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AN
EVALUATION OF CAPITAL STRUCTURE AND PROFITABILITY OF BUSINESS ORGANISATIONS
ABSTRACT
Capital
structure decision is a vital one in any organization that is striving to
achieve profitability. Therefore, the main objective of this study is to
examine the effect of capital structure on performance of quoted manufacturing
companies in Nigeria. In achieving this, Secondary data source was employed;
data was collected from the Nigerian stock exchange fact book and the annual
report of the selected quoted companies. In this research, the Sample data
collected from the ten (10) randomly selected firms among these industries were
from (2010-2014) and their financial statements for five years extracted and
analyzed. The study made use of three measures of Return on Assets, thus,
short- term debt (STD), total debt (TD) and growth size (E_TA) to reveal
whether capital structure has any significant effect on profitability. The
study employed panel data analysis by using Fixed-effect estimation,
Random-effect estimation and Pooled Regression Model. The empirical findings
revealed clearly that the two measures have negative significant effect on
profitability of manufacturing firms listed on the Nigeria Stock Exchange while
one has a positive effect. The study therefore, recommends that the management
of Nigerian quoted manufacturing firms should work very hard to optimize the
capital structure of their quoted manufacturing firms in order to increase the
returns on equity, assets and investment. They can do that through ensuring
that their capital structure is optimal.
CHAPTER ONE
INTRODUCTION
1.1 BACKGROUND TO THE STUDY
Whether a
business is newly born or it is an ongoing, it requires fund to carry out its
activities as no success is achievable in the absence of fund. The needed fund
may be for daily running or business expansions. This tells us how important or
essential fund is in the business, this fund is referred to as capital .it is
therefore a symbol of a company’s financial liabilities.
This study
focuses on the association between capital structure & profitability of
some manufacturing firms listed quoted in Nigeria. Capital structure is one of
the most puzzling issues in corporate finance literature (Brounen &
Eichholtz, 2001). The concept is generally described as the combination of debt
& equity that make the total capital of firms. The proportion of debt to equity
is a strategic choice of corporate managers. Capital structure decision is the
vital one since the profitability of an enterprise is directly affected by such
decision. Hence, proper care and attention need to be given while determining
capital structure decision.
Capital
structure is the proportion or each type of capital debt and equity used by a
business organization. Many organizations employ debt in their capital
structure because of its benefits. One of the benefits is that interest on debt
is tax deductible and reduces tax liability of the organizations concerned.
Furthermore, failure to pay interest commitment can result to financial
backwardness. The financial managers consider so many factors in their capital
structure decisions because of the implications in the use of debt. The factors
are cost of capital, debt capacity cash flow. Etc. In the statement of affairs
of an enterprise, the overall position of the enterprise regarding all kinds of
assets, liabilities are shown.
Capital is a
vital part of that statement. The term “capital structure” of an enterprise is
actually a combination of equity shares, preference shares and long-term debts.
A cautious attention has to be paid as far as the optimum capital structure is
concerned. With unplanned capital structure, companies may fail to economize
the use of their funds. Consequently, it is being increasingly realized that a
company should plan its capital structure to maximize the use of funds and to
be able to adapt more easily to the changing conditions (Pandey, 2009). The
relationship between capital structure and profitability is one that received
considerable attention in the finance literature.
Capital
structure is important to understanding how a business is run and financed, and
can be easily evaluated by looking through a corporate balance sheet. Capital
structure refers to the relationship between a company’s assets and
liabilities, including how the assets are funded and the amount of debt managed
by the firm. The capital structure decision is crucial for business
organizations. The capital structure decision is important because of the need
to maximize returns of the firms, and because of the impact, such a decision
has on the firm’s ability to deal with its competitive environment. The capital
structure of a firm is a mixture of different securities. In general, firms can
choose among many alternative capital structures. For examples, firms can
arrange lease financing, use warrants, issue convertibles bonds, sign forward
contracts or trade bond swaps. Firms can also issue dozens of distinct
securities in countless combinations to maximize overall market value (Abhor,
2005, p.438).
A number of
theories have been advanced in explaining the capital structures of a firm.
