EFFECTS OF FINANCIAL LEVERAGE ON COMPANY PERFORMANCE (A CASE STUDY OF NIGERIA BOTTLING COMPANY)

CHAPTER ONE

1. 1.    INTRODUCTION

1.2 BACKGROUND OF THE STUDY

Firms at every stage of growth and development, from concept to maturity need fund in order to survive. The aim of every business is to maximize the wealth and welfare of its owners.

Without finance, the aim of every business cannot be met. This finance can be said to be the life wire or spinal cord of any firm.

Financing is the acquisition of cash or other assets through means such as the sale of stocks, retaining net profit and increase of debts. A firm’s capitalization consists of internally generated funds and due to the fact that a company may not be able to raise all the funds which it requires internally, it may depend on additional external financing.

This capitalization of the firm would therefore incorporate both internally generated funds and external funds which comprise both short and long term loans.

Financial leverage, the subject matter of this study, has to do with the use of external, funds in generating profit for the firm which is primarily the maximization of shareholders wealth and welfare. Usually, there exist varying financing structures. A simple common stock structure is one whereby no use is made common stock structure does not have the ability of enjoying the advantages of financing leverage. The use of financing leverage causes the financial structure of a firm being simple and also the impact the owners have on the firm increases by the issuing of common stock whereas the claims the creditors have on the firm, increases with the use of borrowed funds.

Leverage therefore is greatly considered when investment is being undertaken by investors. By this, investors prefer a firm that is less levered than one that is highly levered.

However, the level of activity that can take place in a firm depends on the level of activity that goes on in the economy. The economy has a direct effect on the activity of the firm and assists such firms with debt financing.

1.3     STATEMENT OF THE PROBLEM

          Companies that use debt and equity as a source of financing are bound to face some ups and downs. The Nigeria Bottling PLC tends to face:

i)       At some point in time there exist indiscriminate issue of common shares to the general public, to this end, it results in the dilution of corporate control.

This is usually the case, if there are no pre-emptive rights entrenched in the regulation of the company.

ii)      The use of other debt instruments and common stock gives the new common stock owners the right to enjoy the same source of profit as the long standing holders of common stock in the organization.

This is unfair to the existing shareholders, who have toiled over the years with the firm.

iii)     Dividend payment to the owners of the equity is not a tax deductible expense. To Nigeria Bottling Company, debt instrument were used for financing. To this effect, interest payment on such instruments should be tax deductible.

iv)     Excessive use of debt and equity might result in over categorization of the firm. Hence, a decline in further earnings.

v)      Indiscriminate use of debt and equity as a source of financing eliminates   the benefits of trading on equity.

vi)     The cost of floating new issues is often very prohibitive, the funds expended in investigation and underwriting stock and debt in the excess of the cost used in issuing debt instruments.

1. 1. RESEARCH QUESTIONS

In-order to elicit information from respondents, the following research questions were generated:

1. How can the effects of financial leverage be analyzed on the performance of a company?
2. What are the relationships between the levels of debt carried out by the company?
3. In which way can the economic condition prevail to find out its effect on the company cost capital?
4. In analyzing the debt and equity of the company performance (The Nigeria Bottling Company) on capitalization, what are the things that are likely to result?
5. How do we investigate the stock and the debt in the excess of the cost used in issuing debt instrument?
6. What are the effects of the operations of the economy which the company operates?

1.5     OBJECTIVES OF THE STUDY

The objective of the study includes the following:

1. To analyze the possible effects of financial leverage on the company’s performance.
2. To establish the relationship between the level of debt carried by the company and its profit
3. Also with regard to the economic condition that prevail, to find out its effect on the company cost of capital
4. To analyze the debt and equity which might result in over capitalization of the firm.

1. To investigate and underwrite stocks and debt in the excess of the cost used in issuing debt instrument.
2. Finally, the sector of the economy which the company operates would be critically reviewed in order to find out how it affects the operations of the firm therein.

