IMPACT OF EXTERNAL FINANCING ON FIRM PERFORMANCE EVIDENCE FROM NIGERIA QUOTED MANUFACTURING FIRMS 1999-2012

ABSTRACT

The use of external financing can be described as a balancing act between higher returns for shareholders versus higher risk to  shareholders. Though external financing can boost stock performance of firms,  it  is  still  inconclusive as  to  its  impact  on performance of  firms  in developing economies like Nigeria. It  is,  therefore, against this  background that  this  study investigated the impact of external financing on earnings per share; pay-out ratio; dividend per share; return on assets and return on equity of Nigerian manufacturing firms. The study adopted the ex-post facto research design. Panel data were collated from the Annual financial Statement of Quoted Manufacturing firms as well as from the Nigerian Stock Exchange Factbook for the period 1999 – 2012. Five (5) hypotheses which state that External Financing does not have positive and significant impact on earnings per share; payout ratio; dividend per share; return on assets and return on equity of Nigerian manufacturing firms were tested using the Ordinary Least Square (OLS) regression technique. The independent variable was External Finance while the dependent variables were earnings per share (EPS), payout ratio (PR), dividend per share (DPS), return on assets (ROA) and return on equity (ROE).   The result of this study revealed that External Financing had negative and non-significant impact on earnings per share, payout ratio, dividend per share and return on equity while its impact on return on assets was found to be positive  and  significant.  The  implications  of  the  finding  reveal  that  in  Nigeria,  External Financing does not magnify earnings attributable to shareholders in terms of the book value measures. However, it increases the asset structure of these firms. This study therefore recommends, among others, that Nigerian manufacturing firms should utilize more External Financing in their capital structure up to the optimal level to leverage on the magnifying effect of external financing on shareholder’s wealth.

1.1      Background to the study

CHAPTER ONE

INTRODUCTION

In most developing economies like Nigeria, the financing policies of firms may become relevant because managers in a company invest in new plants and equipments to generate additional revenue and income. While the revenue belongs to the owners of the company and can be distributed as either dividend paid to owners or retained in the firm as retained earnings, the retained earnings could be used for a new investment or capitalized by using it to issue bonus shares.   But where the retained earnings are not enough to support all profitable investment opportunities, the company may forgo the investment or raise additional capital, thus altering the financial structure of firms (Olugbenga, 2012).

According to Pandey (2005) the financial structure of a firm is a long term plan, set up as trade- off among conflicting interests and identified as the major function of a corporate manager. They determine the appropriate combination or mix of equity and debt in order to maximize firm value. This major function of corporate managers has generated so  much debate along the following line; the relationship between leverage and profitability; the optimal mix between equity  and  debt  and  the  determinants  of  corporate  financial  structure.  The  underlining assumption of these debates is to effectively understand the factors that influence the financing behaviour of firms.

In order to explain and/or understand the financing behaviour of corporate managers, so many theories have emerged. The earliest is the neoclassical view of finance dominated by the Miller- Modigliani  theorem,  also  known  as  the  capital  structure  irrelevance  theory  (Miller  and Modigliani 1958), according to the theorem, given the assumption that “firms and investors have the same financial opportunities, under conditions of perfectly  competitive financial markets, no asymmetries of information between different agents and the same tax treatment of different forms of finance, the corporate financial policy is irrelevant. The theory establishes that, the stock market valuation of a firm is based exclusively on the earning prospects of the firm and not on its finance structure. In effect, internal and external finance are viewed as substitutes and firms  could  use  external  finance  to  smoothen  investment  when  internal  finance  fluctuates (Yartey, 2006).

Another strand of literature on the financing structure of firms is based on the managerial theory of investment also known as the modified M-M theorem. Proponents of this theory argue that the fundamental  determinant  of  investment  is  the  availability  of  internal  finance.  Therefore, managers tend to push investment programmmes to a point that the marginal rate of return is below the  level which would have  maximized shareholder’s welfare. The  manager pursues overinvestment policies using internal finance which help them bypass the capital market. This is usually in the managers’ desires for growth. The bypass of the capital market has the effect of managers not being subjected to the discipline of the stock market, thus the level of cash flow is irrelevant for the firm’s investment decisions in neoclassical theory, but rather what matters is the cost of capital” (Yartey, 2006).

