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Impact of Financial Leverage on Firm Value

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Published: Mon, 04 Sep 2017

Introduction

If there is debt in a company’s capital, such a company is termed leveraged or geared company.

A gearing ratio demonstrates the relationship between fixed interest and equity capital in the finance of a business Measured:

Fixed Interest Capital OR Fixed Interest Capital

Capital Employed Equity

The financial lever is a norm in measuring the scale of using debt in the firm’s capital structure. One of the most important issues in financial discussions is obtaining a blend of capital structure which has the most attractions for the investors. The structure of capital is a required link between debt and the equity that provides financial needs for preparing the company’s properties.

STATEMENT OF RESEARCH QUESTION

There is a negative and significant correlation between financial leverage and firm.

1.There is a negative and significant correlation between financial leverage and earnings per share

2.There is a negative and significant correlation between financial leverage and price earnings ratio.

3.There is a negative and significant correlation between financial leverage and returns to equity.

4.There is a negative and significant correlation between financial leverage and operating profit.

WHY INTERESTING

The above research questions are interesting as they will address the following:

Provide answer on the impact of gearing on the firm’s value; reconcile the argument as to whether financial leverage has relationship with earning per share; the level of correlation between financial leverage and price earnings ratio as well as operational profit. The questions will also seek to highlight the risks associated with leverage.

Relation to previous research (Theoretical Framework)

CAPITAL STRUCTURE THEORIES

A company’s capital structure shows all the sources of finance a company is utilizing to finance its operations.

Capital structure refers to how a company finances its operations and it is usually made up of:

  1. Ordinary share capital
  2. Preference share capital
  3. Debt capital.

There are two main theories about the effect of changes in gearing on the WACC and share value. There are:

a.The traditional view

b.The net operating income approach

For which a behavioral justification was proposed by Franco Modigliani and Melton H. Miller (M & M) in 1958 (Gitman, 2006).

TRADITIONAL VIEW

The traditional view states that debt capital is cheaper than equity and that such a company can increase its value by borrowing up to a reasonable limit (the “optimal” level of gearing).

Return Kw

Ke

Kd

P GEARING

With the traditional theory, the following assumptions hold sway:  

1.The cost of debt will remain constant until a significant point is reached when it would start to rise.

2.The WACC will fill immediately an external source of finance is introduced and will bring thereafter as the level of gearing increases.

3.The company’s market value and the market value per share will be maximized where WACC is at the lowest point.

M-M’S SUPPORT OF THE OPERATING INCOME APPROACH

The original normative theory of company valuation and capital structure was put forward in form of a behavioral justification of the Net Operating Income Approach by Franco Modigliani and Melton H. Miller (M-M) in 1958 (Gitman, 2006).

To appreciate the propositions by M-M, it will be better to understand the M-M assumptions which are stated below.

From these assumptions, M-M set out their three propositions.

PROPOSITION I

This states that a company cannot change the total value of its securities just by splitting its cash flow into different streams; the company’s value is determined by its real assets, not by the securities it issues. Thus, capital structure is irrelevant if the company’s investment decisions are taken as given.

PROPOSITION II

The expected rate of return on the equity of a geared company increases in proposition to the debt-equity ratio (debt/equity), expressed in market values; the rate of increase depends on the spread between the expected rate of return on a portfolio of all the company’s securities, and the expected return on the debt.

PROPOSITION III

This provides a rule for optimal investment policy by the company: “The cut – off point for investment in the company will in all cases be the WACC and will be completely unaffected by the types of security used to finance the investment.

Consequently, if the first two propositions hold, the cut-off rate used to evaluate investments will not be affected by the type of funding used to finance them, whatever may be the capital structure. The gain from using debt (at lower cost) is offset by the increased cost of equity (due to increased risk) and WACC therefore remains unchanged.

Proposed methods

STATEMENT OF METHOD

Secondary data from financial database will be used.

To determine the impact of leverage on the value of firm, a thorough study will be taken on each entity in the integrated chain.

My choice of the above data collection method rested on their validity and research question. I also consider them to be less costly in relation to others.

The study will try to integrate various academic literatures and examine the impact of financial leverage on the value of firms. Therefore, I shall obtain unbalanced panel comprising 25 companies listed on the Nigerian Stock Exchange for the period ranging from 2001- 2010 with relevant information over the last years. These firms and their published accounts will be used to determine the variable that will be stated.

CHOICE OF THEORY

There are two basic theories about the impact of financial leverage on firm’s value; the traditional theory and the Modigliani & Miller’s theory. I shall base my study on the theory which seem more realistic with empirical fact.

