DEDICATION

This research study is dedicated to Almighty Allah, the Most Beneficent and the Most Merciful.

iii
 ACKNOWLEDGEMENT

And never say of anything, “I shall do such and such thing tomorrow.” Except with saying “If
Allah will!”….. (Q18:23-24).

Special thanks and praises are due to Almighty Allah who created me and showered his mercy

on me right from my birth, through my academic journey, to this moment. It has never been by

my might but His mercy. I say ‗Alhamdulillah‘.

My profound gratitude and appreciation goes to my parents through whom Allah created me. To

my father, MR. Abdul Rasheed Babayanju, I say ‗Jazakumullahu khaeran kesiro fi dunnia, wa fil

akhirat‘. May Allah bless you with His gift to you, and may the receiver give thanks and reach

the maturity of years and be granted piety. And, to my late mother, MRS.AMINAT ADUFE, I

say ‗Jazakallahu khaeran kesiro fil akhirat‘. I pray to Allah to forgive you, have mercy on your

soul and accept her into Paradise (Al-jan‘nat firdaus) and protect her from the purnishment of the

grave and Hell-fire. Amin

I wish to express my appreciation to the Head, Department of Management and Accounting,

Prof. T.O Asaolu FCA for his leadership role. My supervisor, Alhaja Adesunkanmi (Mrs.),

deserves special appreciation for sparing her time to supervise this project work despite her busy

schedule. I say Jazakumullahu Khaeran. May Almighty lifts you up to the greatest high in your

chosen career. I will not forget to appreciate other members of staff of the department and OAU,

both teaching and non-teaching, for their contributions towards successful completion of my

programme in the department, especially my part advisers: Mr. Akande and Miss Olasanmi, Dr.

R.O Salawu ACA, Mr. Y.T Agbaje, and my friend, Miss F. Obi ACA. To all of you, I say

THANK YOU.

iv
Unlimited is my gratefulness to the following personalities: Dr. K.O Owolarafe, Head,

Department of Agricultural Engineering whom Allah used to piloting me into the department

when the road seemed close; and Alhaja R.T Oladepo ACA (Mrs.), whom I knew towards the

end of my sojourn but gave me unforgettable support and assistance. Thank for being my school

father and mother. I say Jazakumullahu khaeran. May Allah bless you and your family with His

mercy. My favourite tutor, Mr. O.L. Aluko FCA (O.L.Aluko & Co); and Mr. & Mrs. Adebayo

(Banwill Cuisine), thank for your support.

To whom much is given, much is expected. I am also using this medium to thank my uncles,

aunties, brothers and sisters who had, in one way or the other, been supportive through my

journey especially aunty Raimat, Mrs.Adeyemi, uncle Ilias, Mr Surajudeen, Mr. Afunku

Oluwaseyi, aunty Folasade, Asc Ayorinde, Mr.Animasaun Rasheed ACA, Mr. Babayanju

Jimoh, Mr Adeyemi Nofiu and others. My siblings, brothers and sisters: Ramat, Adiat, Amid,

Modinat, Kafayat, Jamii, Azeez, Balqees, Roqoyah, Faidat, Shakirullah, Gbemisola, Funmilayos,

Remilekun and others. I say thank you for your understanding and being there for me. May we

live to benefit one another.

Friends in need are friends in deed. Supports and contributions of my friends, both at home and

in school, worth appreciated. Saliu Abdul-Wasii, Toguwa Sulaimon ACA, Mogaji Jamii ACA,

Salami Abdul-Wasii, Adeniji Saheed, Oketokun Taofeeq, Bashir Lukman, Adenekan Monsur,

Mrs. Abass Risqut ACA, Sowunmi Oluwaseun ACA, Elemide Abiodun ACA, Kamiyo Aliu

ACA, Edun Abdulazeez ACA, Babarinde Oluwaseun, Olowogemo Semiu, Agbolade Abdul-

Kabir, Oyelade Fahd ACA, Faniyi Nurudeen, Adekambi Ahmed, the two Abenis, members of

the following associations: MSSN-OAU, Excel Club (esp Gen 06, FPI), SSCA-OAU, IQ Niche-

OAU, and others whom I might have forgotten to mention their names. Thank you all for being

v
there for me. May God Almighty spares our souls to continue be of assistance to one another.

My friends and course mates (Management and Accounting, 2011/2012 set) especially,

Olatubosun Akinola, Orisajuyitan Banjo ACA, Olubodun Mutiu, Ogundepo Blessing, Adewuyi

Ahmed and host of others, you are all appreciated. I pray that we all succeed in life.

I must not forget to appreciate organisations that awarded me scholarships to support my

education: Obafemi Awolowo University Muslim Graduates‘ Association (UNIFEMGA), AG

Leventis (Egba), Odua Investment Company Ltd and Federal Government of Nigeria. May you

continue to flourish.

Last but not the least my future partner and children, thank for being there for me to have ‗in sha

Allah‘.

BABAYANJU ABDUL-GANIY A. BSc. AAT, ACA

January, 2013.

vi
 TABLE OF CONTENTS

TITLE PAGE….………..……………………………………………………………………… ...i

CERTIFICATION…..………………………………………………………………………… …ii
DEDICATION.. ............................................................................................................................. iii
ACKNOWLEDGEMENT ............................................................................................................. iv
TABLE OF CONTENTS .............................................................................................................. vii
ABSTRACT ................................................................................................................................... ix
CHAPTER ONE: INTRODUCTION ......................................................................................... 1
1.0 BACKGROUND TO THE STUDY ................................................................................ 1
1.1 STATEMENTS OF PROBLEM ...................................................................................... 4
1.2 OBJECTIVES OF THE STUDY ..................................................................................... 5
1.3 RESEARCH HYPOTHESES .......................................................................................... 5
1.5 JUSTIFICATION OF THE STUDY ............................................................................... 6
1.6 SCOPE AND DELIMITATION OF THE STUDY ......................................................... 7
CHAPTER TWO: LITERATURE REVIEW ............................................................................ 8
2.0 INTRODUCTION ............................................................................................................ 8
2.1 CONCEPTUAL REVIEW ............................................................................................. 10
2.1.0 THE CONCEPT OF CAPITAL AND CAPITAL STRUCTURE .......................... 10
2.1.1 CAPITAL ................................................................................................................ 10
2.1.2 CAPITAL STRUCTURE ....................................................................................... 11
2.1.3 MEASURES OF CAPITAL STRUCTURE ........................................................... 12
2.1.4 MEASURES OF CAPITAL STRUCTURE ........................................................... 16
2.1.5 DETERMINANTS OF CAPITAL STRUCTURE ................................................. 18
2.2 REVIEW OF THEORETICAL LITERATURES .......................................................... 23
2.2.0 CAPITAL STRUCTURE THEORIES ................................................................... 23
2.2.1 NET INCOME APPROACH .................................................................................. 26
2.2.2 NET OPERATING INCOME APPROACH .......................................................... 28
2.2.3 TRADITIONAL APPROACH ............................................................................... 30
2.2.4 MODIGILIANI AND MILLER (M-M) HYPOTHESIS ........................................ 32

vii
 2.2.5 TRADE-OFF THEORY ......................................................................................... 38
2.2.6 PECKING ORDER THEORY ............................................................................... 39
2.2.7 AGENCY COST THEORY ................................................................................... 39
2.3 REVIEW OF EMPERICAL LITERATURES ............................................................... 40
CHAPTER THREE: RESEARCH METHODOLOGY ......................................................... 43
3.0 INTRODUCTION ...................................................................................................... 43
3.1 VARIABLES DEFINITIONS AND CALCULATIONS........................................... 43
3.2 DATA AND SAMPLE ............................................................................................... 44
3.3 SOURCES OF DATA AND METHOD OF ANALYSIS ......................................... 45
3.4 THE MODEL SPECIFICATION ............................................................................... 46
CHAPTER FOUR: DATA ANALYSIS AND PRESENTATION.......................................... 49
4.0 INTRODUCTION ...................................................................................................... 49
4.1 VARIABLES AND OBSERVATION ....................................................................... 50
4.2 DESCRIPTIVE STATISTICS .................................................................................. 51
4.3 THE RESEARCH RESULTS .................................................................................... 52
CHAPTER FIVE: SUMMARY, CONCLUSION AND RECOMMEDATION ................... 64
5.0 INTRODUCTION .......................................................................................................... 64
5.1 SUMMARY ................................................................................................................... 64
5. 2 CONCLUSION .............................................................................................................. 66
5.2.1 Results of Analysis ................................................................................................. 66
5.2.2 Conclusion .............................................................................................................. 67
5. 3 RECOMMENDATIONS ............................................................................................... 69
5.3.1 Recommendations ................................................................................................... 69
5.3.2 Suggestion for Further Study .................................................................................. 70
REFERENCES ............................................................................................................................. 71

viii
 ABSTRACT

The study examined the relationship between capital structure and corporate performance in

Nigeria using a sample of ten (10) quoted firms, over the period 2008-2010. The objective are to

evaluate the companies‘ performance in terms of proportion of debts in its capita; To determine

the relationship between cost of debt and cost equity; To analyze the nature of relationship

between capital structure and corporate performance.

The study employed the use of panel data using pooling regression model. Method of Ordinary

Least Square (OLS) is used to estimate the regression line. The variables used are debt equity

(DE) ratio, debt to total assets(DTA), interest cover (IC) to proxy capital structure while earnings

per share (EPS) return on equity(ROE), return on asset(ROA) and Tobin‘s Q were used to proxy

corporate performance.

The findings of the study showed positive relationships between EPS and DTA; ROE and DE;

ROE and IC; ROA and DTA; ROA and IC; Tobin‘s Q and DTA. Negative relationships were

reported between EPS and DE; EPS and IC; ROE and DTA; ROA and DE; Tobin‘s Q and DE;

Tobin‘s Q and IC.

Generally, the research results showed that there is no significant relationship between capital

structure and corporate performance of Nigerian companies. This is due to high costs of

borrowing in the country. In view of the stated fact, the study suggests better use of borrowed

funds; emphasizes equity financing, effective fiscal and monetary policies, and importance of

efficient management (corporate performance).

ix
x
 CHAPTER ONE

INTRODUCTION

1.0 BACKGROUND TO THE STUDY

Every business organization, be it sole proprietorship, partnership, incorporated companies or

public corporations requires finance (i.e. capital). There are various sources through which this

capital is raised depending upon the form of the business organization involved. For instance, the

major source of finance for sole proprietorship is personal savings. Other sources of raising

finance by sole proprietors are loan from friends, family, cooperative society and sometimes,

from banks. The sources of finance for partnership are not so different from that of sole business.

