International Journal of Business and Social Science

Vol. 3 No. 22 [Special Issue November 2012]

Capital Structure and Firm Value: Empirical Evidence from Ghana

Samuel Antwi1, 2 Ebenezer Fiifi Emire Atta Mills3 Professor Xicang Zhao1 School of Finance and Economics, Jiangsu University 301 Xuefu Road, Zhenjiang, Jiangsu, Peoples Republic of China
2 1

Koforidua Polytechnic, P.O.Box KF981, Koforidua, Ghana

3

School of Business Administration, Jiangsu University 301 Xuefu Road, Zhenjiang, Jiangsu Peoples republic of China

Abstract
This study seeks to provide evidence on the impact of capital structure on a firms value. The analysis was implemented on all the 34 companies quoted on the Ghana Stock Exchange (GSE) for the year ended 31st December 2010. The ordinary least squares method of regression was employed in carrying out this analysis. The result of the study reveals that in an emerging economy like Ghana, equity capital as a component of capital structure is relevant to the value of a firm, and Long-term-debt was also found to be the major determinant of a firms value. Following from the findings of this study, corporate financial decision makers are advised to employ more of long-term-debt than equity capital in financing their operations since it impacts more on a firms value.

Key Words: Capital structure, firm value, Ordinary Least Squares, Agency Cost 1.0 Introduction
The Modigliani and Miller theory, proposed by Modigliani and Miller (1958 and 1963), forms the basis for modern thinking on capital structure. In their seminal article, Modigliani and Miller (1958 and 1963) demonstrate that, in a frictionless world, financial leverage is unrelated to firm value, but in a world with tax-deductible interest payments, firm value and capital structure are positively related. Miller (1977), added personal taxes to the analysis and demonstrates that optimal debt usage occurs on a macro level, but it does not exist at the firm level. Interest deductibility at the firm level is offset at the investor level. In addition, Modigliani and Miller (1963) made two propositions under a perfect capital market condition. Their first proposition is that the value of a firm is independent of its capital structure. Their second proposition state that the cost of equity for a leverage firm is equal to the cost of equity for an unleverage firm plus an added premium for financial risk. However, other theories such as the trade off theory (Myers,1984), pecking order theory (Myers and Majluf,1984) and agency cost theory (Jensen and Meckling, 1976) argue that if capital structure decision is irrelevant in a perfect market, then, imperfection which exist in the real world may be adduce for its relevance. Such imperfections include bankruptcy costs (Baxter, 1967, Kraus and Litzenberger, 1982; and Kim, 1998), agency cost (Jensen and Meckling, 1976), gains from leverage-induced tax shields (De Angelo and Masulis, 1980) and information asymmetry (Myers, 1984). Taking it turn from the above, Pandey (2004) states that the capital structure decision of a firm influences its shareholders return and risk. Consequently, the market value of its shares may be affected by the capital structure decision. The objective of a firm should therefore be directed towards the maximization of its value by examining its capital structure or financial leverage decision from the point of view of its impact on the firm value. 103

