CHAPTER ONE
INTRODUCTION
1.1 Background to the Study
All forms ofbusiness organisation whether large or small need money to startand to meet their
daily and long-time obligations if they want to maintain a going concern status. These
businessesexist to achieve various goals which includeprofit maximization, shareholder value
maximization, sale volume and sale revenue maximization, increased market share, survival,
ethical goal, and satisficing. Achieving these goals translates into meeting harmonized
expectations of stakeholders.Focal to this sought-after accomplishment is informed consideration
of financing channels available to the firm. The financing optionsavailable to a firmare debt or
equity which forms itscapital structure. According to Chechet, Garba and Odudu (2013), a
perfect combination of debt and equity is very important to the growth and future of a firm if
properly utilized. Thus, the importance of capital structure decisions in the achievement of a
firm‟s goals cannot be over emphasized.
The theory of capital structure was first introduced by Modigliani and Miller (1958) in their
seminal paper on therelevance of capital structure to the value of a firm under perfect market
based on some assumptions (where there are no transaction costs, no corporate and personal
taxes, symmetric information, amongst others). Thus, the irrelevancy theory arguably forms the
basis of modern thinking on capital structure in finance. For the past decades following the work
of Modigliani and Miller, intensive research has been conducted to empirically test the validity
of their theory. Capital structure research has focused on whether financial decisions become
relevant if these assumptions are relaxed. As noted by Bevan and Danbolt (2002), under market
imperfections, firms will determine and attempt to select level of debt-equity mixthat will make
an optimal capital structure. Therefore, determining optimal capital mix has been the focus of
corporate finance literature.
Capital structure according to Martina (2015) is the way a corporation finances its assets through
the mixture of debt and equity. Whether a firm is financed by debt or equity or a combination of
both has some implications. As both involve costs to the company, there is need for the company
to choose the right option that minimizes its cost and in most cases companies tend to choose the
most probable least-cost combination. Thus, the debt and equity proportions are the measurement
tools for capital structure. Determining debt and equity is an important decision faced by
companies.Consequently,studies indicate that companies without borrowings (unlevered firms)
show less fluctuations in their earnings, whereas companies with borrowings (levered
companies) show greater fluctuations in their earnings when there are changes in their financial
performance (Ojo, 2012; Akhtar, Javed, Maryam, & Sadia, 2012and Hasanzadeh, Torabynia,
Esgandari& Kordbacheh, 2013). Some specific implications of borrowing on levered firms are
outlined as follows: borrowings require interest payments that in effect, slash firms‟ net incomes,
interest expenses are costs that increase the volatility of net incomes and thus, affect EPS and
borrowings also relatively reduce the proportion of the equity in a company‟s capital structure
and thus, reduce the number of shares outstanding. Therefore, companies have to carefully
structure their capital mix so that the best result can be achieved.Chechet etal (2013) opined that
an optimal combination of capital structure is one that not only maintains the stability but also
enhances the firm‟s wealth.
However, many factors are considered when making this important financial decision, because a
wrong turn may lead the firm to financial instability or distress which is not the aim of a going
concern. According to Akbar and Bhuntton (2012), capital structure of any firm is based on
definite characteristics or cost and benefit analysis of debt and equity. Also, Chechet et al (2013)
are of the opinion that since capital structure decision is a long term issue, by identifying the
factors that determine capital structure overtime, manager will be informed and know how to
adjust their financial mix to the optimal level. As such, researchers have dived into what
constitutes and determines the best capital mix that maximizes the firm‟s value. Thus,
determinant of capital structure have been debated for several years yet it still remains the most
significant unsettled issue in the field of corporate finance (Shehu, 2012; Martina, 2015; Butt,
2016).
Therefore, extant literature has identified factors that determine capital structure
choice.However, these factors according to Bundala and Machogu (2012), are not conclusive and
cannot be generalized because there are micro factors that can be influenced by technology and
operative political policies of a particular country. Masnoon and Anwar (2012) also observed
that apart from country specific and institutional factors, firms related factors are major
important factors that can influence capital structure choices. Therefore, industry factors, firmspecific factors and macroeconomic factors are among the determinants of capital structure.
These factors play important roles in capital structure decisions and are variables that affect the
firm decisions both externally and internally (Shehu, 2012). These factors are distinct and are
believed to impact differently on capital structure of firms. The incentives range from liquidity,
profitability, growth, size, age, non-debt tax shields, business risk, asset tangibility, industry
median, expected inflation among others. So, firms‟ managements need to be aware of them so
that appropriate decisions on capital mix can be taken.
Firm Profitability is the determining measure of the economic success of a firm in relation to
capital employed which invariably serves as the basic concern of its shareholders (Nawaiseh,
2015). A company that is not making profit may find it difficult to finance future growth
opportunities.This is because lenders may be reluctant to give loan to firms with poor financial
position. Also, such firms would not have retained earnings which can be accumulated and used
to finance viable projects. Thus, profitability is a firm characteristic that plays an important role
in the financing choice of corporate managers. Therefore, profitable firms have strong financial
position; hence, access to relatively cheaper debt or retained earnings for investments.
