CAPITAL STRUCTURE OF MANUFACTURING FIRMS IN NIGERIA A CRITICAL ANALYSIS OF FOODS BEVERAGES AND TOBACCO SECTOR

CHAPTER ONE

INTRODUCTION

1.1       BACKGROUND OF THE STUDY

Capital structure, otherwise referred to as, financial structure, is the means by which an organization is financed. It is the mix of debt and equity capital maintained by a firm. The extant literature is awash with theories on capital structure since the seminal work of Modigliani and Miller (1958). How an organization is financed is of paramount importance to both the managers of 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. This study wants to contribute to the debate on the relationship between capital structure and firm performance from the agency cost theory perspective using Nigerian data. This study seeks to provide answer to the question, “does capital structure affects financial performance of firms?” Data of thirty firms listed on the Nigeria Stock Exchange (NSE) between 2001 and 2007, representing 210- firm year observations was used for the study. 

An efficient economic system calls for a dependable mechanism to allocate its resources and

optimized leadership of land, labour and Capital. In a market economy, this allocation process consists largely of a set of private decisions, which are directed by a network of free markets and flexible prices. Important among these decisions are capital investments decisions that are vital at two levels for the future operability of the individual firm making the investment, and for the economy of the nation as a whole. At the firm level, capital investment decisions have implications for many aspects of operations, and often exert a crucial impact on survival, profitability and growth. At the national level, the proper planning and allocation of capital investment are essential to an efficient utilization of other resources, poorly placed investment reduces the productivity of labour and materials and sets a lower ceiling on the economy’s potential output.

There have always been controversies among finance scholars when it comes to the subject of capital structure. So far, researchers have not yet reached a consensus on the optimal capital structure of firms. The ability of companies to carry out their stakeholders’ needs is tightly related to capital structure. Therefore, this derivation is an important fact that cannot be omitted. Capital structure is one of the popular topics among the scholars in finance field which aims to resource allocation. The capital structure of a firm is very important since it is related to the ability of the firm to meet the needs of its stakeholders. The theory of the capital structure is an important reference theory in enterprise’s financing policy. It refers to the firm’s financial framework. It’s a financial term means the way a firm finances their assets through the combination of equity, debt, or hybrid securities (Saad, 2010).

In short, capital structure is a mixture of a company’s debts (long-term and short-term), common equity and preferred equity, that is, its essential on how a firm finances its overall operations and growth by using different sources of funds. Whether or not an optimal capital structure exists is one of the most important and complex issues in cooperate finance. Modigliani-Miller (MM) theorem is the broadly accepted capital structure theory because is it the origin theory of capital structure theory which had been used by many researchers. 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. An appropriate capital structure is a critical decision for any business organization. Financing decisions is one of the important areas in financial management to increase shareholder’s wealth. To determine the extend managers achieve this object, we can relate it to the performance measurement of company. 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.

Financial managers are difficult to exactly determine the optimal capital structure. A firm has to issue various securities in a countless mixture to come across particular combinations that can maximum its overall value which means optimal capital structure. Although optimal capital structure is a topic that had widely done in many researches, we cannot find any formula or theory that decisively provides optimal capital structure for a firm. If irrelevant of capital structure to firm value in perfect market, then imperfections that exist in reality may cause of its relevancy.

In practice, firm managers who are able to identify the optimal capital structure are rewarded by minimizing a firm’s cost of finance thereby maximizing the firm’s revenue. If a firm’s capital structure influences a firm’s performance, then it is reasonable to expect that the firm’s capital structure would affect the firm’s health and its likelihood of default. From a creditor’s point view, it is possible that the debt to equity ratio aids in understanding banks’ risk management strategies and how banks determine the likelihood of default associated with financially distressed firms. In short, the issue regarding the capital structure and firm performance are important for both academics and practitioners. 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, price earnings ratio, growth in sales, market capitalization etc (Barbosa & Louri, 2005).

Most of the theory in corporate sector is based on the assumption that the goal of firm should be to maximize the wealth of its current shareholders. One of the major cornerstones of determining this goal is financial ratio. Financial ratios are commonly used to measure firm performance. Generally, corporations include them in their annual reports to stakeholders. Investment analysts provide them for investors who are considering the purchase of a firm’s securities. Financial ratios represent an attempt to standardize financial information to facilitate meaningful comparisons. It provides the basis for answering some very important questions concerning the financial well being of the firm. Its objectives are to determine the firm’s financial strengths and to identify its weaknesses. The essence of financial management is the creation of shareholder value. According to Ehrhard and Bringham (2003), the value of a business based on the going concern expectation is the present value of all the expected future cash flows to be generated by the assets.

1.2 STATEMENT OF THE PROBLEM

For many years the link between capital structure and the financial performance of the firm has been the subject of intense debate and research and yet there is insufficient evidence to clear this argument. Researchers have not reached an agreement on how and to which extent the capital structure of firms’ impacts on their value and performance. However, the studies and empirical findings of the last decades have at least demonstrated that capital structure has more importance than in the simple Modigliani-Miller model. The relationship between capital structure and corporate performance is one that has received considerable attention in the finance literature. This is because it represents one of the most controversial issues in the field of finance.

The inconclusive controversy was sparked off by Modigliani and Miller (1958) argument, that there is no optimal capital structure and therefore capital structure decisions are of no value to the firm. This ignited a lot of contributions from many scholars who include: Stigliz (1969), Miller (1977), Ross (1977), Jensens and Meckling (1976), Myers (1984), Rajan and Zingales (1995), Myers (2001), among others. Based on Ebaid (2009) research, capital structure has weak-to-no influence on the financial performance of listed firms in Egypt. By using three accounting-based measurement of financial performance which is Return On Asset (ROA), Return On Equity (ROE), and Gross Profit Margin (GPM), the empirical tests reveals that capital structure (particularly short-term debt and total debt) measured by ROA have a negative impact on an organization’s performance.

