EFFECT OF CAPITAL STRUCTURE ON THE PERFORMANCE OF NIGERIA MANUFACTURING FIRM
- Project Research
- 1-5 Chapters
- Quantitative
- Regression
- Abstract : Available
- Table of Content: Available
- Reference Style: APA
- Recommended for : Student Researchers
- NGN 3000
BACKGROUND TO STUDY
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. 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. Firms enter into transactions with suppliers of finance (be they debt holders or equity holders) when raising capital for assets. The right to partake of the cash flows generated from the assets lies with these suppliers. The debt-to-equity ratio of a firm determines how these cash flows will be shared between debt holders and equity holders. In other words, if firms are set up to maximize equity holder's wealth, then the proportion of cash flows disbursed to debt holders becomes important. The different types of financing, however, are also associated with different levels of costs. An examination of the net benefit of a firm's assets should incorporate these cost differences along with the value of such assets.
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, 2009 and Ross, et al 2012) and possibly few other interest bearing debts. The capital structure theory originated from the famous work of Modigliani and Miller (M&M) (2008). 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. M&M (2008) pointed out the direction that capital structure must take by showing under what conditions the capital structure is irrelevant. Titman (2011) lists some fundamental conditions that make the M&M proposition hold as: no (distortionary) taxes, no transaction cost, no bankruptcy cost, Perfect contracting assumptions and complete and perfect market assumption. The M&M publication became a subject of considerable debate both theoretically and empirical research. 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.
The agency cost theory is premised on the idea that the interests of the company's managers and its shareholders are not perfectly aligned. In their seminal paper Jensen and Meckling (2006) emphasized the importance of the agency costs of equity in corporate 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 (2007) 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. Berger and Bonaccorsi di Patti (2006) stipulate that more efficient firms are more likely to earn a higher return for a given capital structure, and that higher returns can act as a buffer against portfolio risk so that more efficient firms are in a better position to substitute equity for debt in their 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 one or more of the key conditions are relaxed.
Miller (2007) 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. Though, debt ratios in developing countries seem to be affected in the same way and by the same types of variables that are significant in developed countries. However, there are systematic differences in the way these ratios are affected by country factors, such as GDP growth rates, inflation rates, and development of capital markets.
The manufacturing sector consists of establishments that use mechanical or chemical processes to transform material or substances into new products. An establishment is usually at a single physical location and is often called a plant, factory, or mill. It ordinarily uses power-driven machines and equipment for handling materials. Its products may be final products that consumers will purchase, such as an automobile or a chair, or they may be goods for use by other manufacturers, such as parts for automobile engines or rolls of upholstery fabric. A manufacturing establishment may also assemble parts or perform blending operations. Manufacturers are in the business of producing physical units of output for consumption by end users or other manufacturers. One goal of production is to consume as few inputs as possible to produce a quality output.
Capital structure is closely linked with corporate performance (Tian and Zeitun, 2007). Corporate performance can be measured by variables which involve productivity, profitability, growth or, even, customers' satisfaction. These measures are related among each other. Financial measurement is one of the tools which indicate the financial strengths, weaknesses, opportunities and threats. Those measurements are return on investment (ROI), residual income (RI), earning per share (EPS), dividend yield, return on assets (ROA),, growth in sales, return on equity (ROE),etc (Barbosa and Louri, 2012). For the purpose of this study, performance is measured by three proxies namely; return on equity (ROE), return on assets (ROA) 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. This study attempts to reduce the gap by analyzing a capital structure question from a Nigerian business environment.
Statement of the Problem
In reality, optimal capital structure of a firm is difficult to determine. Financial managers have difficulty in determining the optimal capital structure. A firm has to issue various securities in a countless mixture to come across particular combinations that can maximize its overall value which means optimal capital structure. In Nigeria investors and stake holders do not looks in details the effect of capital structure in measuring their firms performance as they may assume that attribution of capital structure is not related or dose not contribute to the performance of a firm, but not knowing that it plays an imperative role in the performance of any firm. Therefore there is need for more integrative research to resolve the controversies. The standard of increasing capital in Nigeria became higher hard to achieve due to the associated risk of raising capital and due to these a firm has to issue various securities in countless mixtures to come across particular combinations that can maximize it over all value. Due to this leverage has become a global issue of business financing decision and nigeria qouted nigeria manufacturing firm.The fact that effect of capital structure on the performance of firm has been over looked by investors and due to the encounters business loss and also researcher on these research has not been able arrive at a grounded conclusion. Which will give investors ground to see the imperative nature of capital structure on business performance. Also over the years leverage has become a global issue of business financing decision and Nigeria quated manufacturing firms are not exception. With these problems the researcher decided to carrying on these research of effect of capital structure on the performance on manufacturing firms in Nigeria.
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