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CHAPTER ONE

INTRODUCTION
1.1 BACKGROUND TO THE STUDY
Capital structure is the means by which an organization is bankrolled. It is the mix of debt
and equity capital maintained by a firm. The extant literature is full of theories on capital
structure since the pivotal work of Modigliani and miller (1958) as found in Chinaemerem
and Anthony (2012). How an organization is financed is of paramount importance to both the
managers of the firms and providers of funds. This is because if a wrong mix of finance is
employed, the performance and survival of the business enterprise may be seriously affected.
Capital structure of a firm is the mix of debt, equity and other sources of finance that
management of a firm uses to finance its activities. Different firms use different proportion or
mix. A firm may adopt to use all equity or all debt. All equity is preferred by investors as
they are not given conditions on the type of investment and usage of funds from providers.
All debt is preferred by investors in a country where debt interest is tax deductible. Firms use
a mix of debt and equity in various proportions in order to maximize the overall market value
of the firm (Abor, 2007).
Capital structure is expedient for decision making of business firms, and facilitates
maximisation of return on investment, as well as boosts the efficiency of financing and
dividend decisions. Financing decision facilitates the survival and growth of a business
enterprise, which calls for the need to channel efforts of businesses towards realising efficient
financing decision, which will protect the shareholders interest. This implies effective
planning and financial management through combination of an optimum capital structure by
managers so as to maximize the shareholders wealth. A firm can finance investment decision
by debt, equity or both. Such capital gearing could have implications for the shareholders
earnings and risk, which could eventually affect the cost of capital and the market value of
the firm. Capital structure decision is one of the most crucial decisions made by financial
managers, and borders on the mix of debt and equity used by firms in financing their assets.
Perceived as the pivotal to the growth and future of a firm, it is useful in dividend policy,
project financing, issue of long term securities, financing of mergers, among others.
One of the many objectives of a company financial manager is to ensure the lower cost of
capital and thus maximize the wealth of shareholders. Capital structure is one of the effective
tools of management to manage the cost of capital. A firm's capital structure has an important
influence on the financial performance and firm efficiency Ghosh, (2008); Margaritis and
Psillaki, (2007). A firm could increase or decrease its leverage by either issuing more debt to
buy back stock or issuing stock to pay debt. The objective of managing capital structure is to
mix the financial sources used by the firm in a way that will maximize the shareholders'
wealth and minimize the firm's cost of capital. This proper mix of funds sources is called
optimal capital structure. Then how should a firm choose its debt to equity ratio? And, what
is the optimal capital structure for a firm? Whether or not such an optimal capital structure
exists? What are the potential determinants of such optimal capital structure is an issue in
corporate finance (Myers,1984). Several theories have been put forward on the subject, but it
seems consensus is yet to be reached. For instance, circumstances may make it advantageous
to increase the proportion of debt capital, which include increasing the gearing as a result of
its tax deductible advantage. There is an upper limit to debt finance however, for not only are
there obvious dangers in the presence of large fixed interest charges against corporate
income, but there are practical limits to the amount of funds which may be borrowed.
The performance of a firm has to do with how effectively and efficiently it is able to' achieve
the set goals which may be financial or operational. The financial performance of a firm
relates to its motive to maximize profit both to shareholders and on assets (Chakravarthy,
1986) while the operational performance concerns with growth and expansions in relations to
sales and 'market value (Hofer & Sandberg, 1987). Since capital is employed by firms to
achieve the firm's set goals, and performance is said to be the goals so set, both capital
structure and firm performance are therefore expected to be proportionally related and
influenced one another. Thus, determination of the appropriate capital structure for the wealth
maximizing firm is a central area in the study of business finance and has spawned numerous
articles and studies by academics and practitioners alike. Consequently, this study examines
the determinants of capital structure among manufacturing firms in Nigerian.
1.2 STATEMENT OF PROBLEM
Capital structure is one of the contentious issues in finance. Various theories have been put
forward by researchers to justify the existence of optimal capital structure of a firm. It is in
fact a puzzle. The theories have been developed to try to unearth the financing preferences
managers may have in selecting a particular capital structure (Abor, 2007). Different nations
have different tax regulations and culture Suh (2008) as cited in Musiega, Chitiavi and Alala
(2013) (hence the results of one nation may not apply to other nations as the interactions
between various variables may not be the same. Hence Nigeria a developing nation require
such a research to enable managers and investors to undertake judicious investment decisions
as researches in this area are only centred on developed nations. Many empirical and
theoretical studies have proven that capital structure really influences firm's value but the
major concern contemporarily in modem cooperate finance is how to resolve the conflicts
between the managers and the owners in the control of resources and how will that control
mechanism speak on the firm performance (Jensen, 1986;1989). Going by the Agency Cost
Theory, the only control mechanism to checkmate the managers' excesses to pursue the firm's
overall goals is the introduction of more leverage in financing the firm. If more of debt is
employed, the treat of liquidation, debt servicing, which may eventually result to loss of jobs
to the managers will result to cost reduction thereby leading to efficiency and subsequently
improved performance. On this basis, this study considers the impact of capital structure on
firm's performance from the Agency Cost Theory perspective that higher leverage results in
the reduction of agency cost, improves efficiency and thereby making the firm more
profitable.
1.3 OBJECTIVE OF THE STUDY
The main objective of this study is to investigate the impact of capital structure on
profitability of the Nigerian listed firms. Related to the main objective, the research is
committed to specifically examining the following on the Nigerian listed firms:
(a) To assess the impact of debt ratio on firm performance in Nigeria and also
(b) To study the impact of equity financing on firm performance In Nigeria.
1.4 RESEARCH QUESTION
1. Does debt ratio have an impact on firm performance in Nigeria?
2. Does equity financing have an impact on firm performance in Nigeria?
1.5 HYPOTHESES
H1: there is no significant relationship between debt ratio and profitability of the Nigerian
firms.
H2: there is no significant relationship between equity financing and profitability of Nigerian
firms.
1.6 SCOPE OF THE STUDY
The study focuses on the performance of firms in the Nigerian manufacturing sector
based on their capital structure formation. The reason for limiting the scope to the
manufacturing firms is to give a direction and have a sizeable unit for a case study Among
these firms are major players in the Nigerian manufacturing Industry whose activities cover
all majorly manufacturing services, hence a study on these firms can be generalised. The
period of assessment has also been limited to 2007-2012. This is to ensure that the result
reflects the current trend in the operations of the selected organizations.

