This paper presents empirical findings on the impact of capital structure (leverage) on performance of quoted firms in Nigeria. The main objective of this study is to determine the overall effect of capital structure on corporate performance of Nigerian quoted firms by establishing the relationship that exists between the capital structure choices of firms in Nigeria and their return on assets, return on equity and tobin’s Q (a market performance measure). The effect of institutional factors such as size, tax and industry on firms’ performance was also established. The study employed panel data analysis by using Fixed-effect estimation, Random-effect estimation and Pooled Regression Model. The usual identification tests and the Hausman’s Chi-square statistics for testing whether the Fixed Effects model estimator is an appropriate alternative to the Random Effects model were also computed for each model. The empirical results based on 2003 to 2007 accounting and marketing data for 101 quoted firms in Nigeria lend some support to the pecking order and static tradeoff theories of capital structure. A firm’s leverage was found to have a significant negative impact on the firm’s accounting performance measure (ROA). An interesting finding is that all the leverage measures have a positive and highly significant relationship with the market performance measure (Tobin’s Q). It was also established that the maturity structure of debts affect the performance of firms significantly and the size of the firm has a significant positive effect on the performance of firms in Nigeria The study further reveals a salient fact that Nigerian firms are either majorly financed by equity capital or a mix of equity capital and short term financing. It is therefore suggested that Nigerian firms should try to match their high market performance with real activities that can help make the market performance reflect on their internal growth and accounting performance.
1.1 Background to the Study
Capital structure is one of the finance topics among the studies of researchers and scholars. Its importance derives from the fact that capital structure is tightly related to the ability of firms to fulfil the needs of various stakeholders. Capital structure represents the major claims to a corporation‟s assets. This includes the different types of equities and liabilities (Riahi-Belkaoni, 1999). The debt-equity mix can take any of the following forms: 100% equity: 0% debt, 0% equity: 100% debt and X% equity: Y% debt. From these three alternatives, option one is that of the unlevered firm, that is, the firm 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.
Research on the theory of capital structure was pioneered by the seminal work of Modigliani and Miller (1958). Significant empirical and theoretical extensions followed and the broad consensus paradigm, at least until recently, is that firms choose an appropriate (optimal) level of debt, based on a tradeoff between benefits and cost of debt (Krishnan and Moyer, 1997). It has also been argued that profitable firms were less likely to depend on debt in the capital structure than less profitable ones and that firms with high growth rates have high debt to equity ratios (see Harris and Raviv,1991, Krishnan and Moyer, 1997, Tian and Zeitun, 2007). There is no doubt that benefits abound in the use of debt in the capital structure of the firms. The main benefit of debt financing is the tax-deductibility of interest charges, which results in lower cost of capital (Krishnan and Moyer, 1997). Does it then mean that a firm should go on increasing the debt proportion in its capital structure? If every increase in debt financing were going to increase the earnings for the shareholders, then every firm would have been 100% debt financed. However, there are certain costs associated with debt financing. So, between the two extremes of whole equity financing and whole debt financing, a particular debt-equity mix is to be decided. Any attempt by a firm to design its capital structure therefore, should be undertaken in the light of two propositions: first that the capital structure be designed in such a way as to lead to the objective of maximizing shareholders wealth, second, that, though the exact optimal capital structure may be impossible, efforts must be made to achieve the best approximation to the optimal capital structure.
In practice, firms differ from one another in respect of size, nature, earnings, cost of funds, competitive conditions, market expectations and risk. Therefore, the theories of capital structure may provide only a broad theoretical framework for analyzing the relationship between leverage and cost of capital and value of the firm. A financial manager however, should go beyond these considerations as no empirical model may be able to incorporate all these subjective features. There are in fact, a whole lot of factors, qualitative, quantitative and subjective, which should be considered and factored in the process of planning and designing a capital structure for a firm. Besides, these considerations, care should be taken to ensure that the capital structure is evaluated in its totality and a finance manager should find out as to which capital structure is most advantageous to the firm. The firm should also suitably take care of the interest of the shareholders, debt holders and management. Above all, the legal provisions (if any) regarding the capital structure should also be considered.
