DOWNLOAD THE COMPLETE PROJECT

903 Users found this project useful

THE IMPACT OF CAPITAL STRUCTURE AND PERFORMANCE

CHAPTER ONE

INTRODUCTION

1.1      BACKGROUND OF THE STUDY

The theory of capital structure is an important reference theory and perhaps, one of the most puzzling issues in corporate finance. The determination of optimal capital structure which maximizes firm’s value has frustrated theoretician for decades. The early works made numerous assumptions in other to simplify the problem and assumed that both the cost of debt and cost of equity were independent of capital structure and that the relevant figure for consideration was the net income of the firm. However a closer look suggests that the costs of debt and the cost of equity are important and relevant figure for consideration.

Pandey (1999) defines capital structure to mean a mix of long term sources of funds, such as debentures long term debt, preference share capital, and equity share capital including reserves and surplus (i.e. retained earnings). Pandey goes further to say that some companies do not plan their capital structure and it develops as a result of the financial decision taken by the financial manager, but ultimately, they may face considerable difficulties in raising funds to finance their activities.
Also with unplanned capital structure, these companies may fail to economize the use of their funds. In order to fortify the firm against these severe consequences, it is being increasing realized that a company should plan its capital structure. Anup and Pual (2010). Debt provides tax shield benefit to firms. Capital structure planning is also advisable to be able to maximize the use of funds and to adapt easily to changing economic conditions.
Capital structure simply means an enterprises mixture of debt and equity financing. Debt and equity is probably the reason why Brounen and Elchholts (2001), make the assertion that the announcements of season equity offerings cause negative price reactions, whereas the news of an additional debt issue is followed by an increase in stock prices whether or not the structure of capital has an impact on performance is one of the most complex and important issues in corporate finance.
A number of assertions have been made on this very issue. Chen (2001) examines the relationship between ownership structure and firm value in the case of China. The result shows that there is a strong positive relationship between concentrated ownership and corpora value. Earlier, it was asserted that ownership structure plays an important role in a firm, particularly in determining the directions and goals of the firm which influence performance, and in turn, affects shareholder’s wealth as well as stakeholders’ benefits (Porter, 1990; La Portal et al, 1998; and Jensen, 2000).
The modern theory of capital structure originated from the path breaking contribution of Modigliani and Miller, in 1958. They opined that under perfect capital market assumption, that is, if there are no bankruptcy costs, no taxes, and the capital market is frictionless, the firm value is independent of the structure of capital. This is what is referred to or known as the M and M capital structure irrelevant proposition. In 1963, under considering corporate taxes, Modigliani and Miller modified their conclusion to recognize tax shield. Because debt can reduce the tax to be paid, the best capital structure of an enterprise should be 100% of debt. However wonderful, the second proposition might look like, it is purely unreasonable and unattainable in the real world. According to Brounen and Elchholtz (2001), these two classical publications triggered a stream of studies and hypotheses overtime, which contributed to the clarification of the capital structure puzzle.
Jensen and Meckling (1976), introduced the concept of agency cost and investigated the nature of the agency cost generated by the existence of debt and equity. When considering corporation tax, bankruptcy and agency costs, at the same time, the trade – off theory can be introduce to derive the existence of the optimum capital structure. Leland (1994) extends the results of Merton (1974) and Black and Cox (1976) to include taxes, bankruptcy cost to derive the optimum capital structure. DeAngelo and Masulis (1980) argue that the existence of non debt corporate tax shields such as depreciation deductions is sufficient to overturn the leverage irrelevancy theorem.
The theories of capital structure over the years have not specially and specifically examined the impact equity and debt financing will have on the performance of the organization. This is the focus of this research paper. The necessity for companies to engage in both short and long term financing of project an d the tax shield advantage expose the short coming of the equity financing and highlight the important of leverage or debt financing. However, agency cost and bankruptcy cost put a limit to the use of long term debt financing as a source of capital. This trade – off puts forward the puzzle of examining the best mix of structure of capital that will increase or improve the performance of a firm. Performance measures are assessed, among other factors with earnings per share (EPS) and the share value in the stock exchange. This is in line with Pandey (1999) who, while stressing the relevant of capital structure, opines that it will be pertinent to accept capital structure decision as a significant managerial mode of operation. According to him, it influences the shareholders return and risk. Consequently the market value of shares may be affected by the capital structure decision. This means that companies have to plan their capital structure if they must improve their performances.
Apart from debt and equity, preference share is another form of financing. Although both the rate of interest on debt and the dividend paid on preference share are fixed irrespective of the company’s rate of return, preference dividend are paid only when companies earn profits. The rates of equity or common dividend are not fixed, but depend on the dividend policy of the company. The use of fixed cost sources of finance, such as debt and preference share capital to finance the asset of the company is known as financial leverage or trading on equity (Pandey, 2005). Akintoye (2008) opines that financial leverage measures a firm’s exposure to financial risks. Therefore the degree of financial leverage indicate the percentage change in earnings per share (EPS) emanating from a unit percentage change in earnings before interest and tax (EBIT).
Pandey (2005) asserts that if the assets financed with the use of debt yield a return greater than the costs of debt, the earning per share (EPS) increases without an increase in the owners’ investment. Akintoye (2008) observes that financial leverage can accelerate EPS under favorable economic conditions but decreases EPS when the goings are not good for the firm. The unfavorable effect of financial leverage on EPS is more severe with more debt in the capital structure when EBIT is negative. Similarly, the firm’s financial leverage can increase shareholders’ return and as well could increase their risk. Pandey therefore, observes that the financial leverage employed by a company is expected to earn more on the fixed charges funds than the cost. The surplus (deficit) will increase (decrease) the return on owners’ equity referred to as double –edged sword. Financial leverage provides the potentials of increasing the shareholders’ wealth as well as creating the risk of loss to them. Pandey adds that the EPS also increase when preference share capital is used to acquire assets. He however, notes that the impact is more pronounced in the case of debt for the following reasons:

