e-sRC

CHAPTER ONE
INTRODUCTION
1.1 Background to the Study
Finance is an integral aspect of the strategic decision making process of corporate
organisations. The drive towards the achievement of set objectives; principal of which
includes maximisation of shareholders’ wealth, influences choices as to source of long term
funds and its efficient utilisation through investment in assets for productive activities. The
selection of a particular form of long term finance or a mix of choices, constitute what is
commonly referred to as the ‘capital structure’ of corporate entities (Pratheepkanth, 2011).
Discourse and research on this conceptusually has at its fore, debt and equity studied as a
whole; equity being finance sourced through investment inshares of a company. Debt in this
regard,refers to interest based funds inclusive of those raised through the issue of debt
securities on the capital market and the contracting of long or short term loans from the
money market financial institutions such as banks.
A less discussed but important component of capital structure is finance lease which is a
peculiar asset-based form of debt financing resulting in the acquisition of a physical noncurrent asset instead of liquid cash(Kraemer-Eis & Lang, 2012). Consequently, a
representation of a lease liability as well as the corresponding leased asset is made on the
statement of financial position of firms. Besides the use of equity (shareholders’
investments), debt instruments or facilities and hire purchase agreements, leasing is another
finance avenue resorted to in asset acquisition where substantial capital outlay is involved. As
noted by Feldman (2002), an industry, for instance aviation, which employs expensive
high technology equipment, rather than make an outright purchase from available resources
or secure procurement through regular debt, can opt for lease.
Leasing is an arrangement whereby a party, lessee obtains the right to use an asset for a
defined period of time in exchange for a consideration of regular lease payments to another, a
lessor (Yan, 2006). It makes for an attractive source of finance due to its characteristic
advantages. According to Adebisi (2003) as cited in Oko and Essien (2014), there are
opportunities for cash conservation as the terms of payment for leased assets can be designed
to match the cash flow patterns of lessee entities. Akinsulire (2011) stated the ease with
which leasing agreements can be arranged especially for companies with liquidity problems,
poor collateral availability and payment track record which constitutethe basis for credit
worthiness assessments when other forms of finance are being sought such as loans.
Subsequent to this ease is the flexibility with which lease terms, periodic payments and
options to purchase could be adjusted in contrast to conventional debt financing (Malik,
Saeed, Ahmed & Javed, 2012).
The suitability of leasing by corporate bodies can be seen in that it presents with less threat of
loss of company control through bankruptcy, or the dilution of shareholding associated with
the use of either debt or equity methods of financing (Owoeye, 2004).The Federal Inland
Revenue Service of Nigeria (FIRS) Circular (2010) highlighted the growing popularity of
leasing due to the domestic high costs of non-current assets, the shortage of foreign exchange
raising costs of its imports and the accessibility through leasing, of a hundred percent (100%)
credit financing. This is in contrast to financial institutions providing a percentage of asset
value in loans to be augmented by the borrower. Wyslocka and Szczepaniak (2012)
buttressed the point of significant lease patronisation as it tends to be evident amongst firms
of varying scales and forms.
Leasing has become a customised financing mechanism employed by many sectors of an
economy(Amembal, 2005). Oko and Anyanwu (2012) noted the growth of lease industries to
be above 10% annually in developed countries such as the United States, United Kingdom
and Japan. In Africa, Wright (2004) pointed out the countries- Malawi, Uganda, Tanzania
and Ghana as having gained from international lease cooperation. Though the lease industry
of the continent is generally still gaining ground compared to what obtains in the advanced
economies, Nigeria, in addition to Morocco, Egypt and South Africa, was placed among the
top 50 countries in 2013 and 2014 by volume of lease transactions valued at 0.68 and 0.50
billion dollars respectively (White Clarke Group, 2015& 2016).Oko and Essien (2014)
describedthe Nigerian lease sectoras heterogeneous in size as well as form (small, medium
and target ticket markets) anddependent on the operations, buying capacity and management
orientation of firms.
The Equipment Leasing Association of Nigeria (ELAN, 2015) highlighted the relevance of
this finance alternative to the Nigerian economy given its contribution to capital formation in
excess of 1.6 trillion nairawithinthe years, 2000-2014. The lease industry in 2015 recorded a
growth rate of 27.39% with an outstanding volume of transactions valued at 1.1trillion naira.
