CHAPTER ONE

INTRODUCTION

1.1 BACKGROUND OF THE STUDY

The Modigliani-Miller theorem is one of the cornerstones of modern corporate finance. At its heart, the theorem is an irrelevance proposition; it provides conditions under which a firm’s financial mix does not affect its value. Giglio (2022), in a comprehensive study of the Modigliani-Miller model, reaffirms that the theorem identifies the conditions under which the choice between issuing debt or equity to finance a given level of investment has no impact on company value, and that consequently there is no optimal level of debt relative to a company’s own resources. The theorem’s originator explained the core idea as follows:

… with well-functioning markets (and neutral taxes) and rational investors, who can undo the corporate financial structure by holding positive or negative amounts of debt, the market value of the firm—debt plus equity depends only on the streams of income generated by its assets. It follows, in particular, that the value of the firm should not be affected by the share of debt in its financial structure or by what will be done with the returns paid out as dividends or reinvested (profitably)… (Modigliani, 1980, p. xiii)

In fact, what is currently understood as the Modigliani-Miller theorem comprises three distinct results from a series of papers published in 1958, 1961 and 1963. The first proposition establishes that under certain conditions, a firm’s debt-equity ratio does not affect its market value. The second proposition establishes that a firm’s leverage has no effect on its weighted average cost of capital—that is, the cost of equity capital is a linear function of the debt-equity ratio—while the third proposition establishes that the firm’s value is independent of its dividend policy. A systematic review by Abdulkadir, Bello and Muazu (2023) on capital structure and firm performance in Nigeria confirms that these foundational propositions continue to anchor contemporary empirical debates, even as researchers increasingly document real-world market frictions that challenge the theorem’s ideal-world assumptions.

Miller (1991:217) succinctly explains the intuition for the theorem with a simple analogy, saying:

…think of the firm as a gigantic tub of whole milk. The farmer can sell the whole milk as it is, or he can separate out the cream and sell it at a considerably higher price than the whole milk would bring…

…the Modigliani-Miller proposition says that if there were no costs of separation (and of course, no government dairy support program), the cream plus the skim milk would bring the same price as the whole milk…

The essence of this argument is that increasing the amount of debt lowers the ratio of outstanding equity—selling off safe cash flows to debtholders, which leaves the firm with more valued equity, thus keeping the total value of the firm unchanged. Put differently, any gain from using cheaper debt is offset by the higher cost of riskier equity. Hence, given a fixed amount of total capital, the allocation of capital between debt and equity is irrelevant because the weighted average cost of capital remains the same for all possible financing combinations.

Spurred by these arguments that in an ideal world without taxes a firm’s value is independent of its debt-equity mix, economists have sought conditions under which the financial structure of the firm would matter. A comprehensive review of the evolution of modern capital structure theory by Nguyen and Nguyen (2023) traces how several factors influence the debt-equity mix, including differential taxation, informational asymmetries, bankruptcy costs, issues of control and dilution, and the agency problem. Critically, the review demonstrates that the major theoretical frameworks—from the agency cost perspective to the signalling approach—have produced competing yet complementary empirical predictions that continue to be tested in emerging markets today.

The central question, therefore, remains: Do corporate financing decisions affect a firm’s value, and if so, how much? An enormous body of research, both theoretical and empirical, has been devoted to answering these questions since the foundational works on capital structure irrelevance were first published. Scholars have approached the problem from various angles, including the relationship between taxation and dividend policy, the role of leverage in incentivising or discouraging investment, and the conditions under which information asymmetry renders the financing mix relevant to market valuation.

Research into the relationship between taxation and dividend policy showed that personal tax considerations make dividends less attractive relative to capital gains, and that share prices respond imperfectly to dividend payments on ex-dividend dates. Studies on leverage and investment demonstrated that debt finance can increase incentives for stockholders to pursue risky projects that transfer wealth from bondholders without maximising the combined value of all securities—a finding that undermines value creation. In contrast, the agency cost perspective argues that higher leverage aligns the interests of managers and stockholders by forcing managers to hold a larger stake in the firm, thereby reducing agency conflict and creating value. A further strand of argument holds that leverage enhances value by compelling the firm to distribute resources that might otherwise be wasted on poor investment decisions by entrenched managers.

The possibility that leverage can cause firms to under-invest has also received substantial attention: when the gains from new investment are shared with existing risky bondholders, equity holders may prefer to forgo positive net-present-value projects, to the detriment of total firm value. The interaction between personal taxes at the investor level and corporate interest deductibility has similarly been shown to complicate the classical view that debt is an unambiguously cheap source of finance, since any corporate-level tax shield may be offset by higher personal taxes paid by bondholders, leaving the total value of the firm unchanged regardless of leverage.

