IMPACT OF CORPORATE DIVERSIFICATION AND FINANCIAL STRUCTURE ON THE PERFORMANCE OF COMMERCIAL BANKS IN NIGERIA

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ABSTRACT

This study analyzed the impact of corporate diversification and financial structure on the performance of Commercial Banks in Nigeria. A sample of ten (10) Commercial Banks ranking most based on their asset base was selected through judgmental sampling technique and the relevant secondary data was obtained from the annual reports of the selected Commercial Banks in Nigeria over a twenty-year period (2001-2020). The data obtained were analyzed using panel data analysis on Eviews 9. The findings of this study show that service diversification, geographical diversification and financial structure positively affect the performance of Commercial Banks in Nigeria. This study recommends that bank management should ensure that the modifications arising from environmental forces and the need to remain relevant to their stakeholders do not pressurize them into expanding their financial services into areas where it faces a high degree of competition or lacks prior lending experience as this can lead to a fall in bank returns.





TABLE OF CONTENTS


Title Page                                                                                                                    ii

Declaration                                                                                                                 iii

Certification                                                                                                                iv

Dedication                                                                                                                   v

Acknowledgments                                                                                                      vi

Table of Contents `                                                                                                     vii

List of Tables                                                                                                              viii

Abstract                                                                                                                       ix

 

CHAPTER 1: INTRODUCTION                                                                           1

1.1       Background to the Study                                                                                1

1.2       Statement of Problem                                                                                     6

1.3       Objectives of the Study                                                                                  8

1.4       Research Questions                                                                                        8

1.5       Research Hypotheses                                                                                      9

1.6       Significance of the Study                                                                               9

1.7       Scope of the Study                                                                                          10

1.8     Limitations of the Study                                                                                   10

 

CHAPTER 2: LITERATURE REVIEW                                                               11

2.1       Conceptual Review                                                                                         11

2.1.1    Corporate diversification                                                                    11

2.1.2   Benefits of diversification                                                                               12                    

2.1.3    Disadvantages of diversification                                                                        14        

2.1.4    Types of Diversification                                                                                   15           
2.1.5    Financial structure                                                                                         17        

2.1.6    Factors to be considered when designing the financial structure of a firm     19

2.1.7    Firm's performance                                                                                        20

2.1.8    Conceptual framework of hypotheses and independent variables                          23

2.2       Theoretical Framework                                                                                  23

2.2.1     Modern portfolio theory                                                                                                24

2.2.2    Resource Based View (RBV)                                                                         25

2.2.3 Signalling theory                                 26

2.3       Empirical Review of related Literature                                                          27

2.3.1     Summary of Literature                                                         39

2.3.2     Research Gap                                                                     59

 

CHAPTER 3:  METHODOLOGY                                                                         60

3.1       Research Design                                                                                             60

3.2        Type and Method of Data Collection                                                                          60

3.3        Population of Study                                               60

3.4        Sampling Technique                                                                                                         61

3.5        Method of Data analysis                                       61

3.6       Model Specification                                                                                       61                    

3.7       Description of Research Variables          62                 

3.7.1             Dependent variable                                                                                         62                  

3.7.2      Independent variables                                                        63


CHAPTER 4: DATA PRESENTATION, ANALYSIS AND INTERPRETATION OF RESULT                     65

 

4.1       Data Presentation                                                                                            65

4.2       Analysis of Data                                                                                             73

4.3       Test of Hypotheses                                                                                         75

4.4       Discussion on Findings                                                                                   77


CHAPTER 5: SUMMARY OF FINDINGS, CONCLUSION AND RECOMMENDATIONS                                  78

 

5.1        Summary of Findings                                                                               78

5.2        Conclusion                                                                                                78

5.3       Recommendations                                                                                          79

5.4       Suggestions for Further Studies                                                                   79

5.5       Contributions to Knowledge                                                    80        

References                                                          81

Appendix                                                                        93

 

 

 

 

 

LIST OF TABLES

2.1:      Summary of Empirical review                                                                                  42

4.1:      Selected corporate diversification, financial structure and performance variables 65

4.2:      Extracted probability from Hausman Test                                                               74

4.3       Output for analyzed data using dependent variable ROA                                        74

 

 

 

  

 

CHAPTER 1

INTRODUCTION


1.1 BACKGROUND OF THE STUDY

Changes arising from environmental forces coupled with the necessity for firms to survive in today’s fiercely competitive market are causing many firms to have a rethink on how to be more efficient and productive so as to retain their investors in future times. These influences pose serious tasks as well as new opportunities for the growth and development of firms (Ojo, 2011).

