THE DETERMINANTS OF A FIRM’S CAPITAL STRUCTURE IN NIGERIA

CHAPTER ONE

INTRODUCTION

1.1          BACKGROUND OF THE STUDY

There are countless papers on the subject of capital structure. In fact, in every firm, three major problems require the undivided attention of the financial manager. They are:

Working capital (managing day to day cash flow of the business).

Capital budgeting (where to invest).

Capital structure (the finance policy/debt-equity choice).

The fact that one of the most researched fields in corporate finance is capital structure, should give us a hint of its importance. Since the important work of Modigliani and Miller (1958) on the irrelevance of capital structure in investment decision, a rich theoretical literature has emerged that models firms’ structure choices under different assumptions. Many theories regarding capital structure have been developed and many of them have also been empirically tested.

What are the factors that determine the choice of capital structure of a firm? Is there a relationship between a firm’s capital structure and its value? These are some of the questions that have to be answered by firms when making capital structure decisions.

Capital structure policy deals with the financial of a firm’s activities with debt, equity and intermediate securities. With regards to capital structure, thanks to Modigliani and Miller (1958, 1963) whose premier work has paved the way for a vast theoretical framework on capital structure.

Despite the existence of many theories on capital structure, there is little consensus on how firms choose their capital structure. In fact, much remains to be done in understanding the link between the theory and practice of capital structure. In 2001, in a paper released by Graham and Harvey, an attempt was made to fill this gap by providing evidence on the practice of corporate finance theories through a comprehensive survey of the managers of U.S. firms. This study attempts to do the same but in the Nigeria context. However, this work will differ largely in focus and scope from that carried out by Graham and Harvey. Unlike Garvey and Harvey who focused on numerous aspect of corporate finance including capital budgeting, cost of capital and capital structure, this work focuses primarily on capital structure.

A great number of the empirical studies carried out were conducted in developed counties and it is a fact that capital structure choice has not received as much attention in developing countries as it has in developed countries. Apart form the limited amount of empirical research carried out by, for example, Hamid and Singh (1992), Singh (1995),Brada and Singh (1999), Prasad (2000), and booth et al (2001), there is little on capital structure theories from developing countries.

The reason for this low volume of research on capital structure in developing countries is due to the fact that corporate finance (capital structure in particular) did not exist as an area of research investigation in developing countries until recently. This in itself results from the fact that a majority of the developing countries until recently have followed the state sponsored route to development and have also until recently, assigned a relatively insignificant role to the private corporate sector.

In most developing countries, the corporate sector is still in its embryonic state. This has been found to be the case irrespective of the in addition to this, most of the corporate financing needs of these developing countries were met by regional and international development banks. All in all, there is a deficiency in empirical research on the capital structure choice of firms in developing countries. This study therefore helps to fill this deficiency by studying the capital structure choice of a developing country such as Nigeria.

As a result of the macroeconomic changes that have occurred in the Nigeria economic environment involving the deregulation of trade, liberalization of the exchange rate and the achievement of monetary stability, a discussion of the relationship between the development of the financial system, economic growth and capital structure of companies has become highly relevant. Despite the role played by the state in the economy, it can nevertheless implement policies that establish structures and rules for the financial system that are more favourable to corporate investment and long term growth.

In a country like Nigeria, a lot of restrictions exist that limit the ability of firms for access much needed external financing. Also, the costs of alternative forms of long term debt may differ as firms will attempt to select various levels of debt and equity in order to reach an optimal capital structure. This study attempts to extend our knowledge of the determinants of capital structure.

A firm’s objective should be directed to the maximization of its value. A firm would no doubt prefer to have a capital structure that maximizes its firm value if capital structure decisions have an impact on its value. A lot of theories on the relationship between capital structure and the value of a firm exist among which we have the net income theory and the M and M (Modigliani and Miller) theory. It has been discovered that while the development of capital structure has evolved rapidly, empirical research has lagged behind. Consequently, the aim of this research is to add to the empirical literature by providing survey evidence on the determinants of capital structure.

1.2          STATEMENT OF THE RESEARCH PROBLEM

The determination of the relationship between leverage and various factors is the primary purpose of this investigation. The literature throws light on the various factors taken into consideration by a firm in determining its capital structure. Vasiliou et al (2004) for example examines the capital structure of Greek firms providing evidence of the significance of size and tangibility factors.

Though a research may not have answers to every problem, we are confident that at least some problems can be answered by a research. In view of this, the intention of this research work is to specifically find answers to the following questions.

Is there an ideal capital structure?

What is the best choice between debt and equity?

Which of the predominant theories of capital structure best describes the financing strategies of an enterprise?

To what extent can gearing be explained by market to book size, profitability and tangibility?

Whenever the issue of capital structure is brought up, it is essential that a clear-cut relationship established for such criteria exists.

1.3          OBJECTIVES OF THE STUDY

In Nigeria, much attention has not been devoted to capital structure determinants in Nigerian firms. This research work therefore has a primary aim of discovering what the most important determinants affecting capital structure preferences among Nigeria firms are and from these to carry out further examination to find out which capital structure theories are relevant to Nigeria. Another core objective of this study is to determine whether the facts learned form related literatures on studies of developed countries apply to those economies alone of whether they can find room to operate in other economies, specifically Nigeria.

In line with the above stated, the objectives of this study include:

Ascertaining and examining the determinants of this study.

To determining what level of debt and equity a firm should employ in order to reach an optimal capital structure.