The complexities of today’s business require firms to source funds through internal and external financing for  its  operations. External financing options involve  financing activities through public offerings of equity (Ritter, 1991; Loughran and Ritter, 1995; Spiess and Affleck-Graves,

1995), private placement  of equity, (Hertzel, et..al 2002), public debt  offerings (Spies and Affleck-Graves,1999) and bank loans, (Billett, et al, 2001). These options that are available for the financing pattern of firms, though with their disadvantages enable firms to fully tap opportunities and strengths which maximize shareholder’s wealth as well as ensure future stock returns.

Another school of thought, generally referred to as the traditional school opine that capital structure matters and this  brought out other financial theories on the  issue. These theories consider various effects of corporate taxation on leverage, capital structure and financial distress; agency effects,  theory of dividend payments,  signaling effects  and  preference of firms  for internal sourcing of funds rather than external (Fabozzi, 2012). The static trade-off hypothesis views debt to equity ratio as being determined by a trade-off between the cost and benefit of borrowing. According to Shyran and Myers, (1999), in finding optimum debt ratio, it requires a trade-off so that the benefit of tax shield is weighed against the backdrop of financial distress. This will ensure that the firm maintains a healthy debt ratio. Therefore, the static theory of

optimal capital structure predicts a point in the activity of the firm at which there is a positive correlation between debts and return on assets before interest and taxes. At this point, the firms have more income that will shield them from cost of financial distress.

The pecking-order theory has also tried to explain the financing behavior of firms. According to Myers and Majluf (1984), the theory states that companies prioritize their sources of financing. Firstly, firms prefer to use internal financing, secondly, they resort to borrowing when internal financing is not available and lastly to issuing of equity when both internal and external finances and debt servicing are not available. The reason for this order according to Beasley et.al (2007) is the issue of information asymmetries as managers known more about the firm’s performance and prospects than outsiders. This view holds that managers are likely to issue company shares when they believe shares are undervalued but will be more inclined to issues when they believe that shares are overvalued. As such, the assumption is that shareholders are aware of this likely managerial behavior and thus regard equity issues with suspicion (Beasley et.al, 2007).

The  contribution of the  pecking order theory in explaining the  behaviour of firms can  be observed on why the most profitable firms generally borrow less. According to Berzkalne (2012) it is not because they have low target debt ratios but because they don’t need outside money. However, less profitable firms issue debt because they do not have sufficient internal funds for their capital investment programme and because debt is first in the pecking order for external finance.  The  pecking  order  theory does  not  deny  that  taxes  and  financial  distress  can  be important factors in the choice of capital structure. However, the theory says that these factors are  less  important than managers’ preference for internal over external funds and  for debt financing over new issues of common stock (Berzkalne, 2012).

Conversely, the  dynamic  model counteracts the  static  trade–off hypothesis by arguing that capital structure is not static but changes through time as firms face new developments and new information about market conditions (Fabozzi et al, 2012). The agency theory states that there is conflict of interest among shareholders, debt holders and manager, because there arise agency cost to the firm. These costs in the form of monitoring and restrictive covenants embodied to

protect the interests of shareholders and debt-holders against the agency cost, incurred when managers of firms raise and invest funds so that the wealth of firm is maximized (Pandey, 2005).

In between the dynamic model and agency theory is the dynamic trade – off theory which stipulates that the business conditions of the firm is not static, but that the firm’s leverage changes, that is, it is dynamics. In such a situation, firms try to utilize or maximize the conditions to foster growth opportunities, not holding to the utilization of tax shield. Thus, when these growth opportunities are envisaged, the agency cost theory comes into play and achieves the motivation behind the dynamic hypothesis of the trade-off hypothesis.

These theories are based on the findings from developed economies with developed and robust debt and equity markets. In developing economies such as Nigeria, the debt  market is not developed, and the debt and equity are not alternative sources of funding to a firm. For instance, equity trading constitutes about 80% of all market activities in the new issue and stock market (see the Nigerian Stock Exchange Factbook (various years). Also, the government development stock constitutes more than 95% of total debt traded on the exchange. Such financing constraint will not give Nigerian firms the latitude to combine equity and debt in line with the above theories.