As profit-oriented organizations that seek to minimize costs and maximize returns in every venture undertaken, commercial banks are adopting various strategies to respond to these forces in order to be sustained in their business. They render financial services with the aim of making profit, offer services that encompass a broad range of monetary transactions required to obtain a financial good (something tangible that lasts, whether for a long or short time). Such transactions include real estate, consumer finance, banking, insurance, investment funding, issuing securities, asset management inter alia (Irena, 2020).

In every geographical location where economic activities takes place, commercial banks are always present and can be seen in both or either local, national, regional and international financial centers. Being among the major financial services providers in any economy, commercial banks play important roles in the progress of the said economy. They carry out financial intermediation function that the problem associated with direct financing such as transaction costs, information asymmetry and counter party risk are being taken care of.

Theoretically, the financial goal of any firm is to maximize owner's economic welfare; a properly defined and clearly stated objective is the moving force that moves the firm to the desired position in the nearest future. Other objectives of a firm include growth, expansion, survival, market leadership, benefit maximization and shareholders wealth maximization (Ihemeje, 2014).   

In order to achieve the aforementioned objectives, commercial banks have to enlarge their coast - expanding their business operations beyond their usual horizon i.e. from rendering core banking services the normal way to better and more efficient ways. Business operations by nature are risky ventures as a positive correlation exists amidst risk and expected return. As commercial banks expand their business operations; they are also being exposed to more risk.

Risk can be said to be the unpredictability associated with future returns from an investment. Risk and uncertainty are often used interchangeably, yet they do not mean the same thing. Strictly, implies a scenario in which the future outcome is unknown, but the likelihood of various possible future outcomes may be assessed with some degree of confidence, probably based on knowledge of past or existing events. In other words, probabilities of possible outcome can be estimated. Uncertainty on its own connotes a condition where the future outcome cannot be predicted with any degree of confidence from knowledge of past or existing events. Hence with uncertainty, no probability estimates are available (Osuala, 2009). Risk is also the probability of loss inherent in an organization's operations and environment such as competition and adverse economic conditions (Orina, 2011).

According to Gupta (2011), having a single investment is a risky decision; as such, it is important to diversify investment portfolio. Scattering investments among numerous, dissimilar investments reduce the risk of a sudden, unexpected outcome. In a diversified portfolio, a loss (risk) in one investment is offset by gains from another investment. Portfolio theory has it that risk cannot be totally eliminated; rather it can be reduced to the barest minimum. One of the ways of reducing risk in the operation of a firm is through diversification.

Diversification is an investment strategy that aims at reducing risk while maximizing returns. It does this by disseminating vulnerability of a portfolio to diverse asset classes and within each asset class. The thinking is that; if one sector or one holding goes down, the whole portfolio will not sink and may even experience gain elsewhere (Javier, 2020). The primary reason for diversification is hinged on minimizing the variability of portfolio returns without jeopardizing the expected rate of return (Osuala, 2009).                       

Increasing profitability, market share, debt capacity, growth opportunity, risk reduction, and the need to use human and financial resources efficiently are also some of the aims of corporate diversification (Afza, Talat, Choudhary, and Mian, 2008). 

Sanjay, (2019) gives some reasons for diversification to be for growth in business operations, to ensure maximum utilization of the existing resources and capabilities and also to escape from unattractive industry environments

Corporate diversification is among the fundamental strategic alternatives available to organizations to sustain growth and search for higher profits (Nwakoby and Ihediwa, 2018).                             Li and Greenwood (2004) opined that companies whose products are threatened by environmental uncertainty or by declining phase of their life cycle curve will prefer to engage in diversification to overcome the risk arising from current industries. Furthermore, firms may engage in expanding its product line and activities to different sectors where environmental uncertainty is reduced and, profitability is higher, such that a company may confirm its survival which will make its cash flow more reliable.

According to Phung and Mishra (2016), changes in economic or industrial conditions can force management to diversify their business. 

Managers tend to diversify their business to get more benefits from the current market with minimum risk. Globalization offers firms the privilege to enlarge their trade beyond the usual boundary for profit maximization. Thus, corporate diversification strategy becomes important for the expansion and growth of firms in competitive and dynamic environments. The aim for corporate diversification is increased profitability, market share, debt capacity, growth opportunity, risk reduction, and the need to use human and financial resources efficiently (Afza, et al., 2008). Diversification also helps firms to explore different markets (Gomes and Livdan 2004). 

