FIRM CHARACTERISTICS AND CAPITAL STRUCTURE

CHAPTER ONE

INTRODUCTION

1.1   Background to the Study

The foundation for theories and research focus on the subject of capital structure began with the introduction of Modigliani and Miller’s (M&M) theoretical model about corporate capital structure in 1958 which is considered to have created the turning point for modem corporate finance theory. The theory provides insight into a firm’s capital structure decision in a capital market free of taxes, transaction costs, and other frictions. Following on the famous irrelevance theory of Modigliani and Miller (1958), most theories such as the Pecking’s order theory, Agency theory and Trade off theory have sought to explain capital structure by introducing frictions omitted in the original Modigliani and Miller framework. Capital structure refers to the different options used by a firm in financing its assets (Bhaduri, 2002). Generally, a firm can go for different levels/mixes of debts, equity, or other financial arrangements. In their attempt to maximize the overall value, firms differ with respect to capital structures. This has given birth to different capital structure theories that attempt to explain the variation in capital structures of firms over time or across regions.

According to Myers (1984), there is no universal theory of the debt-equity choice, and no reason to expect one. However, there are several useful theories as identified earlier each of which helps to understand the debt-to-equity structure that firms choose.

These theories can be divided into two groups either they predict the existence of the optimal debt-equity ratio for each firm (so-called static trade-off models) or they declare that there is no well-defined target capital structure (pecking-order hypothesis). Static trade-off models understand the optimal capital structure is achieved when the marginal present value of the tax shield on additional debt is equal to the marginal present value of the costs of financial distress on additional debt. On the other hand, the pecking-order theory suggests that there is no optimal capital structure but firms ration between internal financing (retained earnings) to external funds depending on the extent of perceived information asymmetry in the financing environment. A number of factors may influence the financial structure of companies. For example, Salawu (2007) identified factors such as ownership structure and management control, growth, profitability, issuing cost, and tax issues associated with debt as the major factors influencing bank’s capital structure. Bevan and Danbolt (2002) also highlighted company size, profitability, tangibility, growth opportunities, non-debt tax shields and dividend as possible determinants of the capital structure choice.

The focus of this study is to examine the validity of these factors in influencing capital structure of quoted companies in Nigeria. This is imperative as the corporate sector in Nigeria is characterized by a large number of firms operating in a largely deregulated and increasingly competitive environment. Since 1987, financial liberalization has changed the operating environment of firms, by giving more flexibility to the Nigerian financial managers in choosing the firm’s capital structure (Salawu, 2007). In addition, there are only a limited number of studies that examine factors which influence the capital structure of Nigerian firms. As Salawu and Agboola (2008) noted that though the capital structure issue has received substantial attention in developed countries, it has remained neglected in the developing countries. Importantly too, is that we may not necessarily expect findings from developed economies to be replicated in the Nigerian context as a result of several country specific factors. Therefore, the study examines the determinants of capital structure using selected quoted companies in Nigeria.

1.2   Statement of Problem

Capital structure decision is an area that is of interest to a diverse range of stakeholders in a firm ranging from management, creditors, shareholders and investors amongst others. Though this research area has received considerable attention from researchers in developed countries, there are still some unsettled issues.

Firstly, Chandrasekharan (2012) claimed that studies have not been unanimous with regards to the factors that actually determine capital structure. The empirical work (Adesola 2009; Baral, 2004; Ezeoha & Francis 2010; Fama & French, 2002) so far has not, however, sorted out which of these are important in various contexts. Therefore, the study will contribute importantly in this regards, by showing the factors that influencing capital structure with focus on Nigerian firms.

Secondly, the existing empirical evidence is based mainly on data from developed countries (G7 countries). For example Titman and Wessels (1988) and Chaplinsky and Niehaus (2003) focused on United States companies; Kester (1996) compared United States and Japanese manufacturing corporations; Rajan and Zingales (2005) examine firms from G7 countries; and Wald (1999) used data for G7 countries except Canada and Italy. Findings based on data from developing countries have appeared only in recent years (Salawu, 2007). . The reasons for this neglect are discussed by Bhaduri (2002). He notes that until recently, the corporate sectors in many lesser developed countries (LDCs) faced several constraints on their choices regarding sources of funds. Access to equity markets was either regulated, or limited due to the underdeveloped stock market (Bhaduri, 2002). Therefore, this study will fill this gap since it examines the determinants of capital structure from a developing country and this contributes in increasing the research evidence from developing economies in general and Nigeria in particular.

1.3   Research Questions

Against the background of the foregoing problem statements, the following research questions have been formulated to guide the direction of the study;

1.     What is the relationship between profitability and capital structure?

2.     What is the relationship between company size and capital structure?

3.     What is the relationship between growth rate and capital structure?

1.4   Objective of the Study

The broad objective of this is study is to ascertain capital structure and firm characteristics using empirical evidence from Nigeria. The sub-objectives are to:

1.     examine the relationship between profitability and capital structure,

2.     determine the relationship between company size and capital structure,

3.     investigate the relationship between growth rate of the firm and capital structure.

1.5   Statement of Hypothesis

The research hypotheses are as follows;

Hypothesis One

H_O:   There is no significant relationship between profitability and capital structure

H_I:    There is significant relationship between profitability and capital structure.

Hypothesis Two

H_O:   There is no significant relationship between Company size and capital structure

H_I:    There is significant relationship between company size and capital structure.

Hypothesis Three

H_O:   There is no significant relationship between growth rate of the firm and capital structure

H_I:    There is significant relationship between rate of the firm and capital structure.

1.6   Significance of the Study

Firms in Nigeria will benefit from this research work as they can make use of the capital structure related information in their decision making. This research work will be of great importance to government as it would give them enough information necessary for implementation of policies that would improve the capital structure of firms in Nigeria. This research will be useful to researchers who are intending to carry out research on this topic as it will guide and act as reference material to them.

1.7   Scope of the Study

The focus of this study is to examine the determinants of capital structure in selected quoted companies in Nigeria. The population of the study comprises quoted companies listed on the Nigerian stock exchange. The sample will consist of a selection of 25 companies quoted on the stock exchange using the simple random sampling technique; the time period for the study is 2012 – 2015.

1.8   Limitations of the Study

The following are the limitations of the study

1.     Finance: lack of adequate and sufficient finance in terms of the cost of collecting data, and processing the required information hindered the smooth conduct of this project.

2.     Non-availability of necessary books in the school library: Little or no relevant literature textbook to consolidate the
available information.

3.     The inability to obtain a complete random sample.

1.9   Definition of Terms

1.     Capital: This is wealth in the form of money or other assets owned by a person or entity available for a purpose such as starting a company or investing.

2.     Capital Structure: This refers to the different options used by firms in financing assets.

3.     Firms: A firm is a business organization such as corporation, limited liability company or partnership that sells goods and services to make profit.

4.     Debt Financing: This is the raising of money by a firm for working capital or capital expenditure by selling bonds, bills or notes to individual and/or institutional investors.

5.     Financing: Financing is the act of raising funds or capital for business activities for making purchase or investing.

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