Despite the theoretical appeal of capital structure, researchers in financial
management have not been able to find a model for an optimal capital structure.
The best that academics and practitioners have been able to achieve are
prescriptions that short –term goals (Abor, 2005, p.438).
Profitability
and capital structure relationship is a two way relationship. On the one hand
profitability of firm is an important determinant of the capital structure, the
other hand changes in capital structure affect underlying profits and risk of
the firm that is reflected in the value of the firm.
The most
important decision all corporate managers should take into consideration is the
way in which the long-term capital requirements of their companies should be
financial. Capital structure is the permanent financing of a firm represented
primarily by equity and long-term liability without including all short-term
credits. Many factors have to surface in order to determine the capital
structure of a business organization.
These factors are what the financial managers
consider first in order to determine appropriate capital structure suitable to
his firm. Some of the factors are: cost of capital, floatation costs, and size
of the company, government policies and market condition. The combination of
debt and equity has some implication. The first is that debt-equity ratio,
which is regarded as an indicator of risk.
The
profitability of any business organization will determine whether it will
remain in business or not especially in the long run. Profitability is normally
measured using return on capital employed, return on equity, earning per share,
and return on assets, net profit margin and gross profit margin.
Capital structure has been a major issue in
financial economics ever since Modigliani and Miller showed in 1958 that given
frictionless markets, homogeneous expectations; capital structure decision of
the firm is irrelevant. By relaxing the assumptions and analyzing their
effects, theories seek to determine whether an optimal capital structure exists
or not, and if so what could possibly be its determinants. The relationship
between capital structure decisions and firm value has been extensively
investigated in the past few decades. Capital structure could have two effects;
according to Desai (2007) firms of the same risk class could possibly have
higher cost of capital with higher leverage. Second, capital structure may
affect the valuation of the firm, with more leveraged firms, being riskier and
consequently valued lower than the less leveraged firms. If the manager of a
firm has the shareholders' wealth maximization as his objective, then capital
structure is an important decision, for it could lead to an optimal financing
mix which maximizes the market price per share of the firm.
Nigeria is a
developing country with a single stock exchange (Nigerian Stock Exchange NSE)
but with few branches across the country, accommodate about 260 securities.
Like other developing economies, the area of capital structure is relatively
unexplored in Nigeria. Limited research work exists on this area, like salawu
(2007) studied empirical analysis of determinant of capital structure of 50
selected non-financial companies between 1999 and 2004. This study built on
that of Salawu (2007) by adding to exogenous variables, using a wider time
frame and considering the impact of the previous year’s leverage on the current
year ones. (CBN report 2009)
1.2 RESEARCH
PROBLEM
The owners
of a company will not like to lose the control they have in their company by
issuing more shares to the public in order to finance their capital projects.
Instead, they do borrowing, this means using debt instrument like debenture
stock. These owners of the business should not fail to know that whether there
is profit or not that the debentures should be settle their interest. Nobody
can perfectly predict the future, there can be business boom and there can
equally be stump in business. The problem then is how can business combine debt
and equity financing in order to ensure profitability?
The emergent
nature of the Nigerian capital market with its inherent problems of inactive
debt market, shallow nature of the market, buy and hold syndrome of Nigerian
investors and so on, coupled with the unconducive socio-political environment make
firms in Nigeria to rely more on the money market than the capital market for
their funds requirement. Hence the money market is dominant in the Nigerian
financial system.
The
difficulty facing firms in Nigeria has to do more with the financing – whether
to raise debt or equity capital. The issue of finance is so important that it
has been identified as an immediate reason for business failing to start in the
first place or to progress (Graham, 1996). Thus, it is necessary for firms in
Nigeria to be able to finance their activities and grow over time, if they are
ever to play an increasing and predominant role in creating value added, as
well as income in terms of profits.
The
multiplier effects of this aberration put a question mark on the true relationship
between capital structure and profitability of quoted manufacturing firms in
Nigeria. That is, whether trade – off theory which supports a positive
relationship or pecking order theory which supports a negative relationship.
The study seeks to examine this relationship.
1.3 PURPOSE OF THE STUDY
The present
study is aimed at achieving some objectives. The main objective of this
research work is as follows:
Ø To determine the relationship between capital
structure and profitability of listed firms in Nigeria.
