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effect of leverage on business and finance risk.

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CHAPTER ONE

INTRODUCTION

 

  • Background of the Study

 

In corporate finance it is common to decompose the riskiness of a firm into business risk and finance risk, this categorization allows one to analyze separately the sources of risk that are inherent in most firms. Business risk is usually viewed as the uncertainty in sales and the degree of operating leverage.  Financial risk refers to uncertainty in future net income due to the fixed costs of using debt financing or financial leverage. (Morgan and zumalt 1980).

 

Luoma and Spiller (2002) points that the trade-off  between a potentially higher Shareholders return and the potential decreases in financial strength and solvency is an important part of making financing decisions because inappropriate financing decisions make firm’s risk larger. Furthermore, luoma and Spiller (2002) discover that a particular usage of preferred stock and debt in financing the firm’s assets creates financial risk which is directly associated with firms financial leverage. Levy and Sarnat (1994), the impact of financial leverage is likely to be positive under good economic condition while its impact is likely to be negative under a bad economic condition of the country. Thus, increasing the variability of firms return due to improper use of obtained funds will expand the firm’s financial risk .Ultimately, the firms uncertainty in the future will increase when the trend of investment of potential risk averse-investors is lower. In the light of the above fact that effective use of obtained funds can reduce firms financial risk and make firm profitable. Ahmed Shiek and wang (2011) state that inappropriate selection of securities such as debts or preferred stock lead the firm towards a financial distress and ultimately to bankruptcy.

Leverage is a major component of the financial structure of firms, and unlike other causes of risk the management has complete control over the risk resulting from leverage. It exists whenever a company has fixed costs whether in the firm’s operational or financial activities, meaning having operational leverage or financial leverage. A firm can finance its investments by debt and equity ,the use of fixed-charged funds such as debt  and preference capital along with the owners equity in the capital structure is described as financial leverage or gearing (Dare and Sola, 2010). An unlevered firm is an all-equity firm, whereas a levered firm is  made up of ownership equity and debt. Financial leverage takes the form of a loan or other borrowing (debt), the proceeds of which are re-invested with the intent to earn a greater rate of return than the cost of interest. if  the firms marginal rate of return on asset ( ROA ) is higher than the rate of interest payable on the loan , then its overall return on equity (ROE) will be higher than if it did not borrow (Laurent, 2005). On the other hand, if the firms return on assets (ROA) is lower than the interest rate, then its return on equity (ROE) will be lower than if it did not borrow. Leverage allows a greater potential returns to the investor than otherwise  would have been available, but the potential loss is also greater: if the investment becomes worthless, the loan principal and all accrued interest on the loan still need to be repaid (Andy, Chuck & Alison 2002). This constitutes financial risk (Pandy 2005). The degree of this financial risk is related to the firm’s financial structure.

Operating leverage is the fraction of a company’s costs that are fixed. Firms with a lower fraction of variable costs and a higher fraction of fixed costs have a higher operating leverage, which means many costs can’t be scaled down in periods of declining sales. This increases the risk of loss and makes operating profit less predictable. However, operating leverage is not necessarily bad. Though it magnifies losses when sales decline, it can increase profit in periods of sales growth.

A business with high operating leverage benefits when sales go up because fixed costs remain the same as revenues increase. The phrase “leveraging fixed costs” refers to getting more production from the same fixed costs. Thus, a company with higher leverage generates bigger profits during these periods. However, the company must pay those same fixed costs even in a period of declining sales. Therefore, a company with higher operating leverage will experience bigger losses when sales drop.

The variance of a company’s operating profit is a measure of its business risk. Many factors contribute to these fluctuations, including changing customer demand, pricing decisions, the positioning of competitors, government regulation, worker productivity and the cost of supplies. Some of these factors are external to the company, while others are the result of management decisions. Operating leverage is one of the largest contributors to business risk that management has the power to control.

Business risk is only one component of a company’s total risk. Financial risk is another important component. The use of debt funding is called financial leverage. Like operating leverage, financial leverage magnifies positive and negative returns. Usually, management determines and controls operating leverage and financial leverage. Management should carefully weigh the risks and rewards associated with either kind of leverage for decision making purposes.

 

1.2 Statement of the Problem                            

 

Numerous researches in finance have focus on these two measures of risk, their determinants and even their intersection. Myers (1991) identified financial leverage as one of the ten unresolved problems in corporate finance. Sealey and Lindley (1996) in examining business risk in banks they utilize a view of the commercial banks as a depository financial institution, that is, the output of a bank is measured by its earnings assets and its input consist of a loan able funds that are acquired or produced by the operations of the firm (its deposit and borrowing activities). Having debt or preferred stock capital is a vital decision made by firms because the return on equity is expected to be higher with debt capital (Bodie, Kane, & Marcus, 2008; Modigliani & Miller, 1958). Considering the trade-off between a potentially higher shareholders return and the potential decreases in financial strength and solvency is an important part of making financing decisions (Luoma & Spiller, 2002) because inappropriate financing decisions make firms risk larger. However, Penman (2008) points that equity and capital investors expect to yield a return from the investment exceeding the cost of capital of equity or debt despite of risk of the investment.

