CAPITAL STRUCTURE AND MARKET VALUE OF COMPANIES

Abstract

This study examines the relationship between capital structure and market value of a company, it is motivated by a desire to explain debt (leverage) used by five manufacturing companies listed in Nigeria stock exchange in 2012 financial year. Debt financing were discussed, income gearing, cost of capital, cost of debt, the weighted average cost of capital, capital structure and its effect on share price/cost of capital, the relationships between the use of financial leverage and share price. It also discussed financial innovation for improving capital structure, issues and theories of capital structure, the role of the capital market in share prices valuation, factors that influence share prices and behaviour of share prices. In light of this discussion, a number of questions arose to determine if shareholders fund has a significant impact on the market value of the firm. This then led to the formulation of two hypotheses which were analyzed using the ordinary least square regression technique on the companies. The findings revealed that the two performance variable has significant impact on the market value of the firm. The result of this study was observed that variable of equity (shareholders fund) has a significant relationship with the market value. It was recommended among others that Nigerian companies should try to ascertain the optimal capital structure to be adopted as a policy in order to create a balance in satisfying the shareholders desire and management of capital structure decision. It was concluded that any researcher that intends to research on this area in finance in the future should investigate into other factors influencing the market value apart from capital structure.

TABLE OF CONTENTS

Title page

Certification

Dedication

Acknowledgement

Abstract

Chapter One: Introduction  

1. Background to the study
2. Statement of problem
3. Research questions
4. Objectives of the study
5. Research hypothesis
6. Significance of the study
7. Scope of the study
8. Limitation of the study
9. Definition of terms

Chapter Two: Literature Review

1. Introduction
2. Debt financing
3. Income gearing
4. Cost of capital
   1. Cost of debt
   2. Cost of equity
   3. The weighted average cost of capital 
5. Capital structure and its effect of share prices/cost of capital
6. The relationship between the use of financial leverage and share prices
   1. Independent hypothesis net operating income (NIO)
   2. Dependent hypothesis net income theory (NI)
   3. Traditional approach  
7. Financial innovation for improving capital structure
   1. Debt for equity swap
   2. Debt for debt swap
8. Issues and theories of capital structure
   1. The market timing theory
   2. Pecking order theory
   3. Trade off theories
   4. Agency conflict
   5. Stakeholders co investment theory
   6. The organizational theory
9. The role of capital market in share price evaluation

2.9.1        The factors that influence share price

1. Behaviour of share price
   1. The random hypothesis

Chapter Three: Research Method and Design

1. Introduction
2. Research design
3. Description of population of the study
4. Sample size
5. Sources of data collection
6. Method of data presentation
7. Method of data analysis

Chapter Four: Date Presentation, Analysis and Interpretation

1. Introduction
2. Presentation of data
3. Data analysis
4. Hypothesis testing

Chapter Five: Summary of Findings, Conclusion and Recommendation

1. Introduction
2. Summary of findings
3. Conclusion
4. Recommendation   

CHAPTER ONE

INTRODUCTION

Background to the Study

One of the cornerstones of the modern corporate finance theory is the capital structure irrelevancy proposition (Modigliani & Moller 1958). Modigliana & Moller (1958) conclude that the market value of any firm is independent of its capital structure. It is observed that the options capital structure is closely related to the growth potential of the firms (McConnel & Servaes 1995; Jung, Kim & Stulz 1996) and some other valuables such as the size and the industry characteristics.

Debt policy and equity ownership structure matter and the way in which they matter differ between firms (McConnell & Servaes). Leland and Pyle (2007) propose that managers will take debt/equity ratio as a signed by the fact that high leverage implies higher bankruptcy risk (and cost) for low quality firms since managers always have information advantage over the outsiders, the debt structure may be as a signal to the market. Rose model suggests that the value of firms will rose with the leverage since increasing leverage increases the market perception of value.

Suppose there is no agency problem i.e. management acts in the interest of all shareholders, the manager will maximize the firm’s value by choosing the optional capital structure, highest possible debt ratio; high quality firms need to signal their quality to market, which the low quality firms try to imitate.

According to this argument, the debt level should be positively related to the value of the firm. Assuming information asymmetry, the pricing order theory (Myers & Majurf 1984) predicts that firms will follow the peeking order as optimal financial strategy. The reason behind this theory is that if the managers act on behalf of the owners, they will issue securities at a higher price than they are truly worth.

The more sensitive the security, the higher the cost of equity capital, since the action of the manager is giving a signal to the market that the securities are overpriced. Stulz (1990) urge that it can have both positive and negative effect on the value of the firm (even in the absence of corporate taxes and bankruptcy cost). He develops a model in which debt financing can both alleviates the over investment problem. Stulz (1990) assumes that managers have no equity ownership in the firm and receive utility by managing a larger firm. The “power of manager” may motivate the self interest managers to undertake negative present value projects. To solve this problem shareholders force firms to issue debt. But if firms are force to pay out funds, they may have to forgo positive present value project. Therefore, the optimal debt structure is determined by balancing the optimal agency cost of debt and the agency cost of managerial discretion.

According to Stulz (1990), McConnel and Servaes (1995) Jung, Kim, (1996), the influence of the debt on the firm’s value depends on the presence of growth opportunities. For firms facing low growth opportunities, debt ratios are negatively related to the firm’s value.

Capital structure is the mixture of permanent sources of funds a firm uses in financing its operations, primarily represented by long term debt, preference stock common equity, debenture which exclude all short term credit i.e. overdraft.