Out of this, finance leases accounted for a significant 75%with serviced industries including
the oil and gas, transportation, manufacturing, telecommunications and agriculture (ELAN,
2016).Collectively, these industriescan also be discerned to have contributed to a consistent
positive growth rate in leasing between the periods 2007-2015 with only a stunt in
progression recorded from 2009-2012.
In the literature of finance, the impetus for leasing is well supported by the capital structure
theories considering certain attributes of firms.Modigliani-Miller Theorem(1958) initially
proposed the existence of perfectcapital markets devoid of taxes, transactioncosts, bankruptcy
costs, information asymmetries and agency costs facilitating fluid access to finance by
entities. The assumption of this state correspondingly implied that it was irrelevant which
method of financing an organisation used to conduct its operations as it was presumed to
have no varying effect on the value of firms. With Fisseha (2010) noting the reality of the
practical world being that markets are in fact imperfect, it brings to light the constraints
associated with financial contracting and thus, capital structure, based on the frictions that
apply to respective organisations.
Later deliberations on the Modigliani-Miller Theorem gave rise to other theories of firm
capital structure that attempted to explain finance contracting in consonance with the
identified market imperfections that subsist. Theories such as the agency cost, pecking order
and bankruptcy costs consider these imperfections that are by extension, either characteristics
in themselves discernible of firms (information asymmetry and agency costs) or a function of
some (bankruptcy costs in the case of financially distressed firms which in turn is a
consequence of leverage positions). The theories equally provide for firm attributes which are
not market imperfections but could explain choices of finance by firms (profitability and
growth opportunities).
In the context of the pecking order theory (Myers, 1984; Myers & Majluf, 1984), where
information asymmetry abounds, higher costs of capital may prevail due to the consideration
of risk (Cortez & Susanto, 2012). Financiers’ attempt at forestalling the problems of ‘adverse
selection’ (from an obscured perception of firm risk profiles) and ‘moral hazard’ (a tendency
of firms to engage in riskier activities than accounted for by the lenders or investors)results in
higher interest rates and required rate of returns.
In light of this, finance leases may therefore be a last resort alternative. Sharpe and Nguyen
(1985), Ezzell and Vora (2001), Chau, Firth and Srinidhi (2006) corroborated that leases
lower the costs of external financing associated with adverse selection and moral hazard.Its
preference and ease in contracting could be attributedto the fact that it presents with priority
over all other forms(secured, unsecured debt and equity) in the event of bankruptcy. Finance
leases potentially lower costs of financial distress to a lessor, due to higher capacity for
repossession of leased assets than even collaterals in secured debts (Smith & Wakeman,
1985). From this, it can be inferred that companies with a likelihood of bankruptcywould be
predisposed to leasing assets, being easier to contract(Krishnan & Moyer, 1994).
Expanding on the proposition, Myers and Majluf (1984), Harris and Raviv (1991) contended
that investors in avoiding adverse selection, discount the prices of equity thereby making it
costlyand compellingfirms to follow an order of preference in financing.Profitability of firms
is said to reduce the tendency to engage in leasing as it provides first stage level of internal
financing (Erickson & Trevino, 1994). Growth-opportuned firms on the other hand, may
require significant funds from external sources for which a strategy of maintaining low-risk
debt structures (as obtainable in leasing)may be deployed. Fama and French (2002) related
this to forestalling underinvestment in the absence of internal funding.Finance leasing can
likewiseimprove liquidity positions for high growth firms through cash conservation such
that positive correlations between growth and leasing could be expected as found byLasfer
and Levis (1998), Callimaci, Fortin and Landry (2011) and;Malik, Saeed, Ahmed and Javed
(2012).
With corporate entities beingmajorlycharacterised by the separation of ownership and
control, agency problems in form of management compromise of shareholders’ interests and
associated costs may arise as propounded by Jensen and Meckling (1976) in the agency cost
theory. By the mitigating alignment of interests of managers and shareholders through e.g.
directors’shareholding andintroduction of debt, the cash at disposal could however,
incentivise managers to pursue risky investments (asset substitution) aimed at generating high
returns for the shareholders in whose interests they act(Smith &Warner, 1979).
The subsequent exposure of debt holders to the risk by their investments and entitlement to
only a fixed portion of the gain where the payoff is positive, leads to the constitution of
mechanisms safeguarding their interests. These could be in the likes ofdebt covenants
restricting management pursuit ofrisky though profitable investments, and demand for high
interest rates. Myers (1977) highlighted further, the resultant underinvestment by corporate
entities. In finance leasing, this, in addition toasset substitution could be
avoidedbycommitting a firm to the use of an asset over the period of lease (Smith & Warner,
1979; Zhou, 2014).
