Page 1 of 16

Journal for Studies in Management and Planning

Available at

http://edupediapublications.org/journals/index.php/JSMaP/

ISSN: 2395-0463

Volume 03 Issue 08

July 2017

Available online: http://edupediapublications.org/journals/index.php/JSMaP/ P a g e | 393

Determining the Effect of Capital Structure on the

Performance of Deposit Money Banks: Evidence from Nigeria

BY

PAUL, NDUBUISI Ph.D

Abstract

This study sets out to evaluate the effect

of capital structure on the performance

of Deposit Money Banks (DMBs) using

Nigeria as reference point. Data for the

study were obtained from secondary

sources specifically from the audited

annual financial reports of some selected

Deposit Money Banks in Nigeria. The

data were analysed using Autoregressive

Distributed Lag (ARDL) method.

Findings revealed mixed impact of

capital structure variables on

performance indicators. The result also

showed positive relationship between

bank size and performance indicators

used in the study. Despite the mixed

results, the study recommends that

bank management should place more

emphasis on using retained earnings to

finance investments followed by owners

equity in that order as recommended by

pecking order theory.

Keywords: Pecking order theory,

capital structure, return

on asset, return on equity,

bank performance

INTRODUCTION

Corporate financing decisions, one of the

four major corporate decisions, are quite

complex processes. Theories in

corporate finance may only have

explained certain facets of the diversity

and complexity of financing choices.

Researches over the years have given no

accepted conclusion on the exact

determinants and relationship between

capital structure and firm performance in

either developed or emerging

economics. Graham and Harvey (2001)

argued that, although a lot of studies

have been done in investigating capital

structure of the firms, the results

obtained are still unclear. This,

according to them, might be due to

wrong measurement of key variables,

investigation on wrong models or issues,

misspecification of managerial decision

process or unresponsive of owner- managers. Capital structure is very

important DMBs because it has an

impact on long-term corporate profits,

(Aurangzeb and Hag, 2012), It

represents the banks financial framework

which consists of the debt and equity

used to finance the firm. Decision

regarding type of capital structure of a

bank should play a critical role since

capital impacts on profitability and

solvency of Deposit Money Banks

(DMBs).

An optimum capital structure which

gives maximum returns to shareholders

plays an important role in the growth

and .progress of any bank. As in Singh

and Singh (2016), assert that "the proper

and right combination of debt and equity

will always lead to market value

Page 2 of 16

Journal for Studies in Management and Planning

Available at

http://edupediapublications.org/journals/index.php/JSMaP/

ISSN: 2395-0463

Volume 03 Issue 08

July 2017

Available online: http://edupediapublications.org/journals/index.php/JSMaP/ P a g e | 394

enhancement". In making capital

structure decisions managers should

consider the significant difference

between the industry and the individual

banks.

The effective management of capital

structure ensures the availability of

required fund to finance the future

growth and enhance the financial

performance of the firm. Capital

structure is the combination of debt and

equity that finance the banks strategic

plan. Gitman (2009) emphases that

capital structure policy is a policy

concerning the optimal combination of

the use of external and internal sources

of funds to finance an investment and

also to support the banks operations in

an effort to increase its profits and

achieve a higher value. It is important to

have optimal combination of funds from

internal and external sources in banks

capital structure to avoid a highly

leveraged bank, with maximum debt

source of finance in its capital structure

which results in the bank finding-its

freedom of action restricted by its

creditors and may have its profitability

affected with the payment of higher

interest costs.

The problem financial managers are

faced with in capital structure decision is

that there is yet no clear cut guideline

that can be consulted when taking

decision regarding optimal capital

structure. An optimal capital structure

enhances the competency of the firm and

impacts higher returns to shareholders

compared to the return provided by an

all equity firm. Akinsurile (2008) argues

that most financial managers make

capital structure decisions not

necessarily out of empirically verified

evidence. Myers (2001) asserts that large

number of business failures in the past

have been due to the inability of the

financial managers to correctly identify

and take advantage of the economical

sources of financing for their firms based

on empirically verified information.

