The Effect of Capital Structure on Corporate Performances

The Effect of Capital Structure on Corporate Performances

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Chapter one on The Effect of Capital Structure on Corporate Performances

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 ratio.  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.  

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?  

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.  

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.  

 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.

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.  
LIMITATIONS: The following constraints faced the researcher and limited his efforts in elaborating the research work. 
FINANCE: The researcher is a full time student and has been discouraged from traveling to or visiting all the companies in Onitsha to collect data for her study due to lack of fund.  She has therefore chosen very few companies because of proximity and ease of contact to the management.
TIME: This project work has just few weeks time.
LIMIT: It would have been desired for a longer time to exhaust the topic and extend the coverage but it was not possible.  A minimum of six months could have been appreciated.
PRESSURE OF ACADEMIC WORK:  The researcher have been hindered by pressure of academic work from achieving the extensive research this work should have deserved.  

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.  
REFERENCES
1.   John C. Odike (2001); Managerial Economic 1st Edition.
2.   Modigliani and Miller, (1968); The cost of capital corporation finance and theory of investment, Arch or and D’ Ambosio p. 425.
3.   Ibid: p426 Linter J. (1963); The cost of capital and optimal financing of corporation growth journal of finance. Vol. xviii  No. 2.

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