A list of factors relative to capital structure decisions such as profitability, growth of the firm, size of the firm, debt maturity, debt ratio, tax and tangibility have been identified; however, considerations affecting the capital structure decisions can be studied in the light of minimization of risk. A firm’s capital structure must be developed with an eye towards risk because it has a direct link with the value (Krishnan and Moyer, 1997). Risk may be factored for two considerations: (1) that capital structure must be consistent with the firm‟s business risk, and (2) that capital structure results in a certain level of financial risk.
Business risk may be defined as the relationship between the firm’s sales and its earnings before interest and taxes (EBIT). In general, the greater the firm’s operating leverage-the use of fixed operating cost- the higher its business risk. Although operating leverage is an important factor affecting business risk, two other factors also affect it-revenue stability and cost stability. Revenue stability refers to the relative variability of the firm’s sales revenues.
This behaviour depends on both the stability of demand and the price of the firm’s products. Firms with reasonably stable levels of demand, and products with stable prices have stable revenues that result in low levels of fixed costs. Firms with highly volatile demand, products and prices have unstable revenues that result in high levels of business risk.
Cost stability is concerned with the relative predictability of input price. The more predictable and stable these input prices are, the lower is the business risk, and vice-versa. Business risk varies among firms, regardless of the line of business, and is not affected by capital structure decisions (Krishnan and Moyer, 1997). Thus, the level of business risk must be taken as given. The higher a firm’s business risk, the more cautious the firm must be in establishing its capital structure. Firms with high business risk therefore tend toward less levered capital structure, and vice-versa (Stohs and Mauer, 1996).
The firm’s capital structure directly affects its financial risk, which may be described as the risk resulting from the use of financial leverage. Financial leverage is concerned with the relationship between earnings before interest and taxes (EBIT) and earnings before tax (EBT). The more fixed-cost financing, i.e. debt (including financial leases) and preferred stock, a firm has in its capital structure, the greater its financial risk. Since the level of this risk and the associated level of returns are key inputs to the valuation process, the firm must estimate the potential impact of alternative capital structures on these factors and ultimately on value in order to select the best capital structure.
From the foregoing, a capital structure is said to be efficient, if it keeps the total risk of the firm to the minimum level. The long term solvency and financial risk of a firm is usually assessed for a given capital structure. Since increase in debt financing affects the solvency as well as the financial risk of the firm, the excessive use of debt financing is generally avoided. It may be noted that the balancing of both the financial and business risk is implied so that the total risk of the firm is kept within desirable limits. A firm having higher business risk usually keeps the financial risk to the minimum level; otherwise the firm becomes a high-risk proposition resulting to higher cost of capital.
After over half a century of studies on this great topic, economists and financial experts have not reached an agreement on how and to which extent firms‟ capital structure impacts the value of firms, their performance and governance. However, the studies and empirical findings of the last decades have at least demonstrated that capital structure has more importance than was found with the pioneering Miller-Modigliani model. We might probably be far from the ideal combination between equity and debt, but the efforts of fifty years of studies have provided the evidence that capital structure does affect firms‟ value and future performance. This study is an attempt to contribute to the empirical studies on how capital structure affects firm‟s performance in the Nigerian context.
1.2 Statement of Research Problem
The financing decision mix of debt and equity represents a fundamental issue faced by financial managers of firms. 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 is still no conclusive empirical evidence in the literature about how capital structure influences corporate performance of firms in Nigeria. According to Kochar (1997), poor capital structure decisions may lead to a possible reduction/loss in the value derived from strategic assets. Hence, the capability of a firm in managing its financial policies is import ant, if the firm is to realize gains from its specialized resources. The raising of appropriate fund in an organization will aid the firm in its operation; hence, it is important for firms in Nigeria to know the debt-equity mix that gives effective and efficient performance, after a good analysis of business operations and obligations.
From our preliminary observation of the financial reports of firms considered in this study, debt financing for quoted companies in Nigeria corresponds mainly to short term debts. Also, external finance for Nigerian listed firms as observed from their annual reports often far exceed investments for most of the firms. However, using excessive amounts of external financing can result in the overleveraging of a company, which means the business has extensive obligations to institutional and individual investors who can disrupt the company‟s operations and financial returns.