Pursuant to the above, it could be posited that leasing be regarded as a substitute to regular
debt. However, the literature remains divided with a section viewing lease to be a
complement and thus giving rise to the coinage- ‘Leasing Puzzle’ (Ang & Peterson, 1984).
Where extended debt financing is a function of borrowing capacity as inferred from the
leverage position in the financial statements, finance leasing in particular could be a
substitute having the same payment structure and encroaching effectof a capitalised liability
(Myers, Dill & Bautista, 1976; Lewellen, Long & McConnell, 1976; Miller & Upton, 1976;
Franks& Hodges, 1978; Adedeji & Stapleton, 1996; Deloof & Verschueren, 1999; Kang &
Long, 2001; Mendes, 2015).
The argument for complementary relationships takes root in the contention that highly
levered firms are constrained to the point that leasing becomes the only procurable option.
Substitution itself can ironically be seen to givestrength to the proposition that leasing is
indeed a complement source of finance (Lewis& Schallheim, 1992; Lasfer & Levis, 1998;
Filareto-Deghaye & Severin, 2007; Eisfeldt & Rampini, 2009;Malik, Saeed, Ahmed & Javed,
2012).Considering the vast theoretical premise, a motivation to investigate the underlying
characteristics of corporate entities that influence finance leasing decisions arises. This is
partly predicated upon the assertion of Morais (2013) that there is absence of conclusive
evidence from studies across the globe on the direction and significance of relationship
between firm attributes and leasing.
Likewise, with the persistent liquidity constraints experienced by businesses in Nigeria; high
costs associated with other methods of financing; improvements in funding for lease
operators enhancing capacity, as well as changes in the regulatory framework better securing
lease transactions (ELAN, 2015), it is expected that leasing would be a commonly procured
source of finance.However, the fact that in 2015, 80% of the transaction spread was handled
by non-bank lessors whose concentration was on financing the Micro, Small and Medium
scale Enterprises (MSMEs) (ELAN, 2016), it can be inferred that leasing may not be
predominant in the corporate sector inclusive of listed non-financial firms with access to
other forms of financing through the capital and money markets. It thus becomes imperative
to ascertain in those companies identified as leasing, what firm attributes drive its presence
given the dearth of empirical studies on the matter in Nigeria.
1.2 Statement of the Problem
Sharpe and Nguyen (1995), Mungami (2013) contended that little attention has been paid to
empirical research on leasing in the capital structure of firms. This is more so evident in the
limited number of studies emanating from the developing economies for which availability
and access to financing options are posed with challenges (Ayyigari, Dermiguc-Kunt &
Maksimovic, 2006). Reviewing a cross-section of studies on leasing in Nigeria, it is found
that issues broadly dealt with centredon enhancing development of the lease industry (Oko &
Isu, 2013; Oko, 2013; Oko & Essien, 2014; Oko & Egwu, 2014), lease financing effects
on;liquidity position (Kurfi, 2005), financial performance of businesses (Hassan, 2008;
Akinbola & Otokiti, 2012)andreporting compliance of lessee firms with accounting standards
(Mamman, 2006). None of these studies focus on the relationship between firm attributes and
finance leasing despite the fact that the former affect the decision of organisations to venture
into leasing arrangements.
Few studies available though, having a close link in the aim of explaining lease finance in
firms, vary significantly on the basis of methodology and coverage. In recognition of the low
level of leasing in comparison to other countries such as South Africa, and the cultural
tendency to utilise loans even at high cost of capital, Oko and Egwu (2014) sought to
determine the impact of psychology of asset ownership on leasing by corporate entities in
Nigeria. The methodological approach thus focused on psychological variables (and not firm
attributes) by assessing the management orientation of leasing and non-leasing firms. In the
same vein, citing a preference for bank loans, Oko and Isu (2013) identified the causes of
poor levels of leasing from a marketing perspective by assessing the principles, strategies and
policies adopted in the banking industry (as against the lease industry)which secures for them
an edge over the activities of leasing businesses thus, affecting the patronage of lease finance.
