CHAPTER ONE

INTRODUCTION

1.1 BACKGROUND TO THE STUDY

Capital structure is the means by which an organization is bankrolled. It is the mix of debt

and equity capital maintained by a firm. The extant literature is full of theories on capital

structure since the pivotal work of Modigliani and miller (1958) as found in Chinaemerem

and Anthony (2012). How an organization is financed is of paramount importance to both the

managers of the firms and providers of funds. This is because if a wrong mix of finance is

employed, the performance and survival of the business enterprise may be seriously affected.

Capital structure of a firm is the mix of debt, equity and other sources of finance that

management of a firm uses to finance its activities. Different firms use different proportion or

mix. A firm may adopt to use all equity or all debt. All equity is preferred by investors as

they are not given conditions on the type of investment and usage of funds from providers.

All debt is preferred by investors in a country where debt interest is tax deductible. Firms use

a mix of debt and equity in various proportions in order to maximize the overall market value

of the firm (Abor, 2007).

Capital structure is expedient for decision making of business firms, and facilitates

maximisation of return on investment, as well as boosts the efficiency of financing and

dividend decisions. Financing decision facilitates the survival and growth of a business

enterprise, which calls for the need to channel efforts of businesses towards realising efficient

financing decision, which will protect the shareholders’ interest. This implies effective

planning and financial management through combination of an optimum capital structure by

managers so as to maximize the shareholders’ wealth. A firm can finance investment decision

by debt, equity or both. Such capital gearing could have implications for the shareholders

earnings and risk, which could eventually affect the cost of capital and the market value of

the firm. Capital structure decision is one of the most crucial decisions made by financial

managers, and borders on the mix of debt and equity used by firms in financing their assets.

Perceived as the pivotal to the growth and future of a firm, it is useful in dividend policy,

project financing, issue of long term securities, financing of mergers, among others.

One of the many objectives of a company financial manager is to ensure the lower cost of

capital and thus maximize the wealth of shareholders. Capital structure is one of the effective

tools of management to manage the cost of capital. A firm's capital structure has an important

influence on the financial performance and firm efficiency Ghosh, (2008); Margaritis and

Psillaki, (2007). A firm could increase or decrease its leverage by either issuing more debt to

buy back stock or issuing stock to pay debt. The objective of managing capital structure is to

mix the financial sources used by the firm in a way that will maximize the shareholders'

wealth and minimize the firm's cost of capital. This proper mix of funds sources is called

optimal capital structure. Then how should a firm choose its debt to equity ratio? And, what

is the optimal capital structure for a firm? Whether or not such an optimal capital structure

exists? What are the potential determinants of such optimal capital structure is an issue in

corporate finance (Myers,1984). Several theories have been put forward on the subject, but it

seems consensus is yet to be reached. For instance, circumstances may make it advantageous

to increase the proportion of debt capital, which include increasing the gearing as a result of

its tax deductible advantage. There is an upper limit to debt finance however, for not only are

there obvious dangers in the presence of large fixed interest charges against corporate

income, but there are practical limits to the amount of funds which may be borrowed.

The performance of a firm has to do with how effectively and efficiently it is able to' achieve

the set goals which may be financial or operational. The financial performance of a firm

relates to its motive to maximize profit both to shareholders and on assets (Chakravarthy,

1986) while the operational performance concerns with growth and expansions in relations to

sales and 'market value (Hofer & Sandberg, 1987). Since capital is employed by firms to

achieve the firm's set goals, and performance is said to be the goals so set, both capital

structure and firm performance are therefore expected to be proportionally related and

influenced one another. Thus, determination of the appropriate capital structure for the wealth

maximizing firm is a central area in the study of business finance and has spawned numerous

articles and studies by academics and practitioners alike. Consequently, this study examines

the determinants of capital structure among manufacturing firms in Nigerian.

1.2 STATEMENT OF PROBLEM

Capital structure is one of the contentious issues in finance. Various theories have been put

forward by researchers to justify the existence of optimal capital structure of a firm. It is in

fact a puzzle. The theories have been developed to try to unearth the financing preferences

managers may have in selecting a particular capital structure (Abor, 2007). Different nations

have different tax regulations and culture Suh (2008) as cited in Musiega, Chitiavi and Alala

(2013) (hence the results of one nation may not apply to other nations as the interactions

between various variables may not be the same. Hence Nigeria a developing nation require

such a research to enable managers and investors to undertake judicious investment decisions

as researches in this area are only centred on developed nations. Many empirical and

theoretical studies have proven that capital structure really influences firm's value but the

major concern contemporarily in modem cooperate finance is how to resolve the conflicts

between the managers and the owners in the control of resources and how will that control

mechanism speak on the firm performance (Jensen, 1986;1989). Going by the Agency Cost

Theory, the only control mechanism to checkmate the managers' excesses to pursue the firm's

overall goals is the introduction of more leverage in financing the firm. If more of debt is

employed, the treat of liquidation, debt servicing, which may eventually result to loss of jobs

to the managers will result to cost reduction thereby leading to efficiency and subsequently

improved performance. On this basis, this study considers the impact of capital structure on

firm's performance from the Agency Cost Theory perspective that higher leverage results in

the reduction of agency cost, improves efficiency and thereby making the firm more

profitable.

