Empirical Note on Debt Structure and Financial Performance in Ghana: Financial Institutions' Perspective

Copyright © 2016 by John Gartchie Gatsi PhD.

Library of Congress Control Number:   2016900385

ISBN:      Hardcover      978-1-5144-4831-1

                Softcover        978-1-5144-4830-4

                eBook              978-1-5144-4829-8

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Rev. date: 01/14/2016

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CONTENTS

Acknowledgements

List of Figures

List of Tables

List of Abbreviations

List of Appendix

Dedication

Chapter 1: Overview

Introduction

The Gap to Consider

Objectives

Research Questions of Interest

Significance of the Study

Scope of Study

Chapter 2: Theoretical and Empirical Review

Theoretical Review

Theories of Capital Structure

M and M proposition I.

M & M proposition II.

The static trade-off theory.

Agency cost theory.-

Information asymmetry cost.

The pecking order theory.

Models based on product/input and output market interactions

Debt Structure and the Issue of Tax Benefits

Bankruptcy cost.

Theories of banking.

Theories of insurance

Prospect theory/ expected utility theory

Determinants of Debt Structure

Firm level characteristics.

Macroeconomic variables.

Financial Performance Measures

Empirical Review

Empirical evidence in relation between capital structure and financial performance.

Empirical review based on the performance and the controlling variables.

Conceptual Framework

Chapter 3: Methodological and Estimation Issues

Research Design

Population

Sampling

Data Collection

Measurement of Debt Structure

Firm level variables.

Asset structure.

Financial Performance

Panel Regression Model

Model specification.

Estimation Method

Data Analysis Plan

Chapter 4: Empirical Analysis of Test Results

Nature of Debt Structure

Testing For Difference between the Capital Structure between Banks and Insurance Firms

Testing For difference between Financial Performance of Banks and Insurance Companies

Descriptive Statistics

Correlation Analysis of Insurance Companies

Correlation Matrix of the Banks

Correlation Matrix of the Financial Institutions

Regression Results for Banks

Panel Regression Results for Insurance Companies

Panel Regression Results for the Financial Institutions

Chapter 5: Summary of the Work

Conclusions

REFERENCES

APPENDICES

ACKNOWLEDGEMENTS

I am grateful to my mentor, Steven Tippins who provided useful guidance during the project. I am also grateful to Samuel Gameli Gadzo and Innocent Senyo Kwasi Acquah for their valuable contributions leading "to’’ the completion of this project. I equally appreciate the support of my family during the period of writing this book

LIST OF FIGURES

Figure 1. Conceptual Framework.

LIST OF TABLES

Table 1 Average Short term Debt for the Financial Institutions from 2002 to 2011

Table 2 Average Long Term Debt to Total Capital Ratio from 2002 – 2011

Table 3 Average Total Debt to Total Capital Ratio from 2002 – 2011

Table 4 ANOVA of the Debt Structure Indicators

Table 5 ANOVA of the Financial Performance Indicators

Table 6 Descriptive Statistics for Banks

Table 7 Descriptive Statistics for Insurance Companies

Table 8 Descriptive Statistics for the Financial Institutions

Table 9 Regression Result of ROA as Dependent Variables of the Banks

Table 10 Regression Result of ROE as Dependent Variables of the Banks

Table 11 Regression Using TQ as Dependent Variable of the banks

Table 12 Regression Result for ROA of Insurance Companies

Table 13 Regression Result for ROE of Insurance Companies

Table 14 Regression for TQ of Insurance Companies

Table 15 Regression Result of ROA of the Financial Institutions

Table 16 Regression Result of ROE as Dependent Variables of Financial Institutions

Table 17 Regression Result of Tobin’ Q as Dependent Variables of Financial Institutions

LIST OF ABBREVIATIONS

LIST OF APPENDIX

Appendix A List of Companies used in the Study

Appendix B Correlations Matrix for Insurance

Appendix C Correlations Matrix for Banks

Appendix D Correlation Matrix for Financial Institutions

DEDICATION

This work is dedicated to my family

CHAPTER ONE

Overview

Introduction

Research interest in capital structure has received renewed momentum since the publication of Franco Modigliani and Merton Miller in 1958 which concluded that whether a firm is levered or not, the overall value of the firm remains the same, and shareholder wealth cannot be enhanced by altering the debt to equity ratio. The position of the findings were derived based n some ideal assumptions which meant firm operates in a perfect competitive environment with full availability of relevant information, and allows for borrowing and lending at competitive rate at zero tax. Debt structure is an important part of capital structure discourse since debt is generally divided into short term and long term. It is therefore relevant to consider the debt structure as it affects financial performance (Head & Watson, 2010).