With regard to the overall influence of diversification on commercial bank performance, Boyd and Prescott (1986) recommended that the optimal efficiency of a commercial bank is one where it is well diversified as possible. Acharya, Hasan, and Saunders (2004) suggested that there seems to be diseconomies of diversification for any commercial bank that expands into industries where it faces a high amount of competition or lacks prior lending experience. These diseconomies arise in the form of a worsening of the credit quality of loan portfolios simultaneously with a fall in returns (perhaps due to worse monitoring, adverse selection, higher overheads, or some combination of these factors). 

However, according to Bernstein (1996), diversification is mainly vital for a commercial bank given its nature as a financial intermediary. In like manner, its efficiency is measured by how well the said commercial bank achieves an optimal risk trade-off (the most desirable return with an increase in risk) in the mix of its business activities. When the most desirable returns are achieved in banking, such returns provide important sources of equity especially if reinvested into the business (Flamini, McDonald and Schumacher, 2009).

As one of the imperative topics in finance literature, diversification is crucial for commercial bank as financial institution; when commercial banks diversify their credit portfolio, it increases their performance and reduces the credit portfolio risk (Turkmen and Yigit, 2012).

Whenever commercial banks opt in for diversification, extra capital becomes a necessity (Afza, et al., 2008).    According to Lewellen (1971), having in mind that a good  financial structure will maximize shareholders value, firms that are diversified require more debt financing than firms that are not diversified. Thus, financial structure is a vital factor that affects the firms' financial performance.                                                                            Financial structure is how a company finances its assets and operations. It is the amalgam of debt and equities used in financing a firm’s assets and manage its day-to-day operations.  Every firm is free to choose its own structure; both private and public firms have access to more or less the same type of sources of funds except for equity. However, a firm must not live with just any haphazard blend of debt and equity.  The kind of financial composition that one deploys affects the WACC (Weighted average cost of capital) of that company. It, in turn, has a direct attitude on the valuation of that firm. A firm should strive for an optimal structure if it wants to maximize its value. A firm that depends more on the debt could have an increased return on investment. However, having a financial structure with more debt could prove risky if a company is unable to honor its obligation. A financial structure with more debt can be undertaken by a firm that is either oligopoly or monopoly as one can easily predict its sales and cash flows. Contrariwise, it will be difficult for a firm operating in an extremely competitive industry to support such a financial mix. It is because the competition could result in volatile returns and cash flows. And, this, in turn, could result in the firm missing its debt obligations. The way out for such a firm is to move towards a structure that has more equity and less debt (Sanjay, 2021).

Since a firm's business activities and growth depend largely on its financial structure, firms need to make their investment decisions with great care as this demands the estimation of the worth of certain projects based on timing, size, and estimation of the future cash flow of the  (Mehmood, Hunjra and Chani, 2019).                                                                                     As one of the major finance firms in Nigeria, the survival of commercial banks especially; in an era where one banking firm takes over or merges with another has become so challenging. Looking at the complex, globalized, and challenging business environment around the globe today, there is a great need for the survival and better financial performance of commercial banks in Nigeria. To foster the survival and better performance of commercial banks, corporate diversification and financial structure are some of the important factors to be considered (Mehmood, et al., 2019). Therefore, this study seeks to determine the impact of corporate diversification and financial structure on the performance of commercial banks in Nigeria.


1.2 STATEMENT OF THE PROBLEM

Over the years, one of the central themes for research studies in finance has been corporate diversification. Factors like  saturated  domestic  markets  and  a  quest  to secure  bigger  market  shares  globally has spurred diversification; hence making it to become an important business growth strategy (Denis and Yost, 2002; Lee, 2013).                                            Large number of firms across the globe  engage  in  diversification  through  mergers,  acquisitions,  development  of  new product  lines  or  opening   of   new   businesses  across international borders (Martin  and  Sayrak,  2003). 

According to Lewellen (1971), diversified firms need more debt financing than non-diversified firms as the effective financial structure maximizes the value for shareholders. Firms have choices to raise their capital by various means including internally generated fund, new equity issue or various types of debt. The decision to select sources of finance is referred to as financing decision. Financing decision is a very critical decision with great implications for the firm's performance. Theories proposed by the researchers to explain the financing decisions have always been subject of considerable debate.

