EFFECT OF CAPITAL STRUCTURE ON THE PROFITABILITY OF

SELECTED COMPANIES IN NIGERIA

BY

JULIUS SAMUEL

CHAPTER ONE

INTRODUCTION

1.1 Background to the Study

Investment opportunities have expanded and financing options have

widened in the wake of liberalization and globalization of economic policies

across the world, and above all dependence on capital markets has increased.

A new business requires capital and still more capital is needed if the firm is

to expand. The required funds can come from many different sources and by

different forms (Sebastian, 2010). Two major sources are available for firms

willing to raise funds for their activities. These sources are internal and

external sources. The internal source refers to the funds generated from within

an enterprise which is mostly retained earnings. It results from success

enterprises earn from their activities. Firms may in the same vein look outside
to source for their needed funds to enhance their activities. Any funds sourced

not from within the earnings of their activities are termed external financing

(Ishaya, 2014).

Bradly, et. al (2004) defines capital structure as a company’s

combination of debt as well as equity. It is frequently challenging for

companies to identify the right mixture of debt and equity as it implicates

various factors like risk and profitability. When the business is entirely funded

by common stock, all cash flow goes to the shareholders. Whereas on the

other hand, when the business is funded with both debt and equity securities,

it divides the cash flows into two parts, a safe part that goes to the debt

holders and a riskier portion which goes to the shareholders (Bradley, et al.,

2004). Generally companies have the option of choosing between many capital

structures. There are various kinds of debt as well as equity such as ordinary

and preferred. Companies may go for lease financing, issue bonds; on the

other hand they may also issue different kinds of securities in many

combinations (Gill, et.al, 2011).

At the heart of capital structure decisions is the search for the optimal

capital structure which is the level of capital that maximises profitability and

shareholders' value. Following the corporate finance theory, the capital

structure does have an impact on a firm’s cost of capital; it plays a crucial part

in determining the cost of capital which therefore consequently affects the

business’ profitability (Abor and Biekpe, 2012). Of all the aspects of capital

investment decision, capital structure decision is the vital one, since the

profitability of an enterprise is directly affected by such decision. Hence,

proper care and attention need to be given while making the capital structure

decision. There could be hundreds of options but to decide which option is

best in firm's interest in a particular scenario needs to have deep insight in the

field of finance as use of more proportion of debt in capital structure can be

effective as it is less costly than equity but it also has some limitations because

after a certain limit it affects company's leverage. Therefore, a balance needs to

be maintained. The cost of capital (interest plus dividends) serves as the

benchmark for a company’s capital budgeting decisions therefore the optimal

mix of debt and equity is vital. Furthermore the shareholders wealth

maximization theory also indicates that firms should maintain the ideal

combination of debt and equity financing, the optimal capital structure, which

maximize returns as well as the firm’s value and which reduce significantly

the cost of capital. In other words, the one which best helps the business to

achieve its main goal (profitability in most case). Thus, this study seeks to

evaluate the effect of capital structure on the profitability of selected

companies in Nigeria.

1.2 Statement of the Problem

The performance of a firm has to do with how effectively and efficiently it is

able to achieve the set goals which may be financial or operational. The

financial performance of a firm relates to its motive to maximize profit both to

shareholders and on assets (Berger and Patit, 2002) while the operational

performance concerns with growth and expansions in relations to sales and

market value (Hofer & Sandberg, 2007). Since capital is employed by firms to

achieve the firm's set goals, and performance is said to be the goals so set,

both capital structure and firm performance are therefore expected to be

proportionally related and influenced one another.

 Many empirical and theoretical studies have proven that capital

structure really influences firm's value but the major concern contemporarily

in modern cooperate finance is how to resolve the conflicts between the

managers and the owners in the control of resources and how will that control

mechanism speak on the firm performance (Jensen, 2006). Going by the

Agency Cost Theory, the only control mechanism to checkmate the managers'

excesses to pursue the firm's overall goals is the introduction of more leverage

in financing the firm. If more of debt is employed, the threat of liquidation,

debt servicing, which may eventually result to loss of jobs to the managers

will result to cost reduction thereby leading to efficiency and subsequently

improved profitability. On this basis, this study considers the impact of capital

structure on firm' profitability of Nigerian from the Agency Cost Theory

point of view that higher leverage results in the reduction of agency cost,

improves efficiency and thereby making the firm more profitable.

1.3 Objectives of the Study

The main objective of this study is to assess the effect of capital structure on

the profitability of Nigerian companies. The specific objectives however, are;

1. To assess the impact of long term debt on firms’ performance in

Nigeria.

2. To evaluate the impact of Short term debt on firms performance in

Nigeria

3. To evaluate the impact of debt/equity ratio on the profitability of

Nigerian companies.
1.4 Research Questions

Based on the above stated objectives, the following research questions have

been developed to guide our study;

1. What is the impact of long term debt on firms’ performance in Nigeria?

2. What is the impact of short term debt on firms’ performance in Nigeria?

3. What is the impact of debt/equity ratio on the profitability of Nigerian

companies?

1.5 Research Hypotheses

In view of the stated objectives of this study and the research questions posed

above, the following research hypotheses have been formulated to be tested in

the course of this study so as to provide answers for the raised research

questions;

H01: Long term Debt has no significant impact on firms’ performance in

Nigeria.

H02: Short term Debt has no significant impact on firms’ performance in

Nigeria.

H03: Debt/equity ratio has no significant impact on the profitability of

Nigerian companies.

1.6 Significance of the Study

This study sought to establish the effect of capital structure on the

performance of companies in Nigeria. Its output will be significant in the

following ways.

i. Managers of Nigerian firms have the sole obligation of maximizing

shareholders wealth and may be able to use the output of this

 research to predict the possible outcomes of the changes the firm

undertakes on capital structure

ii. The output of this study might help firms’ management be aware of

the invisible cost of capital borne by their shareholders as a

consequence of their capital financing decisions.

iii. The study may be of help to scholars and academicians who may

wish to use its findings as a basis for further research on capital

structure and its impact on firms’ performance.

1.7 Scope of the Study

This study seeks to assess the effect of capital structure on the performance of

companies in Nigeria. However, the scope of this study shall be limited to

assessing the impact of capital structure on the performance of manufacturing

companies listed on the Nigerian Stock Exchange (NSE) from 2005 to 2014.

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