1.4 RESEARCH QUESTION
The
objectives are translated in this research question and will be answered based
on the empirical evidence generated.
The
following is the main research question guided in this study:
1) To what
extent does capital structure influence profitability of listed quoted
manufacturing companies in Nigeria?
1.5
STATEMENT OF HYPOTHESIS
The
following hypotheses have been formulated to guide this study.
Ho: There is
no significant relationship between capital structure and profitability of
manufacturing firms in Nigeria.
1.6 SCOPE
AND LIMITATIONS OF THE STUDY
Not minding
that capital structure has many implications on a company such as
profitability, market value of shares and financial distress, this study took
at the relationship between capital structure and profitability of business
organization. Business organization studied was some listed quoted
manufacturing companies in Nigerian.
This
research is limited to ten quoted manufacturing companies in Nigeria; some of
the other quoted listed firms researched on do not have complete data of
relevant variable due to cessation of operation or problems with Nigerian Stock
of Exchange (NSE) and Securities Exchange Commission (SEC). The study excludes
financial, utility and other highly regulated industry to avoid any distortions
in the result due to industry specific requirements.
1.7 SIGNIFICANCE OF THE STUDY
Business
financing is a very important business decision. Corporate financial managers
have to decide whether to employ more of debt or more of equity whichever
measure is adopted has effects. Everybody should bear in mind that the main
objective of every business is to make profit of which this research work will
through its findings achieve the followings:
Ø To convince corporate managers of the
relationship between capital structure and profitability of business
organization and will enable them make appropriate decision to that effect.
Ø It will help intending investors to plan
their capital structure very well from the statement in order to maximize
profit.
Profitability
is regarded as a major determinant of capital structure, a part that bankruptcy
costs, agency costs, taxes, and information asymmetry etc. are considered in
determination of capital structure.
The topic of
capital structure has been widely explored, though the study is relevant in the
different time period and different context to find out whether the evidence
concerning the capital structure issue and its various aspects are relevant to
a given set of companies in a given period. Given this significance, current
study attempts to understand and research on capital structure and its effect
on profitability, an important relationship that is not given much attention
before, of large firms in Nigerian in the present context.
This will be
of good advantage to future researchers in their research work.
1.8 DEFINITION OF TERMS
Capital
Structure: Capital structure as an avenue through which an organization
provides funds to its general operations by using altered sources of money.
It involves the mixture of equity and
debt.
Profitability:
It is the measurement of overall earning capacity of a firm .Profitability is
the primary target of a firm to achieve in long run for the development of
its organization over the years.
Long term
assets: The worth of a company's possessions, tools and other capital
resources. These are informed on the left side of the balance sheet. Assets
that are not in intention to be
twisted into cash or be devoted within one year of the balance sheet date.
Short term
assets: These are assets held with a company within a year or lass then
one year. It includes account
receivable, cash at bank, cash in hand etc. Current assets show the liquidity
of an organization. These assets are consumed within a year or in the operating cycle without
upsetting the regular process of an
organization.
Long term
liabilities A long- term liability is one the company imagines to pay over
the course of more than one
year.
Short term
liabilities: Is one the company supposed to pay in the short term with in
the period of one year or
less than one year using assets prominent on the present balance sheet. The obligations that will
settle by short term assets are known as
short term liability.
Return on
equity: Is the amount of money that is returned to the shareholders from their equity and it computes the
prosperity of owner's assets. Return on equity assess an organization's
profitability by informative how much profit a company produce with the money shareholders
have invested.
Financial
Leverage: This is the use of fixed charges source of fund such as debt and preference capital along with the
owner’s equity in the capital structure.
DEBT: Debt
is loan borrowed from outsider to finance a business. It is repayable and receives a return in form of interest
charged on the amount of debt outstanding.
EQUITY: It
is a permanent investment in a company. Equity investment makes a person a part owner of the
company. This is also a method of long-term financing. It includes share capital,
share premium and reserves.
Listed
Quoted Companies: Is a company whose shares can be bought or sold on the stock exchange, it also a company
issuing the security must meet the
requirement s of the exchanges it wishes to be traded.
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