1.7 SIGNIFICANCE OF THE STUDY
The significance of this study is that it will help the investors to create such a portfolio that
yield them maximum profit. It will also enable them that how a choice of capital structure
effects the financial performance of the company. This study is utmost importance to both
researchers and business analysts as it looks into the realm of capital financing. This study
adds to existing literatures to verify the claim of traditional theory of capital structure. There
are two broad views on the impact of capital structure on the performance of firms, while one
asserts the significance of capital structure in determining firms performance; the other says
capital structure does not play any significant role in determining the performance of firms.
While various researchers have incorporated other firm specific factors like size, efficiency
and asset growth into their model, this study contributes to existing studies by looking at the
effect of macroeconomic variables which are outside the control of the firm like gross
domestic product and inflation on firms performance. Also unlike most works, the firms are
carefully classified into lowly and highly geared firms, this enables us make comparisons and
arrive at a more reliable conclusion.
1.8 OPERATIONAL DEFINITION OF TERMS
CAPITAL STRUCTURE: A mix of a company's long-term debt, specific short-term debt,
common equity and preferred equity. The capital structure is how a firm finances its overall
operations and growth by using different sources of funds.
DEBT RATIO: A financial ratio that measures the extent of a companys or consumers
leverage. The debt ratio is defined as the ratio of total debt to total assets, expressed in
percentage, and can be interpreted as the proportion of a companys assets that are financed
by debt.
EQUITY FINANCING: The process of raising capital through the sale of shares in an
enterprise. Equity financing essentially refers to the sale of an ownership interest to raise
funds for business purposes.
FIRM PERFORMANCE: Firm performance as we refer to it in this work, is a subset of
organizational effectiveness that covers operational and financial outcomes.












REFERENCES
Abor J & Biekpe N. (2007) How do we explain the capital structure of SMEs in sub-Saharan
Africa? Evidence from Ghana. Journal of Economic Studies Vol. 36 No. 1, 2009 pp.
83-97.
Modigliani, F and Miller, M (1958): The cost of capital, corporation finance and the theory
of investment. American Economic Review, 48, pp 261- 297.
Ghosh, Arvin (2008), Capital Structure and Firm Performance, United States: Transaction
Publishers.
Margaritis, Dimitris and Psillaki, Maria (2007), Capital Structure and Firm Efficiency,
Journal of Business Finance & Accounting, Vol. 34, Issue 9-10, 1447-1469.
Myers S.C., (1984). The capital structure puzzle. Journal of Finance 34 (3), 575-592.

Hofer and Sandberg. (1987). Capital Structure paradigm. Journal of science Academy, 8(1).
Chakravarthy, B. S. (1986). Measuring Strategic Performance. Strategic Management
Journal
7, 437-58.
Jensen, M. (1986). Agency cost of free cash flow, corporate finance and takeovers. American
Economic Review Papers and Proceedings, 76, pp. 323-329.
Jensen, M. (1989). Eclipse of public corporation. Harvard Business Review, 67(5), pp. 61-74.
Musiega M.G, Chitiavi M.S and Alala O.B (2013) Capital Structure And Performance:
Evidence From Listed Non-Financial Firms On Nairobi Securities Exchange (Nse)
Kenya: International Journal for Management Science and Technology 1 (2)1.
Chinaemerem O.C and Anthony O (2012) Impact of Capital Structure on the Financial
Performance of Nigerian Firms: Arabian Journal of Business and Management
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