ABSTRACT
The issue of value creation for stakeholders of the firm as a result of the composition of its financial mix can be traced to the seminal work of Modigliani and Miller (MM) in 1958. Their argument is the irrelevance of the financing mix of firms on value. Thus, whether the firm uses equity or debt, the value of the firm does not change. There have been several theories after the works of MM carried out by several scholars either criticizing or supporting the Modigliani and Miller Irrelevance theorem. The Trade-off theory of capital structure suggests that there is an advantage to finance the firm with debt and also a cost of financing with debt. As a result, firms are assumed to trade-off the tax benefits of debt with the bankruptcy cost of debt when making their financing decisions. However, present and potential investors need single information which is, the value creating potential of the firm no matter the composition of the firm’s financing mix. Therefore this study had the following objectives; to determine the impact of debt financing on the ability of the firm to make profit; to determine the impact of debt financing on the ability of the firm to maximise the use of its assets; to determine the impact of debt financing on the firm’s earning power on per share basis; to determine the impact of debt financing on the ability of the firm to reward shareholders on per share basis; to determine the impact of debt financing on the firm’s ability to meet its’ financial obligations as at when due and to determine whether debt financing enhance the value of Nigerian firms. The ex post facto research design was adopted to enable the researcher make use of secondary data and determine cause-effect relationship for twenty-eight quoted Nigerian firms for the period 2004-2008 on a firm by firm as well as on aggregate basis. The Ordinary Least Square (OLS) estimation technique was adopted using SPSS statistical software to evaluate objectives one to five where ratio values of Total Debt Rate (TDR) was used as the independent variable while Net Profit Margin (NPM), Total Asset Turnover (TAT), Earnings Per Share (EPS), Dividend Per Share (DPS) and Current Ratio (CR) as dependent variables, while adopting a bankruptcy model, the Multiple Discriminant Analysis Model (MDA) to evaluate objective six using MDA’s Z- score benchmark of 2.675 to determine value (Rashmi and Sinha, 2004; Xing and Cheng,
2005). The study revealed that on a firm by firm basis there were mix variations of the impact of Total Debt Rate on the firms’ value parameters (NPM, TAT, EPS, DPS and CR) across firms sampled while on aggregate basis; there was a positive non-significant impact of Total Debt Rate on Net Profit Margin; there was a negative non-significant impact of Total Debt Rate on Asset Turnover Rate; there was a positive non-significant impact of Total Debt Rate on Earnings per Share; there was a positive non-significant impact of Total Debt Rate on Dividend per Share and there was a negative non-significant impact of Total Debt Rate on Current Ratio and twenty firms created value as a result of the firms’ use of debt financing representing 71.4% of firms sampled while eight firms representing 28.6% of firms did not create value. From the foregoing therefore, the use of debt financing enhances the value of Nigerian firms, thus could be used to enhance shareholders’ wealth, however further studies could still be carried out as to determine why some firms did not enhance value as a result of the used of debt finance in the financial mix of Nigerian firms .
CHAPTER ONE
INTRODUCTION
1.1 BACKGROUND OF THE STUDY
The Modigliani-Miller theorem is one of the cornerstones of modern corporate finance. At its heart, the theorem is an irrelevance proposition; the Modigliani-Miller theorem provides conditions under which a firm’s financial mix does not affect its value. No wonder, Modigliani (1980, xiii) explains the theorem as follows:
… with well-functioning market (and neutral taxes) and rational investors, who can undo the corporate financial structure by holding positive or negative amount of debt, the market value of the firm-debt plus equity, depends only on the streams of income generated by its assets. It follows,
in particular, that the value of the firm should not be affected by the share
of debt in its financial structure or by what will be done with the returns paid out as dividend or reinvested (profitably)…
In fact, what is currently understood as the Modigliani-Miller theorem comprises three distinct results from a series of papers (1958, 1961 and 1963). The first proposition establishes that under certain conditions, a firm’s debt-equity ratio does not affect its market value. The second proposition establishes that a firm’s leverage has no effect on its weighted average cost of capital (that is, the cost of equity capital is a linear function of the debt-equity ratio) while the third proposition establishes that the firm’s value is independent of its dividend policy.