In opposition to other studies, Amjed (2011), revealed a significant negative relationship amid firm performance and long term debt and also a significant positive relationship between profitability and short term debt. Karimi and Kheiri (2017), opined that financial structure statistically has no significant effect on company’s value. Ng’ang'a (2013) revealed a negative relationship between financial structure and firm performance. Abdallah (2014) found a clear-cut influence of financial structure on company’s value.

Previous studies on diversification and firm performance have shown contradictory results. In developed countries; for instance, a positive relationship was found to exist among corporate diversification and firm performance (Kim, Hoskisson, and Lee, 2014; Montgomery, 1994; Park and Jang, 2013). The findings of these studies support market views, resource-based views, internal market efficiencies, and internationalization theories (Ali, Hashim and Mehmood, 2016). Several researchers noted a negative correlation among corporate diversification and firm performance (Berger and Ofek, 1995; Lang and Stulz, 1994; Lu and Beamish, 2004; Kim and Mathur, 2008; Meyer, Milgrom and Roberts, 1992; Wan and Hoskisson, 2003).

It is worthy to note that majority of the studies carried out on corporate diversification are focused on the U.S. and European markets; few studies have also been done on Asian markets.  In emerging  markets such  as India,  Hong Kong,  Indonesia,  Malaysia  and  South  Korea  the  few studies  that  have  been  undertaken  have  yielded  the same  puzzling results  as  those in  developed countries (Lins and Servaes, 2002).

However, there is not much research on corporate diversification in frontier markets like Nigeria. Taking cognizance of the complex, globalized and challenging world we live in, there's a great demand for the survival, continuity and better operation of Commercial Banks. In this wise, this study seeks to determine what impact corporate diversification and financial structure have on the performance of Commercial Banks in Nigeria.


1.3 OBJECTIVES OF THE STUDY

The broad objective of this study is to ascertain the impact of corporate diversification and financial structure on the performance of Commercial Banks in Nigeria.

The specific objectives are to;

  1. Evaluate how service diversification affects the Return on assets of Commercial Banks in Nigeria.
  2. Investigate the effect of geographic diversification on the Return on assets of Commercial Banks in Nigeria.

3.     Assess the influence of financial structure on the Return on assets of Commercial Banks in Nigeria.


1.4  RESEARCH QUESTIONS

1.     How does service diversification affect the Return on assets of Commercial Banks in Nigeria?

2.     What impact does geographic diversification have on the Return on assets of Commercial Banks in Nigeria?

3.     In what way does financial structure affect the Return on assets of Commercial Banks in Nigeria?


1.5 RESEARCH HYPOTHESES

HO1:   Service diversification does not have a statistical significant effect on the Return on asset of Commercial Banks in Nigeria.                              

HO2:   Geographic diversification does not significantly influence the Return on assets of Commercial Banks in Nigeria.

HO3: Financial structure has a significant impact on the Return on assets of Commercial Banks in Nigeria.


1.6 SIGNIFICANCE OF THE STUDY

The importance of this study is to offer experimental information on the impact of corporate diversification and financial structure on the performance of Commercial Banks in Nigeria. This study will also be of immense value to firms, investors/shareholders, government, academicians and other relevant stake holders.

Firms in emerging markets engaging or intending to engage in corporate diversification will gain more knowledge on the influence of diversification on their institution. It will also aid them to ascertain if the current diversification mechanism they adopted is beneficial or detrimental to the well-being of their institution. Furthermore, it will aid firms in choosing the appropriate mix of liabilities and equities in their financial structure in order to ensure that shareholders receive higher returns on their investments at a reduced rate of risk.                            

Investors/shareholders through this study will have a better knowledge of the monetary health of the firms they intend to invest their hard earned money in as a firm’s performance indicates whether the company is worth investing or not.

Government through this study will have more information about the operations of the firms in their jurisdiction; it will enable them make policies that can foster the efficient operations of firms which in turn will facilitate economic development through provision of employment, payment of corporate tax and provision of basic amenities for its citizens.

Academicians will find this study to be a positive contribution to existing knowledge on corporate finance and financial structure. It will also aid future researchers on corporate diversification and financial structure. This study will also serve as a basis upon which further research can be built on.


1.7 SCOPE OF THE STUDY            

This research work is undertaken to determine the impact of corporate diversification and financial structure on the performance of Commercial Banks in Nigeria over a twenty year period (2001 - 2020). This timeframe was selected for easy accessibility of relevant data.


 1.8 LIMITATIONS OF THE STUDY                     

This study is limited by sample size. The sample size comprises of ten Commercial Banks selected out of the twenty Commercial Banks in Nigeria.

 

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