Table of Contents
2.0 REVIEW OF RELATED LITERATURE
2.1 Theoretical Framework
2.1.1 Pecking order Theory
2.1.2 Trade off Theory
2.1.3 Agency Theory
2.1.4 Irrelevancy Theory
2.1.5 Free Cash flow Theory
2.2 Conceptual Framework
2.2.1 Concept of Financial leverage
2.2.2 Concept of firm Performance
2.3 Empirical Review
This study applies a desktop review to investigate the existing empirical research evidence on the effect of financial leverage on firm performance and reports whether the results are indistinguishable between developed and developing economies. Most businessmen as well as limited liability companies in developed and developing countries such as Nigeria prefer to run their businesses with their personal funds, donations from family members, share capital respectively. This always poses a puzzle as to what amount of debt or equity to use to obtain an optimal capital structure in order to maximize shareholders’ wealth. The findings reveal that the existing empirical crams and conclusions there on are mixed, inconsistent and difficult to generalise. This indicates the pressing need for country, especially Nigeria to engage on studies of this nature.
Background to the Study
One of the most debatable issues in corporate finance literature is the relationship between leverage and firm performance. This debate started with the celebrated irrelevance theorem of Miller and Modigliani (1958) which brought about a revolution in corporate finance. According to this theorem in a perfect capital market, where there are no transaction costs and where perfect rationality and certainty prevails, the capital structure choice is of no relevance. Some of the other renowned contributions to corporate finance are by Jensen and Meckling (1976)“agency theory” and Myers (1984) “pecking order” theory. Interestingly, the origin of pecking order theory, as proposed by Myers, is asymmetric information, meaning that company has more information about company affairs than the outsiders. The view of Jensen and Meckling (1976) is that shareholders prefer high risky and high pay-off projects because they have limited liability if project fail, on the contrary if the project is successful then the shareholders enjoy high residual cash flows after paying the debts. However after a series of modifications made by Jensen and Meckling (1976), it was revealed that the level of debt in a firm financing does have impact on a firm’s behavior and its performance. On the other side, as leverage increases it increase the agency costs because the interests of shareholders and debt holders are different resulting in an increase in the total cost of the company.
The key objective of firm financing decisions is wealth maximization and the quality of any financing decision has an effect on firm’s profitability (Syed, Fasih and Rehman, 2013). Financial decision making is very important for the profitability of any firm. Financial decisions include long term financing and short term financial decisions. The long term decisions are mode of capital sourcing and dividend decisions while the short term financing decisions involve liquidity decisions. The key responsibility of determining the optimal mix of debt and equity that will ensure maximization of shareholders wealth falls under the financial managers (Obonyo, 2015). The capital structure of a firm is the mix of debt and equity the firm uses to finance its real investments (Myers, 2001)
Notably, financial leverage can be described as the extent to which a business or investor is using the borrowed money. Thus, it is a measure of how much firm uses equity and debt to finance its assets. As debt increases, financial leverage increases Maghanga and Kalio (2014). In the words of Dogan (2013), financial leverage is a measure of how much firms use equity and debt to finance its assets. A company can finance its investments by debt and equity. The company may also use preference capital. The rate of interest on debt is fixed irrespective of the company’s rate of return on assets. The financial leverage employed by a company is intended to earn more on the fixed charges funds than their costs. As debt increases, financial leverage increases. In fact, financial leverage is a criterion to measure the application rate of firm capital structure. The managers of the firms, whose liabilities increase to a large extent, normally have more motivation in order to satisfy credit makers via profit management, which shows in the extent of the firm’s performance.
In the same vein, there are two parties that will be concerned about the firm performance due to leverage; one will be equity holders, who are owners of the firm and they carry the highest risk in the business as they have a residual claim to the assets of the firm. They are rewarded through appreciation of the value of their share equity and through dividends. Secondly are the debt holders, they are rewarded through interest payment and their principal will be repaid. They take assets of the firm as collateral and have first claim on the assets of the firm in case of failure to honor the debts by the firm (Harris and Raviv, 1991). Thus, firm performance is a matter of great concern to regulators, practitioners as well as accounting researchers as it is a result of every decision made by manager in the course of steering the affairs of a firm. The study therefore seeks to review empirical evidence on the effect of financial leverage on firm performance.
Statement of the problem
The research problem is to review existing empirical studies on the effect of financial leverage on firm’s performance, and bring out the gap in literature. Most businessmen in developed and developing countries such as Nigeria prefer to run their businesses with their personal funds and donations from family members. The same thing plays out in limited liability companies, they always prefer to use their share capital to run the business rather than mixing the funds with long term borrowing that may pose problem for them in terms of paying interest on yearly basis as well as repayment of principal amounts on maturity. This, however has become a puzzle and also called for optimal capital structure in order to know the exact equity and debt to use for wealth maximization.
