CHAPTER ONE

INTRODUCTION

1.1      BACKGROUND OF THE STUDY

Recent developments within the global economy coupled with the financial crisis and credit crunch in the last decade have made researchers developed further interests in studying the banking sector. Furthermore, because of the increasing spate of globalization, the effect of these incidents has trickled down into the African banking sector hence banks in Africa have been influenced by the changing nature of banking services worldwide (Ahmed & Rehman, 2011). Regardless of such developments, banks are graded on the premise of their profitability, branch network, and customer service. As the main functions of banks are to accumulate surplus funds and make them available to deficit sectors of the economy, they create profits through lending and borrowing activities hence, the larger the size of the bank, the higher the expenditure. However, competition within the banking sector has tightened due to technological advancements and major changes in the financial and monetary environment of banks (Spathis et al., 2014). Since studies have shown an existing relationship between capital structure and bank profitability, there is a need for banks to determine their optimal capital structure to maximize their profitability and minimize losses in order to withstand the competition. The change in the capital structure as well as prudent regulatory capital requirement notwithstanding, some of the deposit money banks still experienced liquidity squeeze in recent years leading to intervention by the CBN, the intervention was considered as the saving grace for the affected banks. However, it is imperative that the deposit money banks determine the most optimal financing mix which minimizes the cost of financing as well as maximizes returns for the banks. To this effect, therefore, analysts and policymakers have expressed divergent opinions as to which of the components of capital available to deposit money banks boost their profitability. In literature, three differing views have been put forward by scholars of corporate finance: First, a positive relationship between high equity-to-debt ratio and firm profitability such that firms depend more on owners’ funds than borrowed funds. The second is a relationship between high debt-to-equity ratio and firm profitability such that firms rely heavily on borrowed funds relatively to owners’ funds. The last scenario depicts a middle position between owners’ funds and borrowed funds. The applicability of any given scenario at any particular point in time, however, depends largely on the cost of financing, particularly of the borrowed funds. Capital structure is the mix of long term sources of a fund such as a debenture, long term debt, preference share capital and equity share capital including reserve and surpluses and retained earnings (Pandey 2015). It is a way firm finances its assets across the blend of debt, equity or hybrid securities (Saad 2010). Capital structure decision is fundamental for any business organization because of the need to maximize return to the various stakeholders and also because of the fact that such a decision has a great impact on the firms’ ability to deal with the competitive environment (Awunyo and Badu, 2012). One crucial issue confronting managers today is how to choose the combination of debt and equity to achieve an optimum capital structure that would minimize costs and maximize return to the owners of the business. Optimum capital structure means the minimum weighted average cost of capital that maximizes the value of the organization (Saeed, 2013). Every manager of organizations attempts to ascertain a particular combination that will minimize costs and maximize profitability and the firm’s value but unfortunately, they do not have a clear cut guideline that they can consult when making the decision in connection with optimal capital structure (Saeed, 2013). Modigliani and Miller (1958) advocated that the market value of the firm is independent of its capital structure. Although their theory is based on non-existing assumptions of perfect market conditions, which include no taxes, no transaction cost, etc. The ruling decisions add no value and are of no concern to managers. The indication would suggest that this does not exist in reality. Traditional school advocates that leverage increase the firms’ value and thereby increase the wealth of the shareholders. However, Barclay and Smith (2005) assert that much debt can destroy a firm’s value by causing financial distress and over investment and too little debts can also lead to underinvestment and negatively affect returns, particularly in large and matured firms. It, therefore, becomes imperative to make the right choice in determining optimal capital structure that will ultimately result in the growth, the value of investment made, the various categories of investors particularly equity investors (Watson and Head 2007). Nigeria is targeted as one of the twenty (20) most developed economies of the world by 2020. The role of the banking sector in achieving this aim cannot be underestimated. The banking sector must, therefore, be strong in performing the basic function of financial intermediation so that the depositor’s confidence can be secured and also be in a position to compete favourably in the global financial market. The relationship between capital structure and profitability is one that should receive considerable attention in the finance literature. The research regarding the effect of capital structure on profitability will help us to know the potential problems in profitability and capital structure. The modern industrial firm must conduct its business in a highly complex and competitive business environment. Therefore, this kind of research findings is benefited in selecting the capital structure to attain the optimum level of the firm’s profitability. This study shows the statistical analysis applied seeking to discover whether there is any relationship between capital structure and profitability of the deposit money banks in the Banks, Finance & Insurance sector.

