CAPITAL STRUCTURE AND FINANCIAL DECISIONS ON PROFITABILITY OF QUOTED INSURANCE COMPANIES IN THE NIGERIAN STOCK EXCHANGE.

CAPITAL STRUCTURE AND FINANCIAL DECISIONS ON PROFITABILITY OF QUOTED INSURANCE COMPANIES IN THE NIGERIAN STOCK EXCHANGE

This research work is aimed at determining the capital structure and financial decisions, its link to the profitability of quoted insurance companies in the Nigerian stock exchange. So far, most studies on this topic focus on the determinants of capital structure with emphasis on tangibility, liquidity, risk, and growth as the basic factors that will determine the capital structure. Their interests have been majorly on manufacturing industries and composite insurance companies. In this study, the researcher has added size using the natural logarithm of the total assets to depict it and tried to shift focus to the issue of quoted insurance companies as well as go further to x-ray the impact of these determinants to the profitability of this companies. He also went further to establish a relationship between capital structure and profitability. The study has its basis on quoted insurance companies. Hence, comparing it globally and contemporarily. The research work is, therefore, a global and of course an issue-based concept.

CHAPTER ONE

INTRODUCTION

Background of the Study

Capital is an essential tool in every organization. Capital is seen as the life-wire of every venture, be it profit and or non-profit oriented. A business cannot function effectively without adequate capital. A business has three sources through which it can raise funds; the first is the sale of ordinary shares, the second is the proceeds from operating activities, and the third is outsourcing or non-interest bearing. However, the sources of these funds either from in-source or out-source will make the finance team reason together with fundamentals and conclude on the optimal mix of both sources of funds. However, when a firm has a lower level of financial risk by employing lower levels of debt in its capital structure. The reasoning together prompts the capital structure. Therefore, the capital structure according to Abor (2005), capital structure decision plays a very significant role in the financial performance of any company. Capital structure is, therefore, the way a company finances its assets through the mixture of equity, debt or hybrid securities. According to Ubesie (2014) whether a business is newly born or it is ongoing it requires funds to carry out its activities. These funds referred to as capital. Capital therefore to the means of funding a business. Capital structure decision represents the mix of debt and or equity that a company uses to finance its business (Damodaran, 2001.)According to Akeem et al (2004), one of the importance of capital structure is that it is tightly related to the ability of firms to fulfill the needs of various stakeholders. The capital structure represents the claims to a corporation’s assets which includes the different types of both equities and liabilities (Riahi-Belkaonui, 1999). According to Alfred, (2007) as cited in Akeem et al, (2014) a company’s capital structure implies the proportion of debt and equity in the total capital structure of the company. A company’s capital simply refers to the combination of long term debt and equity financing. According to Dare and Sola (2010) as cited in Akeem et al (2014) there are various alternatives to debt equity-ratio. These include 100% equity: 0% debt, 0% equity debt and X% equity: Y% debt. From these three alternatives option, one is that, of the un levered company, that is, the company that shuns the advantage of leverage (if any).  Option two is that of a company that has no equity capital. This option may not be realistic or possible in the real-life economic situation; because no provider of the fund will invest his money in a company without equity capital. This is what it refers to as “Trading on equity”. That is, it is the equity element that is present in capital structures that motivate debt providers to give their scarce resources business (Chechet and Olayiwola, 2014). Option three is the most realistic one in that, it combines both a certain percentage of debt and equity in the capital structure and this, and the advantages of leverage (if any) are exploited. However, the following are the factors that determine capital structure; company size, profitability, risk, company growth, tangibility, liquidity, etc. it is very obvious that the capital structure of a firm is difficult to determine. The extant literature is full of theories on capital structure, following the seminar of Modigliani and Miller (1958), a firm has to issue various securities in a countless mixture to come across particular combinations that can maximize its overall value which means optimal capital structure (Ong& Tech, 2011). Therefore, the issue of how an organization is financed is of paramount importance to both managers and providers of funds. This is because if a wrong mix of finance is employed, the performance and survival of the business enterprise may be seriously affected (Osuji&Odita, 2012). Capital structure is closely linked with corporate performance (Tian&Zeitun, 2007, as cited in Ong& Tech, 2011). Corporate performance can be measured by variables that involve productivity, profitability, growth or, even customers’ satisfaction. Financial measurement is one of the tools which indicate the financial strengths, weaknesses, opportunities, and threats. Those measurements are returned on investment (ROI), residual income (RI), earning per share (EPS), dividend yield, price-earnings ratio, growth in sales, market capitalization, etc. (Barbosa & Louri, 2005).