1.6   SIGNIFICANCE OF THE STUDY

The significant of the study is to enable us to evaluate how the economy affects the performance of the Nigeria Bottling Company PLC.

This study will therefore enhance an understanding on how financial leverage can be said to thrive well in an economy that employs more funds to increase investment and as such, profit tends to increase.

The study will be of utmost importance to the school library, students in management and for future project writers and researchers who wish to use it as reference for their study.

1. 1.      STATEMENT OF RESEARCH HYPOTHESIS

HYPOTHESIS 1

HO:   The economic environment within the period of study does not affect the level of debt financing by the firm under study.

HI:     The economic environment within the period of study affects the level of financing by the firm under study i.e. the Nigeria Bottling Company.        

HYPOTHESIS 2

HO:   The level of debt financing employed does not affect the performance of the firm under study.

HI:     The level of debt financing employed affects the performance of the firm under study.

HYPOTHESIS 3

HO:   The state of economy measured by the Gross Domestic Product does not affect the performance of Nigeria Bottling Company PLC.

HI:     The state of the economy measured by the Gross Domestic Product affects the performances of the firm under study.

NOTE:

HO:   Implies Null Hypothesis

HI:     Implies Alternative Hypothesis.

1. 1.          JUSTIFICATION OF THE STUDY

Several studies have been conducted to examine the performance of companies through financial leverage, especially in developed countries.

Despite the large volume of literature in developed countries on the sensitivity of financial leverage, there are dearth of such researches in developing countries, especially in Africa and Nigeria to be precise.

Some scholars and authors such as; Determinant of Dividend Decisions (Inanga, 1975 and 1978), The Corporate cost of capital (Inanga, 1987), Financial Decisions (Soyode 1978, Oyejide 1987, Ariyo, 1999, Adelegan 2007).

These literature texts show that financial leverage is significantly important for the overall performance of a company.

This project work however, seeks to contribute to the existing bodies of literature by examining effects of financial leverage on company’s performance citing the Nigeria Bottling company as case study.

Since economic environment is dynamic rather than static, this study is not only crucial but also justifiable. Considering the fact that Nigeria is still struggling to emanate from the recent economic recession which had a great impact on the financial sector where manufacturing firms seek to fund their investment.

In terms of policy contribution, this project will help the policy makers, especially the financial sector of the economy, to formulate and implement policies that can aid leverages on finance for companies so as to realize their potentials in investment, employment of labour and contribution to economic growth.

1. 1.          SCOPE OF THE STUDY

The scope of this study centers on the company within the manufacturing sector of the Nigerian economy. “NIGERIA BOTTLING COMPANY PLC” a rational analysis would be carried out in order to reach a final objective conclusion.

The limitation of the study includes data, since data used are only data in published reports for financial analysis.

The confidentially of such data is therefore reserved to the company. Given the economic trend i.e. inflation which affect the levels of activities of the firm as well as firms with debt financing also.

1. 1. DEFINITION OF TERMS
2. FINANCE

This is the income of a company raised and administered. It deals with methods for supplying capital needed to acquire, develop and operate real property

1. FINANCING INVESTMENT

This is the purchase of simple stock or bond compared to real investment in a capital asset such as real estate or plant and machinery.

1. FINANCIAL LEVERAGE

This is the use of external financing in order to raise the profit of the company that employs it. It has effect on the per share earnings of the common stock of a company when large sums must be paid for bond interest or preferred stock dividend or both, before the common stock is established to share in earnings.

Financial leverage may be advantageous for the common stock when earning are good enough but may work against the common stock when earning decline.

4.       DEBT FINANCING

 This is the long term borrowing of money for business, usually in exchange for debt securities, for the purpose of obtaining working capital or other funds necessary for operational needs.

1. EQUITY FINANCING

This is the acquisition of money for capital or operating purposes in exchange for a share or shares in the business being financed.