Specifically, partnership capital is sourced through partners‘ capital contribution, loan from

partners and from banks. For incorporated companies, capital is raised through issue of different

classes of shares to public (investors) for subscription, external borrowing from investors in form

of debenture and loan from banks. Public corporations are not left out. They obtain finances

through allocation, grants and subventions from government as well as external borrowing from

individuals and corporate bodies.

One of the fundamental concepts of business accounting is ―Entity Concept‖. The concept holds

that the business and its owner(s) are separate and distinct. Though strict application of this

concept is more pronounced in incorporated companies than any other form of business

organizations, every business is presumed to be operating along this distinction. As a

consequence of this, any contribution made to the business by its owners or other investors are

obligations (claims against) on the part of the business. The business is obliged to reward these

contributories in form of interest, dividend and so on out of its profit. However, for business to

1
meet this obligation consistently, its performance must be positive and commensurate with the

capital employed.

The various sources of raising the capital (finance) by the business is being referred to as

financial structure while the composition of the capital, in terms of the ratio of capital

contribution by owners(equity) and borrowed fund from external sources (debt), is termed

capital structure. A business that is solely financed by the owners contributions (equity) is

referred to as unlevered firms while those financed by both sources (debt and equity) are

referred to as levered firms. It is usually argued that returns required by the external providers of

capital on their investment are lower relative to returns to the owners of the business. Another

proposition, based on the above, is that levered firms perform better than unlevered firms in

terms of their market value, returns to shareholders and wealth creation. Various writers and

researchers have worked on this- the relationship between capital structure and corporate

performance.

Since today it is widely accepted that the primary role of managers is to maximize the wealth of

shareholders using the efficient allocation of resources (Worthington and West, 2001, 2004;

Rappaport, 1986, 1998). Therefore, it is very important to explore the relationship between the

level of debts and firm performance.

The focus on the capital structure appeared in the late 1950s with studies of Lintner (1956),

Hirshleifer (1958) and Modigliani and Miller (1958) (Chakraborty, 2010). Although Modigliani

and Miller (1958) suggests that in the perfect capital market, financing strategies do not affect

the value of the firm, but later they argue that firm value can be increased by changing the capital

structure because of tax advantage of debts (Modigliani and Miller, 1963) (Ali Saeedi and Iman

2
Mahmoodi, 2011). After the pioneering work of these scholars, several research works have

been carried out by the academics and researchers on the relationship between capital structure

and corporate performance. For instance, in Iran, Ali Saeedi and Iman Mahmoodi, et al (2011)

etc. reported positive relationship between capital structure and corporate performance while, in

Jordan, Zeitun, R. and Tian, G. G., (2007); etc reported a negative relationship.

In Nigeria, Omorogie A&Erah Dominic (2010); Simon – Oke and Afolabi, Babatunde (2011)

etc., reported positive relationship while Onaolapo, Adekunle &Kajola, Sunday (2010) indicated

that negative relationship exist between capital structure and firm performance. Some researchers

even reported poor or no relationship. These controversial and debatable findings motivated me

in joining the researchers of this exciting and interesting study- Capital Structure and Corporate

Performance. However, this will be from Nigerian perspective.

Corporate performance can be measured by variables which involve productivity, profitability,

growth or, even, customers‘ satisfaction. These measures are related among each other. Financial

measurement is one of the tools which indicate the financial strengths, weaknesses, opportunities

and threats. According to Barbosa & Louri (2005), those measurements are return on investment

(ROI), residual income (RI), earning per share (EPS), dividend yield, price earnings ratio, growth

in sales, market capitalization etc. (Ong Tze San and Teh Boon Heng, 2010). In a market

oriented economy like Nigeria, profitability is generally considered as the best overall indicator

of the corporate performance. Profitability reflects the outcome of all capital structure decision:

debt equity choice, and of course, the underlying efficiency with which inputs are converted to

outputs in corporate organizations. (Omorogie A and Erah Dominic, 2010).

3
As claimed, does capital structure affect profitability; is there any relationship between debt-

equity ratio and return on assets (ROA); has there any significant relationship between earning

per share (EPS), return on equity (ROE) and capital structure. All these and others are what this

study seeks to examined.

1.1 STATEMENTS OF PROBLEM

The need to expand business operations, maximize returns and to diversify risks compels firms

to source for fund outside its ownership. Unlike in the past when businesses were being financed

solely by owners contributions, companies nowadays obtain external finances in form of short

and long term loan from money market as well as debt (long term loan) form capital market by a

way of debentures. These, they claimed, have lower costs as compared to cost of equity (i.e.

return to shareholders), perhaps, because of tax advantage of interests payable on debts. Thereby,

mixing shareholders fund (equity) with loan creditors (debts) in an attempt to maximize returns

and wealth. Consequently, it is expected that the firm‘s value, as measured by its performance,

being increased as it mixes debts with equity. Put differently, a positive relationship is expected

between the proportion of debt-equity and firm performance.

Although capital structure and its impact on the value and performance of companies had been

study for many years, researchers still cannot agree on the extent of the impact. In the light of

this, this study attempts to investigate the existence and type of relationship between capital

structure and corporate performance. To address this problem, the study will answer the

following research questions:

 What is the relationship between debt-equity ratio and return on assets (ROA)?

4
  Is there any significant relationship between earnings per share(EPS) and debt-equity

ratio?

 Is there any relationship between cost of debts (kd), cost of equity (ke) and weighted

average cost of capital(WACC-kw)

 To what extent do changes in interest rate affect firms‘ value?

1.2 OBJECTIVES OF THE STUDY

The general objective of the study is to determine the relationship between capital structure and

corporate performance. To meet this objective, the study will focus on the following specific

objectives:

1. To evaluate the companies‘ performance in terms of proportion of debts in its capital-

earnings per share (EPS) and debt-equity(DE) ratio

2. To determine the relationship between cost of debt and cost equity and- interest cover

(IC) and return on equity (ROE)

3. To analyze the nature of relationship between capital structure and corporate

performance- return on asset (ROA) and ratio of debts to total assets(DTA)

1.3 RESEARCH HYPOTHESES

The following hypotheses will be tested in the course of the study; null hypotheses (H0) and

alternate hypotheses (H1) will be stated thus:

1. H0:There is no significant relationship between capital structure and corporate

performance in Nigeria

5
 H1: There is significant relationship between capital structure and corporate performance

in Nigeria

2. H0: There is no significant relationship between cost of debt and cost of equity

H1: There is significant relationship between cost of debt and cost of equity

1.5 JUSTIFICATION OF THE STUDY

Any business organisation that opens up itself to external finance is prone to risks. This study is

more concerned with financial risks, which is associated with the introduction of debt financing

into capital structure of the firm. Financial risk to stockholder is based on the debt to equity ratio.

Funds sourcing, if possible, should be between the financier and the firm, but when a third party

surfaces, it then become a leveraged financing.

The case whereby a firm‘s creditor has access or claims on the earnings of the firms, opens up

the firm to more risks while a firm in which the creditor has no claim on the firm‘s earnings

reduces its risks. But now, the first firm, that is, the levered firm would have a reduction in

expected values of earnings whereas the second firm which is the unlevered firm will anticipate

much more increase in earnings.

This study is, thus, important because financial resources and its sources (structure) are

paramount in the running or performance of any business enterprise. It will provide recent

evidence on the debate of capital structure paradigm and the relevance of the capital structure

and the firm‘s theory in the Nigerian context. It seeks to contribute to efforts being made to

reposition the financial system to enable it play key roles in corporate performance in Nigeria at

this level of economic development. The findings of this study will also help management of

6
corporate entities to make optimum decision as to the level of debts to include in the capital

structure to ensure optimum performance. It will generally provide a guide to investing public in

selecting business to invest in having information about current level of the company‘s capital

structure. For the academics and researchers, the study will help in resolving the long time

debate over the relationship between capital structure and corporate performance.

Owing to above, no doubt, this study is worthwhile and comes at the right time when efforts are

being channeled towards repositioning Nigerian economy to achieve the set goal - ‘Vision

20:2020’.

1.6 SCOPE AND DELIMITATION OF THE STUDY

This study is limited in scope to the effect of (and relationship between) capital structure and

corporate performance in Nigeria using panel data of a sample of ten (10) listed companies on

Nigerian stock Exchange. It, however, does not include the effect of ownership structure.

Therefore, the result of this study is expected to be applied in Nigeria context. Time and

resources are the major constraints of the study.

7
 CHAPTER TWO

LITERATURE REVIEW

2.0 INTRODUCTION

Firms choose and adjust their financing mix that would enhance their performance. The

financing mix to choose has been a debate from corporate financial economists. At the outset of

such debate is, among the other issues, the question of the relevance of a firm‘s strategic

financing decisions for its valuation. Not surprisingly, large bodies of both theoretical and

empirical research developed in the literature. Among these strand of literature, the firm‘s capital

structure and corporate performance emerged as one of the most researched topics in corporate

finance. With respect to the contention surrounding the corporate capital structure theory, Myers

(1984) calls it a―puzzle‖; Rojan (1997) calls it an ―enigma‖; and Stiglitz (1989) calls it

a―dilemma‖.( Omorogie A. Nosa and Erah Dominic Ose, 2010).

A business invests in new plant and equipment to generate additional revenues and income—the

basis for its growth. One way to pay for investments is to generate capital from the firm‘s

operations. Earnings generated by the firm belong to the owners and can either be paid to them in

the form of cash dividends or ploughed back into the firm. The owners‘ investment in the firm is

referred to as owners’ equity or, simply, equity. If management ploughs earnings back into the

firm, the owners expect it to be invested in projects that will enhance the value of the firm and,

hence, enhance the value of their equity. But earnings may not be sufficient to support all

profitable investment opportunities. In that case the firm is faced with a decision: Forgo

profitable investment opportunities or raise additional capital. A firm can raise new capital either

8
by borrowing or by selling additional ownership interests or both. (Frank J & Pamela P., 2003).

Funds raised by borrowing are being referred to as debts, and these may be in form of

debentures, loan stock or bank loan. The proportion of owners‘ equity and debts in the capital is

known as capital structure.

This chapter will be divided into three sections: 1. Conceptual review 2. Theoretical review

and, 3. Empirical review with following subsections: concept of capital structure; measure of

capital structure; determinant of capital structure; capital structure theories; optimum capital

structure; corporate performance; and the relationship between capital structure and corporate

performance.

9
2.1 CONCEPTUAL REVIEW

2.1.0 THE CONCEPT OF CAPITAL AND CAPITAL STRUCTURE

2.1.1 CAPITAL

The concept of capital has numerous definitions in the field of finance and related literatures.

Bhabatosh Banerjee, 2008, posited that there are two possible approaches to the concept of

capital. One of them is the ‗fund‘ concept while the other is the ‗asset‘ concept of capital. This

classification seems to be comprehensive and thus will be adopted in this study for proper

understanding.

