1.0 Background
Capital structure decisions are critical for the profitability and or growth objectives of for-profit organizations. Financial managers are given the liberty of choosing the components of their capital structure as long their maximize the value of the stock and at the same time achieve some of the core objectives of firms. Some of these include maximization of the company’s value. Managers all over the world strive to find a combination of investment with the best gearing ratio. According to Huber (2011) excessive use of debt financing could lead to too much of the firm's profits being used to pay off long term debts, which significantly lowers the shareholder’s wealth. On the other hand, overreliance of equity, limits the amount of capital a firm can amass for its growth strategies. In this light, financial managers have to identify the tradeoff between the use of debt and equity and the impact of the same on the value of the firm.
The debate on the impact of a company’s capital structure on its value has been of significance since the 1950s. In 1958, the Miller and Modigliani (MM) theory suggested that the gearing ratio has no influence whatsoever on the value of a firm given that firm operates in a perfect market (Huber, 2011). The MM subsequent article (1963) indicated that, in the presence of corporation tax, the gearing ratio has an impact on the value of a firm because the rate of return of stock increases with the increase in the gearing ratio (debt/ equity ratio). Additionally, the 1663 MM proposition led to the realization that a levered firm enjoys the benefit of interest rate payment deduction (expense) unlike the firms that opt to use equity since the dividend payments, in this case, are compulsory..
According to Focardi, & Fabozzi (2004), the impact of capital structure on the value of a firm seems to differ with the situation of the firm. For instance, firm’s placed in developed economies have been found to be affected by other factors rather than the gearing ratio. Some of these factors include politics, the size, growth, and profitability of the firms and such. On the other hand, firms located in developing economies, such as Nigeria, the financial market is competitive and characterized by high-interest rates. For this reason, most companies rely heavily on the use of retained earnings to boost their capital. Additionally, the low per capita income reduces the people’s ability to invest their savings in stock. As such, there is a clear difference in approaching the impact of capital structure on the value of a firm. For this study, the independent variables are debt, equity, and gearing ratio, while the dependent variable is the share price. Debt represents what a firm owes to its creditors and indicate the leverage level of a company. According to the trade-off theory of capital structure, the use of debt in a company’s capital structure leads to increased tax deductions and increases the leverage level. Consequently, this increases the profitability of the company. It is vital to consider the debt levels since it represents risks faced by a company for example bankruptcy.
Equity is a common method of financing in most companies around the world. It is preferred to debt financing as it reduces the risks of bankruptcy if a firm is unable to meet its repayment of debts as in the use of leverage. The use of equity in a company’s capital structure is endorsed in the pecking order theory of capital structure. The latter stated that a company should first employ its equity before opting to use debt to optimize its value. The gearing ratio represents the level of debt or equity employed in a company’s capital structure. In as much as it is attractive for finance managers to use leverage, excess use of debt leads to a high gearing which in turn poses a high risk for the continuity of the company. In the midst of the debate over the choice of the components of the capital structure, given the risk associated with high gearing and the limit to growth with the reliance on equity and retained earnings, it is vital that managers remain keen on the best practices in capital structure management to maximize the value of the firm.
Companies have been using debt in their capital structure as it reduces the cost of capital and ultimately leads to increased profitability of a firm. Using this financing method, companies have been able to provide their shareholders with more value as debt provides a sound alternative of capital. However, financial managers should control the use of debt use of debt financing with the aim of keeping the soundness of the company’s credit worth. Even with this challenge, finance managers, especially those in emerging economies can find hope in the growing focus on the topic to address the impact of capital structure on the value of the firm’s stock.
1.2 Statement of the problem
Financial managers strive to find the best fit for the use of equity financing and debt financing to maximize the value of their firm. A firm has the liberty of choosing the capital structure that would be best in maximizing the value in the market. However, the choice of the primary methods of financing that is equity financing has its pros and cons. As such, managers rely on finding a perfect match between equity financing and the use of leverage as the sources of the firm's capital.
Making this choice in itself is a challenge for financial managers, especially in developing economies like Nigeria. According Guerard & Schwartz (2007), the use of excess leverage puts a firm at a financial risk in the incident that it is unable to pay the debts as per the contract. In this case, the company faces a risk of liquidation. In developed economies, variables that have been determined to be the primary determinant of a firm's market value include the size of the firm. Others include the profitability of the enterprise, the risk exposure and at some times the ability of the management. The daunting problem to a manager remains on the choice of the sources of capital given the risk that both equity and debt financing pose on the value of a firm. It is the realization of this problem that guides this research in the identification of the impact of the choice of the capital structure on the market value of the deposit banks in Nigeria.
According to Huber (2011), the use of long-term debt presents a situation where the firm dilutes the ownership of a company, as it is the case with an equity financing. Additionally, raising capital using debt financing is easier compared to calling the members of the public to subscribe to the firm's shares as the Federal Government usually set minimum standards to be met by the latter. In the current economic situation, competition among the players in the banking sector is on the increase, and failure to poise a firm high in the capital market would mean not only low value in the market, but also low profitability as bank customer is more likely to deposit with the high-profile banks.
In emerging economies such as Nigeria, the financial managers in the deposit-banking sector in Nigerian should realize the existence of the problem of choosing the components of the capital structure and find the best fit for the long-term goals of their individual firms. Since the common aims of this type of companies are the maximization of the shareholder's wealth, there is a need to narrow down on the single best method of financing a firm. According to Ogbulu and Emeni (2012), firms in emerging economies should embark on careful use of leverage as a source of capital. As opposed to developed economies where the size or profitability of the business is the primary variables that determine the value of the firm, firms situated in emerging economies have been found to best increase the value of their stock through the use of leverage.