More recent empirical work has revisited these classical positions using larger datasets and more sophisticated panel data techniques. Chukwuma, Nwankwo, Itumo and Inyaeze (2023), in an analysis of debt financing on the financial performance of listed consumer goods companies in Nigeria, found that both short-term and long-term debt exert a significant influence on corporate profitability, while highlighting the role of information opacity in emerging markets. Abdulkadir, Bello and Muazu (2023) and Ganiyu, Adeleke and Olusegun (2023) found that Nigerian manufacturing firms with moderate leverage ratios demonstrated superior returns on assets relative to both underleveraged and highly leveraged peers, suggesting the existence of an optimal capital structure consistent with the trade-off perspective.

In Nigeria, empirical studies on corporate finance and firm value have produced mixed evidence. Early work found that the relationship between corporate ownership and financial leverage was positive, while the relationship between asset tangibility and leverage was negative and non-significant. At the same time, the relationship between leverage and profitability was found to be significant and negative. Related work examining the effect of taxes on business financing decisions and firm value found that earnings and investment were key determinants of firm value, with dividends positively related to value but debt negatively related—findings that pointed to the relevance of the financing mix for Nigerian listed companies even within the constraints of an imperfect capital market.

More recently, Fasasi, Ahmad and Nnejiwuihe (2022) found a significant negative relationship between total debt and profitability among listed agricultural companies in Nigeria. Horsefall (2022) demonstrated that heavy reliance on debt suppresses net profit margins due to fixed interest obligations among consumer goods manufacturing firms. Organ, Temuhale and Ighoroje (2024) examined quoted manufacturing firms from 2019 to 2023 and found that both total-debt-to-total-asset and long-term debt ratios significantly affected return on assets, confirming that optimal leverage decisions remain central to value creation in the Nigerian manufacturing sector.

Ahmadu (2026), examining debt structure and firm value of consumer goods firms in Nigeria, found that the composition of debt—whether short-term or long-term differentially affects market valuation. A parallel study on the value of listed manufacturing firms in Nigeria from 2015 to 2024 found, using Generalised Least Squares regression, that the debt ratio exerted a negative and statistically significant effect on firm value, indicating that high leverage reduces market performance. These findings collectively point to a persistent gap in the literature: the empirical application of the bankruptcy model to determine value enhancement in Nigeria’s listed companies remains underexplored. This is the gap which this study attempts to fill.

1.2 STATEMENT OF THE PROBLEM

The issue of value creation for stakeholders of the firm as a result of the composition of the financial mix has occupied corporate finance scholarship since the foundational irrelevance propositions of the late 1950s. Those foundational arguments maintained that whether the firm uses equity or debt, the value of the firm does not change, provided that certain ideal-market conditions hold. Subsequent scholarship has either challenged or refined this position through a succession of theoretical frameworks. A recent review of capital structure theories by Nguyen and Nguyen (2023) affirms that the major frameworks from the irrelevance theorem through the trade-off model, the pecking-order hierarchy, the agency cost perspective, and the signalling approach all agree that capital structure decisions considerably affect firm performance and are thus value-relevant, though the precise magnitude and direction of this effect remain contested across different institutional environments.

The firm’s financing structure consists of a mix of debt and equity. When the firm uses purely equity capital, the cash flows generated by its assets and operations belong entirely to the equity holders; when there is a mix of debt and equity, the cash flows are split between a relatively safe stream going to the debtholders and a more risky one going to the equity holders. Regardless of the financing option chosen, the risky cash flow streams that go to equity holders must be maximised; hence value must be enhanced for them, as the failure of the firm to do so will have a negative impact on its market value. A study by Abdulkadir, Bello and Muazu (2023) confirmed that an inappropriate financing mix directly erodes the wealth of equity holders, while Eberechukwu and Egbunike (2024) demonstrated that poorly structured capital bases impair the financial performance of listed deposit money banks in Nigeria, reinforcing the practical urgency of the problem.

