THE IMPACT LEVERAGE HAS ON SHAREHOLDERS’ VALUE OF LISTED CONSTRUCTION COMPANIES IN NIGERIA
1.1 BACKGROUND TO THE STUDY
The general problem all business entity face in Nigeria is the choice of finance. Firms at every stage of growth and development, from commencement to maturity need fund in order to survive. The aim of every business is to maximize the wealth and welfare of its owners. Without finance, the aim of all business cannot be met. As such, finance can be said to be the life wire of any firm without which there can be no survival. Financing is the acquisition of cash or other assets through means such as the sale of stocks, retaining net profit and increasing of debt. A firm’s capitalization consists of internally generated funds and due to the fact that a company may not be able to raise all the funds which it requires internally, it may depend on additional external financing, this bringing about leverage. The capitalization of the firm would therefore incorporate both internally generated funds and external funds. Due to the composition of these two sources of fund for the firm, there is a need to strike a balance between them. This balance is called the optimal capital structure. This is the appropriate use of debt and equity that minimizes the firm's cost of capital and maximizes firms’ value. It should however be borne in mind that a non-optimal capital structure or lack of optimal debt and equity mix may lead to higher financing costs and the firm may reject some capital budgeting projects that would have increased shareholders' wealth with an optimal financing.
The need for optimal capital structure will be for the firm to enjoy tax shield and reduce bankruptcy cost. In their seminal article, Modigliani and Miller (1958 and 1963) demonstrate that, in a frictionless world, financial leverage is unrelated to value, but in a world with tax-deductible interest payments, firm value and capital structure are positively related since interest payment from debt help to reduce corporate tax.
Leverage therefore is greatly considered when investment is being undertaken by investors. By this, investors prefer a firm that is less levered than one that is highly levered. However, the level of activity that can take place in a firm depends on the level of activity that goes on in the sector in which the firm operates as well as the financial strength of the firm. Leverage has a direct effect on the activity of the firm and as such will be greatly considered during the planning of the financial policy of the organization.
1.2 STATEMENT OF THE PROBLEM
Empirical studies tends to be less interested on how leverage determines shareholders value per se, and more on how changes in the capital structure of a company affects value (Hitt, Hoskisson, and Harrison, 1991), and thus its overall performance (Jensen, 1986).
Shareholders values vary with different level of debt usages. Shareholder values increase with increase of debt until the marginal benefits from leverage equal to the marginal bankruptcy costs, at this point, the Shareholders value reaches its maximum level, if we further increase the level of debt usages, Shareholders’ values not only increases but also decrease as per the trade-off theory as said by Jensen and Meckling (1976). As such, there is need to study the relationship that exists between these two phenomenons which are financial leverage and shareholders’ value.In the case of Nigeria, scanty of research has been done to investigate the relationship between financial leverage and shareholders’ value. The question of whether or not financial leverage has any impact on the value of shareholders of construction companies listed on the Nigerian stock exchange remains unanswered. This study is intended to provide answer to this question.
1.3 OBJECTIVE OF THE STUDY
This research aims at studying the impact leverage has on shareholders’ value of listed construction companies in Nigeria. Specifically, the objectives of the research are:
i. To assess the relationship between debt ratio and net asset per share.
ii. To assess therelationship between debt ratio and Return on Equity.
iii. To assess the relationship between debt ratio and earnings per share.
1.4 SCOPE OF THE STUDY
This research focus on the construction companies listed on the Nigerian Stock Exchange (NSE). There are nine construction companies listed on NSE. However the research did not cover all the listed construction firms, this was due to insufficiency in terms of data of those companies for the period covered. From the survey carried out in obtaining data at the time of this study, five construction firms had data which were sufficient enough for the study. The period covered in the study runs from 2010 to 2014. All data used for the study were extracted from the financial statement of the selected firms and those financial statements were obtained directly from the NSE library.
1.5 SIGNIFICANCE OF THE STUDY
In a bid to make policies relating to capital structure through knowledge of the effect of financial leverage on the shareholders’ value of firms, this research will be useful to the government in making policies on finance that aim at protecting potential and existing investors.
In order to maintain competitive positions and add value to their companies, today’s financial managers need to make critical business, financial and investment decisions which lead to the long-run maximization of the shareholders’ wealth. This study is foreseen to respond to the need of management to know the impact financial leverage has on shareholders’ value and also help financial analyst when giving financial advices on issue pertaining to capital structure.
The scholars and Academicians; as new challenges and opportunities emerge in the business environment, change is inevitable. This calls for continuous research to ascertain the actual situations rather than living on assumptions. As such, this study will be useful for further research on this subject matter.