The Fund Concept of Capital

According to the fund concept, the capital of a firm is the sum total of the funds that have been

employed for its operations. This definition corresponds to the idea of total capital employed by

the firm and may also be described as ‗financial capital‘. The fund concept recognizes the

separate entity of a firm and considers capital from the liability side of the statement of financial

position.

Though to accountants, capital comprises only the funds originally contributed by the owners

along with the funds that have been subsequently ploughed back into the firm out of the profits

however, funds contributed by the creditors (long term) are also sourced to finance the business

operations and to generate incomes. Therefore, long term borrowing should be included in the

composition of capital. Hence, capital represents the aggregate of share capital, reserves and

surplus, and long term debt.

10
The Asset Concept of Capital

In this approach, capital is defined as money invested in non-current assets and current assets. In

either case, assets may be comprising either tangibles or intangibles including fictitious assets.

To an accountant, asset is a capitalized expenditure and represents claims to services. Asset

needs not be associated with a material object having a tangible existence. Further, though assets

in general should possess value, all assets may not have value in exchange. Thus in so far as the

intangible assets satisfy these criteria, there is no constraint on the part of the accountant to the

inclusion of intangibles among assets. Viewed from this angle, capital represents aggregate of

non-current assets (net of depreciation), intangible assets, investments and current assets.

2.1.2 CAPITAL STRUCTURE

Generally, the term capital refers to the mix of equity and debt in the firms‘ capital. Frank J. et

al, defined capital structure as the combination of debt and equity used to finance a firm‘s

projects. It is common knowledge that corporate enterprises raise their capital from diverse

sources such as the issue of shares, debentures, long-term loans, short-term loans and ploughing

back of profits. Accordingly, in the procurement of capital from diverse sources, as also in the

subsequent commitment of the said capital to various assets, certain proportions or combinations

of various elements have to be maintained. According to Bhabatosh, 2008, this arrangement of

capital is called capital structure.

Capital structure refers to the firm's financial framework which consists of the debt and equity

used to finance the firm. Capital structure is one of the popular topics among the scholars in

finance field. The ability of companies to carry out their stakeholders‘ needs is tightly related to

capital structure. Therefore, this derivation is an important fact that we cannot omit. Capital

11
structure in financial term means the way a firm finances their assets through the combination of

equity, debt, or hybrid securities (Saad, 2010). In short, capital structure is a mixture of a

company's debts (long-term and short-term), common equity and preferred equity. Capital

structure is essential on how a firm finances its overall operations and growth by using different

sources of funds. Modigliani-Miller (MM) theorem is the broadly accepted capital structure

theory because it is the originating theory of capital structure theory which had been used by

many researchers. According to MM theorem, these capital structure theories operate under

perfect market. Various assumptions of perfect market such as no taxes, rational investors,

perfect competition, absence of bankruptcy costs and efficient market. MM theorem states that

capital structure or finances of a firm is not related to its value in perfect market. (Ong Tze San

& Teh Boon Heng, 2011)

Financial Structure and Capital Structure

Browsing through finance literatures, it is found that distinction is usually drawn between

‗financial structure‘ and ‗capital structure‘ of a firm. The sum of various means of raising funds

comprises the financial structure of a firm. In other words, financial structure comprises

shareholders fund and liabilities (long term and short term). When short-term borrowings are

omitted from the list, the remaining claims represent the capital structure. (Bhabatosh, 2008).

2.1.3 MEASURES OF CAPITAL STRUCTURE

2.1.3.1 CLASSIFICATION OF CAPITAL STRUCTURE

The following components of capital structure will be briefly reviewed:

12
Ordinary share capital

This represents the funds contributed by ordinary shareholders through the holding of ordinary

shares. It reflects the ownership position in a company. The holders are called ordinary

shareholders. The holders are entitled to return on their capital known as dividend. The dividend

is not fixed and non-cumulative (i.e. no arrear of dividend). The holders are the true owners of

company and thus bear the risk of ownership.

Preference share capital

Preference share capital is similar to ordinary share capital in that is contributed by shareholders

and cannot force the company into insolvency. It differs from ordinary shares in that it carries a

fixed rate of dividend which may be cumulative or non-cumulative. The holders are also not

entitled to share in retained earnings, voting rights but usually have prior claims over ordinary

shareholders.

Retained earnings

‗Retained earnings‘ is a stock of undistributed profits over the years. It is the part of the

company‘s income that is not paid out to the shareholders as dividend. It constitutes a component

of capital of firm in that they are usually ploughed back into the business as an alternative source

of finance. Retained earnings form part of equity, i.e. owners‘ fund.

Capital reserves

Capital reserves comprise share premium, revaluation surplus, capital redemption fund, fair

value adjustment and other movements in equity not occasioned by additional capital

contribution by shareholders.

13
Debentures

A debenture is a long-term promissory note for raising loan capital. (I.M Pandey,2005).

Debenture is a fixed income security in that the holder (called debenture holders) are entitled to a

fixed interest and repayment of capital at a stipulated date (called maturity date). Holding of

debenture confers on the holder prior claim over other contributors in the event of liquidation.

Debentures may be convertible or non-convertible. It is convertible if it can be converted, fully

or partly, into shares after a specified period of time. Where it cannot be changed to shares, it is

referred to as non-convertible debenture.

Term loans

Term loans represent long-term debt with a maturity of more than one year usually obtained

from banks and other specially created financial institution such as Bank of Industry in Nigeria.

Like debentures, they carry fixed finance charge and are usually secured to guarantee repayment

of capital. Term loans may be short, medium or long depending on the maturity date stipulated.

Bhabatosh, (2009) classified the above constituents of capital structure on various basis such as

nature; sources; ownership; and cost behavior.

Classification according to Nature

A capital structure may be either: (i) simple structure, or (ii) complex structure.

Simple structure: This is where the company is financed from a single source, e.g. equity share

capital including retained earnings.

Complex structure: This is where the firm is financed from more than one source that are not of

identical or allied nature.

14
Classification according to Sources

Here, capital is classified into: (i) internal capital, and (ii) external capital

Internal capital: This includes share capital through bonus issue, capital reserves and retained

earnings.

External capital: This comprises share capital (excluding bonus issue), share premium, forfeited

shares, debentures, long and short-term liabilities.

Classification according to Ownership

Capital is classified into: (i) ownership capital (equity), and (ii) creditorship capital (debt).

Ownership capital: This consists of equity share capital, reserves and retained earnings.

Creditorship Capital: This includes debentures, long-term loans and current liabilities.

In the above classification, preference share capital is either grouped as part of equity or debt.

Both treatments have been justified.

Classification according to Cost Behaviour

This classification is based on behaviour (rate of change) of the rate of return to the provider of

capital over time. Capital is classified into: (i) fixed cost capital, or (ii) variable cost capital.

Fixed cost capital: This comprises capital components with fixed dividend or interest rate such

as preference share capital, debentures and long-term debt.

Variable cost capital: The rate of dividend or interest varies over time. They include equity

share capital and short-term liabilities.

15
2.1.4 MEASURES OF CAPITAL STRUCTURE

Capital structure of firms is measured using various proxies. The most commonly used in

literatures are:

1. Debt ratio or Debt-to-assets ratio

2. Debt-equity ratio

3. Interest coverage

1. Debt ratio

This is a ratio of debt to total capital or, the proportion of debts to total assets. It measures the

extent to which the assets of the firm are financed with debt. Debt ratio is expressed

mathematically as follows:

Total capital equals shareholders‘ equity plus debt capital.

The ratio can be expressed in percentage or decimal.

The above ratio is significant in that it tells the vulnerability of the firm. A higher percentage or

fraction of more than ratio 1:2 (or 50% if measured in percentage) indicates that the company is

more financed by external borrowings and thus highly geared, while a proportion of less than

50% means that the company is less financed by debt than equity and thus less geared.

16
2. Debt-equity ratio

This is a ratio of debt capital to equity capital. It expresses debt as a proportion of equity. It is

given as

A proportion of 1 or 100% indicates that the company‘s operation is evenly financed with debt

and equity. While a proportion of less than unity indicates that equity is more than debt, a

proportion of greater than 1 indicates that debt is more than equity capital.

3. Interest coverage

This is the ratio of net operating income (or EBIT) to interest charges. It indicates the capacity of

the company to meet its fixed financial charges. It is given as

Where EBIT = earnings before interest and taxes.

The inverse of interest coverage gives income gearing, which measures the proportion of net

operating income (EBIT) paid out as interest. Debt ratio and income gearing have a positive

correlation. This is evident in that interest is based on debt capital.

The first two measures are by no means different from each other in that a further manipulation

of one gives the other.

17
Both debt ratio and debt-equity ratio are referred to as capital gearing while interest coverage is

referred to as income gearing.

2.1.5 DETERMINANTS OF CAPITAL STRUCTURE

Firm‘s capital structure is being determined by many factors (variables) within and beyond the

control of the management. According to existing literatures , the following, among others, are

determinants of capital structure: size, profitability, tangibility, growth opportunities, tax, debt

and non-debt tax shields, volatility, and industry standard.

Size

From the theoretical point of view, the effect of size on leverage is ambiguous. As Rajan and

Zingales (1995, p. 1451) claim: ―Larger firms tend to be more diversified and fail less often, so

size (computed as the logarithm of net sales) may be an inverse proxy for the probability of

bankruptcy. If so, size should have a positive impact on the supply debt. However, size may also

be a proxy for the information outside investors have, which should increase their preference for

equity relative to debt.‖ Also empirical studies do not provide us with clear information. Some

authors find a positive relation between size and leverage, for example Huang and Song (2002),

Rajan and Zingales (1995)7 and Friend and Lang (1988). On the other hand, some studies report

a negative relation, for example (Kester, 1986), (Kim – Sorensen, 1986) and (Titman – Wessels,

1988). Moreover, the results are very often weak as far as the level of statistical significance is

concerned.

18
Profitability

There are no consistent theoretical predictions on the effects of profitability on leverage. From

the point of view of the trade-off theory, more profitable companies should have higher leverage

because they have more income to shield from taxes. The free cash-flow theory would suggest

that more profitable companies should use more debt in order to discipline managers, to induce

them to pay out cash instead of spending money on inefficient projects. However, from the point

of view of the pecking-order theory, firms prefer internal financing to external. So more

profitable companies have a lower need for external financing and therefore should have lower

leverage. Most empirical studies observe a negative relationship between leverage and

profitability, for example (Rajan – Zingales, 1995), (Huang – Song, 2002), (Booth et al., 2001),

(Titman – Wessels, 1988), (Friend – Lang, 1988) and (Kester, 1986).

In this study, profitability is proxied by return on assets (defined as earnings before interest and

taxes divided by total assets).

Tangibility

It is assumed, from the theoretical point of view, that tangible assets can be used as collateral.