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Following from this, the objective of this study therefore is; to find out whether the amount of equity used in a firm affect its market value and also to find out whether the amount of debt used in a firm affect its market value. The question now is does the capital structure decision of the firm affect its value? In this research work, effort will be made to provide answer to this question and others. 1.1 Literature review The relationship between capital structure and firm value has been the subject of considerable debate, both theoretically and in empirical research. Throughout the literature, debates have focused on whether there is an optimum capital structure for an individual Firm or whether the proportion or level of debt usage is irrelevant or relevant to the Firms value (Hatfield, Cheng and Davidson, 1994). Pandey (2004) opines that, the capital structure decision of a firm should be examined from the point of its impact on the value of the firm. He further states that if capital structure decision can affect a firms value, then firms would like to have a capital structure which maximizes their value. The aim of a firm should centre therefore on the maximization of its value through capital structure decisions. However, there exist conflicting theories on the relationship between capital structure and firms value that it becomes necessary to capture them into some broad groups. Harris and Raviv (1991) for example, organized their survey of literature around the driving forces behind financial policy and capital structure. They produce a classification based on taxes, bankruptcy cost, agency cost, information asymmetry, interaction with input/or product and corporate control considerations. Sanders (1998) adopted a different approach and classified capital structure theories base on whether particular theory presumes the existence of optimal financial policy and how the theory describes it. According to his classification, there are theories in support of the existence of an optimal debt-equity mix (that is, the trade-off theory), the existence of optimal financial hierarchy (the pecking order theory) and the Modigliani and Miller irrelevance theory of capital structure in relation to a firms value. The capital structure in this study means the term used to represent a combination of long-term debt and equity. Long term debt includes obligations that are not due to be repaid within the next twelve months. Such debt consists mostly of bonds or similar obligations, including a great variety of notes, capital lease obligation and mortgage issues. Generally, debt is money that has been borrowed from another party and must be repaid at an agreed date. The cost of using this money, which also must be paid, is interest. In addition to the requirement to pay interest, debt may also carry restrictive covenants that the borrower must satisfy to prevent default (Jane, Malonis and Cengage, 2000). Thus, a major cost of issuing debt is the possibility of financial distress. (Jane Malonis and Cengage, 2000). According to Ehrhard and Bringham (2003), the value of a business based on the going concern expectation is the present value of all the expected future cash flows to be generated by the assets, discounted at the companys weighted average cost of capital (WACC). From this it can be seen that the WACC has a direct impact on the value of a business. (Johannes and Dhanraj, 2007). The choice between debt and equity aims to find the right capital structure that will maximize stockholder wealth. WACC is used to define a firms value by discounting future cash flows. Minimizing WACC of any firm will maximize value of the firm (Messbacher, 2004). Debt policy and equity ownership structure matter and the way in which they matter differs between firms with many and firms with few positive net present value project (McConnel and Servaes, 1995). Leland and Pyle (1977) propose that managers will take debt-equity ratio as a signal, by the fact that high leverage implies higher bankruptcy risk (and costs) for low quality firms. Since managers always have information advantage over the outsiders, the debt structure may be considered as a signal to the market. Rosss (1977) model suggests that the values of firms will rise with leverage, since increasing the markets perception of value. Early empirical evidence on the trade-off theory (e.g., Bradley, Jarrell, and Kim, 1984) yielded mixed results. However, recent studies examining capital structure response to change in corporate tax exposure (Givoly et al., 1992; Mackie-Mason, 1990; Trezevant, 1992) provide evidence supporting the trade-off theory. Myers (1984) argues that the trade-off theory also fails to predict the wide degree of cross-sectional and time variation of observed debt ratios. Return on stock increases for any announcement of issuer exchange offers. Overall, 55 percent of the variance in stock announcement period returns is explained (Masulis, 1983). Under some conditions capital structure does not affect the value of the firm. Splitting a fund into some mix of shares relating to debt, dividend and capital directly adds value to the company (Gemmille, 2001). The issue of whether financial structure influences economic growth or not. Through heterogeneous panel it was found that significant effects of financial structure on real per capita output, which is in sharp contrast to some recent findings (Arestis and Luintel, 2004). 104

