THE EFFECT OF CAPITAL STRUCTURE ON CORPORATE PERFORMANCES (A CASE STUDY OF SELECTED COMPANIES IN ONITSHA.
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THE EFFECT OF CAPITAL
STRUCTURE ON CORPORATE PERFORMANCES
(A CASE STUDY OF
SELECTED COMPANIES IN ONITSHA.
ABSTRACT
This study examined the effect of
capital structure on corporate performance with reference to selected companies
in Onitsha, Questionnaires and interviews were used to collect information from
the selected companies in Onitsha, Anambra State. Analysis and
observations were made which gave rise to the validity of the conclusion at the
end of the analysis, the major finding were:
1.
That these is a relationship between capital structure and cost of capital.
2.
That capital structure have significant effect on corporate performance (in
terms of profitability)
3.
That there is a high cost of capital which hinders the companies borrowing
ability.
The recommendations for the study among
others were:
1.
That companies should increase their efficiency in use of debt capital.
2.
That since cost of borrowing is so high, if a firm should be able to service
fixed charges associated with senior securities and leasing, it can borrow.
3.
That for improved performance mostly on profitability, the optimum combination
of fund from varying sources which is superior to any alternative combination
is necessary.
The researchers then concludes that:
1.
The inability of many companies to adopt optimal capital structure has been
increasing their cost of capital.
2.
Due to increase in the cost of capital for may firms, they were unable to
borrow in order to meet up their capital investment hence the decrease in their
performance mostly on profitability.
3.
The optimal capital structure is one in which the marginal real cost (the sum
of both explicit and the implicit costs) of each available method of financing
is the same.
PROPOSAL
This study examined the effect of
capital structure on corporate performance with reference to Selected Companies
in Onitsha. Questionnaires and interviews will be used to collect
information from selected companies in Onitsha, Anambra State. The
problem is whether the value of the firm would have been affected by using
different types of securities, analysis and observation will be made which
gives rise to validity of the conclusion at the end of the analysis.
Since there is no project without
limitations the researcher will encounter the problem of finance. The
money needed for transportation, photocopying of material and questionnaires
and also time constraint. The time given to carry out the project is too
small, although the research will put all her effort to see that this does not
affect the project.
The recommendations for the study among
others will be that:
1.
Companies should increase their efficiency in the use of debt capital.
2.
Since the cost of borrowing is so high, companies should focus more attention
on how to service fixed charges associated with securities and leasing.
CONCLUSION: Due to the inability
of many companies to adopt optimum capital structure, coupled with their
inability to source funds through borrowing as a result of increase in the cost
of capital, have been identified as the major constraint militating against
optimum performance especially on profitability.
TABLE OF CONTENTS
Abstract
Table of content
CHAPTER ONE
General introduction
Statement of the problem
Purpose of the study
Research hypothesis
Significance of the study
Scope and limitations
Definition of terms
References
CHAPTER
TWO
Literature
review
Introduction
The concept of capital structure
Security valuation
Review of previous studies
Theoretical foundation
References
CHAPTER
THREE
Research
design and methodology
Sources of data
Primary data
Secondary data
Scope and limitations
Population size
Data treatment and analysis
References
CHAPTER
FOUR
Data
presentation and analysis
Questionnaires
analysis and presentation
Data analysis and presentation
Test and prove of hypothesis
CHAPTER
FIVE
Summary,
recommendation and conclusion
Summary of findings
Recommendations
Conclusion
Definitions of terms
BIBLIOGRAPHY
APPENDIX
CHAPTER ONE
1.1 GENERAL
INTRODUCTION
A Corporation, Private or Public need
capital to enable it achieves its objectives. Capital structure implies
the nature and proportion of elements, which go to make up the capital invested
in a business corporations that are in need of funds exchange their financial
instruments for the money provided by the intermediaries or direct from
savers. This money the corporations convert to tangible assets as
building, land, plant and machinery, motor vehicles etc. Basically, a
corporation uses three main sources of long term and permanent financing viz:
common stock, preferred stock and debt financing (bond). It is the
combination of these finances to particular firm that is termed capital
structure.
There is need for reasonable balance of
different types of securities comprising the capital structure of a firm
otherwise the firm will deplete its financing ability or finance at sub optimal
cost. In achieving this, the cost of capital is important for it has a
major impact on the investment decision and the financing structure of the firm
of which affect the riskiness and size of the firm. Specifically, the
issue has been on whether or not financial leverage effects the firm’s cost of
capital, its value and profitability, hence its corporate performance.