Therefore higher tangibility lowers the risk of a creditor and increases the value of the assets in

the case of bankruptcy. As Booth et al. (2001,) state: ―The more tangible the firm‘s assets, the

greater its ability to issue secured debt and the less information revealed about future profits.‖

Thus a positive relation between tangibility and leverage is predicted. Several empirical studies

confirm this suggestion, such as (Rajan – Zingales, 1995), (Friend – Lang, 1988) and (Titman –

Wessels, 1988) find. On the other hand, for example Booth et al. (2001) and Huang and Song

(2002) experience a negative relation between tangibility and leverage.

19
Growth Opportunities

According to Pamdey (2005), the nature of growth opportunities have an important influence on

a firm‘s financial leverage. Firms with high market-to-book ratios have high growth

opportunities. A substantial part of the value for these companies comes from organizational or

intangible assets. These firms have a lot of investments opportunities. There is also higher threat

of bankruptcy and high costs of financial distress associated with growth firms once they start

facing financial problems. These firms employ lower debt ratios to avoid the problem of under-

development and to avoid cost of financial distress. As market-to-book ratio is used in order to

proxy for growth opportunities, there is one more reason to expect a negative relation – as Rajan

and Zingales (1995) point out: ―The theory predicts that firms with high market-to-book ratios

have higher costs of financial distress, which is why we expect a negative correlation.‖

In this study, the P/B or Tobin’s Q ratio (market-to-book ratio) is used as a proxy for growth

opportunities.

Tax

According to the trade-off theory, a company with a higher tax rate should use more debt and

therefore should have higher leverage, because it has more income to shield from taxes.

However, for example Fama and French (1998) declare that debt has no net tax benefits. As

MacKie-Mason (1990, p. 1471) claims: ―Nearly everyone believes taxes must be important to

financing decision, but little support has been found in empirical analysis.‖

20
Debt and Non-debt Tax Shields

Other items apart from interest expenses, which contribute to a decrease in tax payments, are

labelled as non-debt tax shields (for example the tax deduction for depreciation). According to

Pamdey (2005), debt, due to interest deductibility, reduces the tax liability and increases the

firm‘s after-tax free cash flows. In absence of personal taxes, the interest tax shields increases the

value of the firm. Firms also have non-debt tax shields available to them. For example, firms can

use depreciation; carry forward losses, etc. to shield taxes. This implies that those firms that have

larger non-debt tax shields would employ low debt, as they may not have sufficient taxable profit

available to have the benefit of interest deductibility.

According to Angelo – Masulis (1980, ): ―Ceteris paribus, decreases in allowable investment-

related tax shields (e.g., depreciation deductions or investment tax credits) due to changes in the

corporate tax code or due to changes in inflation which reduce the real value of tax shields will

increase the amount of debt that firms employ. In cross-sectional analysis, firms with lower

investment related tax shields (hol-ding before-tax earnings constant) will employ greater debt in

their capital structures.‖ So they argue that non-debt tax shields are substitutes for a debt-related

tax shield and therefore the relation between non-debt tax shields and leverage should be

negative. ( Patrik BAUER, 2004)

Volatility

Volatility may be understood as a proxy for risk of a firm (probability of bankruptcy). Therefore

it is assumed that volatility is negatively related to leverage. However, as Huang and Song (2002,

p. 9) state based on findings of Hsia (1981): ―As the variance of the value of the firm‘s assets

21
increases, the systematic risk of equity decreases. So the business risk is expected to be

positively related to leverage.‖

The positive relation between volatility and leverage is confirmed by (Kim– Sorensen, 1986) and

(Huang – Song, 2002). Conversely, a negative relation is found by (Bradley et al., 1984) and

(Titman – Wessels, 1988). ( Patrik BAUER, 2004)

Industry Standard

According to Bhabatosh (2008), while planning the capital structure, the firm has to evaluate the

capital structures of other firms belonging to same risk class, on the one hand, and that of the

industry as a whole, on the other hand. If the firm adopts a capital structure significantly out of

line with that of similar units in the same industry, it may not be acceptable to the investors.

Some empirical studies identify a statistically significant relationship between industry

classification and leverage, such as (Bradley et al., 1984), (Long – Malitz, 1985), and (Kester,

1986).

22
2.2 REVIEW OF THEORETICAL LITERATURES

2.2.0 CAPITAL STRUCTURE THEORIES

There are many but competing capital structure theories with the main objective of establishing

the sensitivity of corporate performance (firm‘s value) to changes in capital structure. According

to Barbatosh, 2008, the concern is whether a firm can affect its total valuation (debt plus equity)

and its cost of capital by changing its financing mix. That is, what happens to total valuation of

the firm and to its cost of capital when the ratio of debt to total capital, or degree of leverage, is

varied.

Three different rates of returns (cost of capital) are commonly used in explaining the concept of

capital structure. These are:

1. Cost of debt -Kd

2. Cost of equity -Ke

3. Weighted Average Cost of Capital(WACC) -Ko

1. Cost of Debt-Kd

This is the yield on the firm‘s debt. It is the rate of return required by the lenders (debenture

holders) on their capital. Assuming the debt is perpetual, it is given as

2. Cost of Equity -Ke

This represents the rate of return required by the equity shareholders on their investment in the

company capital. It is given as

23
In case of 100% dividend pay-out ratio, it is given as

3. Weighted Average Cost of Capital (WACC) -Ko

This is the overall capitalization rate for the firm. It is defined as average cost of capital, and

may be expressed as:

Where O=Earnings before interest and tax (EBIT)

Alternatively, WACC is given as weighted average of Kd and Ke as follows:

( ) ( )

Where D= Market value of debt; E= Market value of equity shares outstanding and V= Total

value of the firm i.e. D + E

The concern of the capital structure theories is to ascertain what happens to Kd, Ke, and Ko when

the degree of leverage, D/V, changes.

24
A number of theories explain the relationship between cost of capital, capital structure and value

of the firm. However in this study, the review will limited to the following theories:

1. Net income approach

2. Net operating income approach

3. Traditional approach

4. Modigliani-Miller hypothesis

5. Trade-off theories

General assumptions of capital structure theories

In order to be able to appreciate the argument of each these theories, it is necessary to highlight

the general assumptions underlying capital structure theories. These are:

1. The firm finances from two sources only: equity and debt.

2. There is no corporate tax. This assumption is later relaxed.

3. All earnings are paid out as dividends, that is, 100% pay-out ratio (simply, no retention).

4. The firm‘s assets are ( or aggregate capital consisting of debt and equity) are not growing,

and, hence, its operating income (EBIT) is expected to remain constant in the future

5. The firm can change its capital structure, or degree of leverage, either by issuing shares to

retire debt or by raising more debt to redeem the shares (shares buyback).

6. Investors have the same subjective probability distribution of the expected future

operating income or EBIT for a given firm

7. The firm is a going concern

25
2.2.1 NET INCOME APPROACH

David Durand identified the two extreme capital structure theories- the net income approach and

the net operating income approach. (Bhabatosh, 2008)

According to of the net income approach, the firm is able to increase its total valuation, V, and

lower its weighted average cost of capital (WACC), Kd, as it increases its degree of leverage,

D/V. The optimum capital structure is one at which the weighted average cost of capital is

lowest and the firm‘s total valuation is the greatest. At that structure, the firm‘s share price is

maximized.

The significance of the net income approach is that a firm can lower its weighted average cost of

capital Ko continually by the use of debt, and, thus, increase its total valuation. Reduction in the

cost of capital with more and more use of debt capital and, hence increase in the value of firm

will be possible when

1. the cost of debt Kd is less than the cost of equity Ke and it remains constant; or

2. the firm‘s risk premium is not changed, i.e does not become increasingly more risky in

the minds of investors and creditors, as the degree of leverage is increased.

26
 Cost of Capital Ko

Ke

Kd

Degree of Leverage (D/V)

Figure 2.1: The effect of leverage on the cost of capital under Net Income approach

Figure 2.1 above plots WACC as a function of financial leverage. Financial leverage, D/V, is

plotted along the horizontal axis and WACC, Ko, cost of equity Ke and cost of debt, Kd, on the

vertical axis. It will be noticed that both Ke and Kd are constant. Thus, as more debt is

substituted for equity in the capital structure, being less expensive, it causes weighted average

cost of capital ,Ko, to decrease that ultimately approach the cost of debt with 100% debt ratio

(D/V). The optimum capital structure occurs at the point of minimum WACC. (Pamdey, 2005)

Hence under Net Income approach, the firm‘s value will be maximized when it is 100% debt-

financed.

27
2.2.2 NET OPERATING INCOME APPROACH

Under the Net Operating Income approach, the cost of equity, Ke, increases but the cost of debt,

Kd, the weighted average cost of capital, Ko, and the total value of firm, V, all remain constant as

the degree of leverage is varied. This approach implies that there is no single optimum capital

structure as the cost of capital, Ko, cannot be changed through leverage. All capital structures are

optimal, for the market price per share remains constant with a change in leverage. Thus, the

capital structure would be a matter of indifference to investor.

Apart from the above, other assumptions and viewpoints of the Net Operating Income approach

are:

1. The market capitalizes the value of the firm as a whole ( the split beytween debt and

equity is not important). The value of the firm, V, is found by capitalizing the net

operating income (EBIT) at the weighted average cost of capital, Ko. Thu

2. The value of equity, E, is found as a residual by subtracting the value of the debt, D, from

the (constant) value of the firm (V), i.e.

3. The cost of debt, Kd , is a constant. The cost of equity will be

Where I = Interest charges.

28
The use of cheaper debt capital increases the risk to shareholders. This raises the cost of equity

or capitalization rate.

Ke

Ko
Cost of Capital

Kd

Degree of Leverage (D/V)

Figure 2.2: Effect of leverage on the cost of capital (NOI) approach

The above diagram shows that as the firm increases its degree of leverage, it becomes

increasingly more risky. So, the cost of equity, Ke, increases. However, the use of a greater

proportion of cheaper debt capital offsets the increase in the cost of equity. On balance, however,

the weighted average cost of capital, Ko, remains constant notwithstanding the changes in degree

of leverage.

29
2.2.3 TRADITIONAL APPROACH

The traditional view has emerged as a compromise to the extreme position taken by the Net

income approach. Like the Net Income approach, it does not assume constant cost of equity with

financial leverage and continuously declining WACC. According to this view, a judicious mix of

debt and equity capital can increase the value of the firm by reducing the weighted average cost

of capital (WACC-Ko) up to certain level of debt. This approach very clearly implies that WACC

decreases only within reasonable level of financial leverage and reaching the minimum level, it

starts to increase with financial leverage. Hence, a firm has an optimum capital structure that

occurs when WACC is minimum, and thereby maximizing the value of the firm. (Pamdey, 2005)

The declining value of weighted average cost of capital is as a result of more low-cost debt being

substituted for expensive equity capital. Thereby, cost of equity will increase due to perceived

increasing risk to shareholders caused by introduction of more debts into the capital structure.