In the Ghanaian context, Abor (2005) who is one of the researchers that focused on capital structure, maintains that capital structure decision is crucial for any business organizations that aim at maximizing returns to the various stakeholders. He further explains that capital structure decision is crucial because of the impact such decision has on a firm’s ability to deal with its competitive environment. Amidu (2007) explained that capital structure decision is a strategic choice by corporate managers that reflects the economic environment and risk orientation of managers.

Ross, Westerfield, Jeff and Jordan (2011) posit that capital structure represent the proportions of the firms financing from current liabilities, long-term debt and equity. Dhanasekaran, Kumar, Sandhya and Saravanan (2012) pointed out that capital structure, being total debt to total asset at book value, influences both profitability and riskiness of the firm. From the definitions given by many previous researchers, capital structure can be referred to as the mixture of sources of funds a firm uses (debt, preferred shares, and ordinary shares). The amount of debt that a firm uses to finance its assets is called leverage.

The decision is important not only because of the need to maximize returns to the shareholders, but it is also important because of the impact of such decision on an organization’s ability to deal with its competitive environment (Erol, 2010). Over the past several decades, theories on a firm’s capital structure choice have evolved along many directions, with many models being built to explain a firm’s financing behaviour. The theories suggest that firms select debt structure depending on attributes that determine the various costs and benefits associated with debt and equity financing.

Modigliani and Miller’s publication in 1958, is considered to be the pacesetter in the area after which modern financial economists provide new dimensions and expanded the scope of leverage relevant theories to explain role of debt in different industries. One important theory, the trade-off theory explained the relevance of debt with the existence of taxes and bankruptcy costs (Abu- Rub 2012; Najjar et al 2011). The general result from this theory is that the combination of leverage costs and tax advantages of debt produces an optimal capital structure below full debt financing, as the tax advantage of debt is traded against the likelihood of incurring bankruptcy costs.

The Pecking order theory theory was developed by Steward Myers in 1984 in his paper, Capital Structure Puzzle. Myers (1984) presented two sides of the capital structure issue, which are called static trade-off theory and pecking order hypothesis. The static trade-off theory holds that the capital structure choices may be explained by the trade-off between benefits and costs of debt versus equity. A firm is regarded as setting a target debt level and gradually moving towards it.

The pecking order hypothesis explains, that there is no concise definition for target debt ratio, and firms have an ordered of preference for financing their operations. In the views of Myers, firms prefer retained earnings as their main source of funds for investment followed by debt. The last resort sought by a firm would be external equity financing. The ranking claimed that internal funds were considered as ‘cheap’ and not subject to any outside interference. External debt was ranked next because it was considered to be cheaper and has fewer restrictions compared to issuing equity and also because of the tax deductibility of debt in most countries. The issuance of external equity is seen as the most expensive and dangerous as it can lead to potential loss of control of the enterprise by the original owner and manager; hence, it was ranked the last. Another important theory is called the agency theory and this was developed by Jensen and Meckling in their 1976 publications. This theory considered debt to be a necessary factor in creating the conflict between equity holders and the managers. Jensen and Meckling recommended that, due to increasing agency costs with both the equity holders and debt-holders, there would be an optimum combination of outside debt and equity to reduce total agency costs.

Nivorozhkin (2005) popularized the signalling theory of capital structure that states the managers of the firm posses inside information and they only reveal it by the method of financing. The managers will issue more debt if the future prospect is positive as they are willing to incur higher risk of bankruptcy and other relevant costs of higher debt. Ever since Myers article on the determinants of corporate borrowing in 1977, the literature on capital structure has grown steadily with different theories trying to explain factors affecting capital structure. Many studies have concentrated their empirical research on the determinants of the level of debt or observed debt ratios of firms and explain the cross-sectional regularities in the level of debt. El-Whadid and Singapurwoko (2011) have studied the theoretical determinants of capital structure by examining them empirically.