Analysis of the existing literature on the topic indicates various problems and gaps which act as limitations towards finding the correlation between capital structure and share price in the Nigerian deposit banks. One of the most significant problems is the environment and time gaps in the studies. For instance, the study by Buigut, Soi, Koskei, and Kibet (2013), which investigated the relationship between capital structure and share price focused on Kenyan firms. Another study by Hussain & Gull (2011) examined the same topic but in the Karachi stock market in Pakistan. As such, these studies are inadequate to lead to any conclusion on the exact correlation in the Nigerian setting. Additionally, the existing studies use the ordinary least squares (OLS model) and multiple regression. These methods are not fit for the complexity of the research and fail to give the exact causal relationship of the variables as with the use of panel regression. Lastly, the existing studies use different variables rather than the interest variables, capital structure, and share price. Due to the problems discussed above, there are still several gaps in the research. The variables and the methodogical gaps are the most prominent. This means that further research needs to be while taking the above gaps into consideration.
1.4 Significance of the Study
The research is significant in assessing the impact of the decision of the components of the capital structure of a firm. In a turbulent economic environment and even important for financial managers in emerging economies such as Nigeria. The research focused on the deposit banks in Nigeria, which is one of the promising industries in the county. From the analysis of the present literature on the topic shed light on the following:
1. Deposit banks. The results of this study will equip financial managers in these banks by enabling adopt the most optimum gearing to lower the cost of capital, which would go a long way in improving the value of deposit banks in the county.
2. The public. By helping managers increase the value of their firms by adopting the most appropriate capita structure methods, the public would find investment in the company’s stock fulfilling for investment. The result would benefit the public through the payment of dividends from the companies.
3. The bank customers. The study sheds light into various factors that could affect a firm’s value or leds to its closure. Employing these strategies help the firms have a longer life and thus making the customers have more trust in them. At the same time, the customers’ deposit is cushioned against the risk of closure of the firms.
4. The economy. The research sheds light on ways of improving the market value of deposit banks. By adopting these measures, firms in the industry would grow to foster the development of other industries. With more people investing the companies, investment activities would increase.
2.4 Critical Analysis
The review of the existing literature indicates that most of the studies concentrate on variables different from the focus of this study, that is the relationship between capital structure and share price. The few studies that study the association between share price and capital structure are Buigut, Soi, Koskei & Kibet (2013) and Hussain & Gull (2011). The studies are, however, conducted on firms outside Nigeria, which makes the findings unfit for the Nigerian setting. The studies focus on the Kenyan and Pakistan markets respectively, making them inappropriate in evaluating the correlation of the variables in the Nigerian market.
Other studies investigate the relationship between capital structure and firm value, capital structure and dividend policy, which is far from the subject of the survey. The resulting variable gap makes the existing studies inadequate to solve the research problem in Nigeria. Still on the variables, it is notable that most of the studies did not use controlled variables in the study, unlike this study which uses firm size and age. Control variables ensure the research findings identify the correlation between the study variables. As such, by not using the control variables, the past studies have a problem of narrowing in on the exact relationship between capital structure and share price.
Time is a sensitive factor in attaining satisfactory research findings. A standard time of ten years is necessary to achieve convincing results. On the contrary, all the studies reviewed lasted under ten years. Others lasted only four years. The short span of the studies from some of the studies is as follows: Hussain and Gull, 2011 (2005 - 2009), Skinless, 2011, Oboh and Adekoya, 2012 ( 2005 to 2009), Rezaei and Habashi, 2012 (2006-2011), Klimenok, 2014 (1987-1991), Gharaibeh, 2014 ( 2009-2012) and Idris and Bala, 2015 (2006-2013).
Only a few studies used panel regression, which incorporates heterogeneity of the variables and leads to more accurate variable estimates. Panel regression is also suitable for this study as it involves complex analysis of data, which is required to identify the accurate relationship between capital structure and share price. Panel regression also minimizes the bias of results due to aggregation. Ordinary least squares (OLS) method, which is used in some studies fails to detect the effects of the research moderating factors or control variables. Multiple regression used in the studies by Khan, Naz, Khan, Khan and Ahmad, 2013, Duke, Ikenna, & Nkamare, 2015, Mohohlo, 2013 and Klimenok, 2014 only ascertains the correlation between the variables but fail to define the precise causal mechanism. From this, the studies have been unable to employ a more efficient methodology, creating the need for future research and use of better tools such as panel regression.
2.5 GAP identified
Additionally, this only study that uses the same variables as this research fails to employ control variables. This gives rise to a variable gap, calling for a need for future research with the use of control variables to enhance the accuracy of the findings. At the same time, an environmental gap is identifiable from the review. For instance, the study by Buigut, Soi, Koskei, and Kibet (2013) focus on the Nairobi Stock Market in Kenya, making it unfit for evaluating the impact of capital structure on the share price of Nigerian firms.
Additionally, only a few studies use panel regression. Some of the studies use the ordinary least squares method and other regression methods such as multiple regression. These methods do not lead to the best correlation between the study variables and at the same time do not incorporate the effect of control variables. This results in a methodological gap, meaning there is a need to use a better data analysis tool such as panel regression for better and bias-free results in the future.
References
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