The problems often associated with debt financing, from investors’ or potential investors’ points of view, include the following:

1) Reduction of the firm’s profitability (Fasasi, Ahmad & Nnejiwuihe, 2022; Horsefall, 2022)

2) Loss of flexibility on the use of its assets (Aghaebe & Oranefo, 2024)

3) Reduction of shareholders’ earnings per share (Zouaouid, 2023; Muslim, Wulandari & Rusyidi, 2024)

4) Non-payment of dividends to shareholders (Yisau, Oke & Odukoya, 2024)

5) Increased insolvency risk and liquidity problems (Alokwe, Egbunike & Chika, 2024; Olaoye & Omodara, 2023)

6) Non-enhancement of value as a result of the firm’s use of debt (Giglio, 2022; Nguyen & Nguyen, 2023)

Profitability is an important variable that impacts on the firm’s financial structure. The primary motive of the firm in using debt is to magnify shareholders’ returns through increased profitability, irrespective of economic conditions. The role of debt financing in magnifying shareholders’ returns rests on the assumption that fixed charges can be obtained at a cost lower than the firm’s rate of return on assets. When the earnings generated by assets financed by fixed-charge funds exceed the cost of those funds by an insufficient margin to distribute to shareholders as earnings, a problem exists. A high debt profile reduces the net profit margin because interest expense, a deductible charge must be settled before arriving at net profit, thus reducing the proportion of revenue that filters into profit for shareholders. Fasasi, Ahmad and Nnejiwuihe (2022) confirm this finding among listed agricultural companies in Nigeria, while Horsefall (2022) documents the same suppression effect in the consumer goods sector.

Most debt financing arrangements entered into by the firm are linked to the firm’s assets as collateral, which limits management’s ability to fully maximise the use of those assets to enhance shareholders’ value. Aghaebe and Oranefo (2024) demonstrate that a high debt-to-equity ratio signals elevated financial risk and reduces management’s operational flexibility, since restrictive covenants embedded in debt agreements constrain asset deployment decisions. This impairs the asset turnover ratio, which is a key measure of managerial performance, and consequently limits value creation. The value that would have been created through the full deployment of the firm’s assets is therefore impeded by the existence of debt.

A firm’s earnings per share is one of the most widely used measures of firm performance. Investors track earnings per share over time to determine whether their value as shareholders has increased. The existence of debt in a company’s financial structure introduces fixed interest and principal obligations that reduce the cash flows available for reinvestment or distribution to equity investors. Zouaouid (2023) confirms that both financial and operating leverage interact to determine earnings per share, with higher financial leverage reducing earnings available to equity holders. Muslim, Wulandari and Rusyidi (2024) found that the debt-to-equity ratio exerted a negative influence on earnings per share, which in turn dampened market valuations. In designing the financial policy of the firm, the impact of financing alternatives on the distribution of earnings among shareholders and creditors must therefore be carefully considered.

It is argued that investors operate in a world of brokerage fees, taxes and uncertainty; hence it is better to view the firm in the light of those factors. Without the restrictive assumptions of the irrelevance theorem, the argument that financing decisions do not affect firm value collapses. If certainty is removed, it becomes apparent that most investors prefer some payment in the form of cash dividends currently, to an eventual return in the form of capital gains in the future. The uncertainty associated with future outcomes prompts owners to prefer some current payment as compensation for their invested capital, and current dividends reduce investor uncertainty, thereby lowering the rate at which the firm’s earnings are discounted and supporting a higher firm value. Dabboussi (2024) demonstrated that enhanced profitability enables firms to manage leverage more effectively, thus securing resources for dividends that reduce potential agency conflicts. Yisau, Oke and Odukoya (2024) found that capital structure decisions—particularly long-term debt—significantly influenced shareholders’ wealth maximisation in Nigeria’s listed consumer goods companies, underscoring that the composition of financing matters for dividend sustainability.

Liquidity is generally defined as the ability of a firm to meet its debt obligations without incurring unacceptably large losses. Liquidity risk is the risk that a firm will be unable to meet current and future cash flow obligations, both expected and unexpected, without materially affecting its daily operations or overall financial condition. Alokwe, Egbunike and Chika (2024) and Olaoye and Omodara (2023) confirm that excessive leverage significantly amplifies this risk. An investor wishing to assess the value of the firm will generally consider whether, over time, the firm has been able to meet its financial obligations as they fall due. Lenders similarly apply credit assessment methods to evaluate the financial health of firms before extending credit. The ability of the firm to maintain adequate liquidity is therefore a prerequisite for obtaining loans and sustaining firm value; illiquidity, driven or worsened by excessive debt, erodes value from an investor’s perspective.

Present and potential investors need information about the value-creating potential of a firm and the measures being proposed and implemented by management to enhance that potential, together with their financial impacts. This information enables investors to estimate the value of the firm and make informed investment decisions. Chibueze, Okonkwo and Eze (2024) evaluate how profitability influences manufacturing firm value in Nigeria, using net profit margin and earnings per share as profitability metrics and net assets per share as the indicator of firm value. Their findings confirm that when the firm does not create value for owners and potential owners, resentment occurs, reflected in declining market prices of the firm’s shares.