The implication therefore, is that firms will rely heavily on external financing in the form of external or internal equity and less on bank loans depending on their collateral value. This might also explain the financial mix or structure of Nigerian firms, which is dominated by short-term debt. Unlike developed economies where the financial structure of firms compose of equity and debt, the financing structure of firms in most developing economies is mainly equity based and where debt component is involved, it is usually from deposit money banks or other such financial institutions (Fodio, 2009). Thus, the payment of dividend becomes relevant to investors as reflected in stock prices. This could be explained through the dividend signaling hypothesis (Bhattacharya, 1979; Miller and Rock, 1985). They explained that change in dividend payment is to be interpreted as a signal to shareholders and investors about the future earning prospects of the firm. Generally a rise in dividend payment is viewed as a positive signal, conveying positive

information about a firm’s future earning prospects resulting in an increase in share price. Conversely a reduction in dividend payment is viewed as negative signal about future earning prospects, resulting in a decrease in share price.

Also consistent with bird-in-hand theory argument as developed by Linter (1962) and Gordon (1963) shareholders are risk-averse and prefer to receive dividend payments rather than future capital gains. Shareholders consider dividend payments to be more certain than future capital gains thus a bird in the hand is worth more than two in the bush. Gordon (op cit.) contended that the payment of current dividends resolves investor uncertainty. Investors have a preference for a certain level of income now rather than the prospect of a higher, but less certain, income at some time in the future. The key implication as argued by Linter (1962) and Gordon (op cit.) is that because of the less risky nature of dividends, shareholders and investors will discount the firm’s dividend stream at a lower rate of return, thus increasing the value of the firm’s shares.

The  effect  of external financing on stock returns could  also  explain  the  residual effect  of dividend. As argued by the “dividend as a residual” theory, the pay-out ratio of firms is a function of its financing decision. The investment opportunities should be financed by retained earnings. Thus internal accrual forms the first line of financing growth and investment. If any surplus balance is left after meeting the financing needs, such amount may be distributed to the shareholders in the form of dividends. Thus, dividend policy is in the nature of passive residual. In case the firm has no investment opportunities during a particular time period, the dividend pay-out should be one hundred percent. A firm may smooth out the fluctuations in the payment of dividends over a period of time. The firm can establish dividend payments at a level at which the cumulative distribution over a period of time corresponds to cumulative residual funds over the same period. This policy smoothens out the fluctuations of dividend pay-out due to fluctuations in investment opportunities (Fuei, 2010).

The pricing of securities after the announcement of firms’ external sources of funding tend to be followed by periods of abnormally low returns, whereas corporate announcements associated with internal financing tend to be followed by periods of abnormally high returns (Myers and Majluf, 1984; Myers, 1984). This is especially true in Nigeria where the use of external financing

is viewed by investors as sign of inefficiency in the firms’ operations. Finding the right financing structure encompasses numerous considerations such as growth rate of sales, management risk, liquidity of assets, etc. Thus, without an appropriate financial structure the growth in sales will decline, management risk increase, illiquidity of the firms’ assets, loss of control position of the company which will hinder stock performance of firms.

The use of external financing increases return on equity up to a certain level of operating income not only in a developing economy like Nigeria but also firms in developed economies As the firms grow, higher levels of external financing are needed to cover for investment opportunities available. In a perfect world, management would favor more external financing whenever return on capital exceeds the cost of internal financing (Kraus and Litzenberger, 1973). However, higher returns also result in higher risk to the business (risk return tradeoff). Therefore, the use of external financing is a balancing act between higher returns for shareholders versus higher risk to shareholders.

Theoretically, it has been established that firms which depend majorly on external financing must  promote  their  market  value  through  efficient  utilization  of  resources  and  favourable dividend policy. For instance, it is argued that in an economy where there is non-availability or under-development of long-term end of the debt market, firms in such economy will rely only on the equity market for long-term funding. However, the ability of the firm to raise the needed fund from this segment of the market will depend on the market perception of the profitability of the firm, the firm’s reputation and collateral value, the performance of their shares in the secondary market and past dividend policy.

