1.1 BACKGROUND OF THE STUDY
Capital structure, otherwise referred to as, financial structure, is the means by which an organization is financed. It is the mix of debt and equity capital maintained by a firm. The extant literature is awash with theories on capital structure since the seminal work of Modigliani and Miller (1958). How an organization is financed is of paramount importance to both the managers of firms and providers of funds. This is because if a wrong mix of finance is employed, the performance and survival of the business enterprise may be seriously affected. This study wants to contribute to the debate on the relationship between capital structure and firm performance from the agency cost theory perspective using Nigerian data. This study seeks to provide answer to the question, “does capital structure affects financial performance of firms?” Data of thirty firms listed on the Nigeria Stock Exchange (NSE) between 2001 and 2007, representing 210- firm year observations was used for the study.
An efficient economic system calls for a dependable mechanism to allocate its resources and
optimized leadership of land, labour and Capital. In a market economy, this allocation process consists largely of a set of private decisions, which are directed by a network of free markets and flexible prices. Important among these decisions are capital investments decisions that are vital at two levels for the future operability of the individual firm making the investment, and for the economy of the nation as a whole. At the firm level, capital investment decisions have implications for many aspects of operations, and often exert a crucial impact on survival, profitability and growth. At the national level, the proper planning and allocation of capital investment are essential to an efficient utilization of other resources, poorly placed investment reduces the productivity of labour and materials and sets a lower ceiling on the economy’s potential output.
There have always been controversies among finance scholars when it comes to the subject of capital structure. So far, researchers have not yet reached a consensus on the optimal capital structure of firms. The ability of companies to carry out their stakeholders’ needs is tightly related to capital structure. Therefore, this derivation is an important fact that cannot be omitted. Capital structure is one of the popular topics among the scholars in finance field which aims to resource allocation. The capital structure of a firm is very important since it is related to the ability of the firm to meet the needs of its stakeholders. The theory of the capital structure is an important reference theory in enterprise’s financing policy. It refers to the firm’s financial framework. It’s a 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, that is, its essential on how a firm finances its overall operations and growth by using different sources of funds. Whether or not an optimal capital structure exists is one of the most important and complex issues in cooperate finance. Modigliani-Miller (MM) theorem is the broadly accepted capital structure theory because is it the origin theory of capital structure theory which had been used by many researchers. The prediction of the Modigliani and Miller model that in a perfect capital market the value of the firm is independent of its capital structure, and hence debt and equity are perfect substitutes for each other, is widely accepted. However, once the assumption of perfect capital markets is relaxed, the choice of capital structure becomes an important value-determining factor.
This paved the way for the development of alternative theories of capital structure decision and their empirical analysis. Although it is now recognized that the choice between debt and equity depends on firm-specific characteristics, the empirical evidence is mixed and often difficult to interpret. An appropriate capital structure is a critical decision for any business organization. Financing decisions is one of the important areas in financial management to increase shareholder’s wealth. To determine the extend managers achieve this object, we can relate it to the performance measurement of company. The decision is important not only because of the need to maximize returns to various organizational constituencies, but also because of the impact such a decision has on an organization’s ability to deal with its competitive environment.
Financial managers are difficult to exactly determine the optimal capital structure. A firm has to issue various securities in a countless mixture to come across particular combinations that can maximum its overall value which means optimal capital structure. Although optimal capital structure is a topic that had widely done in many researches, we cannot find any formula or theory that decisively provides optimal capital structure for a firm. If irrelevant of capital structure to firm value in perfect market, then imperfections that exist in reality may cause of its relevancy.
In practice, firm managers who are able to identify the optimal capital structure are rewarded by minimizing a firm’s cost of finance thereby maximizing the firm’s revenue. If a firm’s capital structure influences a firm’s performance, then it is reasonable to expect that the firm’s capital structure would affect the firm’s health and its likelihood of default. From a creditor’s point view, it is possible that the debt to equity ratio aids in understanding banks’ risk management strategies and how banks determine the likelihood of default associated with financially distressed firms. In short, the issue regarding the capital structure and firm performance are important for both academics and practitioners. Capital structure is closely linked with corporate performance (Tian and Zeitun, 2007). 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. 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 (Barbosa & Louri, 2005).
Most of the theory in corporate sector is based on the assumption that the goal of firm should be to maximize the wealth of its current shareholders. One of the major cornerstones of determining this goal is financial ratio. Financial ratios are commonly used to measure firm performance. Generally, corporations include them in their annual reports to stakeholders. Investment analysts provide them for investors who are considering the purchase of a firm’s securities. Financial ratios represent an attempt to standardize financial information to facilitate meaningful comparisons. It provides the basis for answering some very important questions concerning the financial well being of the firm. Its objectives are to determine the firm’s financial strengths and to identify its weaknesses. The essence of financial management is the creation of shareholder value. According to Ehrhard and Bringham (2003), the value of a business based on the going concern expectation is the present value of all the expected future cash flows to be generated by the assets.