Miller (1991:217) succinctly explains the intuition for the theorem with a simple analogy, he says;
…think of the firm as a gigantic tub of whole milk. The farmer can sell the whole milk as it is, or he can separate out the cream and sell it at a considerably higher price than the whole milk would bring…
He continues
…the Modigliani-Miller proposition say that if there were no costs of separation (and of course, no government dairy support program), the cream plus the skim milk would bring the same price as the whole milk…
The essence of Miller’s argument is that, increasing the amount of debt (cream) lowers the ratio of outstanding equity (skim milk) – selling off safe cash flows to debtholders which leaves the firm with more valued equity thus keeping the total value of the firm unchanged. Put differently, any gain from using more of what might be seem to be a cheaper debt is offset by the higher cost of riskier
equity. Hence, given a fixed amount of total capital, the allocation of capital between debt and equity is irrelevant because the weighted average of the two costs of capital to the firm is the same for all possible combinations of the two.
Spurred by Modigliani and Miller’s (1958, 1961 and 1963) arguments, that in an ideal world without taxes a firm’s value is independent of its debt-equity mix, economists have sought conditions under which the financial structure of the firm would matter. Economic and financial theories suggest that several factors influence the debt-equity mix such as differential taxation of income from different sources, informational asymmetries, bankruptcy cost/risks, issues of control and dilution and the agency problem (see Hart, 2001).
Thus, in line with the above, the question now is? Do corporate financing decisions affect firm’s value? How much do they add and what factor(s) contribute to this effect? An enormous research effort, both theoretical and empirical has been devoted towards sensible answers to these questions since the works of Modigliani and Miller (1953, 1961, and 1963). Several foreign and local scholars have theoretically and empirically studied the impact of the firm’s financial mix on the value of the firm from different perspective (see, Jensen and Meckling, 1976; Jensen, 1986; Fama and Miller, 1972; Myers, 1977; Miller and Scholes, 1978; Elton and Gruber, 1970; among others).
In fact, Elton and Gruber (1970) studied the link between taxes, financing decisions and firm value and found that personal taxes make dividend less valuable that capital gain and stock prices fall by less than the full amount of the dividend on ex-dividend days. Fama and Miller’s (1972) study on the financial structure of the firm was on leverage and they argue that leverage (debt finance) can increase the incentive of the stockholders to make risky investment that shift wealth from bondholders but do not maximize the combined wealth of security holders, thus, value is not created. Jensen and Meckling (1976) evaluating financial structure from the agency cost model submit that higher leverage allow managers to hold a larger part of its common stock thereby reducing agency problem by closely aligning the interest of the managers and other stockholders, thus asserting that since the interest of stockholders are protected, value is created. In another paper by Jensen (1986), he said leverage (debt finance) used by the firm enhances value by forcing the firm to pay out resources that might otherwise be wasted on bad investment by managers.
Myers (1977) argues that leverage (debt finance) can make firms to under invest because the gains from investment are shared with the existing risky bonds of the firm. In effect, the agency effect of financing decision work through profitability and can make firms to take better or worse investments and to use assets more or less efficiently. Miller (1977) re-evaluating earlier MM theories on financial structure argues that if common stock is priced as tax free but personal tax rate built into the pricing of the stock, corporate interest payment is then the corporation tax rate. Hence, the tax shield at the corporate level is offset by taxes on interest at the personal level thus debt does not affect firm value. He therefore submit that if there are two firms with the same earnings, before interest and taxes, the more levered firm’s higher after-tax earnings are just offset by the higher personal taxes paid by its bondholders. Therefore, given pre-tax earnings, there is no relationship between debt and value.
In Nigeria, some empirical studies have been done in this area of corporate finance and its effect on the value of the firm. Among such was Ezeoha (2007) who examine the impact of major firm characteristics on the financial leverage of quoted companies in Nigeria and used panel data from 71 quoted Nigeria companies, for 17 years period (1990 – 2006). The result showed that the relationship between corporate ownership and financial leverage was positive across the proxies but more significant within the classes of foreign and indigenous firms. The relationship with asset tangibility was found to be non significant and negative, using total debt ratio or short term debt ratio as the dependent variable. It was also seen from the research study that the relationship between leverage and profitability was significant and negative (see Ezeoha, 2007)
Also, Adelegan (2007) examine the effect of taxes on business financing decisions and firm value in Nigeria. The study which analyses 85 manufacturing firm in Nigeria from 1984 to 2004 found that dividend and debt covey information about profitability of the firm. This information obscures any tax effect of financing decision. However, there was evidence that earnings and investment were key determinants of the firms’ value in Nigeria. The study also found positive relationship between dividend and value and negative relationship between debt and value in firms examined.