According to traditional theory, at a moderate level of leverage, the increase in cost of equity is

more than offset by the lower cost of debt.

On the assumption that the net operating income, the net income and interest are perpetual flows;

and that expected net income is distributed entirely to shareholders. Therefore, the value of

equity is

The value of debt is interest income to debt-holders divided by the cost of debt:

30
The value of firm is given as the sum of values of equity and debt. i.e. E + D. The firm value is

directly given by capitalizing Net operating income by WACC:

The relationship between Ke, Kd, Ko and firm‘s value (V) is depicted in the graph below:

Ke

Ko
Cost of capital

Stage 2
Kd
Stage 1
Optimum Leverage range

Leverage

Figure 2.3: The effect of leverage on the cost of capital under traditional approach

In the first stage, the cost of equity (ke) remains constant or rises slightly with debt. The cost of

equity does not increase fast enough to offset the advantage of low-cost debt. During this stage,

the cost of debt, Kd, remains constant since the market views the use of debt as reasonable

policy. As a result, the overall cost of capital, WACC (Ko), decreases with increasing leverage,

and, thus, the total value of the firm, V, also increases.(First stage-Increasing value)

31
Once the firm has reached a certain degree of leverage, increases in leverage have a negligible

effect on WACC and hence, on the value of firm. it follows that the increase in the cost of equity

due to the added financial risk just offsets the advantage of low-cost debt and hence, the WACC

is at minimum and firm‘s value maximized. (Second stage-Optimum Value)

As the firm attempt to increase the financial leverage beyond the stage 2, the value of firm

decreases with the resulting increase in WACC. This happens because investors perceive a high

degree of financial risk and demand a higher equity-capitalization rate, which exceeds the

advantage of low-cost debt. (Third stage-Declining value)

In summary, the WACC is a function of leverage. It first declines with leverage and after

reaching the minimum point, starts rising.

2.2.4 MODIGILIANI AND MILLER (M-M) HYPOTHESIS

Modigiliani and Miller (1958) do not agree with the traditional view. They argue that, in perfect

capital markets without taxes and transaction costs, a firm‘s market value and the cost of capital

remain invariant to the capital structure changes. The value of the firm depends on the earnings

and risk of the assets (business risk) rather than the way in which assets have been financed

(financial structure. (Pamdey, 2005) In view of this, M-M approach supports the Net operating

income approach.

The Modigliani-Miller hypothesis is based on the following assumptions:

i. Perfect capital markets. This implies, among other things, that (a) there are no

transaction costs, and (b) individual and corporate investors can borrow at the same rate

of interest.

32
 ii. Homogenous information. All the present and prospective investors have identical

estimates of each firm‘s average future earnings.

iii. Homogenous risk classes. Firms operate in similar business conditions and have similar

operating risk. They are considered to have similar operating risk and belong to

homogenous risk classes when their expected earnings have identical risk characteristics.

iv. Full payout. The dividend payout ratio is 100%, that is, firms distribute all net earnings

to shareholders.

v. No taxes. There are no any corporate taxes. This implies that interest payable on debt do

not save any taxes. This assumption is later relaxed

On the bases of the above assumptions, Modigiliani and Miller developed two propositions:

Proposition I and Proposition II.

Proposition I

Under this proposition, M-M hypothesis argues that total market value of firm, V, and its cost of

capital, Ko, are independent of its capital structure. The total market value of the firm is

established by capitalizing the net operating income at a rate appropriate to the firm‘s risk class.

Hence, this proposition is identical to net operating income approach.

The value of firm is given as:

It therefore follows that

( ) ( )

33
Since earnings before interest and tax is calculated before interest, it is therefore independent of

capital structure or leverage. WACC or opportunity cost of capital Ko is equal to the

capitalisation rate of a pure equity stream of its class and is independent of the capital structure.

If earnings and WACC are both independent of the capital structure, the value of the firm must

also constant and independent of the capital structure or leverage.

The relationship between cost of capital and degree of leverage, as hypothesized by M-M, is

shown in the graph below:

Cost of Capital

KO

Degree of Leverage (D/V)

Figure 2.4: Effect of leverage on the cost of capital (M-M hypothesis: Proposition I)

From the curve, the cost of equity, (Ke), and WACC(Ko) remain constant irrespective of changes

in leverage (D/V).

The implication of the M-M proposition I is that values of levered and unlevered firm operating

in the line of business with same risk will be the same since the market value is independent of

capital structure.

Value of levered firm = Value of unlevered firm

VL = VU

34
Should this assumption of not true and the two firms have different market value, it therefore

follows that arbitrage process is possible in which an investor can switch between unlevered firm

and levered firm to increase its return on investment (personal or homemade leverage) and this

will eventually restore equilibrium in the market.

Proposition II

This proposition is based on the reasoning that though the financial leverage does not affect a

firm‘s net operating income, it does affect shareholders‘ return (EPS and ROE). EPS and ROE

increase with leverage when the interest rate is less than the firm‘s return on assets. Financial

leverage also increases shareholders financial risk by amplifying the variability of EPS and ROE.

Thus it causes two opposing effects: it increases the shareholders‘ return but it also increases

their financial risk. Hence, shareholders will required additional return (risk premium) on their

investment to compensate for the increase in the financial leverage.

ke = Ko + Risk Premium

The risk premium depends however depends on the degree of leverage and, it equals the product

of difference between the pure equity capitalisation rate, Ko, and the cost of debt, Kd, and the

degree of leverage (Debt-Equity ratio). In other word,

In summary, M-M proposition II states that the firm‘s cost of equity, Ke, increases in a manner to

offset exactly the use of cheaper debt capital. Impliedly, there is a positive linear relationship

between cost of equity (Ke) and debt equity ratio, (D/E).

35
Modigliani and Miller hypothesis with corporate taxes

As a result of criticisms given to their earlier position of 1958 (irrelevance of capital structure)

based on some critical assumptions such as no taxes, perfect market, uniform borrowing rate etc.,

some of which have been criticised to be unrealistic, M-M changed their position in their article

of 1963 with the introduction of corporate taxes into their model.

According to Bhabatosh (2009), M-M now recognize that the value of the firm will increase or

the cost of capital will decrease with an increase in the leverage as the interest on debt is a

deductible expenses. Between two firms, levered and unlevered, the former will have a higher

for same reason. More specifically, the value of the levered firm, L, will exceed that of unlevered

firm, U, by an amount equal to L‘s debt multiplied by the tax rate, that is,

VL = VU + tD

Where, VL = Value of the unlevered firm

VU = Value of the unlevered firm

t = Corporate tax rate

D = Amount of debt in L

The relationship between cost capital and leverage, as put forward by M-M under relevance of

capital structure, is shown in the diagram below:

36
 Ke

Cost of Capital

Ko

Kd(1-t)

Degree of Leverage (D/V)

Figure 2.4.2: Effect of leverage on cost of capital (M-M hypothesis with taxes)

According to Pamdey (2005), the M-M‘s ―tax-corrected‖ view suggests that, because of the tax

deductibility of interest charges, a firm can increase its value with leverage. Thus, the optimum

capital structure is reached when the firm employs almost 100 per cent debt. He stated further

that the observed experience does not entirely support this view. In practice, firms do not employ

large amounts of debt, nor are the lenders ready to lend beyond certain limits, which they decide.

M-M suggest that firms would adopt a target debt ratio so as not to violate the limits of the debt

level imposed by lenders.

37
2.2.5 TRADE-OFF THEORY

Opponents of irrelevance theory have criticized it by arguing that assumptions used by

Modigliani and Miller, are not realistic. The trade-off theory determines an optimal capital

structure by adding various imperfections including taxes, cost of financial distress and agency

cost, but retains the assumptions of market efficiency suggest that firm target leverage is driven

by three competing forces:

(i) taxes

(ii) costs of financial distress (bankruptcy costs), and

(iii) Agency conflict.

The trade-off theory says that companies have optimal debt-equity ratios, which they determine

by trading-off the benefits of debt-against it cost (Scott, 1976).

In the traditional or original form of the model, the chief benefit of debt is the tax advantage of

interest deductibility (Miller, 1977). The traditional view did not take into account that

shareholders required rate of return would increase as soon as financial leverage will rise.

Modern versions of trade-off theory are based on capital market imperfections (taxes, bankruptcy

cost, agency cost) and argue that there are trade-off advantages and disadvantages associated

with the use of debt capital.

The earlier modern versions of the theory were static. The static trade-off theory of capital

structure explains observed capital structure, as its name implies, as a static trade-off of costs and

benefits of debt.

38
2.2.6 PECKING ORDER THEORY

Pecking order theory (also referred to as the information asymmetry theory) proposed by Myers

states that firms prefer to finance new investment, first internally with retained earnings, then

with debt, and finally with an issue of new equity. Myers argues that an optimal capital structure

is difficult to define as equity appears at the top and the bottom of the ‗pecking order‘. Internal

funds incur no flotation costs and require no disclosure of the firm‘s proprietary financial

information that may include firm‘s potential investment opportunities and gains that are

expected to accrue as a result of undertaking such investments.

2.2.7 AGENCY COST THEORY

The agency cost theory of capital structure states that an optimal capital structure will be determined

by minimising the costs arising from conflicts between the parties involved. Jensen and Meckly

(1976) argue that agency costs play an important role in financing decisions due to the conflict that

may exist between shareholders and debt holders. If companies are approaching financial distress,

shareholders can encourage management to take decisions, which, in effect, expropriate funds from

debt holders to equity holders. Sophisticated debt holders will then require a higher return for their

funds if there is potential for this transfer of wealth. Debt and the accompanying interest payments,

however, may reduce the agency conflict between shareholders and managers. Debt holders have

legal redress if management fails to make interest payments when they are due, hence managers

concerned about potential loss of job, will be more likely to operate the firm as efficiently as possible

in order to meet the interest payments, thus aligning their behaviour closer to shareholder wealth

maximisation.

39
2.3 REVIEW OF EMPERICAL LITERATURES

As earlier stated, capital structure has been one of the most researched topics in the field of

finance. This accounts for plethora of findings and inferences about its relationship with many

variables of corporate performance. The lead research being that carried out by Modigliani and

Miller 1958. According to them, capital structure is irrelevance to value of the firm. This finding

was based on some assumptions which subsequent researcher have described as unrealistic. Five

years later, in 1973, another research conducted by the duo reported that firm capital structure is

relevance to the capital structure. This, they arrived at by relaxing one of their assumption ‗no

taxes‘.