The shortcoming of these studies can be located in the fact that they precluded in analysis,
other possible factors which could influence leasing by firms. It may be that there are certain
features entities portray which make lease financing probable in their capital
structure.Profitability of firms is said to reduce the tendency to engage in leasing as it
provides first stage level of internal financing (Erickson & Trevino, 1994). Growth opportunities in firms require significant funds from external sources for which a strategy of
maintaining low-risk debt structures (as obtainable in leasing) may be deployed. This
forestalls underinvestment in the absence of internal funding (Fama and French, 2002).
Finance leasing can likewise improve liquidity positions for high growth firms through cash
conservation. Agency costs in form of underinvestment and asset substitution could be
avoided by the use of finance leases (Smith & Warner, 1979; Zhou, 2014).
Where extended debt financing is a function of borrowing capacity as inferred from the
leverage position in the financial statements, finance leasing in particular could be a
substitute having the same payment structure and encroaching effect of a capitalised liability.
Finance leases potentially lower costs of financial distress to a lessor, due to higher capacity
for repossession of leased assets than even collaterals in secured debts (Smith & Wakeman,
1985). From this, it can be inferred that companies with a likelihood of bankruptcy would be
predisposed to leasing assets, being easier to contract (Krishnan & Moyer, 1994).
In the presence of information asymmetry, higher costs of capital may prevail due to the
consideration of risk (Cortez & Susanto, 2012). Financiers’ attempt at forestalling the
problems of ‘adverse selection’ (from an obscured perception of firm risk profiles) and
‘moral hazard’ (a tendency of firms to engage in riskier activities than accounted for by the
lenders or investors)results in higher interest rates and required rate of returns. Finance leases
may therefore be a last resort alternative.
The question thus, is how significant are specific firm characteristics such as profitability,
growth opportunities, level of information asymmetry, agency costs, probability of financial
distress and leverage in accounting for the use of leasing by corporate entities?A study of this
nature is relevant given not only the role that leases plays in facilitating asset acquisition and
enhanced productive performance of businesses, but the budding stage at which the industry
still subsists in comparison to others, particularlythe developed nations.
Furthermore, examining studies that have been conducted on the subject matter of interest,
Morais (2013)as earlier mentioned inferred the inconclusiveness of findings due to
conflicting results achieved. This situation holds for the corporate attributes of interest
examined by previous studies perhaps, due to the peculiarities of the individual settings they
were conducted. For instance, mixed findings have been documented on how leasing is
influenced by profitability (Erickson & Trevino, 1994; Lasfer & Levis, 1998; Kang & Long,
2001; Brage & Eckerstom, 2009; Mendes, 2015),growth opportunities(Lasfer & Levis, 1998;
Brage & Eckerstom, 2009;Callimaci, Fortin & Landry, 2011; Malik, Saeed, Ahmed & Javed,
2012; Li, 2014),and information asymmetry (Sharpe & Nguyen, 1995; Lasfer & Levis, 1998;
Callimaci, Fortin & Landry, 2011; Malik, Saeed, Ahmed & Javed, 2012;Neuberger &
Rathke-Doppner, 2012; Li, 2014).
The same incidence of a difference in findings can be discerned for leverage (Franks&
Hodges, 1978; Ang & Peterson, 1984; Lasfer & Levis, 1998; Kang & Long, 2001; FilaretoDeghaye & Severin, 2007;Malik, Saeed, Ahmed & Javed, 2012;Mendes, 2015; BialekJaworska &Nehrebecka, 2016),agency costs (Mehran, Taggart & Yermack, 1999;
Robicheaux, Fu & Ligon, 2008; Brage & Eckerstom, 2009, Mungami, 2013; Munga &
Ayuma, 2015) and financial distress (Smith & Wakeman, 1985; Erickson & Trevino, 1994;
Filareto-Deghaye & Severin, 2007; Li, 2014; Mendes, 2015).A case can therefore be made
for testing what results are determinable in the Nigerian context given that there subsists, a
defined lease industry and a corporate sector including listed non-financial firms prone to
investments in tangible non-current assets.
1.3 Research Questions
The following research questions were raised to guide the study:
i. What is the effect of profitability on finance leasing by listed non-financial firms in
Nigeria?
ii. How do growth opportunities affect finance leasing by listed non-financial firms in
Nigeria?
iii. In what way does information asymmetry affect finance leasing by listed nonfinancial firms in Nigeria?
iv. How does financial distress affect finance leasing by listed non-financial firms in
Nigeria?
v. What is the effect of agency cost on finance leasing by listed non-financial firms in
Nigeria?
vi. How does leverage affect finance leasing by listed non-financial firms in Nigeria