Though, there have been studies in this area of corporate finance in Nigeria, However, most have clustered around the estimation of corporate cost of capital (Inanga 1987, Adelegan, 2001) determinants of dividend decisions (Inanga, 2001; Odedekun, 1995), and financing decision (Adelegan, 2007; Ariyo 1999; Ezeoha, 2007). To the best of the researcher’s knowledge, no study has been carried out using firms’ value parameters to study its’ impact on the value of the firm adopting the bankruptcy model. This is a gap which this study attempts to fill. The essence is to determine from an investors’ or potential investor’s point of view whether value parameters from the financial statements and accounts of quoted firms in Nigeria are affected by the use of debt in the financial mix and the overall impact of debt financing on the value of selected firms taking into account the cost of debt which is bankruptcy.
1.2 STATEMENT OF THE PROBLEM
The issue of value creation for stakeholders of the firm as a result of the composition of the financial mix of the firm may be traced to the seminal works of Modigliani and Miller in
1958. In most of MM’s works, their arguments had always been the irrelevance proposition on the financing choices of firms, thus, whether the firm uses equity or debt, the value of the firm does not change, it must be said that most of their works are based on certain assumption (see MM, 1958; MM, 1961 and MM, 1963). They have been several theories after the works of MM carried out by several scholars either criticizing or supporting the works of
Modigliani and Miller. These theories postulated by these scholars discusses the composition of the financial structure and it influence on the value of the firm such as the irrelevance or relevance theory (MM, 1958; MM, 1961), the trade-off theory (Kraus and Litzenberger,
1973), the pecking-order theory (Myers and Majluf, 1984), agency theory (Jensen and Meckling, 1976), and the signalling theory (Ross, 1977) are among several theories that have tried to explain the impact of the financing choices of firms on the value of the firm.
The firm’s financing structure as agreed by these scholars consists of a mix of debt and equity (Okafor, 1983; Pandey, 2005; Damodaran, 2002; Brigham, 2000). It is in line with these works that Brealey, Myers and Marcus (2004), submit that the firm’s basic financial resources are the streams of cash flows produced by its assets and operations and when the firm uses purely equity capital, the cash flows generated by the assets and operations of the firm belongs entirely to the equity holders while when there is a mix of debt and equity, the cash flows generated by the firms’ assets and operations is split into two, a relatively safe steam that goes to the debtholders and a more risky one
that goes to the equity holders. Therefore, no matter the financing option chosen by the firm, the risky cash flow streams that goes to the equityholders must be maximized, thus, value must be enhanced for them as the failure of the firm to do so will mean a negative impact on the value of the firm, therefore, the firm as a going concern must continue to exist and at the same time generate a premium which motivates shareholders to continue to invest in these firms. In line with the above, the problem often associated with debt financing includes among others from investors’ or potential investor’s points of view are the following:-
1) Reduction of the firm’s profitability (Florackis, 2008)
2) Loss of flexibility on the use of it asset (Brigham, 2000)
3) Reduction of shareholders’ earnings per share (Pandey, 2005)
4) Non payments of dividends to shareholders (Stulz, 1990)
5) Increased insolvency risk/ liquidity problem (Damadoran, 2002)
6) Non enhancement of value as a result of the firms’ use of debt (MM, 1958)
Profitability is an important variable that has an impact on the firm’s financial structure. The primary motive of the firm in using debt is to magnify the shareholders return through increased profitability no matter the economic conditions. The role of debt financing in magnifying the returns of the shareholders are based on the assumptions that fixed charges can be obtained at a cost lower than the firm’s rate of return on assets. Thus, when the difference between the earnings generated by it assets financed by the fixed charges funds and the cost of these funds is not big enough to be distributed to shareholders as earnings a problem exists. Thus, when the amount of debt used in the financing mix of the firm is huge, it reduces the profitability of the firm as a result of the fixed charges paid to debt holders. The net profit margin is used to determine the proportion of revenue that finds its way into profit and since debt expenses is a deductible expenses before arriving at the net profit of the firm, a high debt profile of the firm will thus reduces profit.
Most debt financing arrangement entered into by the firm are often linked to the assets of the firm as collaterals. The firm cannot use the assets without notifying the debtholders. This limits the ability of the firm to fully maximize the use of these assets as to enhance shareholders’ value. Thus, the value which would have been created as a result of the maximization of assets of the firm is impeded. Most managers measure the performance of their firm by the assets turnover ratio, the use of debt financing which is linked to assets of the firm creates a problem for the firm because, management may not want to run the risk of having conflicts with debtholders as a result, the value
of shareholders may not be enhanced as restrictive covenants included in debt financing agreements limit the ability of the firm to fully harness the potentials of the firm’s resources.