The amount of debt that a firm uses to finance its asset is called leverage. A firm worth a lot of debt in its capital structure is said to be highly levered while a firm worth no debt is said to be unlevered.

Pandy (2005, p.5) posited that the mix debt equity is known as a firm’s capital structure. The manager should rigorously strive to obtain the optimum capital structure for the organizational being. It should be noted that the firm’s capital structure is seen as a mixed or when it’s market value of shares is maximized or when it’s weighted average cost is minimized. An appropriate capital structure is a critical decision for any business organization and this decision is very important not just because of its need to maximize shareholder’s wealth or increase the market value of companies, but also because of the impact such decision has on the company’s ability to deal with the competitive environment.

In other developing countries of the world and Nigeria in particular, not much has been written on the conceptual linkage between market value of companies and capital structure, therefore the financial manager should seek that capital structure which maximizes the value of the firm (optional capital structure) are brought to bear. The firm’s optional capital structure should represent a balance between debt and equity. Such advantage that comes from using cheaper debt is just matched by the increase in the financial risk that comes form debt.

Statement of Problem

The capital structure mix that a company decision will definitely have an effect on its market value. A cursory look will be taken on the extent to which capital structure relates to the market values, there is need to seek answers to the following questions:

• There is relationship between capital structure and market value of companies.
• There is optimal capital structure improvement on market value for existing and potential shareholders.
• The shareholders fund has impact on the market value of the firm.
• There are factors that influence the decision of management as regards to capital structure.

Research Questions

1. What is the relationship between capital structure and market value of companies?
2. Does optimal capital structure improve on market value for existing and potential shareholders?
3. Does the shareholders fund have a significant impact on the market value of the firm?
4. What are the factors that influence decision of management as regard capital structure?
   1. Objectives of the Study

The hallmark of business enterprises are probability and accountability which enables the organization to gain public confidence on which the organization thrives. The research work seeks to achieve the following objectives:

1. To establish the relationship between capital structure and the market value of company.
2. To determine the factors that influences the decision of management as regards capital structure.
3. To determine if shareholders fund has a significant impact on the market value of the firm.
4. To ascertain the optimal capital structure that improves on market value for existing and potential shareholders.

Statement of Hypothesis

1. Null Hypothesis (Ho): Capital structure does not have impact on the market value of the firm.

Alternative Hypothesis (Hi): Capital structure has impact on the market value of the firm.

1. Null Hypothesis (Ho): Shareholders fund does not have significant impact on market value of the firm.

Alternative Hypothesis (Hi): Shareholders fund has a significant impact on market value of the firm.

Significance of the Study

This study attempts to produce information to bridge the information needs of the potential and actual investors as well as for the management of companies.

Therefore the following categories will benefit immensely from the findings of this research work.

• Potential Investor: It could serve as a guide in determining the value of the company that would finally have an influence on their investment decision.
• Management: It would expose them to improve practice as well as help control share prices.
• Shareholders: It would help them to estimate and evaluate the returns suitable from their investments.
• Government: It would be beneficial to government in the area of policy formulation and implementation towards sustaining the capital structure policies already in place.
• The Public: It will enlighten the public on the need to invest in a well capital structured company with effective policies. It will also benefit the public in the area of providing relevant information for the future researchers own research work.
• Customers: It would expose them to knowing the company better, thereby making the demand for the companies product increase. It would also make them evaluate the returns suitable from investment.

Scope of the Study

This research work encompasses a comprehensive survey of companies in Nigeria. The fundamental aim of  this study is to analyze the relationship that subsist between capital structure and market value or share price. The data is obtained using a cross section of quoted companies in the Nigerian stock exchange for the period of 2010.

Limitation of Study

• The research study is associated with the problem of data collection principally how to obtain information required for the study is a Herculean task.
• The smallness of the sample size is also as constraints to this research project.
• It is also possible the wrong information has been given intentionally or otherwise, during the data collection process.
• Some of the data generated and analyze were based on fact and figures reported by journals, magazines, newspapers, textbooks, etc. There is the livelihood that historical errors reported by them might be included.

Definition of Terms

• Capital: Capital relates to the proportion of different types of securities both debt and equity issued by a company.
• Capital Structure: Capital structure relates to the mix of the long-term sources of funds by the company.
• Liquidity: It is the ability of the company to meet short term maturing obligation as they fall due.
• Dividend: This is the payment made by a quoted company to its shareholders. It could be either in cash or stock dividends.
• Stock: Stock refers to a fixed interest security issued by companies and it’s also part of the equity capital of the company.
• Stock Exchange: This is a place where stocks, security and share are constantly traded.
• Capital Gains: It occurs when stock exchanged securities are sold at a higher price than it was paid for. Hence, it could be seen as a situation where the share of a company appreciates in value because the earnings power of the company is appreciating.
• Share: A share is the smallest individual unit of capital of a limited liability company which gives its holders the opportunity to receive an amount called dividend.
• Share Price: Share price is the market price of share of a company as stated on the daily listings of activities in the stock exchange.
• Leverage: This is the amount of debt that a firm utilizes in financing its activities. A company is said to be highly leveraged when it has a high proportion of debt stock in its capital structure.
• Shareholders: This is a part owner of a limited liability company and he or she is entitled to vote in annual general meetings of the company and to receive dividends and to obtain a chare in the net assets of the company on its liquidation.
• Quoted Company: This is a company whose share is listed on the stock exchange.