e-sRC

CHAPTER ONE
INTRODUCTION
1.1 Background to the Study
The genesis of the use of external financing by firms can be traced back to the period of micro
trade by barter which was bedeviled by so many problems, including absence of a standard unit
for measurement. This served as a barrier to lending and borrowing. The introduction of money
as a medium of exchange facilitated the development of other forms of business such as sole
proprietorship and partnership which were mainly sustained through internal financing.
However, after the industrial revolution of the 1830s, the nature of business ownership and
financing evolved, partnerships were formed, which lead to the emergence of joint stock
companies. As a result of the formation of large joint stock companies which can take greater
risks in business opportunities, internal sources of finance became insufficient for further
expansion and growth, thus, necessitating business ventures to resort to external financing in
order to boost their efficiency and productivity.
Moreover, expanding into new line of businesses and the possible increase in the number of their
division/ subsidiaries became one of the reasons that necessitated the need for external source of
funding in form of loans, or new equity from creditors, lenders, shareholders and other debt
providers. These could come in form of debenture and loan usually termed as financial leverage
with a fixed rate of charges attached to it in form of interest payment needed for such expansion.
This gives raise to the concept of capital structure or debt/equity mix often referred to as
leverage.
Companies spend a lot of time in trying to fashion out how to finance a project or an operation
using the most appropriate source of financing at the right time. Project financing may
sometimes be achieved through the combination of both internal and external source of finance
which entails the use of debt or issuance of equity or combination of both (Suleiman, 2012).
Thus, optimum financing decision from the best source is very vital to the success and survival
of a firm as it helps in determining financing, investment, liquidity and dividend decision which
in turn helps in maximizing the shareholder’s wealth.
Furthermore, several hypotheses and theories have been postulated with a view to explaining
how capital combination of a firm affects its value. These include the pioneering work of
Modigliani and Miller (1958) which proposed the irrelevancy theory based on the perfect market
assumption. In 1963, Modigliani and Miller relaxed one of their earlier assumptions on corporate
tax, thus making debt financing more advantageous than equity financing. Further development
to the theory was made in 1977 when Modigliani and Miller added personal income tax into their
previous hypotheses and found out that, tax shield can be offset by personal income tax.
However, due to criticism and unrealistic assumptions in Modigliani and Miller hypotheses over
the years, researchers like Jensen and Meckling (1976), Myers and Majluf (1984) decided to
develop other theories such as the agency theory, pecking order theory, trade off theory and the
signaling theory among others in an attempt to explain capital structure further. These theories
explained and exposed different patterns of firm behaviors suggesting that, different features,
attributes or characteristics affect firm’s critical decision such as financing, investing, dividend
and liquidity decision. Some of these factors include profitability, size, age, liquidity, and
tangibility, growth potentials, number of subsidiaries attached to these firms, the source and the
financing structure and how these attributes affect the future risk and return of these firms and
the value of shareholders. While these factors (profitability, size, age, liquidity, and tangibility,
growth opportunity and complexity of business) are specific at firm level, yet other factors are
specific at industry level, others are specific at country’s institutional environment and
infrastructure. Among all these factors, firm-specific variables exert the highest influence on
financial leverage (Onofrei, Tudose, Durdureanu & Anton, 2015). Therefore, corporate managers
must focus primarily on these variables when making debt ratio decisions.
Furthermore, as noted by Mazur (2007), factors affecting capital combination of a firm differ
from one country to another due to changes in the level of economic, technological, cultural and
environmental factors. This variation could logically be applicable to various sectors of an
economy, having different characteristics and unique nature of activities they engage in. This
may be seen from the perspective of those companies that engage in manufacturing activities and
those that engage in service provision. As such, findings from previous researches may not
reasonably be applicable to other industries with unique attributes and different ways of funding
their business activities, especially quoted diversified firms in this current period. Hence, the
need for a specific study to be carried out in this area with a view to examining those unique firm
specific characteristics that impact on the debt structure of quoted diversified companies in
Nigeria.
The use of borrowed money in order to finance business operation or execute a project is termed
as financial leverage (Gill & Mathur, 2011; Rehman, 2013). This may be in different forms,
either short term financing which has to do with cash shortage and current liability management.
