Abstract
This paper examines the impact of profitability on the financial leverage of firms operating in an unstable macroeconomic environment such as Nigeria. Using fixed and dynamic panel models, it finds consistent evidence that the profitability of a firm significantly and negatively affects its short-term debt, but not its long-term debt capital. It attributes this to the unstable nature of the Nigerian business environment and the relative inefficiency of its financial markets. It signals that Nigerian firms could be over-relying on short-term debt and external equity to fund long-term investments – a trend that is capable of increasing cost of capital to a level above any plausible limit.
Highlights
Internal equity is the cheapest source of corporate finance, and its availability is dependent on a firm’s performance
This study investigates the impact of profitability on the financial leverage of firms operating in an unstable macroeconomic environment such as Nigeria
The purpose of this study was to investigate the impact of profitability on the financial leverage of firms operating in an unstable macroeconomic environment such as Nigeria
Summary
Internal equity is the cheapest source of corporate finance, and its availability is dependent on a firm’s performance. According to the "earnings downturn" hypothesis, borrowing to ease financial frictions caused by macroeconomic instability can exacerbate agency and cash-flow problems that are associated with management decisions – leading to a situation where managers might be borrowing to finance non-viable (negative net present value) projects (Hansen & Cutchley, 1990). This brings about depletion of the value of the affected firm, and exposes the firm to higher risk of bankruptcy
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