ABSTRACT
The
issue of value creation for stakeholders of the firm as a result of the
composition of its financial mix can be traced to the seminal work of
Modigliani and Miller (MM) in 1958. Their argument is the irrelevance of the
financing mix of firms on value. Thus, whether the firm uses equity or debt,
the value of the firm does not change. There have been several theories after
the works of MM carried out by several scholars either criticizing or
supporting the Modigliani and Miller Irrelevance theorem. The Trade-off theory
of capital structure suggests that there is an advantage to finance the firm
with debt and also a cost of financing with debt. As a result, firms are
assumed to trade-off the tax benefits of debt with the bankruptcy cost of debt
when making their financing decisions. However, present and potential investors
need single information which is, the value creating potential of the firm no
matter the composition of the firm’s financing mix. Therefore this study had
the following objectives; to determine the impact
of debt financing on the ability of the firm to make profit; to determine the
impact of debt financing on the ability of the firm to maximise the use of its
assets; to determine the impact of debt financing on the firm’s earning power
on per share basis; to determine the impact of debt financing on the ability of
the firm to reward shareholders on per share basis; to determine the impact of
debt financing on the firm’s ability to meet its’ financial obligations as at
when due and to determine whether debt financing enhance the value of Nigerian firms. The ex post facto research design was adopted to enable the researcher
make use of secondary data and determine cause-effect relationship for
twenty-eight quoted Nigerian firms for the period 2004-2008 on a firm by firm
as well as on aggregate basis. The Ordinary Least Square (OLS) estimation
technique was adopted using SPSS statistical software to evaluate objectives
one to five where ratio values of Total Debt Rate (TDR) was used as the
independent variable while Net Profit Margin (NPM), Total Asset Turnover (TAT),
Earnings Per Share (EPS), Dividend Per Share (DPS) and Current Ratio (CR) as
dependent variables, while adopting a bankruptcy model, the Multiple Discriminant Analysis Model (MDA) to
evaluate objective six using MDA’s Z-score benchmark of 2.675 to determine
value (Rashmi and Sinha, 2004; Xing and Cheng, 2005). The study revealed that
on a firm by firm basis there were mix variations of the impact of Total Debt
Rate on the firms’ value parameters (NPM, TAT, EPS, DPS and CR) across firms
sampled while on aggregate basis; there was a positive non-significant impact
of Total Debt Rate on Net Profit Margin;
there was a negative non-significant impact of Total Debt Rate on Asset
Turnover Rate; there was a positive non-significant impact of Total Debt Rate
on Earnings per Share; there was a positive non-significant impact of Total
Debt Rate on Dividend per Share and there was a negative non-significant impact
of Total Debt Rate on Current Ratio and twenty firms created value as a result
of the firms’ use of debt financing representing 71.4% of firms sampled while
eight firms representing 28.6% of firms did not create value. From the
foregoing therefore, the use of debt financing enhances the value of Nigerian
firms, thus could be used to enhance shareholders’ wealth, however further
studies could still be carried out as to determine why some firms did not
enhance value as a result of the used of debt finance in the financial mix of
Nigerian firms .
TABLE OF CONTENTS
Title Page i
Approval Page ii
Certification Page iii
Dedication iv
Acknowledgements v
Abstract vii
List of Tables xi
List of Figures xii
List of Appendixes xiii
Chapter One Introduction 1
1.1 Background of the Study 1
1.2 Statement of the Problem 4
1.3 Research Objectives 8
1.4 Research Questions 8
1.5 Hypotheses of the Study 9
1.6 Scope of the Study 9
1.7 Significance of the Study 10
1.8 Limitation of the Study 11
1.9 Definition of Terms 11
References 13
Chapter Two Review of Related Literatures 16
2.0 Introduction 16
2.1 The Nigerian Stock Exchange 18
2.2 The Financing Decision of the Firm 19
2.3 The Concept of Debt and Debt Financing 20
2.4 The Concept of Value of the Firm 24
2.5 Valuation Methods 25
2.5 .1 Capital Asset Pricing Model (CAPM) 25
2.5.2 Discounted Value Method 26
2.6 The Concept of the Firm’s financing Structure 27
2.6.1 Trade-off Theory 30
2.6.2 The Pecking-order Theory 32
2.6.3 The Agency-cost Theory 32
2.7 Overview of the Modigliani and Miller Theorem 36
2.8 Bankruptcy, Cost of Bankruptcy and Effect on the Firm 41
2.9 The Concept and Uses of Financial Ratios 44
2.10 Profitability and Debt Financing of the Firm 48
2.11 Asset Utilization and the Value of the Firm 48
2.12 Shareholders Earnings (EPS) and the Firm’s Value 49
2.13 Dividends, Dividends Decision and Value of the Firm 51
2.14 Liquidity and the Firms’ Value 57
2.15 The Concept of Multiple Discriminant Analysis 58
References 63
Chapter Three Research Methodology 75
3.1 Research Design 75
3.2 Sources of Data 75
3.3 Sample Size 76
3.4 Sampling Technique 76
3.5 Model Specification 77
3.5.1 Model Justification 79