The theoretical attributes namely; asset structure, growth, uniqueness, industry classification, firm size, earnings volatility and profitability are tested to see how they affect the firm’s debt-equity choice. From that study, they found that debt-levels are related negatively to the uniqueness of a firm’s business. Short-term debt ratios were shown to be negatively related to firm size and past profitability. In their research, El Whadid and Singapurwoko (2011) could not find any effect on debt ratios for volatility, collateral value, future growth and non-debt shield. However, Harris and Raviv (1991) in their seminal work on capital structure determinants found some relationship of those factors with leverage.

They pointed out that leverage positively relates to fixed costs, non-debt tax shields, investment opportunities and firm size. In another classical study, Homaifar et al. (1994) examined the effect of profitability, firm size, future growth, non-debt tax shield, operating risk, dividend policy and uniqueness on the firm’s leverage ratios. Their results showed a positive effect of firm size and future growth of earnings on the capital structure decision. The capital structure study revealed both consistent and contradictory results of the factors affecting capital structure choice of US firms.

Some recent studies on capital structure were attempted on small and medium size firms or small businesses (Romano et al., 2001; Hutchinson et al. 1998) studied the small firms in the United Kingdom. Almost all the studies on capital structure were examined using secondary data. However, there were few interesting studies conducted by interviewing CFO and financial managers to find out the preferences for capital structure and the factors influencing them (Graham & Harvey, 2001; Beattie et al., 2004). There are also some recent studies on capital structure focused on certain industries (Tang & Jang, 2005 for lodging and software firms, Upneja & Dalbor, 2001 for restaurant firms and Guzhva & Pagiavlas, 2003 for airline business).

Bhaduri (2002) did an empirical study of the determinants of corporate borrowing from the Indian perspective. He concluded that the optimal capital structure choice is influenced by factors such as growth of earnings, cash flow of the firm, size of the firm, and product and industry characteristics.

In discussing debt structure of financial institutions profitability and leverage are very important variables. Profitability ratios as explained by Van Horne (2009) classified the ratios into two main types, namely profitability ratios in relation to sales and profitability ratios in relation to investment. He argued that the returns indicate the firms overall effectiveness of operation. Three main ratios, namely gross profit margin, return on investment and return on equity were mentioned. Marfo-Yiadom and Boachie-Mensah (2010) also supported Van Horne (2009) by stating that profitability ratios measures management’s overall effectiveness as shown by returns generated on sales and investments.

Ross, Westerfield, Jeff and Jordan (2011) also explained that return on assets and return on equity are key indicators for assessing the profitability of a company. Regarding leverage ratios, Ross, Westerfield, Jeff and Jordan (2011) posit that leverage ratios are ratios that show the extent to which the firm is financed by debt. The ratios according to them can be classified as short-term debt, long-term debt and total debt.

Studying triangle relationship among firm size, capital structure and financial performance of Turkey based companies, Erol (2011) found out that the impact of firm size on performance and sustainability would vary in line with the way expansion is financed. The study revealed that debt financing increases the risk exposure of the firm. It is noted that many research efforts were directed towards finding the leverage levels and the determinants of leverage. The theoretical determinants of capital structure and the models had been tested by many scholars mainly in large companies of the developed nations. However, there were not many studies done to prove the models and the theoretical determinants of capital structure in the developing countries, especially the countries in financial institutions of Ghana. To add to the literature of capital structure, this thesis is an attempt to study the relationship of debt structure on financial performance of financial institutions in Ghana.

In this study, banks and insurance firms will be analyzed separately to assess the level of leverage and the factors affecting the capital structure choice. The sources of data for this study were the balance sheets and income Statements of financial institutions over 10 years period from 2002 till 2011 which are mainly extracted from the Bloomberg system. A total of thirty financial institutions will be analyzed by bank and insurance classification for the purpose of this study. In the earlier studies, cross sectional regression was dominantly employed to analyze the factors affecting the capital structure choices of firms (Abu-Rub, 2012). However, lately the use of panel data regression became popular in analyzing the determinants