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 profitability 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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