Several accounting researchers have empirically examined the relationship between financial leverage and firm performance. For example Syed, Fasih and Rehman (2013), Obonyo (2015), Ashraf, Ahmad and Mehmood (2017), among several others. These researchers reported that financial leverage has positive effect on financial performance while studies such as the ones of Raza(2013), Liu and Li (2013), Yoon and Jang (2005), Myers (1977) reported otherwise. However, the results that could be obtained from developing economies like Nigeria may be quite different given the differences in the nature of economies and the level of sophistication in the monitoring mechanisms. Though there are studies on the subject matter in developing countries such as the studies by Ojo (2012), Cyril (2016), Enekwe, Agu and Eziedo (2014), and several others, there is still need to explicitly research on this topic as more countries, especially developing countries where business environment is not yet sophisticated, need to find an optimal capital structure that can increase shareholders’ wealth.
This study is therefore designed to make a review of existing empirical literature on the effect of financial leverage on firm performance. The study also adopts the secondary sources of data from articles selected from top accounting journals and research papers on the subject matter so as to guarantee the validity and reliability of the research. The documents reviewed are substantially related to the effect of financial leverage on firm performance. The rest of this paper is organized as follows; section 2 presents review of the related literature; section 3 gives conclusion and lastly section 4 provides the recommendation for the study.
2.0 REVIEW OF RELATED LITERATURE
This section is divided into theoretical framework, conceptual framework, and empirical review subheadings
2.1 Theoretical Framework
This section reviews the theories of earnings management.
2.1.1 Pecking order Theory
The pecking order theory articulated by Myers and Majluf (1984) and Myers (1984), state that firms having high profits tend to attain low debt profile because when firms are more profitable, their first priority is to generate financing through retained earnings because they maximize the value of the existing shareholders. If retained earnings are not sufficient, the firms can then go for debt and if further financing is required they issue new equity. The retained earnings is preferred because it almost has no cost, but if the external resources are used for financing like issuance of new shares it may take very high costs. So we can conclude that if firm is profitable its retained earnings will be high and it will use its retained earnings for its financial needs, so it employees that there is negative relationship between leverage and firms profitability. While firms with low retained earnings will relay on debt financing. This theory reflects problems created by asymmetric information between managers and investors.
This theory, interestingly come to stand as a result of information asymmetries existing between insiders of the firm and outsiders (Siyanbola, Olaoye and Olurin, 2015). The model leads to managers to adopt their financing policy to minimize these associated costs. It means that they will prefer internal financing to external financing and very risky debt to equity. In another words, Ojo (2012) opined that if managers have more information than other parties then information costs rises. Thus firms will prefer issuing shares when they are overvalued or last resort. Managers will use pecking order by first using internally generated funds. If more funds is required then go for cheap debt (capital with fixed interest) before equity (capital with variable interest rate) in financing the firms activities.
2.1.2 Trade off Theory
The static trade off theory explains the concept of capital structure from the optimum point of view, that is, optimum requires a trade off, for example between the tax advantages of borrowed money and the cost of financial distress when the firms find out it has borrowed too much. A value maximizing firm would equate benefit and cost at the margin.
The theory refers to the idea that a company chooses how much debt finance and how much equity finance to use by balancing the costs and the benefits. The classical version of the hypothesis goes back to Kraus and Litzenberger who considered a balance between the dead weight costs of bankruptcy and the tax saving benefits of debt. The theory assumes that there are benefits to leverage within the capital structure of the firm until the optimal capital structure is reached.
2.1.3 Agency Theory
Another theory is the agency theory which is more like asymmetry of information as stockholders favour high-risk projects, in contract with the preferences of debt holders (Jensen & Meckling, 1976). In practice, there may exist a conflict of interest among shareholders, debt holders and management. These conflicts give rise to agency problems, thus, have influence on the firm’s capital structure. These authors identify in fact two types of conflicts that have different implications leading to opposite theories on the link leverage-performance. Firstly, agency costs result from the conflicts of interest between shareholders and managers. The key problem here is the moral hazard behavior of managers that can waste firm resources or minimize their effort rather than increasing firm value, as they have their own objectives. In this way, debt financing raises the pressure of managers to perform (meaning to reduce their waste of resources and to increase their effort) as it reduces “free cash-flow” at the disposal of managers (Jensen, 1986).
Secondly, agency costs also arise because of the conflicts of interest between shareholders and debtholders. Indeed shareholders have incentives to take actions that benefit themselves at the expense of debtholders, and consequently that do not necessarily maximize firm value. This divergence of interests has two manifestations. On one hand, it gives incentives to shareholders to invest in riskier projects than those preferred by debtholders (Jensen and Meckling, 1976). On the other hand, conflicts between shareholders and debtholders can also create underinvestment, as demonstrated by Myers (1977). As a result, the agency costs resulting from the conflicts of interest shareholders-debtholders suggest that a higher leverage is correlated with a lower firm performance.
- Quote paper
- John Joseph (Author), 2018, The Leverage Effect on Financial Performance. A Review of Empirical Evidence, Munich, GRIN Verlag, https://www.grin.com/document/429684