Confirming capital structure relevance theory, Ofek (1993) in his study on relationship between

capital structure and a firm‘s reaction to short term financial distress had shown the result that

high-leverage firms are more possible than their less-leverages counterparts to react

operationally to short-term distress. The high-leverage firms are also more possible to take

personal actions such as restructuring assets and laying off employees when performance

deteriorates. Apart from that, a firm with high leverage will react quickly in financial through

cutting down dividend, restructuring debt and bankruptcy.

Although in different dimension to that of Ofek (1993), a study done by Gleason, Mathur and

Mathur (2000) on relationship between culture, capital structure and performance, using data

from retailers in 14 European countries, shows that capital structures differ by the cultural

classification of retailers which are strengthen to the inclusion of control variables that will

influence capital structure. Furthermore, result also shows that retailer performance is not

depending on the cultural influence. Where else, capital structure will influences performance.

40
Zeitun, R. and Tian, G. G (2007) study investigates the effect which capital structure has had on

corporate performance using a panel data sample representing of 167 Jordanian companies

during 1989-2003. Their results showed a contrary view to that of Mathur and Mathur (2000).

They reported that a firm‘s capital structure had a significantly negative impact on the firm‘s

performance measures, in both the accounting and market‘s measures but that the short-term debt

to total assets (STDTA) level has a significantly positive effect on the market performance

measure (Tobin‘s Q).

Omorogie A. Nosa and Erah Dominic Ose (2010), in their study of capital structure and

corporate performance in Nigeria between 1995 and 2009 using Ordinary Least Squares (OLS)

technique, found that capital structure is high in Nigeria over the years and concluded that capital

structure has not sustained effective funding required for growth and development of

corporations.

In agreement with Agency theory, Onaolapo Adekunle and Kajola Sunday O (2010) reported

that a firm‘s capital structure surrogated by Debt Ratio, DR has a significantly negative impact

on the firm‘s financial measures (Return on Asset, ROA and Return on Equity, ROE) when they

examined the impact of capital structure on firm‘s financial performance using sample of thirty

non- financial firms listed on the Nigerian Stock Exchange during the seven- year period, 2001-

2007. This is in agreement with Zeitun, R. and Tian, G. G (2007).

However, Ali Saeedi and Iman Mahmoodu (2011) examined the relationship between capital

structure and firm performance using a sample of 320 listed companies in the Tehran Stock

Exchange (TSE) over the period 2002-2009 and showed that firm performance, which is

measured by EPS and Tobin‘s Q, is significantly and positively associated with capital structure,

41
while report a negative relation between capital structure and ROA. Moreover, there is no

significant relationship between ROE and capital structure.

Also in 2011, Ong Tze San & Teh Boon Heng reported that there is relationship between capital

structure and corporate performance in their study- relationship of capital structure and corporate

performance of firm before and during crisis (2007) of construction companies which are listed

in Main Board of Bursa Malaysia from 2005 to 2008. For big companies, ROC with DEMV and

EPS with LDC have a positive relationship whereas EPS with DC is negatively related. In the

interim, only OM with LDCE has positive relationship in medium companies and EPS with DC

has a negative relationship in small companies.

42
 CHAPTER THREE

RESEARCH METHODOLOGY

3.0 INTRODUCTION

This chapter presents methodology employed in the study. It includes variables definition and

calculation, data and samples, technique of analysis and model specification.

3.1 VARIABLES DEFINITION AND CALCULATION

The study examined the relationship between capital structure choices and corporate

performance in Nigeria. Performance measures and capital structure are dependent and

independent variables respectively. Four financial performance indicators including EPS, ROA,

ROE and Tobin‘s Q are used as proxies of firm performance.

3.1.1 Earnings Per Share (EPS) which indicates how much earning is created on per share, is

calculated by dividing net income to the average number of common shares outstanding. i.e

EPS is expressed in kobo (or naira) per share.

3.1.2 Return on Asset (ROA). It is a measure of efficient use of assets; how organization

resources are used to generate income. It is calculated by dividing net income plus interest

expenses by total assets. i.e

ROA is expressed in percentage or fraction.

3.1.3 Return on Equity (ROE). ROE is another profitability ratio that measure relativity of

net income to owners‘ contributions. It is defined by dividing net income by equity capital.

43
It is expressed in percentage or fraction.

3.1.4 Tobin’s Q. Tobin‘s Q introduced by Tobin as an appropriate performance measure in

1969 and is defined as follows:

Furthermore, three measures of leverage including the ratio of debts to equity (DE), Debts to

total assets (LTDA) and Interest Cover (CR) are employed. Debt-equity ratio, debt ratio and

coverage ratio are as defined in chapter two. In addition, size of the firm (SZE), which is

measured by logarithm of total assets, is considered as control variable, i.e

3.2 DATA AND SAMPLE

In this study, a sample of ten (10) Nigerian listed firms in the Nigerian Stock Exchange over the

period 2008-2010 is used. The sample was drawn only from the major sectors- building and

construction, oil and gas and, manufacturing (FMCGs). We exclude all of the financial

companies and banks due to they operate in a different way. In order to increase comparability,

the companies which their fiscal and calendar years do not match are excluded.

Finally, the sample was limited to ten companies because of the lack of some companies' data

and, limited time and resources at the disposal of the researcher. The selected companies are:

 Building and Construction(B&C)- Costain (West Africa) Plc, Julius Berger Nigeria Plc,

Dangote Cement Plc and Berger Paint Nigeria Plc;

44
  Oil and Gas- Conoil Plc, Oando Plc

 Manufacturing (FMCGs)- Nestle Plc, UAC, AG Leventis,and Guiness Nigeria Plc.

By doing so, a sample consisting of 30 year-firm observations was obtained.

3.3 SOURCES OF DATA AND METHOD OF ANALYSIS

Secondary data were used in this study. The data were sourced from published annual reports of

the selected companies through websites.

The equation specified for the study was estimated using the ordinary least squares (OLS)

method. The model assists us to determine the R2 values and the F-values as well as the t-value

in order to test the significance of the equation specified.

Determinants of variables

45
Variables Proxies

Capital Structure Debt to Total Asset DTA

(independent variables) Debts to Equity DE

Interest Cover IC

Company‘s size SIZE

Corporate Performance Return on Equity ROE

(dependent variables) Return on Asset ROA

Earnings Per Share EPS

Tobin‘s Quotient Tobin’s Q

3.4 THE MODEL SPECIFICATION

A model is identified if it is in a unique statistical form enabling unique estimates of the

parameters to be subsequently estimated from sample data.

The Pooling Regression Model

This study used pooling regression model to test the influences of capital structure on the

companies‘ performance. Method of Ordinary Least Square (OLS) is used to estimate the

regression line. OLS is used because it minimizes the error between the estimated points on the

line and the actual observed points of the estimated regression line by giving the best fit. All the

dependent and independent variables are pooled cross section time series for estimation. There

are 30 cross section and 3 time periods.

46
In this study, I employed the use of three (3) explanatory variables. In the models, corporate

performance (CP) depends on debt-equity ratio (DE), debts to total assets ratio (DTA) and

interest cover (IC). The general model is given below:

CP = α0 + α1DE + α2DTA + α3IC + ε, where

CP = Corporate performance (which could be EPS, ROE, ROA or Tobin‘s Q)

EPS = Earnings Per Share

ROE = Return on Equity

ROA = Return on Assets

Tobin‘s Q= Tobin‘s Quotient

DE = Debt-Equity ratio

DTA = Debt to Total Assets

IC = Interest Cover

The individual models will be

EPS = α0 + α1DE + α2DTA + α3IC + ε Model……..(1)

ROE = α0 + α1DE + α2DTA + α3IC + ε Model……..(ii)

ROA = α0 + α1DE + α2DTA + α3IC + ε Model…….(iii)

Tobin‘s Q = α0 + α1DE + α2DTA + α3IC + ε Model…….(iv)

α0, α1, α2, α3 & ε are parameter estimates

Whereas α0 is a constant, α1, α2 and α3 are regression coefficients of DE, DTA and IC

respectively, ε is error term.

A priori expectation is given as

α1, α2, α3 ≠ 0

47
The above denotes that a positive relationship is expected between corporate performance and

the following variables; debt-equity ratio (DE), debts to total assets ratio (DTA) and interest

cover (IC).

Model 1 tests the relationship between EPS and capital structure (DE, DTA and IC) in order to

achieve the objective- ―To evaluate the companies‘ performance in terms of proportion of debts

in its capital-earnings per share (EPS) and debt-equity (DE) ratio‖. Model 2 tests the relationship

between ROE and capital structure and this will be used to determine the relationship between

cost of debt and cost equity - interest cover (IC) and return on equity (ROE). Model 3 and 4 are

developed to analyze the nature of relationship between capital structure and corporate

performance- return on asset (ROA) and ratio of debts to total assets (DTA).

48
 CHAPTER FOUR

DATA ANALYSIS AND PRESENTATION

4.0 INTRODUCTION

This chapter is dedicated to the presentation and analysis of data obtained through the annual

reports of the selected companies sourced online. The chapter will present descriptive statistics

of the variables, research findings and interpretation.

49
 4.1 VARIABLES AND OBSERVATION

The variables and observations of each of the selected companies are presented in the table

below.