A firm’s earnings per share is one of the most widely used measure of a firm’s performance. Investors look at the earnings per share of the firm over time as to determine whether their values as shareholders have increased. The existence of debt in a company’s financial structure increases equity’s return potential because it is a cheaper financing source. However, debt also increases equity risk of loss because interest and principal payments are fixed cost that reduces the amount of cashflows available for reinvestment or distributed to equity investors. In designing the financial policy of the firm, the impact of the financing alternatives on the distribution of earnings among shareholders and creditors should be considered. Shareholders care about the return on their investment and managers of public companies care about the reported results, such as earnings per share or return on equity. Therefore, no matter the financing method adopted by the firm. Its’ impacts on shareholders and other various stakeholders must be considered.
It is argued that investors operate in the world of brokerage fees, taxes and uncertainty; hence it is better to view the firm in the light of those factors. Therefore, without the MM restrictive assumptions, their argument collapses. If one removes the assumption of certainty, it will be seen that most investors prefer some payment in the form of cash dividends currently to an eventual return in the form of capital gain in the future. It is the uncertainty associated with the future outcomes of the firm that prompts owners to prefer some current payments as compensation for their invested capital. Because current dividends reduce investor’s uncertainty, they tend to discount the firms’ earnings at a lower rate thereby creating a high value for the firms’ stock. If dividend were not paid, investors uncertainty would increase thereby raising the rate at which the firm’s earning are discounted and lowering the value of the firm’s stocks.
Liquidity is generally defined as the ability of a financial firm to meet its debt obligations without incurring unacceptably large losses. Liquidity risk is the risk that a firm will not be able to meet its current and future cashflows and collateral needs, both expected and unexpected, without materially affecting its daily operations or overall financial condition. An investor that wishes to access the value of the firm will generally consider whether over time the firm has been able to meet its financial obligations as at when due. Also, lenders in evaluating the health of firms apply various
credit assessment methods to determine the credit worthiness of these firms as to determine whether to lend or not. Therefore, the ability of the firm to meet up its financial obligations is a prerequisite to obtaining loans and thus increases in the value of the firm. When such funds are obtained be it for a short term or long term the value of the firm from an investor’s perspective is increased, otherwise no value as illiquidity reduces the value of the firm.
Present and potential investors for their investment decisions need single information, which is the value creating potential of a firm and what endeavour currently are taken and proposed by management for enhancing such value creating potential along with their financial impacts, This information helps present and potential investors to estimate the value of the firm which in turn enables them to take investment decisions. Thus when the firm does not create value for owners and potential owners, resentment may occur which will reflect in the market prices of the firm.
1.3 RESEARCH OBJECTIVES
The specific objectives of this study are:-
(1) To determine how debt financing impacts on the firm’s ability to make profit.
(2) To determine how debt financing impacts on the ability of the firm to maximize the use of its assets.
(3) To determine the impact of debt financing on the firm’s earnings power on per-share basis. (4) To determine the impact of debt financing on shareholders’ return on per share basis
(5) To determine the impact of debt financing on the firm’s ability to meet its financial obligations as at when due and finally
(6) To determine whether debt financing enhance the value of Nigerian firms.
1.4 RESEARCH QUESTIONS
In view of the objectives of this study, the following pertinent questions are asked, these are:- (1) What impact does total debt rate has on the net profit margin of Nigeria firms?
(2) What impact does total debt Rate has on the asset turnover ratio of Nigerian firms? (3) What impact does total debt date has on the earnings per share of Nigerian firms?
(4) What impact does total debt rate has on the dividend per share of Nigerian firms? (5) What impact does total debt rate has on the current ratio of Nigeria firms?
(6) To what extent does the use of debt finance enhance the value of Nigerian Firms?
1.5 HYPOTHESES OF THE STUDY
These are:-
i. There are no positive significant relationships between total debt rate and net profit margin of Nigerian firms
ii. There are no positive significant relationships between total debt rate and the asset turnover ratio of Nigerian firms.
iii. There are no positive significant relationships between the total debt rate and earnings per share and of Nigerian firms.
iv. There are no positive significant relationships between total debt rate and the dividend per share of Nigerian firms.
v. There are no positive significant relationship between total debt rate and the current ratio of Nigerian firms.
vi. Debt financing does not enhance the value of Nigerian firms.
1.6 SCOPE OF THE STUDY
The Nigerian Stock Exchange is presently made up of 36 Industrial classifications (Cashcraft,
2010). These include both the managed fund subsectors and the manufacturing subsectors; however this study covers 28 actively quoted companies in Nigeria between 1999- 2008 which are listed in the first-tier market of the Nigerian Stock Exchange industrial classification excluding foreign listings, Banks, Insurance and other financial subsectors. The exclusion of the insurance, banking, services and foreign listings is based on the nature of services rendered and the desire of the researcher to localize the research. The managed fund subsectors primarily deals with depositors funds thus highly leveraged and as such
determining the impact of debt financing in their financial structure on the firms’ value will be skewed. Also, they represent the lending spectrum of any economy, thus responsible for the supply of fund to the productive subsectors of the Nigerian economy. The exclusion of the foreign listings is based on our focus to consider only Nigerian incorporated firms.
