capital structure on performance of companies in Nigeria and also to determine the appropriate financing means for firms’ performance and also to measure the effect of leverage on the proxies, which are; return on assets (ROA), return on equity (ROE) and return on investment (ROI) using some selected industrial manufacturing firms.

1.3 Objectives of the Study

The main objective of this study is to examine the effect of capital structure on the performance of some Nigerian industrial goods companies. Specifically, it seeks to:

1.      Determine the effect of leverage on the return on equity of industrial goods companies in Nigeria.

2.      Find out the effect of leverage on the return on assets of industrial goods companies in Nigeria.

3.      Evaluate the contribution of leverage to return on investment of industrial goods companies in Nigeria.

1.4 Statement of Hypotheses

In line with the objective of the study, the following hypotheses have been formulated in null form:

1.      H0:  Leverage has no significant effect on the return on equity of industrial goods companies in Nigeria.

2.      H0: Leverage has no significant effect on the return on assets of industrial goods companies in Nigeria.

3.      H0:  Leverage has no significant effect on the return on investment of industrial goods companies in Nigeria.

1.5 Scope of the Study

This study is to be undertaken to critically evaluate the effect of capital structure decision on the performance of some industrial Manufacturing firms in Nigeria and it covers a period of six years, from 2011-2016. This period actually witnessed a boom of financing activities by Nigerian Manufacturing firms prior to the global financial crunch most recently.

1.6 Significance of the Study

 The study will be of significant benefit to a number of individuals. These include the investors to recognize the link between capital structure and financial performance and also choosing appropriate measures to evaluate and analyse the companies’ financial status while committing their hard-earned funds for an expected return. Industrialist and non-industrialist in identifying the appropriate leverage ratio for firms within the industry as leverage ratio varies across the industry.

This study will also be relevant to industrialist in identifying the problem associated with either debt financing or equity financing and identifying the best financing mix which will be more effective at encouraging an efficient operation of the firms. This research will make some significant contribution to the existing body of finance in the area of corporate financing and consequently accounting knowledge in Nigeria.

Also, the government and its agencies will benefit from this study because the study will highlight the need from its findings if necessary for the government to formulate more favourable financial and economic guidelines as the sector demands and this will sustain the operations of Nigerian Manufacturing firms, especially the potential firms yet to be quoted in the stock market and resultantly contributing to GDP of the nation which have been on the decline so far and also improve on employment rate once the sector is viable since the stake holders are interested in knowing the impact of such decisions on an organization performance.

This study will also be of great significance to Manufacturers Association of Nigeria because it brings out the best financing mix which improves a firm’s value and this will go a long way in helping them attain their target and set goals.

Students and researchers who will want to develop a future research on this subject will also benefit from this study and it will contribute in filling the gap of existing body of knowledge in accounting, finance and economics regarding capital structure decision which have been a long debate .

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