Table 1: Variables and Observations

EPS ROE ROA TOBIN'S D/E- DTA- IC

COMPANY YEAR (N) % % Q-ratio ratio ratio (times) SIZE S/N

1
AG LEVENTIS 2008 0.36 11.43 10.83 0.75 0.38 0.23 92.14 16.23

2009 0.40 11.78 10.78 0.69 0.53 0.29 9.53 16.42 2

2010 0.29 8.07 5.13 0.74 0.85 0.41 9.19 16.41 3

NESTLE 2008 12.61 92.25 40.91 5.89 1.89 0.59 176.90 17.76 4

2009 14.81 92.79 35.77 4.27 2.93 0.70 7.74 18.04 5

2010 19.08 84.78 31.48 4.73 2.81 0.69 25.22 18.23 6

CONOIL 2008 2.62 15.31 10.46 1.13 3.65 0.76 2.23 18.64 7

2009 3.33 17.11 15.87 1.10 1.81 0.61 2.50 18.44 8

2010 4.02 18.31 13.98 1.05 1.60 0.59 3.28 18.45 9

JULIUS
BERGER 2008 2.08 37.79 4.19 1.14 19.10 0.91 10.13 18.55 10

2009 2.74 42.23 6.58 1.10 17.92 0.90 13.62 18.83 11

2010 2.33 36.39 5.91 1.29 17.37 0.89 10.05 18.97 12

UAC 2008 2.65 10.30 7.70 0.83 1.09 0.41 9.25 17.80 13

2009 3.14 10.72 7.83 0.97 1.19 0.47 5.09 17.85 14

2010 1.99 8.76 6.54 0.97 1.44 0.51 3.59 17.77 15

OANDO 2008 9.22 18.64 7.44 1.06 5.24 0.81 2.01 19.64 16
2009 19.64

50
 11.32 19.77 8.07 1.03 4.86 0.80 2.15 17

2010 8.29 15.28 9.22 0.88 2.29 0.66 5.23 19.75 18

COSTAIN 2008 2.21 (37.88) 12.94 1.27 (5.86) 1.14 2.61 15.15 19

2009 (0.57) (7.08) (3.87) 0.65 0.55 0.35 (12.85) 15.65 20

2010 0.03 0.43 1.04 0.92 0.76 0.42 1.57 16.08 21

GUINNESS 2008 8.04 32.18 23.40 2.30 0.70 0.34 40.14 18.05 22

2009 9.31 42.95 28.45 2.97 0.99 0.42 10.37 18.31 23

2010 9.18 40.17 26.84 3.99 0.93 0.41 20.01 18.51 24

DANGOTE
CEMENT 2008 36.00 8.49 19.63 1.30 0.27 0.42 N/A 17.94 25

2009 95.00 33.25 26.41 0.90 0.83 0.44 N/A 18.68 26

2010 6.80 145.25 25.83 5.13 2.55 0.46 34.89 19.13 27

BERGER
PAINTS 2008 0.95 12.06 22.40 0.64 - - N/A 14.75 28

2009 0.89 14.38 14.19 0.63 0.55 0.32 309.81 14.68 29

2010 2.03 26.38 19.96 1.00 0.47 0.30 1,238.40 14.83 30

4.2 DESCRIPTIVE STATISTICS

Table 2 below shows the descriptive statistics of the variables. The table shows that all of the

variables have a positive mean. Moreover, mean statistics provide some interesting evidence.

First, the mean capital structure‘s proxies are about 298.9 and 54.24 percent respectively for

debt-equity (DE) and debt-to-total assets (DTA) respectively; and 67.83 times for interest cover

(IC) which indicates Nigerian companies in general, finance their assets by debts. This means

they operate in a risky manner. Second, the mean of the Tobin‘s Q (1.71) is greater than one

which revealed the market value of listed companies in the Nigerian Stock Exchange (NSE) is

51
greater than their book values. This suggests companies should invest more and more in capital.

Finally, the mean of ROE (28.74%) and ROA (15.19%) show that Nigerian companies, by

considering inflation rate, have a poor performance over the period 2008-2010.

Table 2: Descriptive Statistics

STATISTIC EPS (N) ROE (%) ROA (%) TOBIN'S Q DE DTA IC (times) SIZE

Range Statistic 95.57 183.13 44.78 5.26 24.96 1.14 1251.25 5.07

Minimum Statistic -.57 -37.88 -3.87 .63 -5.86 .00 -12.85 14.68

Maximum Statistic 95.00 145.25 40.91 5.89 19.10 1.14 1238.40 19.75

Statistic 9.0383 28.7439 15.1981 1.7104 2.9890 .5424 67.8264 17.6398

Mean Std. Error 3.26246 6.41713 1.97952 .27515 .99777 .04507 42.02279 .27686

Std. Deviation Statistic 17.86923 35.14808 10.84227 1.50703 5.46503 .24688 230.16831 1.51643

Variance Statistic 319.309 1235.388 117.555 2.271 29.867 .061 52977.449 2.300

Statistic 4.199 1.579 .618 1.717 2.173 .375 4.889 -.717

Skewness Std. Error .427 .427 .427 .427 .427 .427 .427 .427
No of
Observations Statistic 30 30 30 30 30 30 30 30

4.3 THE RESEARCH RESULTS

To examine the relationship between firm performance and capital structure, four distinct

regressions models are developed by pairwise combinations of performance measures (including

EPS, ROE, and ROA and Tobin‘s Q) and the proxies of capital structure (STD, LTD and TD).

However, Model 1 tests the relationship between EPS and capital structure; Model 2 tests the

relationship between ROE and capital structure; Model 3 tests the relationship between ROA and

capital structure while Model 4 tests the relationship between Tobin‘s Q and capital structure.

52
REGRESSION ANALYSIS

4.3.1 Relationship between EPS and Capital Structure:

The summary of the EPS regression from ordinary least square analysis is as shown below in the

table:

Table 3: Relationship between EPS and Capital Structure:

Variables Coefficient Std Error t – stat Significant

Constant 10.493 9.066 1.157 .258

DE -.384 .727 -.528 .602

DTA .492 16.435 .030 .976

IC -.008 .015 -.547 .589

Dependent Variable: EARNINGS PER SHARE (N)

α = .05
R2 = .022
F-stat = .199

From the result of the analysis, the regression equation of EPS as a function of the capital

structure proxies will be:

EPS is expressed in Naira.

From the result above, as earlier postulated (i.e. apriori expectation: α1, α2, α3 , ≠ 0), there is a

relationship between capital structure and corporate performance (EPS). However, the test

statistic is not significant at 5% level of significance to conclude that the relationship is

significant. Notwithstanding this, there is negative relationship between EPS and debt-equity

ratio, interest cover while it has positive relationship with debt-to-total assets ratio. With a

53
constant of N10.49, a unit increase in DE ratio will cause about 38.4kobo decrease in EPS and, a

unit increase in interest cover(IC), will cause a decrease of about 1kobo in EPS; whereas, a unit

increase in debt-to-total assets ratio will bring about 49.2kobo increase in EPS, all other variables

are being held constant.

With R2 of 0.022, only about 2.2% changes in EPS can be explained by changes in the capital

structure proxies while the remaining 97.8% is attributed to the other factors outside the model.

Finally, on the hypothesis of study, since the significant value is higher than 0.05, H0 is accepted,

and therefore conclude that there is no significant relationship between capital structure and

corporate performance (EPS) at 5% level of significance.

54
4.3.2 Relationship between ROE and Capital Structure:

The summary of the ROE regression from ordinary least square analysis is as shown below in the

table:

Table 4: Relationship between ROE and Capital Structure:

Variables Coefficient Std Error t – stat Significant

Constant 29.811 17.394 1.714 .098

DE 1.895 1.394 1.359 .186

DTA -13.307 31.533 -.422 .676

IC .007 .030 .242 .811

Dependent Variable: RETURN ON EQUITY (%)

α = .05
R2 = .070
F-stat = .651

From the result of the analysis, the regression equation of ROE as a function of the capital

structure proxies will be:

ROE is expressed in percentage.

Given the non-zero coefficient of the explanatory variables (DE, DTA and IC), there is a

relationship between corporate performance (ROE) and capital structure. Although like the first

model, the result is not significant at 5% level of significance to conclude that the relationship is

significant, there is positive relationship between ROE and debt-equity ratio (DE), Interest

Cover(IC) on one hand and negative relationship negative relationship with debt-to-total (DTA)

assets ratio. It is also observed that the relationship between EPS and debt ratios is opposite to

that between ROE and the debt ratios.

55
With a constant of 29.81%, a unit increase in DE ratio will cause about 1.895% increase in ROE,

while a unit increase in interest cover (IC), will cause an increase of about 0.007% increase in

ROE. Also, a unit increase in debt-to-total assets ratio will result in a decrease of about 13.30%

in return on equity (ROE), while all other variables are being held constant.

With R2 of 0.070, only about 7% of changes in EPS can be explained by changes in the capital

structure proxies while the remaining 93% is attributed to the other factors outside the model.

Finally, on the hypothesis of study, since the significant value is higher than 0.05, H0 is accepted,

and therefore conclude that there is no significant relationship between capital structure and

corporate performance (ROE) at 5% level of significance.

56
4.3.3 Relationship between ROA and Capital Structure:

The summary of the ROA regression from ordinary least square analysis is as shown below in

the table:

Table 5: Relationship between ROA and Capital Structure:

Variables Coefficient Std Error t – stat Significant

Constant 16.262 5.318 3.058 .005

DE -.505 .426 -1.185 .247

DTA .096 9.641 .010 .992

IC .006 .009 .639 .528

Dependent Variable: RETURN ON ASSETS (%)

α = .05
R2 = .086
F-stat = .818

From the result of the analysis, the regression equation of ROA as a function of the capital

structure proxies will be:

ROA is expressed in percentage.

Based on above model, there is a relationship between corporate performance (ROA) and capital

structure. Similarly, the result is not significant at 5% level of significance to conclude that the

relationship is significant; there is positive relationship between ROA and debt-to-total assets

(DTA) ratio, Interest Cover(IC) on one hand and negative relationship negative relationship with

debt-equity ratio (DE).

57
With a constant of 16.26%, a unit increase in DE ratio will cause about 0.505% decrease in

ROA, while a unit increase in debt-to-total assets(DTA) ratio and interest cover (IC), will cause

an increase of about 0.096% and 0.006% increase in ROE respectively, given that all other

variables remained unchanged.

With R2 of 0.086, only about 8.6% of changes in ROA can be explained by changes in the

capital structure proxies while the remaining 91.4% is attributed to the other factors outside the

model.

Finally, on the hypothesis of study, since the significant value (t-stat) is higher than 0.05, H0 is

accepted, and therefore conclude that there is no significant relationship between capital

structure and corporate performance (ROE) at 5% level of significance.

58
4.3.4 Relationship between Tobin’s Q and Capital Structure:

The summary of the Tobin‘s Q regression from ordinary least square analysis is as shown below

in the table:

Table 6: Relationship between Tobin’s Q and Capital Structure:

Variables Coefficient Std Error t – stat Significant

Constant 1.322 .766 1.727 .096

DE -.033 .061 -.531 .600

DTA .904 1.388 .651 .521

IC -6.653E-5 .001 -.051 .960

Dependent Variable: TOBIN’S Q (Ratio)

α = .05
R2 = .019
F-stat = .171

From the result of the analysis, the regression equation of Tobin‘s Q as a function of the capital

structure proxies will be:

Tobin’s Q is expressed in ratio.

Based on above model, there is a relationship between corporate performance (Tobin‘s Q) and

capital structure. Similarly, the result is not significant at 5% level of significance to conclude

that the relationship is significant. While a positive relationship is reported between Tobin‘s Q

and debt-to-total assets (DTA) ratio, negative relationship exist between Tobin‘s Q and other two

variables (DE and IC).

59
With a constant ratio of 1.322, other factors being equal, a unit increase in DE ratio will cause

about an increase 0.904 in Tobin‘s Q ratio; while a unit increase in debt-to-total assets (DTA)

ratio and interest cover (IC), will cause decrease of about 0.033 and 6.653 in ROE respectively.

With R2 of 0.019, only about 1.9% of changes in Tobin‘s Q ration can be attributed to changes in

the capital structure proxies while the remaining 98.1% is attributed to the other factors outside

the model.