CAPITAL STRUCTURE

In the academic literature, there two possible indictors of capital structure, namely, debt-equity ratio, defined as total debt divided by book value of common equity, and a ratio of debt total assets. In this analysis, the ratio of debt to common equity will be used. This will be more useful to explain the choice of a capital structure as compared to the ratio of debt to total assets. This variable shall be denoted as CS in our analysis.

DATA COLLECTION

The collection tools for the research project includes: – Financial times statistical data from Nigerian Stock Exchange, Augusto rating on debt Equity Companies, Financial Index Journal.

Others tool include the company’s annual reports and account, the internet, financial newspaper particularly, Thisday, Institute of Chartered Accountants of Nigeria (ICAN) journals, Financial Standard, Business Times and some other foreign journal consulted at various library.

The testing technique to be employed is regression and correlation analysis with the chi-square X2 distribution, which allows comparisons of an actual observed distribution with a hypothesized or expected distribution.

This method is often referred to as a “goodness of fit” test.

SAMPLE FRAME

The secondary data above will be used in addition to the financial statement and Accounts of selected companies: – Nigerian Breweries Plc, Pharma Deko Plc and Evans Medicals Plc. The result of the investigation will be analyzed and tested.

The firm size shall be determined by its log of sales as published in their financial statements. Firms turnover as a percentage of capital employed will be used in our model. It is often argued that performance is a function of firm size and if we are to make a regression model with performance as response variable, it is important to incorporate firm size in our model. Firm size may be positively or negatively related to leverage. Odeleye (2014) come forward with the idea that large firms may exercise economies of scale, have better knowledge of markets and can employ better management personnel. Firm size also measures a firm’s market power or level of concentration within the industry.

Reflections

Finance: The execution of this project required substantial financial outlay. The sourcing and gathering of data, paying working visit to firm, conducting enquiry to the operations of the company and packaging available information into coherent project, required funding.

Time: It takes time to conduct inquiry, investigation as well as gather, compile analysis and interprets data and then organizes them into a research work. The researcher worked under severe constraints of time as there was a deadline for the submission of the project.

Attitude of the Practitioner: Although some information was readily provided by staff of the organization, a few other relevant ones were considered as confidential and strenuous efforts had to be made to collect some of the information that were regarded as confidential.

Altogether, the limitations were so severe as to vitiate the research outcome, more especially because the researcher managed to overcome the obstacle. Physically, only some selected leveraged companies in manufacturing activities as an option for growth enhancement of market are included to minimize the expenses.

Another limitation is that not all leveraged companies turn out to be successful in relation to market values; this research does not cover those companies.

I obtained all the necessary information I needed for empirical analysis considering the advanced nature of the financial reporting of the firms under review which confounds to international standard? The financial regulation in Nigeria might not be up to date with respect to submission of financial statement.

The gathering of data from some of the company’s department required some payment. This expenses which was budgeted for constituted a challenge, yet there was a possibility of missing some data which is not found on the financial statement of the companies.

This study was carried out with a sample of firms listed on the Nigeria Stock Exchange. The first empirical obstacle will be the availability of data for a minimum of ten trading years for the firms under study. The financial regulations in Nigeria require firms to submit their audited financial statements as well as certain information regarding their firm’s value. However, the data submitted by firms are in hard copy format and they are thus stored at the company’s department in paper format. Given that availability is limited to hard copies, I feel that I will need to bear into mind the time factor involved in the manual gathering of relevant data. Moreover, data regarding a single company might be in different volumes and this might involve delay out of proportion in this assignment.

Timetable

July 2015 – Proposal Submission

August 2015 – Proposal Approval

September/October 2015 – Literature review

November 2015 – submission and amendment of chapter 1based on examiners approval/comment

December 2015 – submission and amendment of chapter 2 based on examiners approval/comment

January 2016 – submission and amendment of chapter 3 and 4 based on examiners approval/comment

February 2016 – submission and amendment of chapter 5 based on examiners approval/comment

March 2016 – Proof reading, final editing, printing/binding and project submission

References

Akinsulire, O. (2002), Financial Management 2002. COEMOL Nig. Ltd

Gitman, L. (2006). Leverage and Capital Structure (4TH Ed). Boston: Pearson Anderson Wiley.

Odeleye, A. (2014) Corporate Financing and Efficiency of Indigenous Energy Firms in Nigeria: A literature Review. International Journal of Energy Economics and Policy. 4(1).


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