Ascertaining how firms choose their capital structure.

Finding out which of the predominant capital structure theories best describe the financing strategies of enterprises.

1.4          SIGNIFICANCE OF THE STUDY

This study is significant because very little empirical study has been undertaken on determinants of capital structure preferences in developing countries. We are firmly convinced that this study will revise, extend as well as crate a new knowledge base particularly as it relates to capital structure and corporate finance in Nigeria especially due to the fact that developing countries like Nigeria posses institutional structures that differ significantly from those in developed countries. (Mayer 1990) states that the financial decision in developing countries differ from those in developed countries.

This study has implications for the reformation of the financial sector in Nigeria. Some of the financial reforms aimed at by developing countries include:

Imposing financial discipline

Developing the capital market

Privatization or decentralization

Introducing competition

It is a source of information for future references.

Thus, this study will greatly help Nigeria in reaching the above goals. This study will greatly help Nigeria’s privatization efforts by putting the government among other things, in a better position to understand how firms in the private sector choose between equity and debt.

This study can aid firms with regards to capital structure in the timing of new issues on the basis of their stock price.

1.5          SCOPE OF THE STUDY

This research will be using selected companies in selecting sectors of the economy for case studies. Dependent and independent variables to be used in this study will be analysed over a suitable time period.

Leverage in financial firms is heavily influenced by explicit and implicit investor insurance schemes such as deposit insurance and hence, all financial firms have been deleted. In addition, their debt-like liabilities are not strictly comparable to the debt issued by non-financial firms. Furthermore, the balance sheets of banks are very different in structure from those issued by non-financial firms.

In conclusion, another reason for the exclusion of financial firms is that banks and other financial firms are subject to specific rules and regulations; their leverage is consequently severely affected by exogenous factors unrelated to direct financing activities. Due to this problem, regulations such as minimum capital requirements may directly affect their capital structure.

To avoid the distortions that result from the combination of the capital structure of both financial and non-financial firms, we recommend that the capital structure choice of financial firms should be a subject of further study.

In conclusion, our study will be restricted to data collected from quoted companies due to the fact that it is very difficult to acquire data from unquoted companies.

1.6          LIMITATION OF THE STUDY

Various limitations can be expected in carrying out a research work of this sort. Some of them include:

1. Data Limitation: Insufficient data is usually acquired therefore the only variables that can be tested are those variables for which secondary data can generate from our research.
2. Temporary Scope: the time frame being adopted may be insufficient for reliability of the results.
3. Variables: The variables in the determinants of capital structure may be imprecisely measured.
4. Response Rate: The response rate from the sample companies may be unfavourable and hence discouraging. This factor can affect the accuracy of the findings of the research work.
5. Sample Size: The sample size can be a limitation to the extent that the number of companies used in the sample may be too small to give accurate results.

As a result of the limitations stated, the data and variables to be collected would be determined by the use of tests developed and designed by and for foreign countries though they would be adopted to fit the Nigerian setting.

1.7          STATEMENT OF HYPOTHESIS

The hypothesis to be tested are stated below:

1. H₀: Profitability is not a determinant of capital structure.

H₁:          Profitability is a determinant of capital structure.

2. H₀: Size is not a determinant of capital structure.

H₁:          Size is a determinant of capital structure.

3. H₀: Growth is not a determinant of capital structure.

H₁:          Growth is a determinant of capital structure.

4. H₀: Tangibility is not a determinant of capital structure.

H₁:          Tangibility is a determinant of capital structure.

 

1.8          DEFINITION OF TERMS

1. CAPITAL STRUCTURE: This is broadly made up of a firm’s amount of equity and debt. The capital structure accounts for long-term equity and debt.
2. FINANCIAL STRUCTURE: This includes short-term debts and accounts payable. It is the right side of the balance sheet detailing how the firm’s assets are financed including all debt and equity issues.
3. AGENCY COST THEORY: This theory states that an optimal capital structure will be determined by minimizing the costs rising from conflicts between the parties involved.
4. PECKING-ORDER THEORY: This theory states that a firm prefers to finance new investment, first, internally with retained earnings, then with debt and finally with an issue of new equity.
5. FIRM’S VALUE: This is sum of the values of all the firm’s securities. Therefore, the sum of the values of equity and debts is the firm’s value.
6. TANGIBILITY: This is defined as the ratio of tangible assets to total assets.
7. MARKET-TO-BOOK: This is can be defined as the ratio of a firm’s book value of its assets less its book value of equity.
8. STATIC TRADE OFF THEORY: This is referred to as tax based theory. It states that an optimal capital structure is obtained where the net tax advantage of debt financing balances leveraged related costs such as financial distresses and bankruptcy, holding firm’s assets and investment decisions consent.
9. DEBT CAPITAL: This refers to capital (usually) with a fixed obligation in terms of interest and principles payment. In out study, debt capital embraces all borrowings such as short-term debt (short-term loans and bank overdraft), long-term debt (long-term loans and debentures) and convertible debentures.
10. GEARING: This is also referred to as leverage. It is a measurement of the extent of external finance employed by an organization.
11. FINANCIAL LEVERAGE: This refers to the employment of fixed interest securities in a firm’s capital structure.
12. INFORMATION ASYMMETRIES: This is a situation where firm managers or insiders are assumed to possess certain information about a firm’s prospects that is not available to investors.
13. FINANCIAL RISK: This is the risk to common stockholders resulting from the use of financial leverage.