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Firms have increased their level of debt relative to their profit. As a result, firm debt in general has risen substantially. They found that those firms having lower debt have higher value than the firm, which has high debt. Thus, firm can maximize its value by choosing low debt or zero debt (Kinsman and Newman, 1998). When the firms investment is large, countervailing incentives lead both high and low cost firms to choose the same capital structure in capital structure in equilibrium, thus decoupling capital structure from private information. When investment is small or medium size, the model may admit separating equilibrium in which high cost firms issued greater equity and low cost firms rely more on debt financing (Spiegel and Spulber, 1997). The presence of corporate tax shield substitutes for debt implies that each firm has a unique interior optimum leverage decision and when firms, which issue debt, are moving toward the industry average from below, the market will react more positively then when the firm is moving away from the industry average. The overall finding is that the relationship between a firms debt level and that of its industry does not appear to be of concern to the market (Hatfield et al., 1994). Debt ratios are found to be decreasing in cash flow or profitability and increasing in the investment of the firm in both countries. The study found positive with pecking order approach and generally inconsistent with the tradeoff approach (Benito, 1999). The firm-specific nature of strategic assets implies that they should be financed primarily through equity; other less specific assets should be finance through debt. Firms are likely to suffer increased costs and decrease performance if they do not adopt suitable governance structures in their transactions with potential suppliers of funds (Kochhar, 1997). It is considered customerdriven financial distress where prices for the firm output decline whenever firm has poor financial status. Employee driven financial distress originates from loss of intangible assets when firm revenue decline. Babenko (2003) examines the state tax effect on optimal leverage and yield spreads to find out the optimal capital structure at the time of financial distress. A negative relationship exists between the ownership of shareholders with large blocks, on the one hand, and the degree of control, on the other hand, with regard to firm value, the second relationship being significant. However, endogenous treatment of these variables then reveals a positive effect for the ownership of the major shareholders on firm value. Leland and Pyle (1977) and Ross (1977) propose that managers will take debt/equity ratio as a signal, by the fact that high leverage implies higher bankruptcy risk (and cost) for low quality firms. Since managers always have information advantage over the outsiders, the debt structure may be considered as a signal to the market. Rosss model suggests that the value of firms will rise with leverage, since increasing leverage increases the markets perception of value. Suppose there is no agency problem, i.e. management acts in the interest of all shareholders. The manager will maximize company value by choosing the optimal capital structure; highest possible debt ratio. High-quality firms need to signal their quality to the market, while the low-quality firms managers will try to imitate. According to this argument, the debt level should be positively related to the value of the firm. Assuming information asymmetry, the pecking order theory (Myers and Majluf, 1984) predicts that firm will follow the pecking order as an optimal financing strategy. The reason behind this theory is that if the manager act on behalf of the owners, they will issue securities at a higher price than they are truly worth. The more sensitive of the security, the higher the cost of equity capital, since the action of the manager is giving a signal to the market that the securities is overpriced. Stulz (1990) argues that debt can have both a positive and negative effect on the value of the firm (even in the absence of corporate taxes and bankruptcy cost). He develops a model in which debt financing can both alleviate the overinvestment problem and the underinvestment problem. Stulz (1990) assumes that managers have no equity ownership in the firm and receive utility by managing a larger firm. The power of manger may motivate the self-interested managers to undertake negative present value project. To solve this problem, shareholders force firms to issue debt. But if firms are forced to pay out funds, they may have to forgo positive present value projects. Therefore, the optimal debt structure is determined by balancing the optimal agency cost of debt and the agency cost of managerial discretion. 1.2 Equity and Firm Value Equity unlike long-term debt includes paid-up share capital, share-premium, reserves and surplus or retained earnings. Igben (2004) defines paid-up capital as the portion of the called-up capital which has been paid-up by the shareholders. He also describes reserves as amounts set aside out of profits earned by the company, which are not designed to meet any liability, contingency, commitment or diminution in value of assets known to exist at the balance sheet date. Reserves may be voluntarily created by directors or statutorily required by law. Share premium is the excess amount derived from the issue of shares at a price that is above its par value. 105