As well as long term financing strategy such as diversifying into a new line of business in order
to increase profitability and expansion in subsidiaries or branches for future growth and total
liability use as debt instrument in financing strategy. A firm may require external source to
sustain these investing activities. These decisions may efficiently be executed by exploring debt
financing in the form of financial leverage. Debts used in business increases shareholders’ risk
and return on investment and sometimes have tax incentives associated with borrowing, but
increases bankruptcy cost (Shehu, 2011).
A firm may also choose to grow either by increasing the number of its subsidiaries which makes
its operations more complex or diversify entirely in different line of business or product. This
may bring about increase in profitability as well as liquidity of the firm. Complexity of business
may be viewed from different perspectives including business complexity resulting from number
of subsidiaries controlled by a firm or geographical complexity which relates to a firm’s
operating regions. According to Grant, Bricker, Fogarty & Previts (1999), firms with more lines
of business or more geographical spread are more complex, more diverse, and are less focused
due to the number of business activities they engage in. On the contrary, a less complex firm that
engages in one line of business, or being wholly contained in one geographical region focuses
more on its operations.
By and large, Heshmati (2001) noted that, small firms with concentrated ownership and
expecting high growth will need more external finance through reliance on external source. This
is because growing firms have little or no internal finance to relay on. Thus, dependence on
external finance informs a firm on the extent to which they are likely to relay on external funding
to meet up with their operational need for cash. It is one of the internal factors that determine the
level of borrowing by a firm.
Profitability influences firm’s growth potentials, this is because, the more profitable a firm is, the
greater its capacity to generate funds internally and the less likely the firm is in defaulting
settlement of its liabilities. Companies with fast growth potentials are likely to have high retain
earning and thus may prefer to use such earning than utilizing external source of financing
(Suleiman, 2012). This justify why firms with potential growth has incentive to collect more debt
for further growth opportunities. In addition, profitability is considered as an essential variable of
financial leverage of a firm. It is already an established fact in pecking order theory that, highly
profitable firms rely more on internal capital due to high revenue generation which reduces
lenders exposure to probability of bankruptcy (Rajan and Zingales, 1995).
Tang and Jang (2007) opined that, market value as a measure of growth opportunity reflects the
market’s expectation on the current net worth of a firm and the firm’s all-future earnings. A firm
with better growth opportunity has great potentials for generating revenue, thus, going for more
debt. This implies that, creditors also on their own part will be willing to extend facilities to
firms with growth potentials.
Nigerian diversified companies are important sector of the economy that engage in entirely
different businesses that fall under one corporate group, usually involving a parent company and
many subsidiaries. They are often multi-industry and most times, large and multinational. They
are made up of different seemingly unrelated businesses, cutting across number of economic subsectors such as consumer goods, oil and gas, banking and so forth.
An important question that needs to be empirically answered is on the specific firm
characteristics that affect the financing pattern of quoted diversified companies in Nigeria.
Therefore, this study aims to determine the effect of firm specific characteristics on financial
leverage of quoted diversified firms in Nigeria.
1.2 Statement of the Problem
Financing decision of a firm has continued to constitute concern amongst financial managers,
analysts, researchers, scholars as well as policymakers, especially with regards to financial
institutions (Ukaegbu, 2015). Previous empirical studies conducted have shown that, diversified
firms mostly employ low leverage in their choice of capital mix (Lewellen, 1997). This is due to
the fact that they can rely on their internal capital market to alter their investment policies and
subsequently raise cash in any of their subsidiaries (Jensen & Meckling, 1976). More so, most
diversified firms carryout their transactions with their subsidiaries by means of tunneling and
propping, which entails the movement of financial resources from parent company to
subsidiaries and vice versa, thus making external source of finance less attractive to them.
Evidence from existing literature on the link between firm specific characteristics and financial
leverage is quite mixed. As such, there is no unanimous agreement on those factors that
determine the financing pattern of firms in different countries and sectors of the economy. For
example, most of the studies concentrated on countries like United State (U.S), Canada, Italy,
Japan, Korea, Thailand and so forth (See Tang & Jang, 2007; Buhtani & Amarjit, 2009; Gill &
Mathur, 2011; Rocca et al 2009; Choi, 2014; & Waranpee, 2011). Findings from these studies
are still mixed and inconclusive. The developing countries have had their own share of research
as evidenced from the empirical literature (See Hijazi & Tariq, 2006; Mishran, 2011; Akinlo,
2011; Shehu, 2011; Regasa, 2013; Kiran, 2013 & Namita 2014). In the same vein, findings from
the African countries like other European countries are still inconclusive on the topic. This may
be due to differences in institutional settings, laws, rules and regulation guiding business
activities in different countries (Rejan & Zingales, 1995). Furthermore, the endogenous nature of
leverage, which makes it sensitive to different measures of firm characteristics, differences in
sample size, variable measurement may be additional factors that have contributed to the mixed
findings (Lee, 2007).
