The Effect Of Capital Structure On Corporate Performances (A Case Study Of Selected Companies In Onitsha)

Project and Seminar Material for Accountancy / Accounting

Abstract

This study examined the effect of capital structure on corporate performance with reference to selected companies in Onitsha, Questionnaires and interviews were used to collect information from the selected companies in Onitsha, Anambra State. Analysis and observations were made which gave rise to the validity of the conclusion at the end of the analysis, the major finding were:

That these is a relationship between capital structure and cost of capital.
That capital structure have significant effect on corporate performance (in terms of profitability)
That there is a high cost of capital which hinders the companies borrowing ability.

The recommendations for the study among others were:

That companies should increase their efficiency in use of debt capital.
That since cost of borrowing is so high, if a firm should be able to service fixed charges associated with senior securities and leasing, it can borrow.
That for improved performance mostly on profitability, the optimum combination of fund from varying sources which is superior to any alternative combination is necessary.

The researchers then concludes that:

The inability of many companies to adopt optimal capital structure has been increasing their cost of capital.
Due to increase in the cost of capital for may firms, they were unable to borrow in order to meet up their capital investment hence the decrease in their performance mostly on profitability.
The optimal capital structure is one in which the marginal real cost (the sum of both explicit and the implicit costs) of each available method of financing is the same.

Chapter One

Introduction

1.1 Background to 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 fulfill 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 and 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 and 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 itsmarket 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 and 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. Since 1987, financial liberalization has changed the operating environment of firms, by giving more flexibility to the Nigerian financial managers in choosing their firms‟ capital structure. Alfred (2007) suggested 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 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 euity financing. However, whether or not an optimal capital structure exists in relation to firm value, is one of the most important and complex issues in corporate finance.

The corporate sector in the country is characterized by a large number of firms operating in a largely deregulated and increasingly competitive environment. Since 1987, financial liberalization resulting from the Structural Adjustment Program changed the operating environment of firms. The macroeconomic environment has not been conducive for business while both monetary and fiscal policies of government have not been stable. Following the Structural Adjustment Program, lending rate rose to a high side from 1.5 percent in 1980 to a peak of 29.8 percent in 1992; but it declined to 16.9 percent in 2006. The high interest rate implies that costs of borrowing went up in organized financial market, thus increased the cost of operations. The Structural Adjustment Program (SAP) came with its conditions, policies that liberalized and opened up the Nigerian economy to the outside world even when the nation‟s domestic produce cannot stand in equal comparison to international commodities, causing unfavorable balance of payment as domestic demand for foreign goods increased also led to the high volatility of the exchange rate system thereby rendering business in Nigeria uncompetitive, especially given high cost of borrowing and massive depreciation of Naira, which culminated to increasing rate of Inflation in Nigeria.

1.2 Statement of Problem

The study of capital structure has traditionally been carried out by finance researchers and at best there has been mixed results. The actual impact of capital structure on corporate performance in Nigeria has been a major problem among researchers that has not been resolved. Hitherto, there has been different methodology, variables, theoretical framework and there is still no concrete conclusive empirical evidence in the literature about how capital structure influences corporate performance of firms‟ in Nigeria.

According to Chandrasekharan (2012), firms‟ size, growth and age are significant with the structure of debt and equity of the firm, whereas, profitability and tangibility are not.

Even our own country research works such as ; Babalola (2014), revealed that according to the dominant corporate finance paradigm, capital structure choice is a trade-off between the costs and benefits of debt, and it has been refuted that large firms are more inclined to retain higher performance than middle firms under the same level debt ratio. In another study, concluded that the manufacturing industry‟s capital structure in Nigeria is consistent with trade-off theory and the hypothesis tested that the corporate performance is a nonlinear function of the capital structure. Ishaya and Abduljeleel (2014), also reveals that debt ratio is negatively related with profitability whereas equity is directly related with profitability. Akinyomi (2013), revealed that each of debt to capital, debt to common equity, short term debt to total debt and the age of the firms‟ is significantly and positively related to return on asset and return on equity but long term debt to capital is significantly and relatively related to return on asset and return on return on equity. His hypothesis also tested that there is significant relationship between capital structureand financial performance using both return on asset and return on equity. Shehu (2011), profitability variable supports the pecking order theory, the tangibility variable supports the trade-off theory, the growth theory supports the agency theory while the size variable supports the asymmetry of information theory.

Following the work of Appah et al (2013), revealed that short term debt, long term debt and total debt have significant negative relationship with performance using return on asset and return on equity, non tax debt and liquidity also shows negative relationship with performance while tangibility and efficiency has a significant positive relationship with performance. Taiwo (2012), in his findings revealed that the sampled firms were not able to utilize the fixed asset composition of their total assets judiciously to impact positively on their firms‟ performance. Owolabi and Inyang (2012), discussed the factors that constitutes the determinants of capital structure in Nigeria and that firms with a huge portion of capital structure composed of external debt finds it difficult to pay back when due because of some factors such as financial distress, bankruptcy threat etc. Ogebe et al (2011), supported the traditional theory of capital structure which asserts that leverage is a significant determinant of firms performance and that there is a significant negative relationship is established between leverage and performance.

