Relationship Between Corporate Capital Structure And Firm Value Of Nigeria

Relationship Between Corporate Capital Structure And Firm Value Of Nigeria


 Background of the Study

Capital structure is the mix of debt and equity that a company uses to finance its business (Damodaran, 2001). In capital structure decisions managers are concerned with determining the best financing mix or capital structure for their firm. Capital structure has been a major issue in financial economics ever since Modigliani and Miller showed in 1958 that given frictionless markets, homogeneous expectations; the capital structure adopted by a firm is irrelevant. By relaxing the assumptions and analyzing their effects, theories seek to determine whether an optimal capital structure exists or not, and if so what could possibly be its determinants. Capital structure could have two effects; according to Desai (2007) firms of the same risk class could possibly have higher cost of capital with higher leverage. Second, capital structure may affect the valuation of the firm, with more leveraged firms, being riskier and consequently valued lower than the less leveraged firms.

If the manager of a firm has the shareholders’ wealth maximization as his objective, then capital structure is an important decision, for it could lead to an optimal financing mix which maximizes the market price per share of the firm. Debt and equity are the two major classes of liabilities, with debt holders and equity holders representing the two types of investors in the firm. Each of these is associated with different levels of risk, benefits, and control. While debt holders exert lower control, they earn a fixed rate of return and are protected by contractual obligations with respect to their investment. Equity holders are there residual claimants, bearing most of the risk and have greater control over decisions. (Roy and Minfang, 2000).

An appropriate capital structure is a critical decision for any business organization. Managers have numerous opportunities to exercise their discretion with respect to capital structure decisions. The capital structure employed may not be meant for value maximization of the firm but for protection of the manager’s interest especially in organizations where corporate decisions are dictated by managers and shares of the company closely held (Dimitris and Psillaki, 2008).


Leland and Toft (1991) states that the value of a firm is the value of its assets plus the value of tax benefits enjoyed as a result of debt minus the value of bankruptcy cost associated with debt. Hence the value of a firm is comprised of both equity and long term debt. Equity includes paid-up share capital, share-premium, reserves and surplus or retained earnings. Igben (2004) defines paid-up capital as the portion of the called-up capital which has been paid-up by the shareholders. He also describes reserves as amounts set aside out of profits earned by the company, which are not designed to meet any liability, contingency, commitment or diminution in value of assets known to exist at the balance sheet date. Reserves may be voluntarily created by directors or statutorily required by law. Share premium is the excess amount derived from the issue of shares at a price that is above its par value. Lastly, retain earnings are profit plough back into a company in order to create more resources for operations and invariably increase in the value of the firm. On the other hand long term debt includes long term loans, debentures and bonds (Igben ,2004).

Modigliani (1980) points out that, the value of a firm is the sum of its debt and equity and this depends only on the income stream generated by its assets. The value of the firm’s equity is the discounted value of its shareholders earnings called net income. That is, the net income divided by the equity capitalization rate or expected rate of return on equity. The net income is obtained by subtracting interest on debt from net operating income. On the other hand, the value of debt is the discounted value of interest on debt.


According to Leland and Pyle (1977) and Ross (1977), the debt level is positively related to the value of the firm and there is a positive effect for the ownership of the major shareholders on firm value.

Different researchers have come up with different results on how the capital structure affects the value of the firm. MM, trade off and pecking order theories have been confirmed empirically by different researchers. Investors care more for dividend than

interest payment of firms in an emerging stock market. Firms with a stable revenue stream and sound asset base facing a lowers the risk of bankruptcy.

There is a correlation implied firms with larger investment opportunities were perceived by lenders to have higher risk (bankruptcy costs). There is a positive impact of corporate taxation on a firm’s debt ratio, suggesting that the corporate tax system provides a systematic incentive for higher leverage. Optimal debt structure is determined by balancing the optimal agency cost of debt and the agency cost of managerial discretion.

Gearing ratio and debt positively affect share prices, while equity negatively affected share prices.

Research Problem

According to Leland, Pyle and Ross (1977), the debt level is positively related to the value of the firm and there is a positive effect for the ownership of the major shareholders

on firm value. Leland, Pyle and Ross (1977) propose that managers will take debt/equity ratio as a signal, by the fact that high leverage implies higher bankruptcy risk (and cost) for low quality firms. Since managers always have information advantage over the outsiders, the debt structure may be considered as a signal to the market. Ross’s model suggests that the value of firms will rise with leverage, since increasing leverage increases the market’s perception of value. Suppose there is no agency problem, i.e. management acts in the interest of all shareholders. The manager will maximize company value by choosing the optimal capital structure; highest possible debt ratio. High-quality firms need to signal their quality to the market, while the low-quality firms’ managers will try to imitate. According to this argument, the debt level should be positively related to the value of the firm.

Akinyomi and Olagunju (2013) in ascertaining the determinants of capital structure of firms in Nigeria found that leverage had a negative relationship with firm size and tax on one hand and a positive relationship with tangibility of assets, profitability and growth on the other hand. However, only with tangibility of assets and tax that significant relationship was established. Furthermore, a significant relationship was established between tangibility of assets and size, tax and size, tangibility of assets and tax, tangibility of assets and growth, and finally between tax and growth in Nigeria.

