CHAPTER ONE
INTRODUCTION
1.1 Background to the Study
Corporate financing decision is one of the most critical factors that affect the capital mix of an
entity, and is mostly influenced by both endogenous and exogenous features of an entity. As a
consequence, capital structure decision is one of the key corporate financial policies that require
careful consideration of financial managers because of its implication on cost of capital and
overall firm value. In financing firm’s operations, corporate financial managers must decide on
the use of internal or external means of financing, the use of debts or equity and the use of short
term or long term sources or a combination of both.
Capital structure describes the way in which an entity raised capital needed for replacement of its
assets, modernization of business processes, diversification and expansion. It is a combination of
various types of equity and debt capital an entity maintains resulting from the firm’s financing
decisions. In setting its financial structure, a firm can choose among many alternatives capital
structures. It may decide to issue a huge amount of debt or in the alternative it can issue very
little debt. The management of a firm therefore set its capital structure in a way that firm’s value
is maximized. In other words, firms often choose different financial leverage level in their effort
to attain an optimal capital structure. This optimal capital structure is the proportion of debt and
equity that minimizes the overall cost of capital and maximizes firm’s value.
Based on the prominent role that capital structure decision plays, Kargi (2011) reiterate that
decisions concerning the proportion of debt and equity are quite challenging for the management
of a firm because a wrong decision may lead to financial distress and eventually, bankruptcy.
Similarly, Harris and Raviv (1991) argue that the evaluation of the capital structure of companies
is imperative because not only does it affect a firm market value, it also affects its real decisions
about employment, production and investment. Issuing equity enables firms to access finance
without being forced to meet interest expense obligation, but dilute ownership. Debt, on the other
hand provides access to capital without ceding control. It provides access to an alternative and
perhaps, a cheaper source of financing up to a certain risk level. However, taking on more debt
increases agency costs (potential agency conflicts) between debt holders and equity holders,
increases financial risk and may eventually lead to bankruptcy in case of default to meet debt
obligations.
How firms make their capital structure decisions and what drives this important management
decision have been one of the most widely researched area in the field of corporate finance.
Since the seminal work of Modigliani and Miller (1958) on the irrelevance of capital structure in
corporate investment decisions, several theoretical literature as well as empirical studies that
model firms’ capital structure choice under different circumstances and assumptions have
emerged. The Modigliani and Miller’s irrelevance proposition was built on the assumption of
perfect capital market and they argue that internal and external funds may be regarded as perfect
substitutes for each other, hence, the total value of the firm and its cost of capital are independent
of capital structure.
The Modigliani and Miller’s path-breaking work elicited finance scholars and financial
economists to advance a number of theories in which capital structure choice becomes relevant.
These theories advanced taxes, bankruptcy costs, information asymmetry, transaction costs,
adverse selection and agency conflicts as the major explanation for the corporate use of debt
financing. Although some of these theories suggest that there is an optimal capital structure, they
do not specifically provide a methodology that financial managers can use to achieve an
optimum debt level. However, these theories provide some help in understanding how the chosen
financing mix affects firms’ value and what drives firm capital structure choice. A number of
financial theories (such as the trade-off and pecking order models) and empirical studies
particularly suggest firm specific characteristics as the main determinants and drivers of firm
capital structure choice. These firm specific characteristics as summarized in Titman and
Wessels (1988) includes assets collateral value, non-debt tax shields, growth, uniqueness,
industry classification, size, earnings volatility and profitability.
Firm size has been one of the variables that is widely believed in empirical studies to explain a
company’s level of debt. Larger firms are likely to have easier access to debt markets and be able
to borrow at lower cost. The larger a firm is, the more information is expected to be available
about it, which reduces the level of information asymmetries in the market, making it possible to
obtain cheap financial resources from lenders. Antonious et al. (2008) posit that the cost of
financial distress increases with expected growth forcing financial managers to reduce the debt in
their capital structure. And in the presence of information asymmetries, firms issue equity
instead of debt when overvaluation leads to higher expected growth. However, internal resource
of growing firms may not be sufficient to finance their positive net present value investment
opportunities and, hence, they have to raise external capital. If firms require external finance,
they issue debt before equity.
According to Guven et al. (2006), profitable companies will employ more debt since they are
more likely to have a high tax burden and low bankruptcy risk. Drobetz and Fix (2003), on the
contrary suggest that due to the costs associated with new equity issues in the presence of
information asymmetries, firms prefer raising capital first from retain earnings, second from debt
and finally from issuing new equity. Debt typically grows when investment exceeds retain
earnings and falls when investment is less than retain earnings. Jensen and Meckling (1976)
argue that due to the conflict of interest between debt providers and shareholders, lenders face
the risk of adverse selection and moral hazard. Consequently, lenders may demand security, and
collateral value may be a major determinant of the level of debt finance available to firms (Harris
and Raviv, 1990). This is based on the notion that tangible assets constitute sound collateral for
loans. Therefore, the greater the proportion of tangible assets on the balance sheet, the more
willing lenders would be to supply loans and leverage would be higher (Rajan and Zingales,
1995).