Bassey et al (2013), revealed that only growth and educational level of firms owners were significant determinants of both long and short term debt ratios, assets structure, abe of the firms, gender of owners and export status impacted significantly on long term debt ratios, while business risk, size and profitability of firms were major determinants of short term debt ratio for the firms under investigation. Simon-Oke and Afolabi (2011), revealed in their study a positive relationship between firms‟ performance and equity financing as well as between firms‟ performance and debt-equity ratio. There is also a negative relationship that exists between firms performance and debt financing due to high cost of borrowing in the country. Semiu and Collins (2011), in their study suggested that a positively significant relationship exists between a firm‟s choice of capital structure and its market value in Nigeria.
In light of all this differences in the findings of the above research work constitute huge problems which this research work will tackle so as to achieve the objective of determining the impact of capital structure on firm‟s performance in Nigeria.

1.3 Objectives of the Study

The main objective of the study is to critically examine the effect of capital structure on corporate performances of firms in Nigeria.

The specific objectives are to;

Determine the relationship between capital structure and cost of capital.
Examine the effect of capital structure on corporate performance (in terms of profitability)
Investigate if high cost of capital hinders the companies borrowing ability.

1.4 Significance of the Study

This study, therefore, contributes 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 helps us to understand the impact of institutional factors on Nigerian firms‟ capital structure choices and how it affects their performance.

Most research studies failed to classify the firms into highly and lowly geared which made it difficult to arrive at a reliable conclusion and comparisons, this study therefore will help other researchers to classify between the highly and lowly geared company which will in turn assist in reaching reliable conclusions.

The study contributes to the existing body of knowledge as it helps to fill up all loopholes arising from other research works. Also, the findings of this study will aid an effective and efficient financing decision of firms in Nigeria. Consultants and financial analysts will find the study helpful in their financial and advisory services to failing and distressed companies.

Furthermore, this research work will also contribute by determining the association between financial leverage and return on asset. It also uses some specific variables (financial leverage, returns on assets and returns on equity) which were not used by other works in order to give a concrete conclusion in analyzing the capital structure on firms‟ performance in Nigeria.

1.5 Research Hypothesis

The researcher tested the truthiness of the statement by either accept or reject the hypothesis statement at 5% significance level.

Hypothesis 1:

Ho: There is no significant relationship between capital structure and cost of capital.
Hi: There is a significant relationship between capital structure and cost of capital

Hypothesis 2:

HO: There is no significant relationship between between capital structure and company profitability.
Hi: There is a significant relationship between between capital structure and company profitability

1.6 Scope of Study

ThestudycoverstheImpact Of Capital Structure On Corporate Performances Of Manufacturing Companies within the time frame of 2012 to 2016. The company used is Guiness Nigeria PLC.

1.7 Limitation of the Study

The limited time at the diposal of the researcher to conclude this research project posed as a major limitation to the researcher as it was difficult to combine school work and this research work completion within the specified period of time.

1.8 Definition of Terms

Capital Structure

Capital structure is how a firm would be able to fund its future investments projects via debt, equity or mixed. Capital structure was also defined by Roshan (2009) as a mix of debt and equity capital maintained by a firm. There is a sign of stability about the meaning of capital structure if newest definition by Narayasanary (2015) is compared with the older definition by Roshan (2009) because both of them considers a mix of debt and equity capital which form a company capital structure.

Company Profitability

This is an outcome or result of company business operations. That company result is the difference between the company revenue and expenditure. Burja (2011) defined company profit or performance as the direct result of managing various economic resources and of their efficient use within operational, investment and financing activities. In this study, company profit was a dependent variable measured by Return on equity and return on asset.

Balance Sheet

Pandey (2010) defined balance sheet and income statement of a company as follows. He defined balance sheet as a statement that indicates the financial condition or the state of affairs of a business at a particular moment in time. To provide more clarification on this, balance sheet consists of information about resources (assets) and company obligations (liabilities) and owners funds (equity) at a particular point of time. Normally balance sheet prepared at a particular date reveal the firm’s financial position at that specific date.

Profit and Loss Account

Pandey (2010) defined profit and loss account as a score board of the firm’s performance during a period of time. Since the profit and loss account reflects the results of operations for a period of time, it is a flow statement. Profit and loss account represents the summary of revenues, expenses and net income or net loss of a company, and net income is the difference between company revenues and expenses at a particular financial year.

Chapter Five

Conclusion and Recommendation

5.1 Conclusion

In this study, our focus was to carryout a critical analysis on the effect of capital structure on corporate performances. The study specifically was aimed at ascertaining if capital structure has helped in fostering and enhancing corporate performances in terms company’s profitability. This study reviewed and anchored its framework on Agency Cost Theory.

The study adopted the survey research design and randomly enrolled participants in the study. A total of 80 responses were validated from the enrolled participants where all respondent are active workers in selected manufacturing companies in Onitsha, Anambra state.

The findings revealed:

That there is a relationship between capital structure and cost of capital.
That capital structure have significant effect on corporate performance (in terms of profitability)
That there is a high cost of capital which hinders the companies borrowing ability.

The researchers then concludes that:

The inability of many companies to adopt optimal capital structure has been increasing their cost of capital.
Due to increase in the cost of capital for may firms, they were unable to borrow in order to meet up their capital investment hence the decrease in their performance mostly on profitability.
The optimal capital structure is one in which the marginal real cost (the sum of both explicit and the implicit costs) of each available method of financing is the same.

5.2 Recommendation

Based on the responses obtained, the researcher proffers the following recommendations:

That companies should increase their efficiency in use of debt capital.
That since cost of borrowing is so high, if a firm should be able to service fixed charges associated with senior securities and leasing, it can borrow.
That for improved performance mostly on profitability, the optimum combination of fund from varying sources which is superior to any alternative combination is necessary.

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