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THE EFFECT OF CAPITAL STRUCTURE ON
THE PROFITABILITY OF QUOTED INSURANCE COMPANIES IN NIGERIA
ABSTRACT
The study
examined the impact of capital structure on the profitability of selected
quoted insurance companies in Nigeria between 2011 and 2016. The data were
obtained from the published financial reports of selected firms. The panel data
analysis was employed in the study.
The findings
showed that: Total debt ratio (β= 0.07; p>0.05) and debt-to-equity ratio (β=
0.01; p>0.05) had insignificant positive impact on return on asset of
selected quoted insurance firms in Nigeria; The combined effect of total debt
ratio and debt-to-equity ratio is statistically insignificant on return on
asset of selected quoted insurance firms in Nigeria (F=2.65; p>0.05); Total
debt ratio (β= 0.14; p>0.05) and debt-to-equity ratio (β= 0.08; p>0.05)
had insignificant positive impact on return on equity of selected quoted
insurance firms in Nigeria; The combined effect of total debt ratio and
debt-to-equity ratio is statistically insignificant on return on equity of
selected quoted insurance firms in Nigeria (F= 1.95; p>0.05); Total debt
ratio (β=0.08; p>0.05) had insignificant positive impact on net profit
margin while debt to equity ratio (β=0.04; p<0.05) had significant positive
impact on the net profit margin of selected quoted insurance firms in
Nigeria;The combined effect of total debt ratio and debt-to-equity ratio is
statistically insignificant on net profit margin of selected quoted insurance
firms in Nigeria (F= 3.55; p<0.05).
The study
concludes that capital structure in the form of debt financing and equity
financing contributes to the profitability of selected quoted insurance firms
in Nigeria, but its influence on profitability is negligible.
The study
suggest that; Insurance companies should introduce more debt, especially
long-term debt, into their capital structure mix as this will have an automatic
effect of reducing the overall cost of capital as a result of its tax advantage
that accrue to the organization when this decision is taken, and this often
could lead to enhanced profitability of the organizations.
CHAPTER ONE
INTRODUCTION
1.0
Background of Study
The success
of insurance companies in Nigeria business environment depends on the ability
of the managers to effectively determine the optimal capital mix which is
necessary to ensure that they make profit and shareholders get to see that
objective fulfilled which is wealth maximization, capital structure decision is
very crucial to any organization; it is very difficult to decide the best
combination of debt and equity. Capital structure reflects the firms financing
strategy. Therefore the optimal capital structure is said to exist when the
debt and equity can be combined to reduce the cost of capital and enhance the
firms’ profitability (Mohammed & Khalifa, 2014).
Modigliani
and Miller (1958) demonstrated the irrelevance of capital structure in firm
value, although the assumption is valuable only in perfect market conditions,
where all investors have free access to market information, there are zero
transaction costs and no tax difference between dividends and capital gains.
However, real economies are far from perfect and thus many financing decisions
theories were developed over time in order to demonstrate the purpose of
capital mix and its role in company value. (Sorana, 2015)
Capital
structure is the way in which a firm finances its operation which can either be
through debt or equity or the combination of both (Brigham, 2004). A number of
theories explained the relationship between profitability and value of firm. It
has been argued that firms with high growth rate have high debt to equity ratio
and it has been observed that bankruptcy has an effect on capital structure
(Zeituna & Tian, 2007). According to (Kochhar, 1997), poor capital
structure may lead to a possible reduction or loss in the value derived from strategic
assets. Hence, the capability of a firm in managing its financial policies is
important if the firm is to realise gain from it specialised resources
(Olokoyo, 2013). The raising of appropriate funds in an organization will aid
the firm in its operation. Hence, it is important for firms in Nigeria to know
the debt equity mix that gives effective performance after a good analysis of
business operation and obligation (Olokoyo, 2013).