1.3 RESEARCH OBJECTIVES

The specific objectives of this study are:

1. To determine how debt financing impacts on the firm’s ability to make profit.

2. To determine how debt financing impacts on the ability of the firm to maximise the use of its assets.

3. To determine the impact of debt financing on the firm’s earnings power on a per-share basis.

4. To determine the impact of debt financing on shareholders’ return on a per-share basis.

5. To determine the impact of debt financing on the firm’s ability to meet its financial obligations as and when due; and

6. To determine whether debt financing enhances the value of Nigerian firms.

1.4 RESEARCH QUESTIONS

In view of the objectives of this study, the following pertinent questions are asked:

1. What impact does the total debt rate have on the net profit margin of Nigerian firms?

2. What impact does the total debt rate have on the asset turnover ratio of Nigerian firms?

3. What impact does the total debt rate have on the earnings per share of Nigerian firms?

4. What impact does the total debt rate have on the dividend per share of Nigerian firms?

5. What impact does the total debt rate have on the current ratio of Nigerian firms?

6. To what extent does the use of debt finance enhance the value of Nigerian firms?

1.5 HYPOTHESES OF THE STUDY

These are:

i. There are no positive significant relationships between total debt rate and net profit margin of Nigerian firms.

ii. There are no positive significant relationships between total debt rate and the asset turnover ratio of Nigerian firms.

iii. There are no positive significant relationships between the total debt rate and earnings per share of Nigerian firms.

iv. There are no positive significant relationships between total debt rate and the dividend per share of Nigerian firms.

v. There is no positive significant relationship between total debt rate and the current ratio of Nigerian firms.

vi. Debt financing does not enhance the value of Nigerian firms.

1.6 SCOPE OF THE STUDY

This study covers 28 actively quoted companies in Nigeria between 1999 and 2008 which are listed in the first-tier market of the Nigerian Stock Exchange’s industrial classification, excluding foreign listings, banks, insurance and other financial subsectors. The exclusion of the insurance, banking, services and foreign listings is based on the nature of services rendered and the desire of the researcher to localise the research. The managed fund subsectors primarily deal with depositors’ funds and are thus highly leveraged; as such, determining the impact of debt financing in their financial structure on firm value would produce skewed results. They also represent the lending spectrum of any economy, thus being responsible for the supply of funds to the productive subsectors of the Nigerian economy. The exclusion of the foreign listings is based on the study’s focus on only Nigerian-incorporated firms.

1.7 SIGNIFICANCE OF THE STUDY

A number of researchers have provided theoretical and empirical insights on the debt financing policies of firms. The subject has been widely acknowledged as one of the most persistent unsolved problems in finance not for want of argument on the subject, but because no accepted, coherent theory of financial structure has emerged that commands universal support across different markets and institutional environments. Nguyen and Nguyen (2023) confirm that even after more than six decades of research, no unified theory commands universal empirical support, and debate continues about the precise conditions under which capital structure decisions affect firm value. This research will be particularly significant to the following groups:

1) MANAGEMENT

In large firms, there is a divorce between management and ownership. The decision-taking authority in a company lies in the hands of managers. Shareholders, as owners of the company, are the principals and managers are their agents. There is therefore a principal-agent relationship between shareholders and managers, which means managers should and must act in the best interests of shareholders, consistent with the objective of maximising shareholders’ wealth. Aghaebe and Oranefo (2024) and Olaoye and Omodara (2023) document that the conflicts of interest between managers and shareholders can be partially mitigated through appropriate debt levels, which discipline management and reduce agency costs. This research will therefore enable management to understand what must be done in the best interests of shareholders when choosing financing options that will help the firm achieve an optimal financial structure and maximise shareholders’ value.

2) INVESTORS AND POTENTIAL INVESTORS

The major beneficiaries of enhanced value created by firms are investors and potential investors. Their monetary contributions in the promotion, incorporation, and continued growth of the firm must be rewarded with a premium above the risk-free rate, thereby compensating them for time and risk. The choice of a financing mix in the financial structure of the firm ultimately determines whether these objectives are met, as internal and external factors may lead to insolvency and subsequent bankruptcy—events that carry substantial direct and indirect costs. Yisau, Oke and Odukoya (2024) confirm that capital structure decisions in Nigeria’s quoted consumer goods companies have a positive and significant influence on shareholders’ wealth maximisation, underscoring the direct stake that investors have in financing decisions. This research will contribute, alongside similar available literature, towards enhancing the maximisation of investors’ and potential investors’ objectives as they concern the value of firms.