In addition, of the several studies conducted in the developed and emerging economies, most of
the studies dwelled on determinants of capital structure of their respective countries. These
include Michaela (2015) who investigated the determinants of Capital structure of micro and
small enterprises in Lasi, Romania; Choi (2014) in Korea, and Waranpee (2011) in Thailand.
Gill and Mathur (2011) however examined those factors that influence the financial leverage of
Canadian firms using one of the variables (Complexity of business) that will be tested using the
Nigerian data, since finding in other economy may not be applicable to our economic settings
due to differences in institutional factors.
Studies from other developing countries include Hijazi & Tariq (2006) who investigated the
determinants of capital structure of listed firms in the cement industry of Pakistan. Mishran
(2011) examined those factors that determine the capital structure of Indian Manufacturing
Sector, Kiran (2013) further investigated the determinant of capital structure of textile, chemical
fuel and energy of Pakistan’s economy, while Regasa (2013), explored the determinants of
financial leverage of unlisted private insurance companies in Ethiopia, lastly, Namita (2014)
examined those variables that determine the leverage and risk of cement companies in India.
In the Nigerian context, most studies concentrated on variables such as firm size, firm age,
tangibility, profitability, liquidity, growth opportunities among others with a large proportion of
these empirical literatures paying more attention to other sectors of the economy to the exclusion
of diversified firms. Good examples include the works of Salawu and Agboola (2008); Akinlo
(2011) which all focused on the Nigeria listed non-financial firms. Mutalib (2010) and Suleiman
(2012) who both examined the determinants of capital structure of cement companies in Nigeria,
Shehu (2011) focused on Nigerian insurance firms, and Olayinka (2011), Suleiman (2011) and
Tajudden (2014) who all explored Nigerian listed conglomerate firms. This study also
concentrated on the conglomerate firms otherwise called diversified companies, but analyzed
different variables. Growth introduced as moderating variable which makes the work different
from the previous studies such as those of Chandrasekharan (2012); Anake, Obim & Awara
(2014) who explored Nigerian listed firms. Akinyomi and Olagungu (2013), dwelled on the
Nigerian manufacturing firms, Akingunola and Oyetayo (2014), conducted a pilot survey on the
SMEs in Nigerian. Lastly, Yadrichukwu and Magaret (2015) explore the Nigerian oil and gas
sector. From the analysis of empirical literature, it can simply be seen that with the exception of
the studies by Olayinka (2011), Suleiman (2011) and Tajudden (2014), all other studies focus on
other sectors. Thus, the need arose to revisit the diversified companies in order to get a better
understanding of financing decision and it determinants in such an important sector of the
economy.
The present study therefore looks at a combination of variables such as dependence on external
finance, profitability and growth opportunity among the companies. It also incorporates a
previously unexplored variable in Nigeria, complexity of business. Even within the developed
economies, only a few studies such as Gill and Mathur (2011) established a direct link between
complexity of business and financial leverage and found the variable to be significant and
positively influence Canadian manufacturing sector’s financial decision. This leaves a research
gap within diversified firms in Nigeria, which this present study intends to fill, with a view to
providing detailed and better understanding of the financing pattern of diversified firms in
Nigeria.
1.3 Research Questions
i What is the effect of complexity of business on the financial leverage of quoted
diversified companies in Nigeria?
ii What impact dependence on external finance has on financial leverage of quoted
diversified companies in Nigeria?
iii What is the effect of profitability on financial leverage of quoted diversified
companies in Nigeria?
iv What impact growth opportunity has on financial leverage of quoted diversified
companies in Nigeria?
v To what extent does growth opportunity moderate the relationship between
complexity of business and financial leverage of quoted diversified companies in
Nigeria?
vi How does growth opportunity moderate the relationship between dependence on
external finance and financial leverage of quoted diversified companies in
Nigeria?
vii How does growth opportunity moderate the relationship between profitability and
financial leverage of quoted diversified companies in Nigeria?