The government and the private sector have invested heavily in creating an enabling environment for doing business in Kenya and, indeed, some companies have performed exceedingly well as a result. Several companies however are experiencing declining performance and some have even been delisted from the NSE in the last decade.

Momentous efforts to revive the ailing and liquidating companies have focused on financial restructuring. However managers and practitioners still  lack  adequate  guidance for attaining optimal financing decisions (Kibet,Kibet,Tenei and  Mutwol, 2011) yet many of the problems experienced by the companies put under statutory management were largely attributed to financing (Chebii, Kipchumba and Wasike ,2011). This situation has led to loss of investors’ wealth and confidence in the stock market. Studies on the relationship between various financing decisions and performance have produced mixed results

Magara (2012) did a study on capital structure and its determinants at the Nairobi Securities Exchange. The study sought to find out the major determinants of capital structure. It was established that from the period 2007 to 2011, there was a positive significant relationship between the firm size, tangibility and growth rate and the degree of leverage of the firm. The study did not take into consideration macro- economic factors like inflation and interest rates.

Mwangi (2010) did a study on capital structure on firms listed at the Nairobi Stock Exchange also tried to look on the relationship between capital structure and financial performance. Data was collected using structured questionnaires. The study identified that a strong positive relationship between leverage and return on equity, liquidity, and return on investment existed. This hypothesis is also supported by a number of studies, to them the benefits of debt financing are less than it’s negative aspects, so firms will always prefer to fund investments by internal sources Jensen and Meckling (1976) Keste

(1986), Rajan and Zingales (1995) (Eriotis, et. al. 1997).and Fama and French (2002) Similarly, Harirs and Raviv (1991) Krishnan and Moyer (1977) and Gleason, Mathur and Mathur (2000) all found a significant and negative impact of capital structure on performance.Despite many researches having conducted on capital structure and the value of the firm, there has been no consensus on relationship between corporate capital structure and firm value of Nigeria

Objective of the Study


The research objective was to establish the Relationship Between Corporate Capital Structure And Firm Value Of Nigeria Specifically, the study sought to:

  1. To establish the relationship between the capital structures of the firms in Nigeria and their return on assets;
  2. To determine the effect of capital structures of the firms in Nigeria on their return on
  • To examine how Nigerian firms‟ sizes impact their

Scope of the Study


The study is designed to examine the relationship between corporate capital structure and firm value of Nigeria. The study covers the period of six (6) years from 2009 to 2014. The study chooses the manufacturing firms as its domain because it covers the larger proportion of industry in Nigeria. The independent variables of the study are capital structure and firm values  proxied by total debt to total assets, total debt to total equity, short-term debt to total assets and long-term debt to total assets, and the dependent variable is represented by financial performance proxied by return on assets. The period of the study is considered appropriate because it coincides with the period within which major reforms took place in the manufacturing sector.

Significance of the Study 

The outcome of this study would contribute to the existing body of knowledge. Because, though there are a lot of studies on relationship between corporate capital structure and firm value around the globe, there is dearth of evidence using data on manufacturing firms in Nigeria. The outcome of the study would therefore serve as a reference material for subsequent researchers and would provide a basis for further research in this area.

It is the hope that the result of this study will be beneficial to both internal and external parties (i.e managers in maximizing investors return, owners in making an informed decision, creditors in ascertaining credit worthiness of a firm, Government in making favorable financing policies etc) to improve on the GDP contribution by the manufacturing sector and also improve on employment rate once the sector is viable since the stake holders are interested in knowing the impact of such decisions on an organization performance.

Also, the government and its agencies will somehow benefit from this study because the study will highlight the need from its findings if necessary for the government to formulate more favorable financial and economic guidelines as the sector demands and this will sustain the operations of Nigerian Manufacturing firms, especially the potential firms yet to be quoted in the stock market and resultantly contributing to GDP of the nation which have been on the decline hitherto.

The results of this study would also be of benefit to managers, shareholders and creditors of manufacturing firms in Nigeria. Managers would be placed on a sound footing to understand the effect of various financing mix on the operations of their firms.

Shareholders would be able to make an informed decision with regard to their equity interest in relation to the debt financing options available to their firms, while creditors would be able to identify the firms that are financially strong enough to settle their claim as at when due.

Definition of Terms

Capital Structure: Capital structure represents the major claim to a corporation‟s assets. This includes the different types of both equities and debt liabilities a firm employs in its business operations.

Optimal Capital Structure: This is the appropriate mix of equity and debt at which the value of a firm is maximized.

Long Term Debts: These are liabilities of a firm whose repayment exceed one year.

Short Term Debts: These are liabilities of a firm whose repayment is within a year.

Equity: Ownership interest in a corporation in the form of common stocks or preferred stocks. It can also be referred to as shares.

Leverage: This refers to the use of fixed charges source of funds such as debt, bond, and debenture capital along with the owners‟ equity in the capital structure. Leverage provides a good avenue of measuring risk. It could also be defined as a relative change in profit due to a change in sales. It can be further divided into operating leverage, financial leverage and combined leverage.

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