Effect Of Capital Structure On The Performance Of Nigeria Manufacturing Firm
Managers of corporate entities are mostly in confrontation with the problem of what combination of capital structure (equity and debt) will maximize returns and value of their firm? The study, therefore, aims at assessing the effect of capital structure on the financial performance of listed manufacturing firms in Nigeria. All manufacturing firm quoted on the Nigeria stock exchange are considered the population for this study. But due to time limit these research is concentrated on one (1) manufacturing company out of these firms whose accounting report as at year-ends 31st December are considered as the sample. Secondary data was utilized from the annual financial report of the sample firm from the year 2005-2015, which was obtained from official website of Nigeria stock exchange. The study used ex-post factor research design to examine the relationship between independent and dependent variables while controlling for other variables. Descriptive statistics, and hierarchical multiple, regression analysis were carried out to test the hypothesis developed in the study. The study found out that there is a positive and significant relationship between firm’s capital structure and corporate financial performance. The study recommend that the equity and debt should be issued at optimal level, due to the fact that as level of debt increases, the capital structure can change from one of internal to one external control. That is to say that firms should consider the mixture of equity and debt since they are major determinants of corporate performance. The study also recommend that debt equity ratio and returns on assets is highly positive and also the relationship between capital employ and returns on investment of Nigeria manufacturing firm is high , key words: capital structure, firm performance, return on equity, return on debt and capital employed.
1.1 Background of the 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.
1.2 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 quoted 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 quoted manufacturing firms are not exception. With these problems the researcher decided to caring on these research of effect of capital structure on the performance on manufacturing firms in Nigeria.
1.3 Research Objective
The main objective of this study was to analyze the effect of capital structure on performance of manufacturing companies listed in Nigerian stock exchange.
The Specific Research Objectives are:
- To determine the relationship between capital structure and profitability of manufacturing companies in Nigerian
- To determine nature of the relationship between growth and profitability of core business operations of manufacturing companies in Nigerian
1.4 Research question
The Research question of this study is;
- What is the nature of the relationship between capital structure and profitability of manufacturing companies in Nigerian
- What is the nature of the relationship between growth and profitability of core business operations of manufacturing companies in Nigerian
1.5 Research Hypothesis
The researcher tested the truthiness of the statement by either accept or reject the hypothesis statement at 5% significance level. There was only one hypothesis statement which was divided into null and alternative hypothesis.
The null hypothesis (H0) and alternative hypothesis (H1) was as follows,
- Ho: There is no significant relationship between capital structure and company profitability.
- HO: There is no significant relationship between growth and profitability of core business operations of manufacturing companies in Nigerian
1.6 Significant of the Study
The results of this study will provide financial guidance to managers, business consultants and investors with the necessary techniques of combining debt and equity and being able to maximize company performance. This study will assist decision makers especially finance managers and policy planners of both public and private companies to formulate better policy decisions in respect of the mix of debt and equity capital and therefore increase shareholders value and reduce bankruptcy costs. This study will be used by investors and other people with the intention of investing to analyze the companies and see what kind of capital structure mix generates more profit for the company. This study will assist other academicians to write further studies concerning financial issues and add the knowledge to the community. Academicians who intend to write dissertations for Bachelor and Masters Degree programs provided in Nigeria and in other parts of the world may use the study results as the reference to support their studies.
This study will assist finance managers and other finance officers in public listed companies to advice on their management about the best source of finance which contribute more profitability of the company. Investors and other company stakeholders after reading this study will be in a position to know the profitability and capital structure indicators of the companies in which they would like to invest and acquire returns in terms of dividends or capital gains.
1.7 Scope of Study
The study covers the Impact Of Capital Structure On The Profitability Of Manufacturing Companies using three manufacturing companies as a case study within the time frame of 2012 to 2016. The company used is Dangote Cement.
1.8 Limitation of the Study
The limited time at the disposal 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.
1.9 Definition of Terms
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.
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.
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.
1.10 Organization of the Study
This chapter presents an introduction of the topic for this research. It highlights the problems associated to the topic which lead to the specification of the objectives of the study geared towards addressing the problems. The chapter also provided the definitions of relevant and related concepts, the scope and limitations of this research.
The second chapter of this study consisted of literature review which clarified definition of key study concepts, theoretical literature of the study where theories related to the study were elaborated. In that section, empirical literature was also reviewed. Moreover, research gap and conceptual framework were part of that section. Chapter three of this study clarified about the methods of data collection, research methodology, data processing and analysis of the study.
Moreover, the study talked about chapter four which talked about study findings and discussion. In that chapter, empirical results of the study were discovered and compared with previous studies and theories of capital structure. Then chapter five of this study talked about the conclusion and recommendation of the study. Finally, this study consisted of final pages which were references and appendices of company data or information used for data analysis purpose. Appendices also consisted of statistical results already analyzed by regression, correlations, and descriptive statistics with the help of STATA computer software program.
Summary, Conclusion and Recommendations
This study used panel data of 3 manufacturing companies for the period of 5 years creating 15 observations of the data. Researcher analyzed the relationship between capital structure variables (independent variables) against profitability variables (dependent variable). Fixed effect regression method was used to measure the relationship between capital structure and return on asset (ROA) while random effect regression model used to test the relationship between capital structure and return on equity of manufacturing companies (ROE). Moreover, partial correlation technique also used to measure the relationship between the study variables in order to support the regression results.
After testing the relationship, researcher revealed the mixed results between capital structure variables and company profitability that means some capital structure variables indicated a negative relationship with company profitability variables while other capital structure variables indicated a positive relationship with profitability variables. Long term debt ratios and short term debt ratios were used as capital structure indicators of manufacturing companies. The random effect regression results indicated a negative relationship between Long term debts to equity (LD/EQ) against return on equity (ROE) at a coefficient of -5.2153 which was also supported by partial correlation results at -0.1581. In terms of short term debt to equity (SD/EQ) against return on equity (ROE), random effect regression results also indicated a negative relationship at -7.7736 which was supported by partial correlations results at -0.2153.Both long term debt and short term debt to equity indicated a negative relationship with return on equity, that means there is no relationship between capital structure and company profitability in terms of return on equity.
Fixed effect regression results indicated a positive relationship between short term debt to assets and return on asset at 0.1683 coefficient level .These results were supported by partial correlation results .Except negative results indicated between long term to equity and short term to equity against return on assets. The positive relation between the variables is consistent with the trade of theory and other previous empirical studies by Abiodum (2012) in Ukraine, and Soyebo (2014) in Nigerian firms. The negative relationship between the variables is consistent with Leon (2016) who used to study manufacturing firms in Sri- Lanka, Tailab (2014) who tested the relationship in American companies, and Lavorskyi (2016) in Ukraine.
The study revealed that, capital structure of listed manufacturing companies in Nigeria affect company profitability in terms of return on assets positively. On the other side, capital structure of listed manufacturing companies has negative relationship with company profit in terms of shareholders fund or return on equity. The results indicate that debt usage has more advantage for companies that depend much on assets to generate profit than those that depend much on equity or shareholders fund to generated company profit
To improve the profitability of listed manufacturing companies in Nigeria, the following recommendations have to be observed. The company management of listed manufacturing companies should increase the use more short term debt to asset ratios because they have much influence on company profitability in terms of both return on equity and return on assets if compared with other capital structure ratios.
Moreover, investors of listed manufacturing companies in Nigeria should review the capital structure of companies before investing in them because the strength of a company capital mix determines the level of returns. More companies in Nigeria should put their financial information through Nigerian stock exchange in order to allow investors to review their capital structure and attracts more investors in their companies
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