Two major schools of thought (the
Traditionalist and Modigliani Miller) extreme views on the issues in
question have been among those involved in the arguments. According to
Modigliani and Miller, in their proposition which states that “the market value
of any firm is independent of its capital structure and is obtained by
discounting its expected return at a rate appropriate to its risk class”1
in their proposition 2 however, it states that the cost of equity is equal to
the cost of capital of an unlevered firm plus the after-tax difference between
the cost of an unlevered firm and the cost of debt weighted by the leverage
ratio2. Their long standing and unresolved opposite views have
become so controversial that it has led many into concluding that the
literature is marked by serious confusion and contradictions. This
particular notion is manifested in the words of LINTER “the decision rule which
have been proposed for determining the optimal capital structure and reliance
on different sources of financing are mutually in-consistent, in the sense that
they have led to often substantially different decision under given sets of
circumstance”3.
We are concerned with whether the way
in which investment proposals are financed matters; and if it does matter, what
is the optimal capital structure. If we finance with one mix of
securities rather than another is the value of the firm affected? This study
will be guide by the definition, which sees capital structure as the
interrelationships among long term dept, preference share and net worth
(ordinary share capital plus reserves and surplus).
Finally, this study will ask some staff
or selected companies in Onitsha, Anambra State how effective and they think
their capital structure have been and what has been the effects on the
corporate performance.
SOURCES OF CAPITAL
This concern on how company or
companies can raise the capital they need for their operations. These
ways can be broadly classified into internal and external sources.
A.
INTERNAL SOURCE OF CAPITAL
An existing business can raise its
capital asset by withholding some part of the revenue it has generated.
Such internally generated capital can take one of several forms.
i.
Depreciation Capital
Depreciation capital can be created
that means keeping some of the earnings aside as provision for capital
consumption during the process of production. This amount can rightly be
regarded as a cost item since it compensation for the part of the fixed
equipment that is being lost during use.
The inability to make allowance for
this depreciation has led to the failure of businesses after take off.
Once a damaged key component of the capital equipment cannot be replaced, the
production process is stopped.
ii.
Ploughing Back Profit
Some part of the profit made by the
businesses is kept back in the business instead of sharing it out as dividend
or personal income to the owners. Such ploughed back funds are
alternatively called retained earnings or undistributed corporate profits in
the case of corporate bodies. When this is done, it means that the
operation of the business can be expanded without involving it in any debt.
The risk of liquidating the enterprise is reduced.
B.
EXTERNAL SOURCES OF CAPITAL
Funds are raised from external bodies
and can be done in one of several ways again. These bodies may not have
any ownership relationship with the business before. Alternatively, those
that were part owners may add more to their original combination.
Examples of such external sources are discussed below.
i.
Bonds and Debentures
Bonds like debenture and mortgages can
be sold to those external agencies that care to buy. Interest on those
bunds are calculated as cost for the purpose of taxation. Therefore
before profits can be declared for tax to be imposed, the amount of interest
paid must have been deducted.
These bond holders lay claim on the
assets of the business first before the shareholders in case of liquidation.
ii.
Issuance and Sale of Preferred Stocks
This class of shares can be sold to new
persons that were never part of the previous ownership. Such shares might
as well be bought more by previous part owners who merely wish to increase
their shareholding. Holders of preferred stocks are paid dividends before
the common stock holders. But they cannot be served until the creditors
have been settled.
iii.
Issuance of New Common Stocks
New shares of common stocks or ordinary
shares or equity shares can be declared and sold to either existing
shareholders or new ones. This is the last group to benefit from the
earnings of the business.
iv.
Direct Loans
Direct Loans can be syndicated from
various types of financial institutions or individual moneylenders. They
earn interest on the amount lent out and do not qualify to have a share of the
profit.
These creditors can force the business
to liquidation when the loans cannot be settled as agreed. A court of law
will declare the business are new exposed to public auction in an attempt to
settle the debts owed.
v.
Grants and Aids
Governments and non-governmental
organizations can asset businesses with nominal or real capital in support of
the production efforts. This source of capital is the only one that does
not involve the firms concerned in direct costs. The donor agency bears
the full cost of such assistance. It is not a debt on the recipient.