In both developed and developing countries there has been an argument on the effect of the capital structure of a firm on firm performance (Nwankwo, 2014). According to Akeem et al. (2014) financial constraints have been a major factor affecting corporate firms’ performance in developing countries especially Nigeria. The basis for the determination of the optimal capital structure of corporate sectors in Nigeria is the widening and deepening of various financial markets. Mainly, the corporate sector is characterized by a large number of firms operating in a largely deregulated and increasingly competitive environment. Since 1987, financial liberalization resulting from the Structural Adjustment Program has changed the operating environment of firms, by giving more flexibility to the Nigerian financial managers in choosing their firms’ capital structure. The macroeconomic environment has not been conducive for business while both monetary and fiscal policies of government have not been stable.

After half a century of studies on this great topic, economists and financial experts have not reached an agreement on how and to which extent firms’ capital structure impacts the value of firms, theory performance, and governance. However, the studies and empirical findings of the last decades have at least demonstrated that capitals structure has more importance than was found with the pioneering miller-Modigliani model. We might probably be far from the ideal combination between equity and debt, but the efforts of fifty years of studies have provided evidence that capital st4ucutrr does affect firms” value and future performance. This study contributes to the empirical studies on how capital structure affects a firm’s performance in the Nigerian context.

The insurance companies are businesses that transfer the risk in exchange for the premium obtained from the insured party. The amount collected as premium from insurance policies may be less than the total sum payable for insurance claims. If this happens, the insurer is expected the reimburse the claims from the equity of the insurance company.

The owners (or investors) of insurance companies are concerned with the return and security of their investments. The concern is whether the insurance company will have sufficient solvency and liquidity to meet its obligations towards the insured party. The financial managers objective of maximizing the assets of the shareholders which is dependent on the management of the lower cost of capital,  reaching the debt, etc are all done to reach the optimal capital structure.

Statement of Research Problem

The choice of capital structure has been a problem especially in terms of the ratio to be allocated to each form, i.e. equity and debt financing. It is believed that for any economy to be developed much attention should be given to its financial sector. In the Nigerian economy, interest rates, foreign currency exchange rates, inflation are all high, which makes both the cost of finance and the cost of doing business relatively very high. However, insurance firms in Nigeria, like those in the other parts of the world, take external funding in the form of debt as part of their working capital management, and most especially, to take advantage of tax-deductibility of interest payment. However, studies examining the impact of capital structure on the profitability of the insurance firms appear scanty. This places a strong emphasis on the need to study how capital structure affects the profitability of the insurance firms in Nigeria. Debt and equity are the two major classes of liabilities, with debt holders and equity holders representing the two types of investors in the company. Each of these is associated with different levels of risk, benefits, and control. The appropriate capital structure is a critical decision for any business organization. This is important not only because of the need to maximize returns to various organization constituencies but also because of the impact such decision have on an organizational ability to deal with its competitive environment.

In reality, the real capital structure of a company in difficult to determine. This will give the financial team a very big task to identify the percentage to be allocated to equity and or debt financing.

The ability of the managing team to reason together to conclude on the optimal of both in sourcing and outsourcing of funds is very difficult to identify the point of optimality at the early stage of a business organization.

After half a century of studies on this great topic, economists and financial experts have not reached an agreement on how and to which extent firms” capital structure impacts the value of firms, their performance, and governance.

Poor capital structure decisions may lead to a possible reduction/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 realize gains from its specialized resources. The raising of appropriate fund in an organization will aid the firm in its operation; hence, firms in Nigeria need to know the debt-equity mix that gives an effective and efficient performance, after a good analysis of business operations and obligations.

Objectives of the Study

1. To establish how equity financing affects the profitability of quoted insurance companies in Nigeria.
2. To establish how debt financing affects the profitability of quoted insurance companies in Nigeria.

Research Questions

1. To what extent can equity financing affect the profitability of quoted insurance companies in Nigeria?
2. To what extent can debt financing affect the profitability of quoted insurance companies in Nigeria?

Statement of Research Hypothesis

Our model has the following research hypotheses which are based on the relationship between the capital structure determinants and profitability.

H0₁: There is no significant relationship between equity financing and the profitability of quoted insurance companies in Nigeria.

