Determinants of Capital Structure of Listed Construction Companies in Nigeria
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Chapter One of Determinants of Capital Structure of Listed Construction Companies in Nigeria
Background to the Study
Financing plays a prominent role in the management of any firm. Every enterprise requires funds both at the initial stage of operations and during the development and sustainable business stages (Panda, 2006). However, the views on what is the most efficient and effective way to source the funds differ due to various reasons. The inadequate level of the funds is associated with business deterioration and therefore the capital requirement of every company shall be determined in advance. Companies have different sources that are available to them to raise money. The selection of the most appropriate source and thus the identification of the optimal capital structure are crucial for the company (Vermaelen and Xu, 2010; Lasher, 2011). While the significance of capital structure is emphasised by Lasher (2011), the determinants of capital structure are not limited by those factors mentioned in previous empirical literature. Company’s leverage can be related to the nature of the business, the purpose of financing, the legal requirements, the period of finance, the advices of financial specialists, the government policies, the attitude of the management, and other internal and external factors (Huang and Ritter, 2007).
This research is motivated by the observation that oftentimes the companies even in related industries and sectors can have different approaches to capital structure. For example, Apple operates in the electronics industry and has only 1/3 of its capital comprised of debt (Apple Annual Report, 2013) whereas Dell has to conduct its operations with the leverage where debt reached 76% of total assets (Dell Annual Report, 2013). Such dramatic differences in the capital structure of the related companies raise a question why the managers of one firm choose to use more leverage whereas the management of the other company uses more of own funds and equity financing. Previous theoretical studies attempted to explain the capital structure and leverage of the businesses by several frameworks such as the trade-off theory, pecking order theory or the irrelevance hypothesis. It is observed that companies tend to seek the target or optimal leverage (Sogorb-Mira and Lopez-Gracia. 2003). However, the analysis that is conducted by Vermaelen and Xu (2010) revealed that the trade-off theory does not hold for all firms.
If the companies followed a pecking order, the preference of financing will be arranged as follows: internal funds, debt and, finally, equity financing. However, empirical evidence that is obtained by Frank and Goyal (2003) contradicted the pecking order theory as net equity issues are related to the financing deficit closer than net debt issues. It is observed that large companies’ display some terms of pecking order behaviour, but these observations are not confirmed when the conventional leverage factors are included (Frank and Goyal, 2003).
There were also attempts to explain the capital structure with the market timing theory. For example, the market timing theory is confirmed by the empirical investigation of Setyawan (2012) who studied a sample of Indonesian companies. It is found that market to book ratio negatively influences market leverage. Elliott et al. (2008) argued that market to book ratio may allow multiple interpretation and therefore is not an optimal method for confirmation of the theory. The authors test the market timing theory by employing an earnings-based valuation model. This way they are able to distinguish between equity mispricing, growth options, and time-varying adverse selection. Nevertheless, the market timing theory is confirmed as well, since market mispricing is significantly prominent for financing decisions (Elliott et al., 2008).
Besides the mentioned explanation of the capital structure decisions, some previous studies also found that the leverage could be related to the agency problems in the company. For example, Zhang and Li (2008) revealed that higher debt to asset ratio significantly affects the agency costs. Thus, when the company is overleveraged, the management will be more inclined to operate in the interests of shareholders because otherwise the company may become insolvent and the managers would lose their job. In light of the past findings, it is interesting to make a new contribution to the knowledge of capital structure and empirically tests the significance of specific determinants that affect leverage in Nigeria. Most of the discussed studies explored the determinants of capital structure in various markets. Based on these premises, this study shall seek to investigate the determinants of capital structure of listed construction companies in Nigeria.
Statement of the Problem
There has been an ongoing debate on the issue of capital structure and financial performance of firms. This controversy is further narrowed down to identifying which of the variables debated is most influential in predicting and determining the capital structure of manufacturing firms. The choice of optimal capital structure of a firm is difficult to determine. A firm has to issue various securities in a countless mixture to come across particular combinations that can m
aximize its overall value which means optimal capital structure. Optimal capital structure also means that with a minimum weighted-average cost of capital, the value of a firm is maximized. According to Rahul (1997), poor capital structure decisions may lead to a possible reduction in the value derived from strategic assets. Hence, the capability of a company in managing its financial policies is important if the firm is to realize gains from its specialized resources. The nature and extent of relationship between capital structure and financial performance of firms have attracted the attention of many researchers. The studies, which are largely foreign based, have however revealed conflicting findings.
In Nigeria, most of the studies did not use other components on capital structure and financial performance. The studies which include Bello and Onyesom (2005), Salawu (2007), Olokoyo (2012), Babalola (2012), Yinusa and Babalola (2012), Sabastian and Rapuluchukwu (2012) and Idode, Adeleke, Ogunlowo and Ashogbon (2014) have left a gap that need to be filled. For example, Salawu (2007), who studied the effect of capital structure on financial performance of selected quoted companies in Nigeria between 1990 and 2004 concentrated on short term debt. His study did not extend to other forms of financing, thus the finding could only be used in the context of short term debt financing. This means even within the purview of debt financing; only the short term aspect of the debt was covered in his study. In reality, a study on capital structure is supposed to cover both types of debt financing.
