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Evaluation of the capital structure of Nigerian Bottling Company

Chukwuemeka Olisamedua MSc Finance (Part-time) Mat. No.: 089025054 Department of Finance, Faculty of Management Sciences University of Lagos Lagos, Nigeria West Africa Abstract This study is borne out of the need to critically evaluate the capital structure of Nigerian Bottling Company. A company's proportion of short and long-term debt is considered when analyzing capital structure. When people refer to capital structure they are most likely referring to a firm's debt-to-equity ratio, which provides insight into how risky a company is. Usually a company more heavily financed by debt poses greater risk, as this firm is relatively highly levered. The capital structure is how a firm finances its overall operations and growth by using different sources of funds. We computed the degree(s) of Leverage(s) ratios i.e the DOL, DFL, DCL, as well as the percentage change in DPS relative to percentage change in EBIT in order to achieve our studys objective. Our results reveal that performance indicators used in our study are significantly sensitive to the capital structure, for most of the companies considered in our study. Our findings reveal the followings: Nigerian Bottling Companys EBIT, EPS and DPS are sensitive to turnover, which is in support of the apriori expectation. The study disputes the present dividend theory which believes that organizations shareholders either support dividend declaration or wealth creation and not the two. Our study shows that both dividend declaration and wealth creation could be relevant to shareholders. We therefore conclude based on our findings, that irrespective of the dividend policy adopted by an organization, the rate of change in capital structure is a major influence on what organisations behaviour is likely to be. In addition this study lend credence to developing a third school of thought in dividend theory, to provide a place for the relevance of both dividend declaration and wealth creation to shareholders as against the present dividend theory which provides for either, of these two schools.

2. Literature Review
2.1. Concepts of Risk and Leverage The relationship of operating leverage and financial leverage with the variability of a firms profit has been widely discussed in finance literature. Financial leverage measures a firms exposure to financial risk. Therefore degree of financial leverage indicates the percentage change in EPS emanating from a unit percentage change in EBIT. In general, a firms short term financing needs are influenced by current sales growth and how effectively and efficiently the firm manages its net working capital. Note that on-going short term financing needs may reflect a need for permanent long term financing, including an evaluation of the appropriate mix and the use of debt and equity, that is, the capital structure. Financial leverage can accelerate EPS under favourable economic conditions but depresses EPS when the goings are not good for the firm. The unfavourable effect of financial leverage on EPS is more severe with more debt in the capital structure when EBIT is negative. Similarly the firms financial leverage can increase shareholders return and as well could increase their risk. According to Pandey (1999), the financial leverage employed by a company is intended to earn more on the fixed charges funds than their costs. The surplus (deficit) will increase (or decrease) the return on the owners equity, referred to as a double-edged sword, financial leverage provides the potentials of increasing the shareholders wealth as well as creating the risks of loss to them. Gaius(2007) Opines that operating leverage is created by fixed operating costs, such as general administrative overhead expenses, contractional employees salaries and mortgage or lease payment, these tend to elevate business risk. The impact of operating leverage is evident, when a given percentage changes in net sales results in a greater percentage change in operating income (EBIT). Mandelkar et al (1984) observe that DOL and DFL combine to magnify a given percentage change in sales to a potentially much greater percentage in EBIT. Infact, operating and financial leverages together cause wide fluctuation in EPS for a given change n sales. If a company employs a high level of operating and financial leverage, even a small change in the level of sales, will have dramatic effect on EPS. A company with cyclical sales will have a fluctuating EPS, but the swings in EPS will be more pronounced if the company also uses a high amount of operating and financial leverage. Therefore, there is the need to combine degree of operating and financial leverages to see the effect of total leverage on EPS associated with a given change in turnover as a result of improved purchasing power enabled by capital structure. Measuring Degree(s) of Leverage(s)

Degree of Operating Leverage (DOL) Earlier on, we defined the degree of operating leverage (DOL) as the percentage change in EBIT relative to a given change in turnover, i.e: DOL = % Change in EBIT % Change in Turnover DOL = % EBIT/EBIT % Turnover/ Turnover The following equation is also used for calculating DOL: DOL = Q(S V) Q (S V) F Where Q is the unit of output, S is the unit selling price, V is the unit variable cost, and F is the total fixed costs. Degree of Financial Leverage (DFL) From the foregoing the financial leverage affects the EPS, when the economic conditions are good and the firms EBIT is increasing, its EPS increases faster with more debt in the capital structure. DFL is defined as the percentage in EPS due to a given percentage change in EBIT. DFL = % Change in EPS % Change in EBIT DFL = % EPS/EPS % EBIT/ EBIT Degree of Combined Leverage (DCL) The degrees of operating and financial leverages can be combined to see the effect of total leverage on the wealth of shareholders as demonstrated by EPS associated with a given change in turnover. The degree of combined leverage (DCL) is calculated, given by the following equation: % change in EBIT x %change in EPS = % in EPS % change in Turnover % change in EBIT % in Turnover Another way of expressing the degree of combined leverage is as follows: DCL = Q (S V) x (S V) F = Q (S V) Q (S V) F Q (S V) F-INT Q (S V)-f-INT Where Q(S-V) is contribution, and Q(S-V)-F-INT, is the profit after interest but before taxes.