The cost of
capital is having greater influence on the Earnings before interest and tax
level of the firm, which will directly affect the amount of earning available
to the investor that finally reflects on the value of the firm. If the manager
of an organization decide not to maintain the capital structure of the firm it
will affect the firm growth and profitability which will later have financial
distress on the profitability of the firm. Firms can also issue dozens of
distinct securities in a countless combination to maxima overall market value
(Abor, 2005).
Profit has
relevance in comparing the efficiency of a business organization. Profitability
is the ability of a lucrative activity to generate revenue higher than expenses
involved. The profitability measures are known as profitability ratios or
accumulated margin (Stefeap, 2008).
Profitability means ability to make profit from all business activities
of an organization. Profitability is the ability of a given investment to earn
a return from its use (Tulsian, 2014). (Erasmus, 2008) noted that financial
performance measure like profitability and liquidity among others provide
available tools to shareholders to evaluate past financial performance and
current position of a company. Profitability is a primary goal of all business
a business that does not make profit cannot survive. The ratios used to measure
profitability are Return on Capital Employed (ROCE), Return on investment
(ROI), Earnings per share (EPS), Gross Profit Margin, Net profit Margin.
Financial
performance refers to the degree to which to which financial objectives being
or has been achieved. It is the process of measuring the results of firm’s
policies and operations in monetary term. Firm performance reflects how
effectively companies manage their resources. There is a multitude of capital
structure indicators that influence the firm performance and profitability
(Sorana, 2015). Firm performance and capital structure has succeeded in
attracting a good deal of public interest because it is a tool for
socio-economic development (Ayad and Mustafa 2015). Erasmus (2008) noted that
financial performance measure like profitability and liquidity among others
provide available tools to shareholders to evaluate past financial performance
and current position of a company. Financial performance plays a large role in measuring
the success of business firms. Evaluating the firm’s performance has three
dimensions: the firms’ productivity, profitability,
1.2
Statement of Research Problem
This study
is undertaken because it has been observed that a lot of research has been done
on effects of capital structure on the profitability of companies like the
effect of capital structure on profitability: An empirical Analysis of listed
firms in Iraq by (Ayad and Mustafa, 2015), the effect of capital structure on
profitability of energy American firms (Mohamed and Tailab, 2014) and Capital
Structure and Firms Performance: Evidence from Malaysian listed firms (Salim
and Raj, 2012).
There are
only a limited number of studies that examine factors that influence the
capital structure of Nigerian firms. Although the capital structure issue has
received substantial amount of attention in developed countries, it has
remained neglected in the developing countries However, little attention has
been paid to effect of capital structure on the profitability of quoted
insurance companies especially in developing countries like Nigeria.
If there has
been any area of finance theory that has attracted the greatest attention and
caused the highest controversy, it is definitely the theory of capital
structure and leverage and how they affect firms’ performance. The choice of
capital structure has however being subject to several debates and
investigations. The capital structure and firms value has been subject to lots
of arguments for many years and it still represented one of the most unresolved
issues in corporate finance literature. Only a few people have developed
theories that have been tested by empirical studies and theories. Morri and
Beretta (2008) explained that numerous theoretical studies and much empirical
research have addressed those issues, but there is no generally accepted theory
and the debates on the significance of the determinant of factors of capital
and profitability is still open.
1.3 Objectives of the Study
The general
objective of the study is to examine the impact of capital structure on the
profitability of quoted insurance companies in Nigeria. The specific objectives
are:
To examine the impact of capital structure
on return on asset of quoted insurance companies in Nigeria.
To examine the impact of capital structure
on return on equity of quoted insurance companies in Nigeria.
To examine the impact of capital structure
on net profit margin of quoted insurance companies in Nigeria.
1.4 Research Questions
Does capital structure has impact on return
on asset of quoted insurance companies in Nigeria.
Does capital structure has impact on return
on equity of quoted insurance companies in Nigeria.
Does capital structure has impact on net
profit margin of quoted insurance companies in Nigeria.