Babalola (2012) who also studied the effect of optimal capital structure on firm’s performance in Nigeria between 2000 to 2009 using samples of 10 firms, concentrated on total debt to total assets. His study excluded the aspect of total debt to equity, short term debt to total assets and long term debt to total assets financing despite the fact that both types of debt financing are used by the sampled firms. More so, his study and those of Bello and Onyesom (2005) and Olokoyo (2012) used Chi-square technique to analyze their data. Chi-square is considered deficient in terms of reflecting time variant and specific characteristic issues. Studies on capital structure and performance of firms are supposed to use parametric techniques that measure both time variant and specific characteristic issues.
Furthermore, the study of Yinusa and Babalola (2012) examined the impact of corporate governance on capital structure decision of ten (10) firms in the food and beverage sector during the period from 2000 to 2009. They used total debt to total assets ratio as proxy of capital structure. The study did not cover other components or types of debt financing such as total debt to total equity, short- term debt and long-term debt. Additionally, Sebastian and Rapuluchukwu (2012) that studied the impact of capital structure and liquidity on corporate returns of manufacturing firms between 2002 to 2006, focused on short-term debt, long-term debt and total debt without including total debt to total equity financing. The study failed to use total debt to total equity as variable of debt financing. Idode, Adeleke, Ogunlowore and Ashogbon (2014) in their study of the influence of capital structure on profitability of banks in Nigeria for the period of 2008 to 2012 covered both debt financing and equity financing. However, they ignored short-term debt and long-term debt which constitute other important forms of financing for manufacturing companies in Nigeria.
Owing to these identified gaps, a study that will cover the various forms of financing mix in order to address the following questions that remain unanswered is desirable: to what extent do total debt to total assets ratio, total debt to total equity ratio, and the ratios of short-term and long term debt to total assets affect the performance of construction firms in Nigeria? This study attempts to provide answers to this fundamental question.
This research will be carried out to answer the following research questions:
i) How do the construction firms’ sizes in Nigeria impact their performance?
ii) What is the extent to which total debt to total asset ratio affect financial performance of listed construction firms in Nigeria?
iii) What is the effect of total debt to total equity ratio on financial performance of listed construction firms in Nigeria?
Objectives of the Study
The main objective of this study is to examine the determinants of capital structure of listed construction companies in Nigeria. However, the specific objectives of the study are:
i) To understand how the construction firms’ sizes in Nigeria impact their performance.
ii) To examine the extent to which total debt to total asset ratio affect financial performance of listed construction firms in Nigeria.
iii) To investigate the effect of total debt to total equity ratio on financial performance of listed manufacturing firms in Nigeria.
The research hypotheses to be tested include:
i) There is a significant relationship between total debt to total equity ratio and financial performance of listed construction firms in Nigeria.
ii) There is a significant correlation between construction firms’ sizes in Nigeria and their performance.
iii) There is no significant reltionship between total asset to total equity ratio and financial performance.
Significance of the Problem
The outcome of this study would contribute to the existing body of knowledge. Because, though there are a lot of studies on capital structure and financial performance around the globe, there is dearth of evidence using data on construction firms in Nigeria. The outcome of the study would therefore serve as a reference material for subsequent researchers and would provide a basis for further research in this area.
It is the hope that the result of this study will be beneficial to both internal and external parties (i.e managers in maximizing investors return, owners in making an informed decision, creditors in ascertaining credit worthiness of a firm, Government in making favorable financing policies etc) to improve on the GDP contribution by the construction sector and also improve on employment rate once the sector is viable since the stake holders are interested in knowing the impact of such decisions on an organization performance.
Also, the government and its agencies will somehow benefit from this study because the study will highlight the need from its findings if necessary for the government to formulate more favorable financial and economic guidelines as the sector demands and this will sustain the operations of Nigerian construction firms, especially the potential firms yet to be quoted in the stock market and resultantly contributing to GDP of the nation which have been on the decline hitherto.
Scope of the Study
The study is designed to examine the determinants of capital structure of listed construction companies in Nigeria. The study covers the period of six (6) years from 2013 to 2018. The study chooses the construction firms as its domain because it covers the larger proportion of industry in Nigeria. The independent variables of the study are capital structure proxied by total debt to total assets, total debt to total equity, short-term debt to total assets and long-term debt to total assets, and the dependent variable is represented by financial performance proxied by return on assets. The period of the study is considered appropriate because it coincides with the period within which major reforms took place in the construction sector.
Limitations of the Study
As it is the case with all studies, this study is associated with some limitations. The findings of this study are therefore to be considered in light of the following limitations:
The study intended to use the entire population of listed construction firms in Nigeria to constitute the population of the study. But some firms do not have complete financial records either on their website or in the office of Nigerian Stock Exchange during the period of the study. The study considered only those firms that meet up with the criterion to form the adjusted population. Therefore, the findings and recommendations of the study may not apply to the firms that were not covered by the study.
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