1.7 SIGNIFICANCE OF THE STUDY
A number of researchers have provided insights, theoretical as well as empirical on the debt financing policies of the firm. However, everyone agrees that the issue is important. This was confirmed by Brealey, Myers, and Marcus (2004:692) when they said that the financial structure theories is one of the seven (7) unsolved problem in finance not for want of argument on the subject but an accepted, coherent theory of financial structure. However, this research will be particularly significant to the following groups:
1) MANAGEMENT
In large firms, there is a divorce between management and ownership. The decision taking authority in a company lies in the hands of managers. Shareholders as owners of the company are the principals and managers are their agents. Thus, there is principal-agent relationship between shareholders and managers therefore managers should and must act in the best interest of shareholders as consistent with shareholders’ wealth maximization objectives of the firm. Therefore, this research will enable management to understand what must be done in order to act in the best interest of shareholders in choosing financing options which will help the firm achieve an optimal financial structure that will maximize shareholders’ value.
2) INVESTORS AND POTENTIAL INVESTORS
The major beneficiaries of an enhanced value created firms are investors and potential investors. Their contribution in monetary terms in the promotion, incorporation, continual existence to the growth of the firm must be rewarded with a premium above their risk free rate, thus, acting as a compensation for time and risk inherent in these firms. The choice of a financing mix in the financial structure of the firm ultimately determines whether these objectives are met as internal and external factors may lead to insolvency and subsequent
bankruptcy of their firms which come with it a cost. Therefore, this research will contribute along with other similar literatures available in this area of finance in enhancing the maximization of investors and potential investors’ objectives as concern the value of firms.
3) ACADEMIC
Essentially, this research intends to contribute significantly to the volume of literature available in this area of finance. In academics, the unknown is never exhausted, as the list of what we do not know could go on forever. Therefore, as a contribution to this area, hints, recommendations about debt financing and its impacts on the value of firms in Nigeria adopting the bankruptcy model in determining whether value have been enhanced or not is our major focus. Localizing the research to the Nigerian settings and environment is particularly important in this research.
1.8 LIMITATION OF THE STUDY
The first major limitation of this study was funding. The locations of the Nigeria Stock Exchange which are scattered all over the country required huge capital outlay for transportation and other logistics.
The second limitation was associated with data generation. Getting statistical data from various financial statements and accounts of the 28 firms under study was a huge problem. In fact, the intention of the researcher was to undertake a 10 year time frame for the study, however, we encountered problem in generating sufficient data to cover the 10 year period thus, necessitating the study of 5 years. This could be attributed to Nigerians at the moment having poor attitude towards data documentation and preservation and where available sentiments do not allow those in charge to release such data even for academic purposes.
Again, the limited availability of local literature on financial structure posed a problem. Though, the intention is to localize the research however, it was difficult to garner quality local literatures in this area. The implication is that foreign theoretical and empirical studies constitute the volume of data used in the review of literature
1.9 DEFINITION OF TERMS
The following terms are defined in this research, these are:
VALUE
The value of a firm is the value of its business as a going concern. (Miller, 1991)
DEBT FINANCING
The use of external sources of funds in the financing mix of firms (Tim, Michael and Sheridan, 1997)
BANKRUPTCY
Legally declared inability of the firm to pay it creditors or stakeholders (Encyclopaedia Britannia, 2008) emphasis is researcher’s inclusion.
NET PROFIT MARGIN
The net profit margin is used to determine the proportion of revenue that finds its way into profit (Pandey, 2005)
TOTAL ASSET TURNOVER
Asset turnover is a financial ratio that measures the efficiency of a company’s use of its assets in generating sales revenue or sales income to the company (Zane, Kane, and Marcus, 2004).
EARNINGS PER SHARE
Earnings per share is the reward of an investor for making his investment from the book value figures of the firm (Patra, 2005)
DIVIDEND PER SHARE
This is the sum of declared dividends for every ordinary share issued (Brigham, 2005)
CURRENT RATIO A diagnostic tool that measures whether or not the firm has enough resources to pay its liabilities over a given period (Ward, 2009)
This material content is developed to serve as a GUIDE for students to conduct academic research
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