Due to the effect of debt on earning per share, financial leverage is an important consideration in planning the capital structure of the firm. Company with high level of earnings before interest and tax (EBIT) can make profitable and wise use of high degree of leverage to increase the return on the shareholders’ equity hence the construct for this investigation. One common method of examining the impact of leverage is to analyze the relationship between the earnings per share (EPS) and the various possible levels of earnings’ before interest and tax. Ultimately, this measures the performance of a firm. Earnings per share (EPS) have been known to be one of the most widely used measures of company’s performance (pandey2005). Owing to the logical presentation of the points above, this studies sets to examine the impact of capital structure on the performance of companies in the petroleum sector.
1.2      STATEMENT OF THE PROBLEM 
Companies all over the world whether big or small, manufacturing or a service providing are usually concerned, about their performance overtime. Increasing profitability, EBIT, EPS and the market value of the share is usually a top priority. In other to achieve this, firms engage in a number of projects financing which bring interest. Abdallah Barakat (2014) financial risks are linked with funding decisions; this means that it is linked with company selection of a combination of its financial structure. Also the need for companies to grow and meet competitive challenges, hence fostering productivity, economic growth, and development is of concern. Equity financing in most cases cannot meet these diverse needs, hence, it has become imperative for firms to use alternative sources of funds. Sourcing for funds could be very frustrating, time consuming especially in times of economic recession where bank loan could be at provocative interest rate. However, while organizations recognize many sources of funds, their main interest is usually that combination which will beef up their performance overtime, hence, the clamor for the appropriate mix of capital that will have a significant effect on performance.
Repositioning our minds on the sensitivity of performance to capital structure, it has become necessary for managers to have a blend of both equity and debt financing. When leverage becomes relatively high, further increases generate significant agency cost (including higher expected cost of bankruptcy financial distress) arising from the conflict between bond holders and shareholders. Most research investigations done on this field (petroleum industry) have not particularly examined the impact of capital structure on performance in Africa, particularly Nigeria, there has been no research finding on this topic. The few ones are in Asia and Europe. Nigeria petroleum managers and investors need to improve the performance of their organizations. These needs influenced the choice of this very topic hence, its vitality and important to the field of knowledge and the economy. Owing to the above, capital structure mix should be well planned, but of what effect will the appropriate mix of capitals have on performance? The performance problems attributed to capital structure coupled with the impact capital structure has on petroleum companies’ performance should be critically examined hence the construct for this research paper investigation. The problems attributed to the impact of capital structure on performance are:

1.3.     OBJECTIVES OF THE STUDY
Carrying out a research investigative paper such as this without some objectives in mind is tantamount to colossal ignorance which may spur up tantrum.
Since the modern proposition of capital structure in 1958, there has been a growing or increasing emphasis on the subject with diverse purposes in mind. To this end, in examining or investigating the impact of capital structure on performance, it is pertinent to bear in mind factors that will influence or maximize performance or profit to the shareholders without attaching any extra cost. This study set out to achieve, but not limited to the following objectives:

1.4.     RESEARCH QUESTIONS 
A research question refers to the major questions to which the researcher seeks to provide answer to during the course of the investigation (Olannye, 2006). Given the hypothetical and critical evaluation of the research problem and objectives, it will be tantamount to a colossal educational hypocrisy not to have benefiting research questions for this investigation. To this end, the following questions accentuated the subject matter of the study.

1.5      RESEARCH HYPOTHESES
Olannye (2006) posits that hypotheses are tentative statements about expected relationship(s) between independend and dependent variables. They are referred to as intelligent guesses, hunches, or conjectural statements between two or more variables which the researcher formulates to guide his research for solution to the problem.
For proper investigation and finding, the following hypotheses are formulated and tested.

Hi: there is a significant relationship between increased leverage and the return on equity (ROE).

Hi: there is a significant relationship between increased leverage and the return on assets (ROA).

Hi: there is a significant relationship between increased leverage and the earnings per share (EPS).

.6      SCOPE OF THE STUDY

  DOWNLOAD THE COMPLETE PROJECT