1.3 OBJECTIVE OF THE STUDY

The main objective of this study is to investigate the impact of capital structure on

profitability of the Nigerian listed firms. Related to the main objective, the research is

committed to specifically examining the following on the Nigerian listed firms:

(a) To assess the impact of debt ratio on firm performance in Nigeria and also

(b) To study the impact of equity financing on firm performance In Nigeria.

1.4 RESEARCH QUESTION

1. Does debt ratio have an impact on firm performance in Nigeria?

2. Does equity financing have an impact on firm performance in Nigeria?

1.5 HYPOTHESES

H1: there is no significant relationship between debt ratio and profitability of the Nigerian

firms.

H2: there is no significant relationship between equity financing and profitability of Nigerian

firms.

1.6 SCOPE OF THE STUDY

The study focuses on the performance of firms in the Nigerian manufacturing sector

based on their capital structure formation. The reason for limiting the scope to the

manufacturing firms is to give a direction and have a sizeable unit for a case study Among

these firms are major players in the Nigerian manufacturing Industry whose activities cover

all majorly manufacturing services, hence a study on these firms can be generalised. The

period of assessment has also been limited to 2007-2012. This is to ensure that the result

reflects the current trend in the operations of the selected organizations.

1.7 SIGNIFICANCE OF THE STUDY

The significance of this study is that it will help the investors to create such a portfolio that

yield them maximum profit. It will also enable them that how a choice of capital structure

effects the financial performance of the company. This study is utmost importance to both

researchers and business analysts as it looks into the realm of capital financing. This study

adds to existing literatures to verify the claim of traditional theory of capital structure. There

are two broad views on the impact of capital structure on the performance of firms, while one

asserts the significance of capital structure in determining firms‟ performance; the other says

capital structure does not play any significant role in determining the performance of firms.

While various researchers have incorporated other firm specific factors like size, efficiency

and asset growth into their model, this study contributes to existing studies by looking at the

effect of macroeconomic variables which are outside the control of the firm like gross

domestic product and inflation on firm’s performance. Also unlike most works, the firms are

carefully classified into lowly and highly geared firms, this enables us make comparisons and

arrive at a more reliable conclusion.

1.8 OPERATIONAL DEFINITION OF TERMS

CAPITAL STRUCTURE: A mix of a company's long-term debt, specific short-term debt,

common equity and preferred equity. The capital structure is how a firm finances its overall

operations and growth by using different sources of funds.

DEBT RATIO: A financial ratio that measures the extent of a company’s or consumer’s

leverage. The debt ratio is defined as the ratio of total debt to total assets, expressed in

percentage, and can be interpreted as the proportion of a company’s assets that are financed

by debt.

EQUITY FINANCING: The process of raising capital through the sale of shares in an

enterprise. Equity financing essentially refers to the sale of an ownership interest to raise

funds for business purposes.

FIRM PERFORMANCE: Firm performance as we refer to it in this work, is a subset of

organizational effectiveness that covers operational and financial outcomes.

REFERENCES

Abor J & Biekpe N. (2007) How do we explain the capital structure of SMEs in sub-Saharan Africa? Evidence from Ghana. Journal of Economic Studies Vol. 36 No. 1, 2009 pp. 83-97.

Modigliani, F and Miller, M (1958): “The cost of capital, corporation finance and the theory of investment.” American Economic Review, 48, pp 261- 297.

Ghosh, Arvin (2008), Capital Structure and Firm Performance, United States: Transaction Publishers.

Margaritis, Dimitris and Psillaki, Maria (2007), “Capital Structure and Firm Efficiency,” Journal of Business Finance & Accounting, Vol. 34, Issue 9-10, 1447-1469.

Myers S.C., (1984). The capital structure puzzle. Journal of Finance 34 (3), 575-592.

Hofer and Sandberg. (1987). Capital Structure paradigm. Journal of science Academy, 8(1).

Chakravarthy, B. S. (1986). Measuring Strategic Performance. Strategic Management Journal

7, 437-58.

Jensen, M. (1986). Agency cost of free cash flow, corporate finance and takeovers. American Economic Review Papers and Proceedings, 76, pp. 323-329.

Jensen, M. (1989). Eclipse of public corporation. Harvard Business Review, 67(5), pp. 61-74.

Musiega M.G, Chitiavi M.S and Alala O.B (2013) Capital Structure And Performance:

Evidence From Listed Non-Financial Firms On Nairobi Securities Exchange (Nse) Kenya: International Journal for Management Science and Technology 1 (2)1.

Chinaemerem O.C and Anthony O (2012) Impact of Capital Structure on the Financial

Performance of Nigerian Firms: Arabian Journal of Business and Management Review Vol 1(12).