IMPACT LEVERAGE HAS ON SHAREHOLDERS

CHAPTER ONE

INTRODUCTION

1.1     BACKGROUND TO THE STUDY

The general problem all business entity face in Nigeria is the choice of finance. Firms at every stage of growth and development, from commencement to maturity need fund in order to survive. The aim of every business is to maximize the wealth and welfare of its owners. Without finance, the aim of all business cannot be met. As such, finance can be said to be the life wire of any firm without which there can be no survival. Financing is the acquisition of cash or other assets through means such as the sale of stocks, retaining net profit and increasing of debt. A firm’s capitalization consists of internally generated funds and due to the fact that a company may not be able to raise all the funds which it requires internally, it may depend on additional external financing, this bringing about leverage. The capitalization of the firm would therefore incorporate both internally generated funds and external funds. Due to the composition of these two sources of fund for the firm, there is a need to strike a balance between them. This balance is called the optimal capital structure. This is the appropriate use of debt and equity that minimizes the firm’s cost of capital and maximizes firms’ value. It should however be borne in mind that a non-optimal capital structure or lack of optimal debt and equity mix may lead to higher financing costs and the firm may reject some capital budgeting projects that would have increased shareholders’ wealth with an optimal financing.

           The need for optimal capital structure will be for the firm to enjoy tax shield and reduce bankruptcy cost. In their seminal article, Modigliani and Miller (1958 and 1963) demonstrate that, in a frictionless world, financial leverage is unrelated to value, but in a world with tax-deductible interest payments, firm value and capital structure are positively related since interest payment from debt help to reduce corporate tax.

          Leverage therefore is greatly considered when investment is being undertaken by investors. By this, investors prefer a firm that is less levered than one that is highly levered. However, the level of activity that can take place in a firm depends on the level of activity that goes on in the sector in which the firm operates as well as the financial strength of the firm. Leverage has a direct effect on the activity of the firm and as such will be greatly considered during the planning of the financial policy of the organization.

1.2     STATEMENT OF THE PROBLEM

Empirical studies tends to be less interested on how leverage determines shareholders value per se, and more on how changes in the capital structure of a company affects value (Hitt, Hoskisson, and Harrison, 1991), and thus its overall performance (Jensen, 1986).

Shareholders values vary with different level of debt usages. Shareholder values increase with increase of debt until the marginal benefits from leverage equal to the marginal bankruptcy costs, at this point, the Shareholders value reaches its maximum level, if we further increase the level of debt usages, Shareholders’ values not only increases but also decrease as per the trade-off theory as said by Jensen and Meckling (1976). As such, there is need to study the relationship that exists between these two phenomenons which are financial leverage and shareholders’ value.In the case of Nigeria, scanty of research has been done to investigate the relationship between financial leverage and shareholders’ value. The question of whether or not financial leverage has any impact on the value of shareholders of construction companies listed on the Nigerian stock exchange remains unanswered. This study is intended to provide answer to this question.

1.3     OBJECTIVE OF THE STUDY

     This research aims at studying the impact leverage has on shareholders’ value of listed construction companies in Nigeria. Specifically, the objectives of the research are:  

1. To assess the relationship between debt ratio and net asset per share.
2. To assess the relationship between debt ratio and Return on Equity.
3. To assess the relationship between debt ratio and earnings per share.