2.2. Optimal Capital Structure Gaius (2007) observes that the optimal capital structure is one, with an equity that minimizes the firms cost of capital and maximizes its stock price. It is important to note here that a nonoptimal capital structure may lead to higher financing projects that would have increased shareholders wealth with an optimal financing by the firm. The effect of different capital structure and differing business risk are reflected in a firms income statement. Operating leverage tends to magnify the effect of fluctuating sales and produce a percentage change in operating income (EBIT) larger than the changes in sales (Akintoye, 2007). In practice, firms tend to use target capital structure a mix of debt, preferred stock and common equity with which the enterprise plans to raise needed funds. Since capital structure policy involves a strategic trade-off between risk and expected return, the optimal capital structure policy must seek a prudent and informed balance between risk and return. The firm must consider its business risk, tax positions, financial flexibility and managerial conservatism or aggressiveness. While these factors are crucial in determining the target capital structure, operating conditions may cause the actual capital structure to differ from the optimal capital structure. Therefore the target capital structure should be used as a guide towards an ideal capital structure that minimizes the WACC while maximizing the shareholders wealth (Gaius, 2007).

The Capital Structure Decision Process

3.Research Methodology
The method of analysis for this study is the use of Degree of Leverage ratios which include: Degree of operating leverage, Degree of financial leverage, Degree of combined leverage, and the percentage change in DPS to the percentage change in EBIT. These ratios are presented below: Where; EPS = Earnings per share DPS = Dividend per share EBIT = Earnings before Interest and Tax. We want to establish the responsiveness of EBIT, EPS and DPS as performance indicators to turnover as a measure of the capital structure. We shall make use of secondary data precisely audited financial statements of Nigerian Bottling Company Plc.

4. Data Analysis And Findings


Summary Table: Ratios expressed in percentages (%)
Nig Bottling Company Plc Descript ion EBIT Turnove r EPS DPS 2009 10,45 5.20 186,52 7.10 0.19 0.50

2008 6 92.10 165,37 3.40 0.80 2.00

% 1411 % 13% -76% -75%

*EBIT and Turnover are in millions of naira


1 DOL DFL DCL %DPS %EBIT 10.28 ( 0.05) ( 5.96) ( 0.05)

4.1. Data Analysis Our summarized table presents the degree of operating leverage derived by using the ratio % EBIT % Turnover

the degree of financial leverage; % in EPS % in EBIT Degree of calculated leverage; % in DPS % in Turnover, and we also adopt % DPS % EBIT The table reveals that in the case of Nigerian Bottling company Plc, there was an increase in turnover though this increment does not reflect a corresponding increase in EBIT, we found out that EBIT is not sensitive to turnover, we therefore consider another performance indicator which is the DPS to establish if the DPS as a performance indicator, is sensitive to turnover, we discovered that the DPS for the year in question is not also sensitive to the turnover following the analysis and given the available details, we conclude that irrespective of the dividend policy adopted by an organization (either dividend supremacy or irrelevance) the RATE OF CHANGE IN CAPITAL STRUCTURE, is a major influence on what organizations behaviour is likely to be.

4.2. Summary Of Findings Having analysed our data, for each Nig Bottling Company Plc, we found out that EBIT, EPS and DPS are sensitive to capital structure. This reveals that irrespective of the dividend policy adopted by an organization (either dividend supremacy or irrelevance) the rate of change in capital structure is a major influence on what organizations behaviour towards dividend policy could be, as to embracing retention or supporting dividend payout.

5. Summary and Conclusion


The study examined the sensitivity of performance indicators to turnover, which is a measure of capital structure, of the Nig Bottling Company Plc. We, to a large extent reviewed previous literature on the key concepts; sensitivity, optimal capital structure, performance, financial leverage, the combined effect of financial and operating leverage among others. We found out that the performance indicators used in our study are significantly sensitive to the capital structure in Nig Bottling Company Plc. Having analysed our data, we came up with the following observations and findings: That EBIT, EPS and DPS are sensitive to capital structure, which falls in line with apriori expectation, i.e an increase in turnover reflects a corresponding increase in EBIT, EPS and DPS, and vice versa . In conclusion, our analysis reveals that irrespective of the dividend policy adopted by an organization, (either Dividend Supremacy or Irrelevance) the rate of change in capital structure is a

major influence on what organizations behaviour is likely to be. In addition this study lend credence to developing a third school of thought in dividend theory, to provide a place for the relevance of both dividend declaration and wealth creation to shareholders as against the present dividend theory which provides for either, of these two schools.

References
[1] Akintoye, I.R. (2006) [2] Akintoye I.R. (2007) Optimising Firm Performance: A Closer Look at The Capital Structure [3] Brenner M and Smidt, S. (1978) Asset Characteristics and Systematic Risks Financial Management (Winter): 33-39. [4] Gahlon, J and Gentry, J (1982) Relationship between Systematic Risk and the Degree of Operating and Financial Leverage. Financial Management (Summer): 15-23 [5] Hite, G.L (1977) Leverage, output effects and he M.M. Theory, Journal of Financial Economics March 177. [6] Mandelker, G and Rhee, S. (1984). The Impact of the Degrees of Operating and Financial Leverage an Systematic Risk of Common Stock. Journal of Financial and Quantitative Analysis. March, 45-50. [7] Pandey (1999) [8] Yang H, and Kwansa, H (1994) Effect of operating and Financing Leverage on firms risk. Journal of International Academy of Hospital Research. Issue 8.