ABSTRACT
The
issue of value creation for stakeholders of the firm as a result of the
composition of its financial mix can be traced to the seminal work of
Modigliani and Miller (MM) in 1958. Their argument is the irrelevance of the
financing mix of firms on value. Thus, whether the firm uses equity or debt,
the value of the firm does not change. There have been several theories after
the works of MM carried out by several scholars either criticizing or
supporting the Modigliani and Miller Irrelevance theorem. The Trade-off theory
of capital structure suggests that there is an advantage to finance the firm
with debt and also a cost of financing with debt. As a result, firms are
assumed to trade-off the tax benefits of debt with the bankruptcy cost of debt
when making their financing decisions. However, present and potential investors
need single information which is, the value creating potential of the firm no
matter the composition of the firm’s financing mix. Therefore this study had
the following objectives; to determine the impact of debt financing on the
ability of the firm to make profit; to determine the impact of debt financing
on the ability of the firm to maximise the use of its assets; to determine the
impact of debt financing on the firm’s earning power on per share basis; to
determine the impact of debt financing on the ability of the firm to reward
shareholders on per share basis; to determine the impact of debt financing on
the firm’s ability to meet its’ financial obligations as at when due and to
determine whether debt financing enhance the value of Nigerian firms. The ex
post facto research design was adopted to enable the researcher make use of
secondary data and determine cause-effect relationship for twenty-eight quoted
Nigerian firms for the period 2004-2008 on a firm by firm as well as on
aggregate basis. The Ordinary Least Square (OLS) estimation technique was
adopted using SPSS statistical software to evaluate objectives one to five
where ratio values of Total Debt Rate (TDR) was used as the independent
variable while Net Profit Margin (NPM), Total Asset Turnover (TAT), Earnings
Per Share (EPS), Dividend Per Share (DPS) and Current Ratio (CR) as dependent
variables, while adopting a bankruptcy model, the Multiple Discriminant
Analysis Model (MDA) to evaluate objective six using MDA’s Z-score benchmark of
2.675 to determine value (Rashmi and Sinha, 2004; Xing and Cheng, 2005). The
study revealed that on a firm by firm basis there were mix variations of the
impact of Total Debt Rate on the firms’ value parameters (NPM, TAT, EPS, DPS
and CR) across firms sampled while on aggregate basis; there was a positive
non-significant impact of Total Debt Rate on Net Profit Margin; there was a
negative non-significant impact of Total Debt Rate on Asset Turnover Rate;
there was a positive non-significant impact of Total Debt Rate on Earnings per
Share; there was a positive non-significant impact of Total Debt Rate on
Dividend per Share and there was a negative non-significant impact of Total
Debt Rate on Current Ratio and twenty firms created value as a result of the
firms’ use of debt financing representing 71.4% of firms sampled while eight
firms representing 28.6% of firms did not create value. From the foregoing
therefore, the use of debt financing enhances the value of Nigerian firms, thus
could be used to enhance shareholders’ wealth, however further studies could
still be carried out as to determine why some firms did not enhance value as a
result of the used of debt finance in the financial mix of Nigerian firms .
CHAPTER ONE: INTRODUCTION
1.1 BACKGROUND OF THE STUDY
The Modigliani-Miller theorem is one of
the cornerstones of modern corporate finance. At its heart, the theorem is an
irrelevance proposition; the Modigliani-Miller theorem provides conditions
under which a firm’s financial mix does not affect its value. No wonder,
Modigliani (1980, xiii) explains the theorem as follows:
…
with
well-functioning market (and neutral taxes) and rational investors, who can
undo the corporate financial structure by holding positive or negative amount of debt, the market value of
the firm-debt plus equity, depends only on the streams of income generated by
its assets. It follows, in particular, that the value of the firm should not
be affected by the share
In fact, what is currently understood as
the Modigliani-Miller theorem comprises three distinct results from a series of
papers (1958, 1961 and 1963). The first proposition establishes that under
certain conditions, a firm’s debt-equity ratio does not affect its market
value. The second proposition establishes that a firm’s leverage has no effect
on its weighted average cost of capital (that is, the cost of equity capital is
a linear function of the debt-equity ratio) while the third proposition
establishes that the firm’s value is independent of its dividend policy.
Miller
(1991:217) succinctly explains the intuition for the theorem with a simple
analogy, he says;
…think of the firm as a gigantic tub of whole milk.
The
farmer can sell the whole milk as it is, or he can
separate
out the cream and sell it at a considerably higher
price than
the whole milk would bring...
He
continues
…the Modigliani-Miller proposition say that if there
were no
costs of separation (and of course, no government
dairy
support program), the cream plus the skim milk would
bring
the same price as the whole milk...
The essence of Miller’s argument is that,
increasing the amount of debt (cream) lowers the ratio of outstanding equity
(skim milk) – selling off safe cash flows to debtholders which leaves the firm
with more valued equity thus keeping the total value of the firm unchanged. Put
differently, any gain from using more of what might be seem to be a cheaper
debt is offset by the higher cost of riskier
Spurred by Modigliani and Miller’s (1958,
1961 and 1963) arguments, that in an ideal world without taxes a firm’s value
is independent of its debt-equity mix, economists have sought conditions under
which the financial structure of the firm would matter. Economic and financial
theories suggest that several factors influence the debt-equity mix such as
differential taxation of income from different sources, informational
asymmetries, bankruptcy cost/risks, issues of control and dilution and the
agency problem (see Hart, 2001).
Thus, in line with the above, the
question now is? Do corporate financing decisions affect firm’s value? How much
do they add and what factor(s) contribute to this effect? An enormous research
effort, both theoretical and empirical has been devoted towards sensible
answers to these questions since the works of Modigliani and Miller (1953,
1961, and 1963). Several foreign and local scholars have theoretically and
empirically studied the impact of the firm’s financial mix on the value of the
firm from different perspective (see, Jensen and Meckling, 1976; Jensen, 1986;
Fama and Miller, 1972; Myers, 1977; Miller and Scholes, 1978; Elton and Gruber,
1970; among others).
In fact, Elton and Gruber (1970) studied
the link between taxes, financing decisions and firm value and found that
personal taxes make dividend less valuable that capital gain and stock prices
fall by less than the full amount of the dividend on ex-dividend days. Fama and
Miller’s (1972) study on the financial structure of the firm was on leverage
and they argue that leverage (debt finance) can increase the incentive of the
stockholders to make risky investment that shift wealth from bondholders but do
not maximize the combined wealth of security holders, thus, value is not
created. Jensen and Meckling (1976) evaluating financial structure from the
agency cost model submit that higher leverage allow managers to hold a larger
part of its common stock thereby reducing agency problem by closely aligning
the interest of the managers and other stockholders, thus asserting that since
the interest of stockholders are protected, value is created. In another paper
by Jensen (1986), he said leverage (debt finance) used by the firm enhances
value by forcing the firm to pay out resources that might otherwise be wasted
on bad investment by managers......
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Item Type: Postgraduate Material | Attribute: 160 pages | Chapters: 1-5
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