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And lastly, retain earnings are profit plough back in to a company in order to create more resources for operations and invariably increase in the value of the firm. This generates our first hypothesis that there is no relationship between equity and firm value. 1.3 Long-term Debt and Firm Value Leland and Toft (1991) state that, the value of a firm is the value of its assets plus the value of tax benefits enjoyed as a result of debt minus the value of bankruptcy cost associated with debt. Modigliani (1980) points out that, the value of a firm is the sum of its debt and equity and this depends only on the income stream generated by its assets. The value of the firms equity is the discounted value of its shareholders earnings called net income. That is, the net income divided by the equity capitalization rate or expected rate of return on equity. The net income is obtained by subtracting interest on debt from net operating income. On the other hand, the value of debt is the discounted value of interest on debt. Consistent with agency costs theory, prior literature indicate that debt is value reducing for high growth firms and it is value enhancing for low-growth firms. Jensen (1986) posits that when firms have more internally generated funds than positive net present value projects; debt forces the managers to pay out funds that might otherwise have been invested in negative net present value projects. This over-investment problem can be lessened if managers are forced to pay out excess funds for servicing debt, therefore enhancing the firms value. Myers (1993) suggests that, a firm with outstanding debt may have the incentive to reject projects that have positive net present value if the benefits from accepting the project accrue to the bondholders without also increasing shareholders wealth. This under investment problem can harm the value of firms, especially for the firms with high levels of future investment opportunities. Building on Jensens (1986) over-investment discussion and Myers (1993) underinvestment discussion, Stulz (1988) argues that debt can have both positive and negative effect on firm value. Aggarwal and Kyaw (2006) also posit that, debt can have both positive and negative effects on the value of the firm so that the optimal debt structure is determined by balancing the agency costs and other costs of debts as a means of alleviating the under and over-investment problems. Specifically, when firms have surplus cash flows, debt will force managers to pay out funds that might otherwise have been invested in negative net present value projects. However, firms with outstanding debt may have incentives to reject projects that have positive net present value if the benefit from accepting the project accrues to the bondholders without also increasing shareholders wealth. In addition, McConnell and Servas (1995) posit that, the seeds of under-investment problem lie in the solution of over investment problem. They investigate the relationship between corporate values, leverage and equity ownership of U.S. firms. They discover that for firms with high P/E ratios or for high-growth firms, value is negatively related to leverage and that in firms with low P/E ratio or low-growth firms, value is positively related to leverage. Their evidence supports the contention that for low-growth firms, leverage act as a monitoring mechanism to enhance firm value, whereas for high-growth firms, leverage causes under investment and destroys the value of a firm. This generates the second hypothesis in this study: That there is no relationship between long term debt and firm value.

2.0 Methodology
2.1 Study Area and Source of Data The population of study is made up of all the 34 companies quoted on the Ghana stock Exchange as at 31st December 2010. The cross-sectional survey research design was adopted in this study. This is because the data used in this study were collected at a particular point in time for each and every year. The sample was made up of all the companies quoted on the Ghana Stock Exchange as at 31st December 2010. The secondary source of data was employed. The data were collected from annual reports and statements of account of the companies under consideration. The regression method of data analysis was adopted in this study. To be specific, the Ordinary Least Square (OLS) technique was adopted. Since this study sets out to test the relationship (association) between firm value and capital structure, the OLS correlation method is appropriate. 2.2 Model Specification The model to be regressed in this study is presented in a relational form as follows:

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International Journal of Business and Social Science Firm value = f (capital structure) Firm value = f (Equity, Debt) With the linear expression of the model being: FV = a0 + b1EQUITY + b2 LTDEBT + e a0, b1 and b2 are parameters to be estimated. The apriori expectation is to follow the line of, b1> 0 and b2 > 0 Where; FV = firm value EQUITY = equity capital. LTDEBT = Long- term debt e = error term.

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3.0 Data Analysis and Result

The purpose of this study as mentioned in the introductory section of this paper is to examine the relationship between capital structure and firm value in Ghana. The regression result obtained from the ordinary least square is presented below: Table 1: Ordinary Least Square Estimation Regressor Coefficient INPT(Firm Value) 1.19209 EQUITY 0.96872 Long Term Debt 0.99876 R-Squared 1.00000 S.E. of Regression 1.21676 DW-Statistic 1.854 Standard Error T-Ratio 2.23795 0.53267 6.42624 1.55611 1.6108 6.20807 R-Bar-Squared 1.00000 F(Stat) 1.74706 (0.00000) Probability 0.59805 0.00000 0.00000