Debt financing affects a company‟s performance because companies will usually agree to fixed repayments for a specific period. These repayments occur regardless of the firm‟s performance. Although equity financing typically avoids these repayments, it requires companies to give an ownership stake in the company to venture capitalist or investors. Thus, the choice of capital structure is fundamentally a financing decision problem which becomes even more difficult in times when the economic environment in which the company operates presents a high degree of instability like the case of Nigeria. Hence, making ap propriate capital structure decision becomes crucial for Nigerian firms.
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. Also, 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 find an appropriate mix of debts and stocks through which a firm can increase its financial performance more efficiently and effectively.
1.3 Objectives of the Study
The main objective of this study is to determine the effect of capital structure on corporate performance of Nigerian quoted firms. The specific objectives derived from the major objective are:
- To establish the relationship between the capital structures of the firms in Nigeria and their return on assets;
- To determine the effect of capital structures of the firms in Nigeria on their return on equity;
- To ascertain the effect capital structures of firms in Nigeria have on their Tobin‟s Q as a market performance measure;
- To examine how Nigerian firms‟ sizes impact their performance.
- To establish the effect of tax on corporate performance; and
- To ascertain the effect of the industrial sector on the performance of firms in Nigeria.
1.4 Research Questions
- What is the relationship between the capital structures of firms in Nigeria and their performance measured by their return on assets, return on equity and Tobin‟s Q?
- How does the capital structure of a firm affect its performance?
- To what extent does maturity structure of debts affect the performance of firms in Nigeria?
- What is the effect of the size of a firm on the performance of firms in Nigeria?
- What is the effect of tax on the performance of Nigerian firms?
- How does the industrial sector affect the performance of Nigerian firms?
1.5 Research Hypotheses
From literature, there is evidence that a firm‟s performance is affected by the capital structure (Tian & Zeitun, 2007, Salawu, 2007, Kim et al 1998, Krisnnan & Moyer, 1997, Rajan & Zingales, 1995, Blaine, 1994). If capital structure does affect a firm‟s performance and value, then a strong correlation between firm‟s performance and capital structure is expected. This study therefore argues that a firm‟s debt ratio affects its performance negatively. Hence, hypothesis 1 and 2 can be stated as follows:
- H0: A firm‟s capital structure does not have significant influence on its accounting performance as measured by the return on assets and return on equity.
H1: A firm‟s capital structure has a significant influence on its accounting performance measured by the return on assets and return on equity.
- H0: A firm‟s capital structure does not have significant influence on its market
performance as measured by Tobin‟s Q.
H1: A firm‟s capital structure has a significant influence on its market performance as measured by Tobin‟s Q.
It has been further argued that short term debt influences a firm‟s performance negatively because short term debt exposes firms to the risk of refinancing (Tian & Zeitun, 2007, Pandey, 2001, Kim et al., 1998, Stohs and Mauer, 1996). It is therefore expected that the debt maturity ratio (short term debt) will have a significant impact on corporate performance because of banking credit policy. Thus, the third hypothesis;
- H0: A firm‟s size does not have a significant influence on a firm‟s performance.
H1: A firm‟s size does have a significant influence on a firm‟s performance
Modigliani and Miller 1963 work incorporated corporate taxes and concluded that with corporate income taxes, leverage will increase a firm‟s value. This occurs because interest is a tax-deductible expense; hence more of a levered firm‟s operating income flows through to investors. DeAngelo and Masulis (1980) present a trade-off model of optimal capital structure that incorporates the impact of debt and non-debt corporate tax shields. They argue that deductions for depreciation and tax-loss carry forwards are substitutes for the tax benefits of debt financing. Their model suggests that firms with large tax benefits relative to assets should also include less debt in their capital structure. According to Kahle and Shastri (2005), ignoring the effect of these tax benefits can potentially impact our understanding of firm profitability and capital structure. However, in the case of companies with large tax benefits from option exercise, operating earnings can increase even if the profitability of the company‟s basic business has not changed . Hence we state the following hypothesis:
1.6 Scope and Coverage of the Study
This study is limited in scope to only quoted firms in Nigeria given that comparison with quoted companies in advance countries will be practically impossible. This is attributable to the differences in reporting standard and the size of the market. The attitude of companies to debt also differs across countries. This study also covers only the non-financial quoted companies. All companies whose business are financial in nature are excluded as they exhibit different characteristics from non-financial quoted companies since their debt-like liabilities are not strictly comparable to the debt issued by non-financial firms. This study is also limited in temporal scope to 5 years i.e. the period from 2003 to 2007. This is done to reduce estimation bias and noises which could be generated as a direct corollary of the global economic downturn in 2008 and 2009.