Tian and Zeitun (2007) found out that firm’s capital structure have a significant and negative impact on the firm’s performance measures in both the accounting and market measures. Indeed, a well attribution of capital structure will lead to the success of firms. As a result, the issues of capital structure which may influence the corporate performance have to be solved. Professor Stewart Myers, when he first presented the pecking order theory of capital structure in 1984, referred to the conflict among the different theories of capital structure as “the capital structure puzzle”. The puzzle has over the years been compounded by the difficulty of coming up with conclusive tests of the competing theories.

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. Optimal capital structure means with a minimum weighted-average cost of capital, the value of a firm is maximized. If capital structure is considered irrelevant to the value of a firm in a perfect market, then imperfections that exist such as absence of corporate tax, bankruptcy cost in reality may cause its relevancy. The standard of increasing capital in Nigeria became higher hard to achieve due to the associated   risk of raising capital.

 Although capital structure and the impact on the value and performance had been studied for many years, researchers still cannot agree on the extent of the impact. In Nigeria, investors and stakeholders do not look in detail the effect of capital structure in measuring their firms’ performance as they may assume that attributions of capital structure are not related to their firms’ performance and value. Indeed, a well attribution of capital structure will lead to the success of firms. Modern financial theory and strategic management which provide basis of associating leverage and firm performance are based on very different paradigms, resulting in opposing conclusions.

Therefore, there is need for more integrative research to resolve the controversies. Strategic management scholars exhibit disparate opinions regarding the possibility of such integration. Oviatt (1984) suggested that a theoretical integration between the two disciplines is indeed possible, and that transaction cost economics and agency theory provide possible avenues. In contrast, Bromiley (1990) believed that the scope for integration is limited, if at all possible. According to him, strategy researchers should neither import empirical results from finance, nor should they work towards integration of strategic and financial research. Therefore, while strategy should expand its domain to study areas traditionally considered in finance, researchers should be careful to maintain a strategic perspective.

Some management researchers have viewed capital structure decisions as arising from the preferences of various stake holders such as managers, board of directors, and institutional investors. Other researchers have viewed capital structure as an antecedent to firm strategy leading to performance evaluation, such as diversification into new businesses. While these studies have definitely contributed to some understanding of the linkages between firm performance and capital structure, they have largely ignored some basic issues confronting researchers and managers alike, namely: Does it matter how firms finance their assets? and do different modes of financing make a difference? While anecdotal evidence suggests that the amount and type of financing should be closely tied to a firm’s performance and few researchers have looked at the firm performance/financing interaction. The choice of an appropriate financing mix constitutes a critical decision for the survival and continuous growth of any business organization not only because of the need to maximize returns to the various interest holders, but also because of the impact such informed decision has on the performance of an organization in a competitive environment.

The survival and growth of a firm need resources but financing these resources has limitations. Therefore, applying these limit resources should be in the way that creates an appropriate share of value for providers and users of resources because without capital the firm would be unable to run, grow and expand their business. However, other studies present different opinion about what type of fund and the optimum capital structure that will improve a firm performance. Acemoglue (1998) and Brounen and Eitchholtz (2001) considered debt financing as a more appropriate form of financing the operation of high risk firms because of the advantage of tax shield available on interest payment, while Myers and Majluf (1984). sees equity financing as more appropriate means of financing high risk firms with a lower success probability and higher cash flow.

Other researchers such as Berkovitch and Israel (1996) and Habib and Johnsen, (2000), see the use of both debt and equity as a more appropriate means of financing a firms operation. Based on these contending views and the resultant conspicuous gap in empirical research on capital structure of manufacturing firms in Nigeria and the appropriate financing means of firm’s operations, corporate managers are faced with a problem of which means of finance and at what level in terms of magnitude will bring about the efficient performance of a firm.  It is with this background that this study sought to critically investigate the impact of Capital structure on firms’ performance in the Nigeria.

1.3 OBJECTIVE OF THE STUDY

The main objective of the study is to critically analyze the effect of capital structure of manufacturing firms on their performance with particular on Nigerian Foods, Beverages and Tobacco sector of the economy. The specific objectives are to determine:

1. Whether the capital structure of the subject firms has positive impact on firm performance.

2. The relationship between firm’s size and capital structure.

3. The relationship between firm’s age and capital structure.

1.4       RESEARCH QUESTIONS

In line with the above objectives, the research questions are as follows:

1. To what extent does capital structure affect financial performance?
2. What is the relationship between firm’s size and capital structure?
3. What is the relationship between firm’s age and capital structure?

1.5       HYPOTHESES OF THE STUDY

Following the objectives and research questions of the study, the research hypotheses shall be:

1. Capital structure of firm has no positive impact on its performance.
2. There is no significant relationship between firm’s size and capital structure.

3.  There is no significant relationship between firm’s age and capital structure.

1.6       SCOPE OF THE STUDY

The purpose of this study is to examine Capital Structure of Nigerian Foods, Beverages and Tobacco sector firms. Therefore, this study will be specifically limited to Critical Analysis of the capital structure of Foods, Beverages and Tobacco sector firms.

1.7 SIGNIFICANCE OF THE STUDY

The researcher strongly believes that this work would provide one of the base materials for manufacturers in applying sound principles of Capital Structure management. The work will further enrich the library, since it will be kept in the library for students to make use of in their academic and research work. It is hoped that the members of manufacturing firms of Nigeria and other institutions will make this work their great companion.