FIRM VALUE = 1.19 +0.96872 EQUITY + 0.99876 LTDEBT (0.53) (1.56) (6.21) R squared = 1.00 R Bar-squared = 1.00 F-stat =1.75 DW-Stat = 1.9 From the above regression result using the Ordinary Least Square (OLS) estimation technique, it would be observed from the adjusted coefficient of determination (R-Bar-squared = 1.0) that about 100% of systematic variation in the dependent variable (firm value) is explained by the independent variables. This implies that the model is a very good fit with a very good predictive power. The F-test which measures the existence of linear relationship between the dependent and independent variable revealed that a significant relationship exist between the variables. The F-calculated value of 1.75 is higher or greater than the Fcritical value of 0.10 at 5% level of significance. Also, from the result, the Standard Error of Regression (SER) is 12.2% which is considered relatively good enough to confirm the predictive power of the model. Therefore, with the SER value, the model above is a very good model for policy making purposes. However, the observed value of DW is 1.9 which is approximately 2.00, revealed that there is the absence of serial correlation in the OLS results. This implies that the result can be used to draw policy suggestion. Furthermore, the analysis of the parameter estimates and their tratios; indicative of the individual statistical significance of the explanatory variables shows that a significant positive relationship exist between Long-term Debt and Firm Value given that the t-calculated (6.21) is greater than the t-theoretical values at 5% (2.06) and 10% (1.70) levels of significance respectively. This indicates that as Long-term Debt increases, the Firm Value also increases. Thus, we reject the null hypothesis that Long-term Debt is not positively related to Firm Value. Furthermore, the results also reveal that Equity is related to Firm Value. The relationship is also statistically insignificant at 1% and 5% significance levels respectively. Consequently; we reject the null hypothesis that Equity is not positively related to Firm Value. The DW-statistic of 1.9 shows that, the existence of stochastic dependence between successive units of the stochastic error term is unlikely; thus, we should be more confident that the estimated coefficient obtained in the study is unbiased.

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Table 2: Diagnostic Tests ****************************************************************************** * Test Statistics LM Version F Version ****************************************************************************** A:Serial Correlation CHSQ( 1)= 16.2823[.003] F( 1, 7)= 2.6586[.123] B:Functional Form CHSQ( 1)= 16.7585[.000] F( 1, 10)= 16.3634[.002] C:Normality CHSQ( 2)= .20337[.903] Not applicable D:Heteroscedasticity CHSQ( 1)= .40197[.526] F( 1, 25)= .37782[.544] ****************************************************************************** A:Lagrange multiplier test of residual serial correlation B:Ramsey's RESET test using the square of the fitted values C:Based on a test of skewness and kurtosis of residuals D:Based on the regression of squared residuals on squared fitted values The null hypothesis of the tests above has no serial correlation, correct functional form, normal distribution and homoskedasticity. Using the F test we reject only the null hypothesis for the functional form. Thus the model does not suffer from serial correlation (autocorrelation) and heteroscedasticity.

4.0 Discussion
Following from the above regression results of long- term- debt and equity as components of capital structure, Long-term-debt was found to be the major determinant of firms value. This is consistent with the findings of Myers and Majlufs (1984) pecking order theory, Myers (1984) trade-off theory, and the traditionalist theory. The reason for this agreement is because both the finding of this research work and the findings of the above mentioned theories took cognizance of the market imperfections present in the real world. These imperfections include bankruptcy cost, agency costs, gains from leverage- induced tax shields and information asymmetries. This finding is however, inconsistent with M&M (1958) theory and Millers (1977) hypothesis with corporate and personal taxes, who find out that long-term-debt, is not related to firms value. Also, Miller (1977) opines that capital structure is unrelated to the value of a firm because the tax benefits which is adduced for the relevance of capital structure in relation to firms value is offset by the fact that shareholders pay more tax than bondholders. This position of Miller (1977) is in consonance with that of Myers (1977) who opines that a firm with outstanding debt may have the incentive to reject projects that have positive NPV which may harm the firms value. Furthermore, this study reveals that in an emerging economy like Ghana, equity capital as a component of capital structure is relevant to the value of a firm. This is in agreement with the claims put forward by the proponents of the pecking order theory and the traditionalist theory of capital structure relevance. However, it is not in agreement with the capital structure irrelevancy theory of Modigliani and Miller (1958), which states that equity capital is unrelated to firm value; and Millers (1977) hypothesis with corporate and personal income tax, which states that the capital structure of a firm does not impact on its market value.