Studies on capital structure are mostly

carried out in developed countries. Only

few studies have been conducted in

developing countries including Nigeria.

The banking industry in Nigeria is an

important sector that is yet to be given

special importance in the capital

structure study.

Capital structure theories, such as trade- off, pecking order and agency cost

theories have been developed to

explained capital structure, but the

problem of optimal capital structure is

still one of the central problems of

corporate finance and has attracted much

attention as a research fertile area

(Noulas and Genimakis, 2011 and

Olayinka, 2011). For these many years

researchers have studied the impact of

capital structure on banks performance,

they still cannot agree on the extent of

the impact.

Although there are existing theoretical

frameworks from finance and strategic

management set out to explain the

determinants of capital structure and the

impact of capital structure on bank

performance, there is still no agreement

among economists and other researchers

in finance as to which of the existing

theories present the best description of

the actual behaviour of banks. With the

mixed and conflicting results from

various studies, the quest for

Page 3 of 16

Journal for Studies in Management and Planning

Available at

http://edupediapublications.org/journals/index.php/JSMaP/

ISSN: 2395-0463

Volume 03 Issue 08

July 2017

Available online: http://edupediapublications.org/journals/index.php/JSMaP/ P a g e | 395

determining the effect of capital

structure on performance of deposit

money banks with Nigeria as reference

point is the focal point of this study.

2.1 Theoretical Framework

The theory of capital structure was first

developed by Modigliani and Miller

(1958), M&M Theory assumes that the

market is perfect and everyone in the

market has perfect information, and no

one individual can influence the price;

there is a single rate of interest for

borrowing and lending; there are no

homogeneous products and that there

exist investors who are rational and no

personal or corporate taxation exist.

These assumptions generated more

researches by scholars since their theory

predicts 100% debt financing (due to

substantial corporate tax benefit), which

is not observed in practice.

M&M theoretical proposition carries the

implications that: (1) financing and

investment policies are independent, (2)

internal and external financing are

perfect substitutes; and (3) the specific

type of the financing contractual

arrangement, either-equity or debt is also

irrelevant. Frank and Goyal (2008)

contend that some of the most common

elements are consideration of taxes,

transaction costs, bankruptcy costs,

agency conflicts, adverse selection, lack

of separability between financing and

operations, time-varying financial

market opportunities and investor

clients' effects.

The trade-off theory of capital structure

states that an organisation's capital is

constituted by both debt and equity and

that their ratio (debt-equity ratio) is a

trade-off between its interest tax shields

and the costs of financial distress. The

theory states that there is an advantage

of financing through debts due to tax

benefit of the debts. However, some

costs arise as a result of debt costs,

bankrupt costs and non-bankrupt costs.

The tax benefit among other factors,

makes the after-tax cost of debt lower

and hence the weighted average cost of

capital (WACC) will also be lower

(Anarfor, 2015). Brigham and Gapenski

(1996) argue that an optimal capital

structure can be obtained if there exist

tax benefit which is equal to bankruptcy

cost. According to the theory, the take is

that as the debt-equity (D/E) ratio

increases then there is a trade-off

between bankruptcy and tax shield and

this as a result, causes an optimal capital

structure for the firm. Despite the

theoretical appeal of debt financing,

researchers of capital structure have not

found the optimal capital structure

(Simerly & Li, 2000).

The pecking-order theory of capital

structure developed by Myers (1984)

and Myers and Majilu (1984) is of the

essence that firm will adhere to the

hierarchy of financing by preferring to

finance itself from internally generated

funds, because the use of such funds

does not send any negative signal that

may lower the stock price of the firm.

When internal finances are depleted, it

will opt for equity (Anarfor, 2015). The

assumption of this theory is that firms

will always follow the hierarchy of

financing through internal funds and

finally as a last resort, finance through

equity which may not be true in practice.

Myers and Majluf (1984) further

postulate that firms that make high