3.5.2 Assumptions for Multiple Discriminant Analysis 80
3.5.3 Explanatory Model Proxies 81
3.6 Techniques of Analysis 83
3.6.1 The Correlation Coefficient 83
3.6.2 The Coefficient of Determination (r2) 84
3.6.3 Durbin Watson (d) Test 84
3.6.4 The Student T-test 85
References 86
Chapter Four Presentation and Analyses of Data 88
4.0 Introduction 88
4.1 Data Presentation 88
4.2 Test of Hypotheses and Analyses of Data 95
4.2.1 Test of Hypothesis One 95
4.2.2 Test of Hypothesis Two 103
4.2.3 Test of Hypothesis Three 112
4.2.4 Test of Hypothesis Four 121
4.2.5 Test of Hypothesis Five 129
4.2.6 Test of Hypothesis Six 137
References 141
Chapter Five Summary
of Findings, Conclusions and Recommendations 142
5.0 Introduction 142
5.1 Summary of Findings and Policy Implications 142
5.1.1 Comparison of the Findings with the Objectives of the Study 145
5.2 Conclusion 148
5.3 Recommendations 151
5.3.1 Recommendation for Selected Stakeholders 152
5.3.2 Recommended Areas for Further Studies 153
References 154
Appendix 156
Bibliography 278
LIST OF TABLES
Table
4.1 Summary Results of Ratio
Analyses for the 28 firm under Study 89
Table 4.2 Summary of Value Parameter Aggregate Values 91
Table 4.3 SPSS Model Summary of Impact of Total Debt Rate on Net Profit Margin on Firm by Firm basis 95
Table 4.4 SPSS Aggregate Result of the Impact of Total Debt Rate on Net Profit Margin 102
Table 4.5 SPSS Model Summary of Impact of Total Debt Rate on Total Asset Turnover on Firm by Firm basis 104
Table
4.6 SPSS Aggregate of Impact of
Total Debt Rate on Total Asset Turnover 111
Table 4.7 SPSS Model Summary of Impact of Total Debt Rate on Earnings per Share on Firm by Firm basis 113
Table
4.8 SPSS Aggregate of Impact of
Total Debt Rate on Earnings per Share 120
Table 4.9 SPSS Model Summary of Impact of Total Debt Rate on Dividend per Share on Firm by Firm basis 122
Table
4.10 SPSS Aggregate of Impact of
Total Debt Rate on Dividend per Share 128
Table 4.11 SPSS Model Summary of Impact of Total Debt Rate on Current Ratio On Firm by Firm basis 129
Table
4.12 SPSS Aggregate of Impact of
Total Debt Rate on Current Ratio 136
Table 4.13 Summary of Result of Multiple Discriminant Analyses138
LIST OF FIGURES
Figure 2.1 Trade-off Theory 31
Figure 2.2 MM proposition 2 37
Figure 4.1 Aggregate Values for Total Debt Rate 92
Figure 4.2 Aggregate value for Net Profit Margin 92
Figure 4.3 Aggregate value for Total Assets Turnover 93
Figure 4.4 Aggregate value for Earnings per Share 93
Figure 4.5 Aggregate Values for Dividend per Share 94
Figure 4.6 Aggregate Values for Current Ratio 94
Figure 4.7 MDA Z-score for the 28 Firms 140
CHAPTER ONE INTRODUCTION
- BACKGROUND
OF THE STUDY
The Modigliani-Miller theorem is one of the cornerstones of modern
corporate finance. At its heart, the theorem is an irrelevance proposition; the
Modigliani-Miller theorem provides conditions under which a firm’s financial
mix does not affect its value. No wonder, Modigliani (1980, xiii) explains the
theorem as follows:
… with well-functioning market (and neutral taxes) and rational investors,
who can undo the corporate financial structure by holding positive or
negative amount of debt, the market value of the firm-debt plus equity,
depends only on the streams of income generated by its assets. It follows,
in particular, that the value of the firm should not be affected by the share
of debt in its financial structure or by what will be done with the returns
paid out as dividend or reinvested (profitably)…
In fact, what is currently understood as the Modigliani-Miller
theorem comprises three distinct results from a series of papers (1958, 1961
and 1963). The first proposition establishes that under certain conditions, a
firm’s debt-equity ratio does not affect its market value. The second
proposition establishes that a firm’s leverage has no effect on its weighted
average cost of capital (that is, the cost of equity capital is a linear
function of the debt-equity ratio) while the third proposition establishes that
the firm’s value is independent of its dividend policy.
Miller (1991:217) succinctly explains the intuition for the theorem
with a simple analogy, he says;
…think of the firm as a gigantic tub of whole milk. The
farmer can sell the whole milk as it is, or he can separate
out the cream and sell it at a considerably higher price than
the whole milk would bring…
He continues
…the Modigliani-Miller proposition say that if there were no
costs of separation (and of course, no government dairy
support program), the cream plus the skim milk would bring
the same price as the whole milk…
The essence of Miller’s argument is that, increasing the amount of
debt (cream) lowers the ratio of outstanding equity (skim milk) – selling off
safe cash flows to debtholders which leaves the firm with more valued equity
thus keeping the total value of the firm unchanged. Put differently, any gain
from using more of what might be seem to be a cheaper debt is offset by the
higher cost of riskier equity. Hence, given a fixed amount of total capital,
the allocation of capital between debt and equity is irrelevant because the
weighted average of the two costs of capital to the firm is the same for all
possible combinations of the two.