However, as opine by Yartey (2006), there is no consensus in literature on how such dependence on external funding could impact on the market value of the firm. For, instance, it is argued that given the high cost of equity, firms will prefer to finance their activities first with internal fund, and will resort to equity only when the internal sources are insufficient. If this theory holds true, the implication is that such firms will declare next to nothing as dividend which could impact negatively on the pricing of the company’s shares in the secondary market. On the other hand,

another school argues that such scenario will put pressure on corporate managers to perform thereby promoting firm performance.

While the theoretical and empirical standpoints on the above issues have been laid down, few literature are available to reconcile these theories with realities in developing economies. This study strived  to  contribute  to  literature  by examining  the  impact  of external  financing  on performance of quoted manufacturing firms in Nigeria.

1.2      Statement of Problem

The Nigerian capital market is skewed towards equity funding which is associated with higher cost of capital and imposes serious financing constraint on corporate managers. Such skewness could influence the financing behaviour of corporate managers and the overall performance of the firm. For instance, the under-development of the long-term end of the debt market could put so much pressure on corporate managers to perform. Such pressure could enhance performance or promote short-termism and stymie or hinder long-term investment that promotes performance on the long-run. The under-development of the debt market could also compel firms to rely so much on internal funds, thereby restraining their ability to pay dividend.

To  empirically  ascertain  the  influence  of  external  funding  on  stock  returns  has  become imperative given the level of corporate failure and moribund firms in Nigeria. The Nigerian capital market which was established in 1960, but started operation in 1961 had 9 government stock.  However,  in  1980  following  the  enterprise  promotion  decree  of  1972,  the  market witnessed increased activities as the total number of equity stood at 23 and government development stock stood at 59. The privatisation exercise which was as a result of Nigerian government decision to adopt the Structural Adjustment Programme (SAP) in 1986 accelerated capital market activities within the period. For instance, the value of equity stock which was N92.4 million in 1973 rose to N348 billion in 1987 and stood at N2, 086.294.59 trillion in 2007. The value of government development stock also rose from N91.1billion to N307.9mmillion in 1987 and stood at N1.665.4 million in 2006 (CBN, 2012).

Important event that promoted capital market activities in Nigeria was the 2004 banking consolidation. It will be recalled that in July 6th, 2004, all commercial banks in Nigeria were mandated to shore-up their share capital to N25b by December 31, 2005 or have their licenses revoked (Donwa and Odia, 2010). Banks in order to comply with this directive used the capital market option. This singular episode astronomically increased capital market activities.  For instance, the total market capitalization stood at N132.95 billion as at 2007 (CBN. 2012; Ogboru, 2000).

From the above analysis, it is evident that the Nigerian capital market is dominated by equity and government development stock. The market for corporate bond is not developed and this has important financing implication for corporate managers in Nigeria. Thus, Nigerian firms will depend more on equity for permanent source of fund and loans from banks for debt component of their funding mix. This also explains the absence of long-term debt in financial structure of Nigerian firms (Ikazoboh, 2011).

According  to  the  trade-off  hypothesis,  in  an  environment  where  a  firm  is  predominantly externally financed and the market for long-term debt is under-developed, corporate managers are under pressure to enhance market performance. This is to ensure secure access to the new issue market according to Baker and Wurgler (2000). Scholars are divided on the influence of such pressure on firm performance. One school argued that such financing pressure could be the needed incentive for managers to maximize shareholders’ wealth thus improving firm performance (Pandey, 2005). Another school, however, argued that such financing pressure could make corporate managers pursue short term goal (shorter-termism) which could stymie corporate performance as a result of under-investment in long-term projects (Ujunwa, et al, 2011).

The two conflicting schools are based on the assumption that investors are not myopic and could effectively monitor managers. This raises an important question on what happens in an economy that is characterized with investors’ myopia. How do corporate managers’ manipulate market indicators to promote access to the new issue market? This study strived to clear our understanding of the financing behaviour of corporate managers in Nigeria, a country that is characterized by the under-development of long-term debt market and myopic investors.