3) ACADEMIC

This research intends to contribute significantly to the volume of literature available in this area of finance. Recent studies such as Chukwuma, Nwankwo, Itumo and Inyaeze (2023), Organ, Temuhale and Ighoroje (2024), and Ahmadu (2026) have enriched the Nigerian empirical literature on debt financing and firm performance, yet the application of the bankruptcy model as a value-enhancement yardstick for quoted Nigerian firms remains underexplored. As a contribution to this area, this research provides recommendations about debt financing and its impact on the value of firms in Nigeria, adopting the bankruptcy model in determining whether value has been enhanced, and localising the findings to the Nigerian institutional setting and environment.

1.8 LIMITATION OF THE STUDY

The first major limitation of this study was funding. The locations of the Nigerian Stock Exchange, which are scattered all over the country, required a substantial capital outlay for transportation and other logistics.

The second limitation was associated with data generation. Obtaining statistical data from the financial statements and accounts of the 28 firms under study was a significant challenge. The original intention was to undertake a 10-year time frame for the study; however, insufficient data necessitated a reduction to 5 years. This could be attributed to poor data documentation and preservation culture in Nigeria, and where data was available, sentiments sometimes prevented those in charge from releasing it for academic purposes.

Again, the limited availability of local literature on financial structure posed a problem. Though the intention was to localise the research, it was difficult to garner quality local literature in this area. As a result, foreign theoretical and empirical studies constitute the bulk of the literature reviewed. This limitation is consistent with observations in the broader field; Abdulkadir, Bello and Muazu (2023) similarly note that empirical work on capital structure in emerging markets like Nigeria has been limited and has historically met with low explanatory power.

1.9 DEFINITION OF TERMS

The following terms are defined in this research:

VALUE: The value of a firm is the market worth of its business as a going concern, encompassing both market-based and accounting-based indicators that reflect the firm’s capacity to generate sustainable returns for its stakeholders. Chibueze, Okonkwo and Eze (2024) operationalise firm value using net assets per share as a measure of the wealth accruing to shareholders from the firm’s operations.

DEBT FINANCING: The use of external borrowed funds in the financing mix of a firm. Ebe, Okeke and Ude (2024) define long-term debt financing as capital acquired from lenders for business operations, with repayment periods of two years or more, particularly applied to substantial and tangible investments.

BANKRUPTCY: The legally declared inability of the firm to pay its creditors or meet its financial obligations. Alokwe, Egbunike and Chika (2024) distinguish direct bankruptcy costs such as legal fees and administrator’s remuneration from indirect costs, which are the hidden operational losses incurred by businesses undergoing financial distress, including loss of customers, suppliers and skilled personnel.

NET PROFIT MARGIN: The net profit margin is used to determine the proportion of revenue that ultimately flows into profit after all operating and financing charges have been deducted. Fasasi, Ahmad and Nnejiwuihe (2022) confirm that a firm’s net profit margin is negatively and significantly affected by its total debt profile, owing to the deduction of interest charges before arriving at net profit.

TOTAL ASSET TURNOVER: Asset turnover is a financial ratio that measures the efficiency with which a company deploys its assets to generate sales revenue. Aghaebe and Oranefo (2024) link restrictive debt covenants to reduced asset turnover by constraining management’s ability to optimally deploy firm assets, thereby impeding overall performance.

EARNINGS PER SHARE: Earnings per share represents the portion of a firm’s net profit allocated to each outstanding ordinary share, serving as a key indicator of the return available to equity investors. Muslim, Wulandari and Rusyidi (2024) confirm that earnings per share is a critical mediating variable through which the debt-to-equity ratio influences market-based firm value.

DIVIDEND PER SHARE: Dividend per share is the total amount of declared dividends attributable to each ordinary share issued by the company. Yisau, Oke and Odukoya (2024) demonstrate that dividend per share is positively influenced by sound capital structure decisions, particularly the appropriate calibration of long-term debt within the firm’s financing mix in Nigerian consumer goods companies.

CURRENT RATIO: The current ratio is a diagnostic tool that measures whether a firm has sufficient short-term resources to meet its current liabilities over a given period. Olaoye and Omodara (2023) confirm that firms adopting a conservative leverage approach demonstrate better current ratio performance and are better positioned to absorb economic downturns without liquidity distress.

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