Determinants of Capital Structure of Listed Construction Companies in Nigeria

CHAPTER ONE

INTRODUCTION

1.1 Background to the Study

Financing plays a vital role in the success and sustainability of any firm. Every business needs funds at its startup stage and throughout its growth and operational phases (Panda, 2006). However, scholars have debated the most effective and efficient methods of sourcing funds. The inadequacy of funds often leads to poor business performance. Therefore, determining a company’s capital requirements in advance is essential for continuity and stability.

Firms have several financing options, and choosing the most suitable source is critical for achieving financial stability. The choice of an appropriate source of funds helps to identify an optimal capital structure (Vermaelen & Xu, 2010; Lasher, 2011). According to Lasher (2011), the capital structure of a firm reflects how effectively it manages its financing mix. Meanwhile, determinants of capital structure vary and are influenced by both internal and external factors. These factors may include the company’s business nature, purpose of financing, management attitude, government policy, financial advice, and legal requirements (Huang & Ritter, 2007).

Interestingly, companies within the same industry may adopt very different financing structures. For instance, Apple’s capital comprises about one-third debt, while Dell finances its operations with debt amounting to 76% of its total assets (Apple Annual Report, 2013; Dell Annual Report, 2013). These variations raise the question of why managers in similar sectors prefer different financing methods. Several theories attempt to explain these differences, including the trade-off theory, pecking order theory, and market timing theory.

According to Sogorb-Mira and Lopez-Gracia (2003), firms generally aim to achieve a target or optimal leverage ratio. However, Vermaelen and Xu (2010) observed that the trade-off theory does not apply universally. Under the pecking order theory, firms prioritize internal financing, followed by debt, and finally equity financing. Yet, Frank and Goyal (2003) found that empirical evidence contradicts this model, showing that equity issuance often correlates more strongly with financing deficits than debt issuance.

The market timing theory offers another explanation. Setyawan (2012), studying Indonesian firms, found that market-to-book ratio negatively affects market leverage. Similarly, Elliott et al. (2008) confirmed this theory by showing that equity mispricing influences financing decisions. They employed an earnings-based valuation model to distinguish between market mispricing, growth options, and adverse selection.

Furthermore, Zhang and Li (2008) discovered that a higher debt-to-asset ratio increases agency costs, as managers become more accountable to shareholders to avoid insolvency. Based on these findings, it is important to analyze the factors that determine capital structure among Nigerian construction firms. This study seeks to contribute to this growing body of knowledge by examining how specific determinants influence leverage in Nigeria’s construction sector.

1.2 Statement of the Problem

The debate over the relationship between capital structure and financial performance remains unresolved. Scholars disagree on which factors most strongly predict the financing choices of manufacturing and construction firms. Determining an optimal capital structure is complex because firms must balance different securities to achieve the best value and lowest capital cost (Rahul, 1997). Poor financing choices can reduce the value of strategic assets, highlighting the need for sound financial management policies.

Although several international studies have explored this relationship, their findings remain inconsistent. In Nigeria, past research has often excluded certain components of capital structure, creating significant knowledge gaps. For instance, Salawu (2007) examined capital structure and firm performance between 1990 and 2004 but focused mainly on short-term debt. His findings, therefore, have limited applicability to long-term financing decisions. Similarly, Babalola (2012) studied optimal capital structure using total debt to total assets but omitted other measures such as total debt to equity, short-term debt, and long-term debt.

Many earlier Nigerian studies, including Bello and Onyesom (2005), Olokoyo (2012), and Yinusa and Babalola (2012), also relied on chi-square analysis. This method fails to capture time-based variations and firm-specific effects, making their conclusions less robust. In addition, Yinusa and Babalola (2012) only examined firms in the food and beverage sector, leaving the construction industry under-researched.

Sebastian and Rapuluchukwu (2012) studied capital structure and liquidity but failed to include total debt to total equity ratios. Similarly, Idode et al. (2014) examined capital structure and profitability in banks but excluded short-term and long-term debt components. Consequently, the literature on Nigeria’s capital structure remains incomplete and fragmented.

Therefore, this study aims to fill these gaps by analyzing how total debt to assets, total debt to equity, and both short- and long-term debt ratios affect the performance of listed construction companies in Nigeria.

1.3 Research Questions

This study seeks to answer the following research questions:

1. How does firm size influence the performance of listed construction companies in Nigeria?

2. To what extent does total debt to total asset ratio affect their financial performance?

3. What is the impact of total debt to total equity ratio on the financial performance of these companies?

1.4 Objectives of the Study

The main objective of this study is to examine the determinants of capital structure among listed construction companies in Nigeria. The specific objectives are:

1. To analyze how firm size affects the performance of listed construction companies in Nigeria.

2. To determine how total debt to total assets influences their financial performance.

3. To assess the effect of total debt to total equity on financial performance.

1.5 Research Hypotheses

The following hypotheses will guide the study:

1. There is a significant relationship between total debt to total equity ratio and financial performance of listed construction firms in Nigeria.

2. There is a significant correlation between firm size and financial performance.

3. There is no significant relationship between total assets to total equity ratio and financial performance.

1.6 Significance of the Study

This research contributes to existing literature on capital structure and financial performance, focusing specifically on Nigeria’s construction sector. Previous studies have concentrated on manufacturing and banking sectors, leaving construction underexplored. Therefore, this study fills a crucial gap and provides a foundation for further research.

Moreover, the findings will benefit managers, investors, and policymakers. Managers can use the results to make better financing decisions that enhance profitability. Investors can use the insights to evaluate firms’ creditworthiness and growth potential. Additionally, government agencies may adopt the findings to design favorable financial policies that encourage investment and improve the sector’s contribution to GDP.

Ultimately, improved financial performance in construction firms will increase employment opportunities and support Nigeria’s economic development.

1.7 Scope of the Study

This study focuses on the determinants of capital structure of listed construction companies in Nigeria. It covers a six-year period, from 2013 to 2018, a timeframe that coincides with key policy reforms in the construction industry. The independent variables are total debt to total assets, total debt to equity, short-term debt to total assets, and long-term debt to total assets. The dependent variable is financial performance, measured by return on assets.

1.8 Limitations of the Study

The study faces several limitations. Some construction firms lack complete financial records on their websites or with the Nigerian Stock Exchange. Consequently, only firms with adequate data were included in the sample. Therefore, the findings may not apply to unlisted or data-deficient firms. Despite these constraints, the study provides valuable insights into how capital structure decisions influence financial performance in Nigeria’s construction sector.