The size of a firm also plays an important role in its capital structure decisions. According to
relevant literature, large firms have the following advantages over smaller firms; they are more
diversified, have easy access to the capital market, receive higher credit ratings for debt issues,
pay lower interest rate on debt capital, have less volatile cash flow, have more dilute ownership,
less prone to bankruptcy and so on (Alkhatib, 2012).
Liquidity is another variable whose importance cannot be over looked in the financial decision
making process of any business organization whose aim is to make profit and maximize the
wealth of shareholders. Liquidity is the ability of a company to meet its short and long term
obligations as at when due.So, the higher the liquidity of a company the better it is able to pay
the debt interests. A company with high liquidity can rely on debt as a great contributor to capital
structure because it can easily pay its debt.On the other hand, such companies may use their own
capital to finance investment (Ghasemi & Razak, 2016).
The tangible assets of a firm can be considered as embodiments of surety to its creditors.
Therefore, the importance of those assets among total assets influences its level of debt. As noted
by Koksal and Orman (2015), tangible assets are likely to have an impact on the borrowing
decisions of a firm because they are less subjected to information asymmetries and they have a
greater value than intangible assets in case of bankruptcy. In addition, the moral hazard risks are
reduced when the firm offers tangible assets as collateral, because this constitutes a positive
signal to the creditors who can request the selling of these assets in the case of default. As such,
tangible assets constitute sound collateral for loans. Therefore, the greater the proportion of
tangible assets on the balance sheet (fixed assets divided by total assets), the more willing
lenders should be to grant loans and the higher the leverage. (Rajan & Zingale, 1995).
Firm Growthsare viewed as intangible assets of firm. Firms with significant future growth
opportunities are likely to face difficulties in raising finance from debt market because intangible
assets are not fully collaterallizable (Jensen & Meckling, 1986). Thus, Fama & French (2002)
posited that, firms with high intangible growth opportunities will use more of equity rather than
debt in their capital structure.
The Nigeria oil and gas sector plays a vital role in the economy. Since the discovery of oil in the
50‟s, there has been a heavy reliance on the income generated from this sector. The revenue
generated by the government from the sector is used in transforming and developing the country.
However, the downstream sub sector of the Nigerian oil and gas sector witnessed a partial
deregulation in April, 2004 during the Obasanjo administration leading to growth and expansion
in the sector (Monday, Ekperiware & Muritala, 2016). According to Fawibe (2009), deregulation
is the removal of government control, withdrawal of sales interference, encouraging free market
operation, and simplification of government rules and regulations for greater market participation
and deepening. Thus, deregulation will undoubtedly improve the efficient use of scarce
economic resources by subjecting decisions in the sector to the operations of the forces of
demand and supply. This will attract new sellers, buyers and investment/investors into the
market.
Consequently, firms in this sector, in order to cope with the expansion resulting from increase in
investment, need additional fund to finance such investment. Selecting the best source of
financing will undoubtedly lead to value maximization and healthy growth. Therefore, managers
in this sector need be furnished with the knowledge of determinants of capital structure to
facilitate their choice of optimal capital mix.
1.2 Statement of the Problem
In an attemptat finding out what informs optimal capital structure choice, researchers have
investigated the determinants of capital structure.Notable among these works are: Bradley,
Jarrell and Kim (1984), Titman and Wessel (1988), Haris and Raviv (1991), Rajan and Zingales,
(1995), Booth, Aivazian, Demirguc and MakSimovic (2001),Frank and Goyal (2003), SorgorbMira (2005), Frank and Goyal (2009), Akbar & Bhutton (2012), Sheikh and Wang (2011),
Chechet et‟al (2013), Ajao and Ema (2013), Ashraf and Rasool (2013) Akinyomi and Olagunju
(2013) and Onaolapo, Kajola and Nwidobie (2015). Aggregately put, firm‟s specific factors,
industry factors and macroeconomic factors were found to have influence on capital structure
choices. However, the inconclusiveness of the underpinning theories and findings of relevant
extant empirical literature calls for further empirical investigation. For instance, the pecking
order theory predicts a negative relation between firm profitability and capital structure while the
trade-off theory predicts a positive relationship between the same variables.
In addition, different methodologies and proxies so far used in studying capital structure and its
determinants leave some gaps to fill. As noted by Rajan and Zingales (1995), identifying more
accurate proxies will strengthen the relationship between theoretical models and empirical
specifications. The main area of concern here is capital structure definitions by different
authors.Some studies used total debt (for example: Eritios, 2007; Wanrapee, 2009; Sheik
&Wang, 2011; Ajao & Ema, 2012; Akinyomi & Olagunju, 2013; Saleem, Rafique, Mehmood,
(2013).Others used long term debt (Shehu, 2011; Ali, 2011; Chandrasekharan, 2012; and
Chechet et al, 2013) to quantify the amount of debt in the capital structure. However, some
studies decomposed debt into total debt, long term debt and short term debt.Notable among this
strand of studies are: Booth et al (2001), Abor (2008), Salawu and Agboola (2008), Kinde (2013)
and Onaolapo et al (2015). The aforementioned studies used book leverage ratio in their
methodological approach to leverage measurements. An interrogation of this proxy reveals the
superiority of market leverage due largely to its economic and statistical importance. In addition,
the studies that use market leverage (such as; Mitto & Zhang, 2008; Frank & Goyal, 2009and
Ovtchinnikov, 2010) are all based in advanced economies; no such studies are found in the
emerging economies especially Nigeria. Hence, a methodological cum empirical gap in Nigeria.