1.2 STATEMENT
OF THE PROBLEM
The use of debt as part of the capital
of a business could either help or worsen the situation of a firm depending on
how well the debt was used. Generally, long-term borrowing is required
for purchase of new fixed assets or expansion of production capacity.
Equally, a firm may use its retained earnings, which is shareholders money or
raise more money within the organization through the issue of new shares. If
loan credit is more than equity capital (owner’s fund) it is wrong and risky
because this will increase the probability of bankruptcy. On the other
hand, corporations need to borrow for its expansion and growth. But as
usual, the choice of capital structure of a firm in the financing of capital
projects determines to a large extent the value, profitability and risk of a firm
to its shareholders.
Therefore, the study wants to seek
answers to the following questions.
1.
If a firm is financed with one mix of securities rather than another, is the
value of the firm affected?
2.
Does it matter, the way in which investment proposals are financed?
3.
Does capital structure have any effect on corporate performance?
4.
What is the optimal capital structure for a firm?
5.
How may corporation establish proper capital mix?
1.3 PURPOSE OF
THE STUDY
1.
The researcher want to find out what happens to the total valuation of the firm
and to its cost of capital which the ratio of debt to equity, or degree of
leverge is varied.
2.
To determine whether companies in Onitsha have been adopting adequate capital
mix
3.
To identify problems affecting or that have been hindering companies from
adopting an adequate capital structure and suggest possible solutions.
1.4 RESEARCH
HYPOTHESIS
In evaluating this research work, we postulate
the following hypothesis in determining the effect of capital structure on
corporate performance. The hypothesis are formulated in both:
Null Hypothesis (H0) and Alternative
Hypothesis (H1)
1. H0:
Capital structure does not have significant effect on corporate
performance.
H1:
Capital structure has significant effect on corporate performance.
2. H0:
Equity financing does not increase the value of the firm more than
debt
financing.
H1:
Equity financing increase the value of the firm more than debt financing.
3. H0:
A corporation should not avoid the use of debt as part of its
capital.
H1:
A Corporation should avoid the use of debt as part of its capital.
4. H0:
Weighted average cost of capital is not an aid to determine proper
capital
mix.
H1:
Weighted average cost of capital is an aid to determining proper
capital
mix.
1.5
SIGNIFICANCE OF THE STUDY
It is important to point out that on
completion of this work by the researcher, it would be of immense significance
to the following:
RESEARCHERS:
Other researchers on the same or similar topic would find this work helpful as
it will form a base of review of related literature and also a stepping-shine
for future researchers.
ECONOMY: This
work will help to improve the national output and thereby national
income. This is because of improvement in the efficiency and
effectiveness of the operations as well as the over all success of companies,
which will be achieved through adequate utilization and management of capital
structure as prescribed by the researcher.
CORPORATION: The
standard of corporations will be increased as a result of the knowledge
acquired from this research work.
MANAGEMENT:
This efficiency of the management would be recognized as a result of their
knowledge on how adequate capital mix could be achieved.
SHAREHOLDERS:
The wealth of the shareholders will be maximized due to efficiency of
management.
1.6 SCOPE AND
LIMITATION
SCOPE:
The study will be based on “effect of
capital structure on corporate performance”. The researcher will restrict
his work to selected companies in Onitsha Anambra State.
Any other reference to materials,
place, items, activities, periods is just for purpose of clarity and vivid
under standing of the topic and not within the scope.
1.7 DEFINITION
OF TERMS
Corporation:
A corporation is an association of persons or a group of persons set up by law
and authorized to act as individual person which is invested with perpetual
succession.
Capital structure:
Capital structure implies the nature and proportion of element, which go to
make up the capital invested in a business.
Cost of Capital:
This is the rate of return that must be achieved from an investment to satisfy
the investors required rate of return.
Financing:
Is the act of issuance of distribution of and purchase of liability and equity
claims issued for the purpose of generating revenue producing assets.
Financial Leverage:
This is a measure of the proportion of debt capital present in the capital
structure of the firm.
Risk:
This is variability of a firm’s returns.
Common Stock:
Is the cushion on which debt is acquired by a corporation and has no maturity
date.
Preferred Stock: Is a hybrid
security that has preference over common stock with respect to dividend and
sharing in assets.
Debt:
Payment which must be, but has not yet been paid to somebody.
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