1.5 Research Hypotheses
H01: Capital structure has no significant
impact on return on asset of quoted insurance companies in Nigeria.
H02: Capital structure has no significant
impact on return on equity of quoted insurance companies in Nigeria.
H03: Capital structure has no significant
impact on net profit margin of quoted insurance companies in Nigeria.
1.6 Operational Models
Objective
One: Capital Structure and Return on
Asset
ROA= f (CAP)
ROA= f (DR,
DER)
ROAit= α0 +
α1DEit +α2DERit + µ
Where:
ROA= Return
on asset
DR= Debt
ratio
DER=
Debt-to-equity ratio
i=
Cross-section of firm; t=time
Objective
Two: Capital Structure and Return on
Equity
ROE= f (CAP)
ROE= f (DR,
DER)
ROEit= α0 +
α1DEit +α2DERit + µ
Where:
ROE= Return
on equity
DR= Debt
ratio
DER=
Debt-to-equity ratio
i=
Cross-section of firm; t=time
Objective
Three: Capital Structure and Net profit
margin
NPM= f (CAP)
NPM= f (DR,
DER)
NPMit= α0 +
α1DEit +α2DERit + µ
Where:
NPM= Net
profit margin
DR= Debt
ratio
DER=
Debt-to-equity ratio
i=
Cross-section of firm (i= 1, 2…., 5); t=time (1, 2… 6)
1.6 Scope of
the study
This study
is concerned with the effect of capital structure on the profitability of
quoted insurance companies in Nigeria; the evaluation of the profitability of
insurance firms is for a period of six years 2011-2016.
1.7
Significance of the Study
Acquiring
knowledge on the effect of capital structure on the profitability financial of
quoted insurance companies in Nigeria will help finance manager to predict
potential problems associated with financing decisions and also help to achieve
the goals of shareholders
This study
have a significant role to play in filling the gap and understanding the effect
of capital structure decision on the profitabilit of quoted insurance companies
in Nigeria. It will also help financial managers to decide and understand the
effect that firm’s capital structure has on profitability in order to maintain
and optimal and ideal capital structure.
It will also
help investor who wants to in insurance companies to understand and analyze the
effect of capital structure on their profitability and maximizing their
objectives. It will also serve as a reference for other researchers in the area
of financial management.
1.8
Organisation of Study
This
research work is organized into five chapters.
Chapter One:
This present the introduction, the statement of problem, objective of study,
research questions, hypothesis, scope of study, significant of study.
Chapter Two:
This chapter reviews the conceptual framework, theoretical framework, empirical
literatures on capital structure and profitability.
Chapter
Three: This present the research methodology used
Chapter
Four: Data analysis
Chapter
Five: This chapter contains findings, recommendation and summary.
1.9
Operational Definition of Terms
Capital
Structure: This is how a firm finances its overall operations and growth by
using different sources of funds. It is a way a company finances its asset
through a combination of equity, debt etc.
Optimal
Capital Structure: This indicates the best debt to equity ratio for a firm that
maximises its value. It is the one which proffers a balance between the debt to
equity ranges thus minimizing the
Long Term
Debts: This consists of loans and financial obligations lasting over one year.
Short Term
Debts: This is made up of any debt incurred by a company that is due within one
year.
Equity: A
stock or any other security representing an ownership interest. This is one’s
degree of ownership after all debts associated with the asset has been paid
off.
Leverage:
This is the investment strategy of using borrowed money, specifically the use
of various financial instruments or borrowed capital to increase the potential
return of an investment. It is the amount of debt used to finance assets.
Risk: This
is the chance that an investment’s actual return will differ from the expected
return, it is the possibility of losing some or all of an original investment.
Financial
Risk: this is the possibility that shareholders will lose money when they
invest in a company that has debt, if the company’s cash flow proves inadequate
to meet its financial obligation.
Business
Risk: this is the possibility that a company will have lower than anticipated
profits or experience a loss rather than taking a profit.
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