H0₂: There is no significant relationship between debt financing and the profitability of quoted insurance companies in Nigeria.

Significance of the Study

The study shall be of great significance to educational institutions, insurance companies, corporate and government bodies, the insurance public, researcher, student and the nation at large.

The researcher’s motive on this intrusive research process is to contribute hos quota to the already developed work on the issue.

To provide the basis of recommendations for the empowerment of insurance business on the Nigerian economy, the research has made it a task upon him to review the activities of insurance companies and the benefit of its recapitalization to the Nigerian economy as a whole.

1. To Insurance Companies: This study will give insurance companies a basis to be able to compare the ratio of the capital structure to be used. Such comparison will point out how well they have done and what capacity they still have for expansion. It will also highlight those areas that are still unharnessed with very high potential.
2. To Policy Holders: The study will enlighten them by knowing the competencies of the insurance industries brought about by this decision. Though the capital structure is dependent on so many factors which policyholders do not know the implications it has directly as customers ignorance of such implications excludes customers from taking advantage of such benefits. Hence, this study will go a long way to making policyholders understand, recognize and utilize such benefits.
3. Regulatory Bodies: Regulatory bodies like the NDIC, NAA, NICON, etc. will know how appropriate the rules and regulations set for insurance companies are through this study. It will point out the previous area in which regulatory frameworks have been created and formulated further to cover up loopholes. As insurance companies have been upgraded through the recapitalization exercise, existing regulations should also be upgraded to bring about consistency and this study gives a pointer to those areas. Especially as it affects taxes and dividend payment.
4. Economics or Finance Experts: This study will serve as a basis for comparing, evaluating and analyzing the rate of growth in the financial sector as well as its relationship to other major indicators in the economy; such comparisons may be used to project or predict further state of affairs of the financial sector and the Nigeria economy.
5. The Government: The study will also serve as a guide to the government in the area of policymaking. It is a basis to assess the extent of improvement brought about by the capital structure decisions and how policies in other areas of the economy will lead to benefit derivation and relationship from and between other areas of the economy and implications of the capital structures. The aims of government and various levels of government all fall within this category because they are in charge of governing individuals and activities the promulgation of laws, regulations and policies i.e. judiciary,    execution, legislative, federal, state and local government.

Scope of the Study/Limitations

The scope of this study is based on the capital structure and financial decisions on the performance level of the quoted insurance companies in Nigeria from 2001 through 2015, hence this will help us in finding reasonably, the profitability level of quoted insurance companies in Nigeria. However, the researcher will use a panel source data of which will be sourced through the Nigerian stock exchange NSE, CBN statistical bulletin and annual reports of the quoted insurance companies in Nigeria between these periods to analyze. Funds at the researcher’s disposal for the conduct of this study may not be sufficient data sources especially when it does with panel data may not be a big task to get which could be closely linked to insufficient time to carry out detailed analysis on the study. Though their exist limitations the researcher had made it a priority to come out with reasonable and useful conclusions on the study.

Definition of Terms

Risk: The possibility of suffering damage or loss in the face of uncertainty about the outcome of an action, future events or circumstances. It is the deviation of an actual outcome from the expected outcome in the presence of uncertainty.

financial risk: This is the increased risk of equity holders due to financial gearing. It is due solely to the capital structure of a firm or the level of gearing.

Business Risk: This is the variability in earnings before interest and tax (EBIT) associated with a company’s normal operation.

Weighted Average Cost of Capital (WACC): This is the composite cost of capital representing the aggregate of the various sources of finance in use. It is used as a discount rate in the appraisal of new investments.

Cost of Capital: This is the minimum rate of return required on an investment project, which will maintain the market value per share of at its current level.

Cost of Debt: This is the rate of return expected by the lenders and usually it is specified during the time of debt issue

Corporate Performance Management: It entails reviewing overall business performance and determining how the business can better reach its goals. This requires the alignment of strategic and operational objectives and the business set of activities to manage performance debt.

Organization of the Study

This research has been organized into five chapters. Chapter one considered the general introduction to the research. Chapter two also looked at a literature review of previous studies that other scholars have done which are related to this study. Chapter three is the Research Methodology. Here the method and procedures used for the study have been systematically described. Chapter Four (Results and Discussions) also discussed the results obtained from analyzing the data collected for the studies with respect to what is already known in the literature or in other previous works. Chapter five also summarized the findings from the research, drawn conclusions for the study and made recommendations.