Further, in testing empirically the relationship between firm characteristics and capital structure
(leverage), what constitute leverage and a clear-cut definition of leverage remain vague in the
academic literature of corporate finance. Whilst some scholars advocate book leverage, some
empirical studies however favours market leverage. According to Myers (1997), managers focus
on book leverage because debt is better supported by assets in place than it is by growth
opportunities. Book leverage is preferred because financial markets fluctuates a great deal and
managers are said to believe that market leverage numbers are unreliable as a guide to corporate
financial policy (Frank and Goyal, 2009). Advocates of market leverage however argue that the
book value of equity is primarily a “plug number” used to balance the left hand side and the right
hand side of the balance sheet rather than a managerially relevant number. Also, while some
studies (see Anifowose, 2010 and Shehu, 2012) see leverage as long term debt or total debt,
some other empirical studies however viewed it to include accounts payable or all liabilities
(And each of these alternative views often results into different empirical outcome).
In view of the solid growth currently being experienced by the Nigerian food and beverages
industry, together with a great deal for expansion in the long run, the need for proper financing
mix and careful capital selection in the sector remains highly imperative. It therefore presupposes
that careful mix of debt and equity in the financial structure of this important industry will
impact on the success and future prosperity of the firms operating in the sector. For the purpose
of this study, five firm characteristics of listed food and beverages entities in Nigeria will be
considered as the independent variables, namely; growth, firm size, profitability, tangibility and
non-debt tax shields. While the dependent variable will be capital structure (leverage) of listed
food and beverages firms in Nigeria. These variables of firm characteristics are expected to yield
an effective statistical result due to their role in explaining the corporate level of debt as
suggested in the literature.
1.2 Statement of the Problem
Corporations fund their operations by raising capital from a variety of distinct sources. The mix
between the various sources, generally referred to as the firm’s capital structure has attracted
considerable attention from both academics and practitioners. As a result of the importance of
capital structure, (as an important management decision), there have been efforts by finance
scholars in search of factors that influence firms to include more or less debt in their financing
mix, and this has long been a subject of debate in corporate finance which dates back to the early
work of Modigliani and Miller’s irrelevance proposition of 1958. Previous empirical evidences
and finance theories such as the tradeoff and pecking order models particularly identified firms’
specific characteristics as important factors that influence firm’s debt/equity choice. Some
studies (see Antonios, Yilmaz, and Krishna, 2008) however argued that though the company
specific factors strongly influences the capital structure decisions of firms, the financing
behaviour of firms is also strongly affected by the market and economic conditions in which the
entities operate.
The relationship between firm characteristics and leverage has been strongly debated over the
years especially in the context of advanced economies of Western Europe and United States.
Despite these numerous studies, there is still disagreement among these studies about the
direction of the relationship between firm characteristics and leverage. Some of the prior studies
include Titman and Wessels, (1988), Harris and Raviv, (1991), Rajan and Zingales, (1995),
Frank and Goyal, (2009), Bevan and Danbolt, (2002) among others. However, in Nigeria, even
though there are limited empirical studies in the area, yet, a lot of gap in methodology and
literature have been identified in these prior studies. In addition, the effect of growth opportunity,
firm size, profitability, asset tangibility and non-debt tax shields on leverage have not been
specifically and extensively studied in the listed food and beverages entities in Nigeria.
Furthermore, some of the empirical studies conducted in Nigeria on firm characteristics and
leverage made use of panel data methodology, and as their method of estimation, these previous
studies employed the use of pooled ordinary least square (OLS) as their method of estimation.
However, OLS is widely believed in the literature of econometrics to be a restrictive model in
terms of panel data estimation. This is for disregarding the space and time dimension of pooled
data. The OLS’s naïve and restrictive assumption of constant coefficients across time and
individual firms in a pooled data may distort the true picture of the relationship between the
dependent and independent variables in a regression model. Therefore, this may affect the
validity of the inferences made by these studies. These prior studies include that of Salawu
(2007), Anifowose (2009), Shehu (2012), among others. Similarly, most of these previous
studies consider only one measure of leverage, which is mostly long term debt. However, studies
conducted by Salawu (2007) and Olokoyo (2012) note that Nigerian listed manufacturing
companies do not make use of much long term debt in their total borrowings. Therefore, analysis
of leverage solely based long term debt may not result into valid conclusion. In essence, this
study made an attempt to fill some of the identified gaps and tries to provide answers to the
following research questions raised.
How does growth opportunity affect leverage of listed food and beverages firms in Nigeria?
What is the impact of firm size on leverage of listed food and beverages companies in Nigeria?
How does profitability affect leverage of listed food and beverage entities in Nigeria? How does
asset tangibility affect leverage of listed food and beverages firms in Nigeria? How does non
debt tax shields affect leverage of listed food and beverages companies in Nigeria?