1.2      STATEMENT OF PROBLEM

Banking sector of Nigeria grew rapidly in last decade, which created new and better opportunities in banking industry, this research tries to find out whether capital structure have a significant impact on the profitability of banks or not. Capital structure mix is a major factor that constitutes profitability of deposit money banks in the world; this is because most banks with healthy mix of both equity and debt are to a large extent performing very well. However, most investors still make very poor investment decision, because they find it difficult to understand the trend of capital structure in most deposit money banks. The problem of this study is to address some of the technicalities involve in understanding the capital structure of deposit money banks in Nigeria. According to Buser (1981), the capital structure decision of a bank is similar to that of a non financial firm. Although there are considerable inter industry differences in the capital structure of firms due to the unique nature of each industry’s business, the intra-firm variations are attributed to the business and financial risk of individual firms. Most studies found a negative relationship between profitability and leverage. Within this framework, Titman & Wessels (2009) contend that firms with high profit levels, all things being equal, would maintain relatively lower debt levels since they can realize such funds from internal sources. Furthermore, Kester (2011) found a significantly negative relation between profitability and debt/asset ratios. Rajan & Zingalas (2016) also confirmed a significantly negative correlation between profitability and leverage in their work. Despite the above empirical works, some authors are of a different opinion. These authors observed a positive relationship between profitability and debt levels in their studies. For example, Taub (2015) in a regression analysis of four profitability metrics against debt ratio found significantly positive association between debt and profitability. Abor (2015) also found a significantly positive relationship between total debt and profitability. From the foregoing discussions based on the available empirical literature, it is crystal clear that results from investigations into the relationship between capital structure and profitability are inconclusive and requires more empirical work. An important question facing deposit money banks or firms in need of new finance is whether to raise debt or equity. In spite of the continuing theoretical debate on capital structure, there is relatively little empirical evidence on how firms actually select between financing instruments at a given point of time in order to attain optimum profitability. Hence, the main problem of this research is to study how the capital structure influences on signalling the bank’s profitability in Nigeria?

1.1      AIMS OF THE STUDY

The major purpose of this study is to examine capital structure, and profitability deposit Money Banks in Nigeria. Other general objectives of the study are:

1. To examine the how capital structure affects the firm efficiency (profitability).

2. To find an optimal capital structure that would be associated with the best performance.

3. To examine the impact of the use of debt and share capital on the profitability of deposit money banks.

4. To examine the impact of capital structure on profitability of deposit money banks.

5. To examine the relationship between capital structure variables and profitability of deposit money banks.

6. To suggest the ways banks can increase profitability through adapting a better strategic framework of capital structure.

1.4 RESEARCH QUESTIONS

1. How does capital structure affects firm efficiency (profitability)?

2. What is the optimal capital structure that would be associated with the best performance?

3. What is the impact of the use of debt and share capital on the profitability of deposit money banks?

4. What is the impact of capital structure on profitability of deposit money banks?

5. What is the relationship between capital structure variables and profitability of deposit money banks?

6. What are the ways banks can increase profitability through adapting a better strategic framework of capital structure?

1.5 RESEARCH HYPOTHESES

Hypothesis 1

H0: Capital Structure has no significant impact on deposit money banking profitability.

H1: Capital Structure has a significant impact on deposit money banking profitability

Hypothesis 2

H0: There is no significant relationship between capital structure variables and profitability of deposit money banks.

H1: There is a significant relationship between capital structure variables and profitability of deposit money banks

1.6 SIGNIFICANCE OF THE STUDY

This study has a number of significant dimensions. The result of this study should provide information to the deposit money banks on the progress so far made in identifying and evaluating capital structure as to enhance growth and profitability of the financial institutions. The result of this study should also reveal how much such progress has impacted on the growth of the entire deposit money banks in Nigeria. The study is very favourable for the citizens who want to know the impacts of capital structure on the banking Industry and the relationship between the current liabilities, long-term liabilities, total liability to assets, total liability to equity, profitability; such as, return on equity, return on assets and EPS. This study recommended to analysts and financial managers should focus on the extreme level of capital structure and the competent use and allocation of resources. This will support to reach the extreme production efficiency in the banking industry of Nigeria.

1.7SCOPE OF THE STUDY 

The study is based on the evaluation of capital structure and profitability of selected deposit money Bank Companies in Nigeria.

1.8 LIMITATION OF STUDY

Financial constraint- Insufficient fund tends to impede the efficiency of the researcher in sourcing for the relevant materials, literature or information and in the process of data collection (internet, questionnaire and interview).

Time constraint- The researcher will simultaneously engage in this study with other academic work. This consequently will cut down on the time devoted for the research work.

1.8 DEFINITION OF TERMS

Management: - This is defined as the process of directing, co-ordination and influencing the operations of an organization so as to obtain desired result and enhance a total performance.

Deposit Money Banks- These are financial institutions, which accept deposit and other loans to the customers.

Money:- This can be defined as anything which passes freely from hand to hand and is generally acceptable in settlement of debt.

Hedging: According to (Ebhalaghe, 2010) defined hedging as a system employed to smoothen out unpredictable fluctuations in financial variables so as to aid planning and avoid embarrassment induced by cash shortfalls.

Capital Structure: Capital structure is a combination of debt and equity that corporate firms used to finance their business operations and growth activities.

Profitability: Profitability is seen as proxy of financial performance, which is one of the main objectives of company’s management.