Finally, on the hypothesis of study, since the significant value (t-stat) is higher than 0.05, H0 is

accepted, and therefore conclude that there is no significant relationship between capital

structure and corporate performance (ROE) at 5% level of significance.

60
4.3.5 CORRELATION MATRIX
Table 7: Correlation Matrix of Model variables

CORRELATION MATRIX

r EPS ROE ROA TOBIN'S Q DE DTA IC

EPS 1.000 .053 .382 .020 -.268 -.190 .023

.
ROE 053 1.000 .688 .834 .068 -.203 .257

ROA .382 .688 1.000 .801 -.353 -.228 .214

TOBIN'S Q .020 .834 .801 1.000 -.206 -.055 .104

DE -.268 .068 -.353 -.206 1.000 .340 .107

DTA -.190 -.203 -.228 -.055 .340 1.000 -.029

IC .023 .257 .214 .104 .107 -.029 1.000

Control Variable: Company Size

Table 7 above presents the correlation coefficients(r) between and within the dependent and

independent variables using company size as control variables. Correlation coefficient measure

the degree of relationship between two variables. The nature of relationship between the capital

structure as proxied by DE, DTA and IC and corporate performance as proxied by EPS, ROE,

ROA and Tobin‘s Q can be viewed at a glance from the matrix.

The correlation is weak where 0 ≤ /r/ ≤ 0.49;

The correlation is strong where 0.5 ≤ / r / ≤ 0.99; and

The relationship is perfect where / r / = 1.

61
The direction of the relationship (positive or negative) depends on the sign of the coefficient.

While a minus sign means negative relationship, a plus (no sign) means a positive relationship.

The correlation coefficients within each group are generally positive except between DTA and

IC where negative correlation is reported. This implies that an inverse co-movement exists

between interest cover and debt-to-total assets ratio of Nigerian Companies. In other word,

whenever there is change (increase / decrease) in debt-to-total assets ratio, the interest cover will

react negatively (decrease / increase). Aside this, other variables within each group move

together in same direction.

As produced by linear regression model 1, EPS has a weak negative correlation with DE and

DTA but a weak positive correlation with IC. Based on this, Nigerian companies will experience

a small fall in their earnings per share as more debts are introduced into their financial structure.

This may be attributed to high cost of capital (interest rate) in the economy. Meanwhile,

additional capital through shares (lowering debt ratio) will increase earnings. Expectedly, an

increase in earnings will result in increase in interest cover but at a lower rate.

Return on equity (ROE), in conformity with linear regression model 2, has a weak positive

relationship with DE and IC and a negative relationship with DTA. The return on equity (ROE)

which is equivalent to cost of equity capital (Ke), by this research result, will be expected to

increase as debts (both current and non-current) is increased relative to equity (shareholders

fund). Just like EPS and IC, ROE and IC move in the same direction. Whenever there is increase

in ROE, IC will also increase but at lower rate. Contrarily, Nigerian companies will experience a

fall in the ROE as the ratio of debts-to-total assets (DTA) is increased. This, as said earlier, may

be attributed to high cost of borrowing in the country.

62
Finally from the matrix, it is also observed that ROA and Tobin‘s Q have the same nature of

relationship with the capital structure proxies as for EPS. This is contrary to the prediction of

GLM (Model 3) in the table 5 and 6 above respectively. Whereas the coefficients of change in

ROA with respect to the capital structure proxies are positive for DTA and IC, it is negative for

DE as shown in table 5. Also the coefficients of changes in Tobin‘s Q with respect to changes in

DE and IC are positive but negative for DTA. This disparity explains the difference between the

two measures. Whereas GLM is estimated for predicting future value of the dependent variable,

correlation coefficient explains the nature and degree of relationship between two variables,

neither one predicts another.

63
 CHAPTER FIVE

SUMMARY, CONCLUSION AND RECOMMEDATION

5.0 INTRODUCTION

This chapter concludes the study with the summary of the previous chapters; conclusions drawn

from review and analysis of data; and recommendations made both for further study and policy

implication.

5.1 SUMMARY

Chapter one of the study discussed introduction to the study whereby background study of

capital structure and corporate performance were enumerated, leading to formation of the

objectives of study. The chapter pointed out the objectives of the study, what the research hopes

to achieve, its significance and the questions it aimed at answering. The chapter also indicated

the scope and limitation of the study.

The objectives are to examine the relationship between capital structure and corporate

performance (as measured by EPS, ROE, ROA and Tobin‘s Q) of companies listed on the

Nigerian Stocks Exchange; nature of the relationship and effect of cost of capital on corporate

performance,

Chapter two reviewed the related literatures relevant to the topic of the study. The chapter

reviewed conceptual, theoretical and empirical literatures related to the study. Various works of

early writers, scholars and researchers were considered. Notably among them are Miller and

Modigliani (M-M 1958 & 1973) capital structure theories, Meckley Pecking order theory, Jensen

and Meckley (1976) agency theory and so on.

64
Chapter three of the study focused on the research methodology employed. This chapter

discussed variables of study and their proxies, data sources, models specification and data

analysis technique. The variables of study are capital structure(independent) and corporate

performance(dependent) using debt ratios(DTA, DE) and interest cover(IC) as proxies for capital

structure while corporate performance is proxied by earnings per share(EPS), return on

assets(ROA), return on equity(ROE) and Tobin‘s Q. The nature of the study enabled the use of

secondary data. Data about the selected companies are gathered through the companies‘

published annual reports. The major tool of analysis employed in the study is Ordinary Least

Square (OLS). Statistics such as measure of central tendencies, intercept, slope, coefficient of

determination and coefficients of correlation were computed.

Chapter four presented the analysis of data and interpretation of research results. Majorly,

results were presented in tables and linear equations form. Descriptive statistics about the capital

structure and performance of each of the selected companies were presented. Regression results

and correlation matrix were also presented to identify various dimensions of relationships

between and within the variables.

Chapter five, being the concluding chapter, will discuss the conclusions drawn from the results

of data analysis and make appropriate recommendations with the belief that it will be of help to

various stakeholders- corporate bodies, researchers and governments in deciding on the efficient

and optimum capital structure.

65
5. 2 CONCLUSION
5.2.1 Results of Analysis

The descriptive statistics result of the variables of study shows that all of the variables have a

positive mean. The mean capital structure‘s proxies are about 298.9 and 54.24 percent

respectively for debt-equity (DE) and debt-to-total assets (DTA) respectively; and 67.83 times

for interest cover (IC)

Based on the panel data regression analysis used in this study, it was discovered that debt

financing and debt–equity ratios are significant factors that determine the profitability (EPS,

ROE, ROA and Tobin‘s Q), used as a proxy for performance of firms.

The results indicate that firm performance which is measured by EPS has relationship with

capital structure. It is positively related to debt-to-total assets but negatively to debt-equity and

interest cover.

There is positive relationship between ROE and debt-equity ratio (DE), Interest Cover(IC) on

one hand and negative relationship negative relationship with debt-to-total (DTA) assets ratio.

There is positive relationship between ROA and debt-to-total assets (DTA) ratio, Interest

Cover(IC) on one hand and negative relationship negative relationship with debt-equity ratio

(DE).

While a positive relationship is reported between Tobin‘s Q and debt-to-total assets (DTA) ratio,

negative relationship exist between Tobin‘s Q and other two variables (DE and IC).

66
5.2.2 Conclusion

Based on the results of the descriptive statistics, it means that Nigerian companies operate in a

risky manner. Second, the mean of the Tobin‘s Q (1.71) is greater than one which revealed the

market value of listed companies in the Nigerian Stock Exchange (NSE) is greater than their

book values. This suggests companies should invest more and more in capital it was deduced that

equity financing played a better role than debt financing. However, it is clear that the

combination of both have a significant effect on firm‘s performance.

On the hypothesis of study, given the results of the regression, there is no significant relationship

between capital structure and corporate performance at 5% level of significance. It is therefore

concluded that debt capital has no significant effects on corporate performance in Nigeria.

Although, positive relationship is reported between return on equity (ROE) and interest cover

(IC), it is not significant and hence second hypothesis is also accepted i.e. there is no significant

relationship between cost of debts and cost of equity. However, this suggests that Nigerian

companies have high costs of capital; they have no access to relatively low cost capital.

Obtaining loan at high costs prevents them from increasing returns to equity holder as more of

such loan is raised.

Notwithstanding the insignificant relationship between capital structure and corporate

performance of Nigerian companies as reported by the study, the results of this study agree to

that of previous researchers- M&M theory of 1958, Simon Oke and Afolabi Babatunde (2011),

Ali Saeedi and Iman Mahmoodi (2011). It is however in contrary to the result of Abor (2005) on

the influence of capital structure on profitability of listed companies on the Ghana Stock

67
Exchange during a five-year period where a significant positively interrelated between SDA and

ROE and shows that firms which earn a lot use more short-term debt to finance their business.

68
5. 3 RECOMMENDATIONS
5.3.1 Recommendations

Based on the results of the analysis and conclusions drawn, the following are the

recommendations, which I hope will be considered and implemented by policy makers both in

public and private sectors, to improve the performance of Nigerian companies:

 For improvement in firms‘ performance, share of equity financing in the capital structure

should be increased. Nigerian companies should prefer raising funds through shares to

debts.

 Also, to avoid conflict of managers with shareholders‘ interests, managers should go for

long run value maximization of the firm which satisfies both managers and shareholders

interest. There should be goal congruence and alignment at running of the organisation.

 Nigerian capital market and regulators should be restructured and, operations improved

upon to provide enabling environment for Nigerian companies to raise funds through

public subscription.

 Financial institutions should be encouraged to provide finance to companies at reasonable

costs. Appropriate legislations should be passed to limit the interest rates being charged

by commercial banks in Nigeria.

 Public interest in investing in shares of the companies should be reinforced. Constant and

adequate awareness programme should be put in place to enlighten and arouse the

interest of investors in buying shares.

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  Inflation and general price levels in the economy should be adequately regulated.

Nigerian government should, as a matter of necessity employs effective and efficient

fiscal and monetary policies (measures) to combat the effect of inflation (both home-

made and imported) on Nigerian economy.

 Finally, Code of Corporate Governance should be formulated, implemented and backed

by sanctions. This will helps to remove agency conflict, stimulates public interests and

enhance performance of Nigerian companies.

5.3.2 Suggestion for Further Study

This study will not be concluded without suggestions on how it can be improved upon by future

researchers.

By employing a sample of 10 listed companies on Nigerian Stock Exchange to evaluate the

relationship between capital structure and corporate performance in Nigeria, I have been able to

identify that Nigerian companies are not better off with debts financing. In future research, it will

be of interest to extend this analysis to cover more companies as well as include different aspects

of ownership structures.

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