The Nigerian capital market is skewed towards equity funding which is associated with higher cost of capital and imposes serious financing constraint on corporate managers.  Such skewness could influence the financing behavior of corporate managers and the overall performance of the firm.   The under development of the long-term end of the debt market could put so much pressure  on  corporate  managers  to  perform.  Such  pressure  could  enhance  performance  or promote short-termism and stymie or hinder long term investment that promotes performance on the long run.   The under-development of the debt market could also compel firms to rely so much on internal funds, thereby restraining their ability to pay dividend. The constraints the developing economy firms face in sourcing external resources through issuing of equity shares in their stock market; will bring out the dividend policy decisions of firms.

1.3      Objectives of the Study

The primary objective of this study is to assess the impact of external financing on performance of Nigerian manufacturing firms.  However, this objective was achieved through the following specific objectives which are:

1.    To ascertain the impact of External Financing on Earnings per Share.

2.  To determine the impact of External Financing on Payout Ratio.

3.  To ascertain the impact of External Financing on Dividend per Share.

4.  To ascertain the impact of External Financing on Return on Assets and

5.  To determine the impact of External Financing on Return on Equity.

1.4      Research Questions

The study strived to provide answers to the following questions:

1.    How  far  does  External Financing  have  impact  on  Earnings per  Share  of Nigerian manufacturing firms?

2.   To what extent does External Financing have positive and significant impact on Payout

Ratio of Nigerian manufacturing firms?

3.  To what extent does External Financing have positive and significant impact on Dividend per Share of Nigerian manufacturing firms?

4.  To what extent does External Financing have positive and significant impact on Return on Assets of Nigerian manufacturing firms?

5.  To what extent does External Financing have positive and significant impact on Return on Equity of Nigerian manufacturing firms?

1.5      Research Hypotheses

In line with the research question raised above, the hypotheses for this study were:

1)   External Financing does not have positive and significant impact on Earnings per Share of Nigerian manufacturing firms.

2)  External Financing does not have positive and significant impact on Payout Ratio of

Nigerian manufacturing firms.

3)  External Financing does not have positive and significant impact on Dividend per Share of Nigerian manufacturing firms.

4)  External Financing does not have positive and significant impact on Return on Assets of

Nigerian manufacturing firms.

5)  External Financing does not have positive and significant impact on Return on Equity of

Nigerian manufacturing firms?

1.6      Scope of the Study

This study will cover the period 1999 to 2012.   The choice of 1999 is that it heralded the beginning of uninterrupted democratic rule in Nigeria; therefore, it is assumed that the impact of democratic rule will open the financial system thereby allowing manufacturing firms to have access to finance. To accommodate this, the study collected data from 1999 and covered all selected quoted manufacturing firms on the Nigerian Stock Exchange from 1999-2012 excluding banked and other financial institutions because of the nature of their funding which is highly leveraged.

1.7                  Significance of the Study

This study is expected to be significant to the following groups. These are:

1.  Academia

There have  been  lots  of studies on the  theory of capital structures and  their  determinants worldwide.  In Nigeria, studies have also been concentrated on the same issue and have often failed to explore the relationship between the financing pattern and stock returns.  This study is peculiar because it would deal with the impact of the financing pattern on Nigeria firms.

2.  Management of Nigerian Firms

The financing pattern of Nigerian firms was shown to be skewed towards equity holdings. This study will be significant since financial managers would be able to know the way out of their dilemma in solving investments policy to pursue.

3.  Policy Makers

The study will help researchers to open new line and on related topics while local and foreign investors will benefit as it will expose the effect of external funding on the values of their shares. The policy makers both in Nigerian and other countries will benefit from the effective policy guide on market department, breadth and sophistication of the capital market, towards enhancing the debt/fixed income capital market and transparency and accountability in the capital market, and  above  all  implement  clear  structures  for  policy  co-ordination  across  financial  service industry regulators. It will also help in checking the decline in share prices by establishing a capital market stabilization fund and the liquidity situation in the economy.

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