EMPIRICAL ANALYSIS OF CAPITAL STRUCTURE AND MARKET VALUE OF COMPANIES

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EMPIRICAL ANALYSIS OF CAPITAL STRUCTURE AND MARKET VALUE OF COMPANIES

ABSTRACT

The central point of this research work is how capital structure could impact on the share price of quoted companies in Nigeria. The researcher desires to reflect on the positive impact which capital structure has on market value of quoted companies in Nigeria. Data used for this research work were collected from secondary sources, which include annual reports and accounts of selected companies in Nigeria and Nigerian stock exchange fact book. These data where analyzed using regression (ordinary least square) method. Review of literature was done to gain greater understanding of the subject matter. It is therefore recommended that companies should ascertain that capital structure mix that maximizes the market value of the company that will automatically increase shareholders wealth.

CHAPTER ONE

BACKGROUND OF STUDY

1.0 INTRODUCTION

Corporate organizations do need funds for varying commercial activities as well as growth; and these funds that could be obtained from various sources are equity capital, retained earnings and debt. According to Unugbro (1998), capital structure is determined by the mixture of long term and equity used by a firm. Capital structure thus denotes the permanent long-term debt, preference share, and ordinary share and excludes short-term debts and overdrafts. Therefore, capital structure is used to denote the proportionate relationship between debt and equity of a corporate organization.

All sources of funds usually have their associated cost of capital and it imposes different obligations cost on the firm. The firm uses these funds obtained to finance it’s operation in anticipation that the corresponding rate of return would be sufficient to cover the resulting cost. An optimal capital structure could be ascertained by comparing respective cost of capital obtained. According Owualah (1998) an optimal capital structure is itself one where the mix of this proportions creates a financial structure for a company that it’s potential value for the owners. According to Pandey (2005:5) the mix of debt and equity is known as firm’s capital structure.

The financial manager must strive to obtain the best financing mix or the optimum capital structure for his or her firm. The firm’s capital structure is considered optimum when the market value of share is maximized. An organization’s capital structure can also be achieved when the Weighted Average Cost of Capital (WACC) is minimized. According to Stephen, Randolph and Bradford (2001:368) thus, there is a choice of the firm’s capital structure so that the WACC is minimized. For this reason, structure is better than another if it results in a lower weight average cost of capital.

According to Jerry and Gordon (1987), the firm’s target capital structure is an important consideration to its financial manager. An appropriate capital structure is a critical decision for any business organization and this decision is very important not just because of it’s needs to maximize shareholder’s wealth or increase the market value of the company, but also because of the impact such decision has on the company’s ability to deal with the competitive environment.

The concept of optimal capital structuring implies that a company’s choice of financing mix between debt and equity matters a great deal but however in reality it has been discovered that there is an acceptable balance between debt and equity financing that most companies should strive to attain in order to maximize their market value or increase shareholder’s wealth. According to Arthur, David, John and William (1998:520), the objective of capital structure management is to mix the permanent sources of funds used in a manner that will maximize the company’s common stock price. Therefore the variation of a company’s capital structure to achieve the acceptable balance between it’s debt and equity when and as time needed.

In Nigeria, just as in other developing countries, not much as been documented on capital structure and the market value of companies. It is often believed that factor that drive market price per share go beyond ideal or proper mix of debt and equity.

The focus of this paper is to undertake an empirical analysis of the relationship of capital structure and shareholder value in Nigeria.

Management thus need to develop an optimal capital structure which implies a perfect mix between the company equity and debt in an optimal way to achieve the main goal of maximizing the shareholders wealth as well as to improve on it’s market value of both the owners and potential shareholders.

1.1 STATEMENT OF PROBLEMS

What ever the capital structure decides a company decides upon, it will definitely have an effect on the company especially in the aspect of it’s market value, thus in order to analyze the extent to which capital structure relates to market values, there is need to seek answers to the following questions.

1. Does capital structure actually affect the market value of company?

2. Does any significant relationship actually exist between capital structure and market value of company?

3. What effect does the capital structure have on the company present and future cash flows?

4. What factors influence the decision of management as regards capital structure?

5. What are the other factors that effect market value?

6. Does the optimal capital structure actually achieve the goal of maximizing shareholders wealth?

7. Does optimal capital structure improve on market value for potential shareholders?

1.2 RESEARCH OBJECTIVE

This research work seeks to achieve the following objectives.

1. To find out the relationship between capital structure and market value of companies (share price).

2. To find out the strengths and direction of the relationship

3. To create awareness to the public on the need to invest in an optimal capital structured company.

4. To find out why the public still has low awareness about the factors that determine low or high market value of quoted companies.

5. To analyze the effect of other factors on share price.

6. To analyze the effect of a fair market value to the company and it’s investors.

1.3 SCOPE OF THE STUDY

The scope chosen by the researcher is the contemporary scope, which is it is time framed. The data obtained from the published accounts and annual reports of quoted companies of interest for 10 years from 1997-2006. The particular annual reports were selected after considering its status in the Nigerian stock exchange (N.S.E)

1.4 RESEARCH HYPOTHESIS

The following hypothesis will be tested

1. (H₀): Capital structure does not have significant

relationship, does not determine market value.

(H₁): Capital structure does have a significant

relationship and this determines market value.

2. (H₀): Optimal capital structure does not maximize

shareholders wealth.

(H₁): Optimal capital structure maximizes shareholder’s wealth

3. (H₀): Optimal Capital structure does not improve on market value

(H₁): Optimal capital structure improves on market value.

1.5 SIGNIFICANCE OF STUDY

This study attempts to produce information to bridge the information needs of the potential and actual investors as well as for management of companies. Therefore the following categories will benefit immensely from the finding of this research work.

1. For the potential Investor: It could serve, as a guide in determing the value of the company that would finally have an influence on their investment decision.

2. For management: It would expose them to improved practices as well as help control share prices.

3. For shareholders: It would help them to estimate and evaluate the returns suitable from their investments.

4. For Government: It would be beneficial to government in the area of policy formulation and implementation towards sustaining the capital structure policies already in place.

5. For the public: it will enlighten the public on the need to invest in a well capital structured company with effective policies. It will also benefit the public in the area of providing relevant information for the future researchers own research work.

6. For employees: It would help them access other potentials after which their efficiency and productivity will increase thereby increasing the productivity of the company as a whole.

7. For customers: It would expose them to knowing the company better, thereby making the demand for the companies product increase. It would also make them evaluate the returns suitable from investment.

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EMPIRICAL ANALYSIS OF CAPITAL STRUCTURE AND MARKET VALUE OF COMPANIES

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