Spurred by Modigliani and Miller’s (1958, 1961 and 1963) arguments,
that in an ideal world without taxes a firm’s value is independent of its
debt-equity mix, economists have sought conditions under which the financial
structure of the firm would matter. Economic and financial theories suggest
that several factors influence the debt-equity mix such as differential
taxation of income from different sources, informational asymmetries,
bankruptcy cost/risks, issues of control and dilution and the agency problem
(see Hart, 2001).
Thus, in line with the above, the question now is? Do corporate
financing decisions affect firm’s value? How much do they add and what
factor(s) contribute to this effect? An enormous research effort, both
theoretical and empirical has been devoted towards sensible answers to these
questions since the works of Modigliani and Miller (1953, 1961, and 1963).
Several foreign and local scholars have theoretically and empirically studied
the impact of the firm’s financial mix on the value of the firm from different
perspective (see, Jensen and Meckling, 1976; Jensen, 1986; Fama and Miller,
1972; Myers, 1977; Miller and Scholes, 1978; Elton and Gruber, 1970; among
others).
In fact, Elton and Gruber (1970) studied the link between taxes,
financing decisions and firm value and found that personal taxes make dividend
less valuable that capital gain and stock prices fall by less than the full
amount of the dividend on ex-dividend days. Fama and Miller’s (1972) study on
the financial structure of the firm was on leverage and they argue that
leverage (debt finance) can increase the incentive of the stockholders to make
risky investment that shift wealth from bondholders but do not maximize the combined
wealth of security holders, thus, value
is not created. Jensen and Meckling
(1976) evaluating financial structure from the agency cost model submit that
higher leverage allow managers to hold a larger part of its common stock
thereby reducing agency problem by closely aligning the interest of the
managers and other stockholders, thus asserting that since the interest of
stockholders are protected, value is created. In another paper by Jensen
(1986), he said leverage (debt finance) used by the firm enhances value by
forcing the firm to pay out resources that might otherwise be wasted on bad
investment by managers.
Myers (1977) argues that leverage (debt finance) can make firms to
under invest because the gains from investment are shared with the existing
risky bonds of the firm. In effect, the agency effect of financing decision
work through profitability and can make firms to take better or worse
investments and to use assets more or less efficiently. Miller (1977)
re-evaluating earlier MM theories on financial structure argues that if common
stock is priced as tax free but personal tax rate built into the pricing of the
stock, corporate interest payment is then the corporation tax rate. Hence, the
tax shield at the corporate level is offset by taxes on interest at the
personal level thus debt does not affect firm value. He therefore submit that
if there are two firms with the same earnings, before interest and taxes, the
more levered firm’s higher after-tax earnings are just offset by the higher personal
taxes paid by its bondholders.
Therefore, given pre-tax earnings, there is no relationship between debt
and value.
In Nigeria, some empirical studies have been done in this area of
corporate finance and its effect on the value of the firm. Among such was
Ezeoha (2007) who examine the impact of major firm characteristics on the
financial leverage of quoted companies in Nigeria and used panel data from 71
quoted Nigeria companies, for 17 years period (1990 – 2006). The result showed
that the relationship between corporate ownership and financial leverage was
positive across the proxies but more significant within the classes of foreign
and indigenous firms. The relationship with asset tangibility was found to be
non significant and negative, using total debt ratio or short term debt ratio
as the dependent variable. It was also seen from the research study that the
relationship between leverage and profitability was significant and negative
(see Ezeoha, 2007)
Also, Adelegan (2007) examine the effect of taxes on business
financing decisions and firm value in Nigeria. The study which analyses 85
manufacturing firm in Nigeria from 1984 to 2004 found that dividend and debt
covey information about profitability of the firm. This information obscures
any tax effect of financing decision.
However, there was evidence that earnings and investment were key
determinants of the firms’ value in Nigeria.
The study also found positive relationship between dividend and value
and negative relationship between debt and value in firms examined.
Though, there have been studies in this area of corporate finance in Nigeria, However, most have clustered around the estimation of corporate cost of capital (Inanga 1987, Adelegan, 2001) determinants of dividend decisions (Inanga, 2001; Odedekun, 1995), and financing decision (Adelegan, 2007; Ariyo 1999; Ezeoha, 2007). To the best of the researcher’s knowledge, no study has been carried out using firms’ value parameters to study its’ impact on the value of the firm adopting the bankruptcy model. This is a gap which this study attempts to fill. The essence is to determine from an investors’ or potential investor’s point of view whether value parameters from the financial statements and accounts of quoted firms in Nigeria are affected by the use of debt in the financial mix and the overall impact of debt financing on the value of selected firms taking into account the cost of debt which is bankruptcy.
THE IMPACT OF DEBT FINANCING ON VALUE OF NIGERIAN FIRMS