5.0 Conclusion
This research work has examined the capital structure theory and its relationship with the value of the firm in the Ghanaian setting, taking into cognisance 34 listed firms. All other theories, except the M-M theory (1958), have attempted to resolve the capital structure puzzle enunciated by M-M (1958) propositions. Each of this theory relaxes conditions under which the M-M (1958) theorem was derived. Based on this and the findings of this study, we can conclusively state that: capital structure decisions have various implications and one of them is its effect on the value of the firm which formed the basis of our study. It is recommended that Firms are strongly advised to always compare the marginal benefit of using long-term-debt to the marginal costs of long-term-debt before concluding on using it in financing their operations. This is because as shown by this work, long-term-debt impacts positively on firms value just like equity capital.

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Appendix 1: Listed Companies and Their Capital Structure, December 2010

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 Firms Golden web Sam-Woode African Champion Industries Aluworks AngloGold Ashanti Ayrton Drug Manufacturing Benso Oil Palm Plantation CAL Bank Camelot Ghana Clydestone Ghana Cocoa Processing Co. Ecobank Ghana Ecobank Transnational Inc. Enterprise Group Fan Milk Ghana Commercial Bank Ghana Oil Company Golden Star Resources Guinness Ghana Breweries HFC Bank Ghana Mechanical Lloyd Co. Pioneer Kitchenware Produce Buying Company PZ Cussons Ghana SG-SSB SIC Insurance Company Standard Chartered Bank Ghana Starwin Products Total Petroleum Ghana Transaction Solutions Ghana Trust Bank -The Gambia Tullow Oil Unilever Ghana UT Bank Equity 677250 331840 5236083 27361000 4113000000 14520354 29530000 76519000 513940 298208 155224 227646000 18944449216 31676000 5216000 173623000 33448448 640640 45163 69775606 14595270 363735 23624595 25263490 118885753 83840538 195981000 1864283 66206000 1705173 290990000 5720823040 41340000 51087000 Long Term Debt 2763712 331839 0 7031000 4442000000 0 0 109390000 415262 0 124176906 80162000 383348198 0 1735000 129911000 762964 180392 5227000 60847152 3465475 12892 8427357 1668192 1300507 3537383 258206000 401639 3691000 43699 0 4431095040 5296000000 8832000 Firm Value 3440962 663679 5236083 34392000 8555000000 14520354 29530000 185909000 929202 298208 124332130 307808000 19327797414 31676000 6951000 303534000 34211412 821032 5272163 130622758 18060745 376627 32051952 26931682 120186260 87377921 454187000 2265922 69897000 1748872 290990000 10151918080 5337340000 59919000

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Vol. 3 No. 22 [Special Issue November 2012]

Appendix 2
Cochrane-Orcutt Method AR (2) converged after 5 iterations ****************************************************************************** Dependent variable is FIRMVALU 34 observations used for estimation from 1 to 34 ****************************************************************************** Regressor Coefficient Standard Error T-Ratio [Prob] INPT 1.19209 2.23795 .53267 [.59805] LTDEBT .99876 1.6108 6.20807 [.00000] EQUITY .96876 6.42624 1.55611 [.00000] ****************************************************************************** R-Squared 1.00000 R-Bar-Squared 1.00000 S.E. of Regression 1.21676 F-stat. F (4, 117) 1.74706[.000] Mean of Dependent Variable 9.42 S.D. of Dependent Variable 4.08 Residual Sum of Squares 9.83E+22 Equation Log-likelihood -3109.6 Akaike Info. Criterion -3114.6 Schwarz Bayesian Criterions -3121.6 DW-statistic 1.854 ****************************************************************************** Parameters of the Autoregressive Error Specification ****************************************************************************** U= -.51413*U(-1)+ -.21440*U(-2)+E ( *NONE*) ( *NONE*) T-ratio(s) based on asymptotic standard errors in brackets ******************************************************************************

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