1.6 PLAN OF THE STUDY
This research is organized into five chapters.
Chapter one provides a brief background on the overall research, statement of the problem, research questions, Objective, scope and the significance of this study. Chapter two reviews the theoretical, methodological, and empirical literatures on leverage and capital structure. For the purpose of clarity, the empirical literature was presented on a table.Chapter three discusses the method and data used for this research. The focus of this chapter is on how the research was conducted in order to derive the findings and conclusions. The research process focuses on sources of data; method of data collection and method of data analysis. In chapter four, the findings of the research are discussed. This is a very essential part of the research as it explains the findings according to the objectives stated in chapter one.
Chapter five concludes the research and gives a summary of the study as well as some recommendations for future research.
In this section, the theoretical literature showing the different underlying theories of financing leverage is enunciated. This chapter also contains methodology literature from past author in analyzing relationship between leverage of firms and shareholders values. Finally, empirical literature was presented. For clarity purpose, the empirical literature as contained in this chapter is presented on a table.
2.2 Theoretical Review
This study is guided by the following theories; the Modigliani and Miller theory, the tradeoff theory, agency theory and the pecking order hypothesis. These theories tend to explain the nature of leverage and capital structure.
2.2.1 Modigliani and Miller Theory
Over the years, alternative theories that explain capital structure and leverage have been developed in order to determine the factors that affect value. Modigliani and Miller (1958) in their first proposition stated that market is fully efficient when there are no taxes. Thus, capital structure and leverage affect neither cost of capital nor market value of a firm. In their second proposition, they maintain that interest payments of debt decrease the tax base, thus cost of debt is less than the cost of equity. The tax advantage of debt motivates the optimal capital structure theory which implies that firms may attain optimal capital structure and increase value by altering their capital structures. Authors like Barneaet al. (1981) support the view of Modigliani and Miller. However, others have contrasted the findings of the earlier studies suggesting that the three key policies of a firm namely; investment, financing, and dividend policy are related (Anderson, 1983). This is predicated on the assumption that Modigliani and Miller's ideal world does not exist. Financial markets are not perfect given taxes, transaction costs, bankruptcy costs, agency costs, and uncertain inflation in the market place.
2.2.2 The Tradeoff Theory
Firms are considered to tradeoff between the benefits and the costs of debt, and based on such tradeoff there will be an optimal capital structure for the firm. Tax reduction on debt and the control of free cash flow problem push firms to absorb leverage in their capital structure, while bankruptcy costs and other agency problems push firms to use less debt.
According to the subject on which costs and benefits are balanced, the tradeoff theory can be divided into two fields, the tax-based and the agency-cost-based (Black and Scholes, 1974). Corporate tax and bankruptcy costs are the central market frictions on which the tax-based tradeoff theory is established. On one hand, interest charges on debt are tax deductible and this advantage pushes firms to use more debt in their corporate financing; on the other hand, bankruptcy costs derived from high-level debt will push firms to use less debt. Quite a few papers discuss the optimal capital structure from the viewpoint of tax-based tradeoff, including Kraus and Litzenberger (1973), Scott (1976), Kim (1978) and DeAngelo and Masulis (1980). Scott (1976) confirms the existence of an optimal capital structure based on a multi-period model of debt, equity and valuation. Then conclude that in an imperfect market, the market value of a non-bankrupt firm depends on both the expected future earnings and the liquidating value of its assets. He further predicts that the optimal level of debt increases with the liquidation value of the firm's assets, the corporate tax rate and the size of the firm.
Kim (1978) discusses debt capacity and the existence of optimal capital structure of firms. He states that in a perfect capital market with frictions of bankruptcy costs and corporate income taxes, the firm has a debt capacity which should be less than 100 per cent, and the debt level of the optimal capital structure should be less than its debt capacity. He also points out those low levels of debt cause the market value of a firm to increase with its levels of debt; while external financial leverage causes a firm's market value to decrease its level of debt.
DeAngelo and Masulis (1980) show a model of corporate tax and differential personal tax, introducing the factor of “non-debt corporate tax shields”, referring to “depreciation deductions or investment tax credits” and “depletion allowances” (DeAngelo and Masulis, (1980). They argue that non-debt corporate tax shields suggest a unique interior optimum leverage decision for each firm in market equilibrium, regardless of whether leverage-related costs are present or not. Based on their model, they predict that the leverage of a firm is negatively related to the non-debt tax shields (NDTS); negatively related to marginal bankruptcy costs; and positively related to corporate tax rates..