1.7 Significance of the Study
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 has on an organization‟s ability to deal with its competitive environment. A company can finance investment decision by debt and/or equity. This is known as financing decision which could affect the debt- equity mix of firms. The debt-equity mix has an overall implication for the shareholders earnings and risk which will in turn affect the cost of capital and market value of the company. It is therefore imperative for financial managers of firms to determine the proportion of equity capital and debt capital (capital structure) to obtain the debt financing mix that will optimize the value of the firm.
The prediction of the Modigliani and Miller Model that in a perfect capital market the value of the firm is independent of its capital structure, and hence debt and equity are perfect substitutes for each other, is widely accepted. However, once the assumption of perfect capital markets is relaxed, the choice of capital structure becomes an important value-determining factor. This paved the way for the development of alternative theories of capital structure decision and their empirical analysis. Although it is now recognized that the choice between debt and equity depends on firm-specific characteristics, the empirical evidence is mixed and often difficult to interpret. Moreover, very little is still understood about the determinants of firms‟ financing mix outside the US and other major developed markets with only a few papers analyzing data from developing countries.
Inter-country comparative studies highlighting differences in capital structure started to appear only during the last two decades i.e. 1990 to 2010. An early investigation of seven advanced industrialized countries (G7) was performed by Rajan and Zingales (1995) where they argued that although common firm-specific factors significantly influence the capital structure of firms across the countries, several country-specific factors also play an important role. This led to further studies on developing versus developed economies.
Dirmirguc-Kunt and Maksimovic (1999) compared capital structure of firms from 19 developed countries and 11 developing countries. They found that institutional differences between developed and developing countries explained a large portion of the variation in the use of long term debt. They also observed that some institutional factors such as the stock market size, the financing structure etc. in developing countries influence the leverage of large and small firms differently.
In an analysis of ten developing countries, Booth, Aivaziam, Demirguc-Kunt and Maksimovic, (2001) found that capital structure decisions of firms in these countries were affected by the same firm-specific factors as in developed countries. They assessed whether existing capital structure theories applied across countries with different structures in firms in ten developing countries and the G7 countries between 1980 and1991 and found consistent relations in both the pooled data results between firm‟s profitability, asset tangibility, growth option and leverage. However, they found out that there are differences in the way leverage is affected by country-specific factors such as GDP growth and capital market development. They therefore concluded that more research needs to be done to understand the impact of institutional factors on firms‟ capital structure choices in different countries.
This study, therefore, has contributed 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 has helped us to understand the impact of institutional factors on Nigerian firms‟ capital structure choices and how it affects their performance. It has also helped us to establish that the western capital structure models exhibit robustness for companies in the Nigerian market to a large extent.
This study also differs from other studies conducted so far in the country based on the fact that the study employs a larger number of quoted firms (a total of 101 quoted firms yielding 505 observation); employs Tobin‟s Q as a market performance measure in the study of capital structure and performance of Nigerian firms; increases the number of estimation parameters/measurement variables based on the theories of capital structure; and employs five year averages in the analysis to avoid problems of short term measurement instability and to reduce estimation bias and noises. Therefore, the study is also contributing to methodological discourse as the study employed both pooled, cross-section and time series data in a panel data framework. In effect, this study has improved on previous studies in terms of techniques used in the analysis of the data of Nigerian firms, by employing the use of panel data estimation model. Consequently, the results obtained from the study has led to the recommendation of some policies and guidelines that will help in decision making and directions of the capital structure of firms in Nigeria in order to improve their performance. Hence, scholars, CEOs of firms and finance managers in Nigeria would find the output of this study a useful database and resource material.
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