Different methodologies have been used in the literature mainly because no single
theoryadequately explains capital structure determinants.Thisgives researchers the liberty to
justifiably choose a relevant theory to underpin their studies. Rajan and Zingales (1995)
emphasized the need to identify the fundamental determinants of capital structure to facilitate
harmonization of the existing capital structure theories. Thus, Frank and Goyal (2009),in their
investigation of factors that determine capital structure decisions, established „six core factors‟.
These are: median industry leverage, market-to-book asset ratio, tangibility, profits, size and
expected inflation.
Frank and Goyal (2009) used different proxies for determinants of capital structure and
alternative capital structure measurements (both book and market measures of capital structure,
although emphasis was laid on market measurement) in testing their relationships before arriving
at the six core factors. However, these core factors were developed based on the study of public
traded American firms. Thus, carrying out such a study in a developing economy like Nigeria is
necessary to facilitate a comparison of empirical findingsin different geographies of different
economic status.Though the findings from relevant literaturesuggest that the insights from
modern finance theories could be applied across countries, but sensitivity to differing
institutional factors remains a relevant issue (Rajan & Zingales, 1995 and Booth etal. 2001). In
the same vein, Rajan and Zingales (1995) noted that the possible impact of different institutional
factors on capital structure choice cannot be appreciated until emphasis is laid on the actual
determinants of capital structure across countries. Rajan and Zingales also emphasized that
incorporating the peculiar factors of capital structure enhances the validity of findings on the
possible impact of institutional environments. The frontiers of the relevant literature known to
the researcher suggest that no study in Nigeria has explored the determinants of capital structure
that are reliably important to facilitate the understanding of the institutional factors as suggested
by Rajan and Zingales (1995).
Furthermore, there exist a good number of studies on the determinants of capital structure in
Nigeria but firm liquidity has so far received scanty attention. That firms in Nigeria use more
short term debt in their financing choice (Salawu & Agboola, 2008 and Onaolapo etal,
2015)necessitates an investigation of liquidity-capital structure nexus in Nigeria. Onaolapo etal
(2015) also noted that categorizing firms according to business sectors is necessary in order to
deepen the understanding of capital structure determination of specific sectors. Therefore, this
study will add liquidity and also introduce expected inflation and median industry leverage as
control variables on the capital choice of the downstream oil and gas business sector.
However, the downstream oil and gas sub sector has been partially deregulated which has
prompted the need to study the sector. This is because deregulation is an economic shock that
considerably affects the operating environment of firms.So,it is pertinent to evaluate the reaction
of capital structure to such a shock (Ovtchinnikov, 2010). To exemplify further, the recent
economic challengesfacing Nigeria in the forms of dwindling crude volume and low oil prices,
security frailties, rising inflation and the associated financial costs have taken their tolls on
investors‟ confidence and companies‟ performance.(Egene, 2016).
Motivated by the foregoing, this study seeks to examine firm characteristics and capital structure
of listed oil and gas firms in Nigeria. Market based methodology is adopted as a justified
departure from the previous studies within the Nigerian context. As noted earlier, Nigerian
studies on capital structure based their measurement on book leverage which is believed to;
produce results which are comparable to other results on capital structure, be in conformity with
theoretical predictions and capture the value of assetsin place (Magwai, 2014). It is worthy
ofnote thatbook leverage overstates the proportion of a firm‟s debt that is used to finance its
assets since there is no room for current value of the firm. This thereby makes potential investors
and lenders to be wary of committing their funds into a company with a high debt/equity ratio.
However, the market leverage which is a modification of the traditional book leverage has the
potential of boosting investors‟ and creditors‟ confidence as it reflects the growth options
reflected in the current market valuesagainst value of assets in place (book value). It thus serves
as a better measure of solvency.In sum, the steps taken so far are hoped to minimize the seeming
inconsistencies amongst the existing theories on capital structure.
1.3 Research Questions
The problem statement raises the following research questions:
- How doesfirm‟s profitability affect the capital structure of listed oil and gas companies in
Nigeria? - To what extent does firm growth influence the capital structure of listed oil and gas
companies in Nigeria? - What effect does asset tangibility have on capital structure of listed oil and gas companies
in Nigeria? - What is the relationship between firm‟s liquidity and the capital structure of listed oil and
gas companies in Nigeria? - What is the impact of firm size on capital structure of listed oil and gas companies in
Nigeria?