Expanding operating activities makes firm to know how the expansion is to be financed. Particularly, the selection of debts and equity capital or an optimum mix of both depends on the availability of internal funds of the firm (Long & Malitz, 1985). Ahmed sheikh & Wang (2011) state that inappropriate selection of securities such as debts or preferred stock lead the firm towards a financial distress and ultimately to bankruptcy. Moreover, a particular usage of preferred stock and debt in financing the firms asset creates financial risk which are directly associated with firms financial leverage (Luoma & Spiller, 2002). The impact of the financial leverage is likely to be positive under good economic condition while its impact is likely to be negative under bad economic condition of the country (levy & Sarnat, 1994). Thus, increasing the variability of firms return due to improper use of obtained funds will expand the firm’s financial risk. Ultimately, the firm’s uncertainty in the future will increase when the trend of investment of potential risk averse –investors is lower. In the light of the above fact that effective use of obtained funds can reduce firms financial risk and make firm profitable.

In business terminology, a high degree of operating leverage, other factors held constant, implies that a relatively small change in sales results in a large change in ROE (Brigham & Gapenski, 1991). Mandelker & Rhee (1984) conducted an empirical study on the relationship between the degree of operating leverage (DOL), degree of financial leverage (DFL) and beta. They provided empirical evidence that the degrees of operating and financial leverage explain a larger portion (38 to 48 percent) of the cross- sectional variation in beta at the portfolio level.

Surveys of empirical studies revealed that consensus have not been reached on the effect of leverage on business risk and finance risk. Many researchers such as   (Al-taani, 2013; Al-tally, 2014; Arowoshegbe & Emeni, 2014; Chinaemerem & Anthony, 2012; Majumdar & Chhibber, 1999; Ogebe et al, 2013; Onaolapo & Kajola, 2010) found a significant negative relationship between leverage and firms performance, other researchers such as also ( Adenugba, Ige & Kesinro, 2016),found financial leverage having  significant effect on firms value. (Akhtar, Maryam & Sadia, 2012; Berger &  Bonaccorsi  dipatti, 2006; Fosu, 2013; Gweji & Karanja, 2014; Ojo, 2012; Rehman, 2013) also found a significant positive relationship between financial leverage and financial performance.

It can be seen from the above reviews of empirical literature that results from investigations on the effect of leverage on finance risk and business risk are inconclusive but rather focused more on one aspect of leverage , therefore more empirical studies are needed. Given the paucity in existing literature, this study will try to fill in the gap by examining both risks (business risk and financial risk) as well as the effect of leverage (financial, operating and total leverage) on those risks of listed deposit money banks in Nigeria. Various researches have been carried out on leverage and risk in banks but on financial performance and capital structure. This research is going to look at something different which has to do with the effect of  leverage ( financial leverage, operating leverage and total leverage) on business risk and finance risk of which it has to do with earnings before income and tax (EBIT) and earnings per share (EPS) of banks, although the concept of operating leverage requires that the cost of a bank be divided into fixed and variable components, this is necessary to identify the contribution of operating leverage to the variability in earnings since the production process of a bank does not employ large amount of capital assets like many industrial or manufacturing firms. So identification of fixed cost and variable cost will be gotten from savings and deposits which include attracting and servicing cost along with interest cost, these cost are all relatively fixed they include mostly personnel cost associated with the sales force i.e. loan officers, bond department, and credit department while variable cost is the personnel and interest cost associated with acquiring loan able funds inputs over and above the stable deposit.  Hence, the main problem of this research work is to examine the effect of leverage on finance risk and business risk on listed deposit money banks in Nigeria.

 

1.3     Objective of the Study  

The main objective of this study is to examine the effect of leverage on business and finance risk of listed deposit money banks in Nigeria. The specific objectives include:

  1. To ascertain the effect of operating leverage on business risk of deposit money banks in Nigeria.
  2. To evaluate the effect of financial leverage on finance risk of deposit money banks in Nigeria.
  • To examine the effect of total leverage on business and finance risk of deposit money banks in Nigeria.

1.4       Research Questions

In relation to objective of the study the following research questions was raised;

  1. What is the effect of operating leverage on business risk of deposit money banks in Nigeria?
  2. What is the effect of finance leverage on financial risk of deposit money banks in Nigeria?
  • What is the effect of total leverage on business and financial risk of deposit money banks in Nigeria?

1.5       Research Hypotheses

The following research questions were raised in line with the above objectives:

H01: operating leverage has no significant effect on business risk of listed deposit money banks in Nigeria.

H02: financial leverage has no significant effect on finance risk of listed deposit money banks in Nigeria.

H03: leverage (operating and financial) has no significance effect on risk (business and finance) of listed deposit money banks in Nigeria.

1 .6      Scope of the Study

The Nigerian banking sector is large; in that, it includes different types of banks, but this research will only restrict itself to listed deposit money banks in Nigeria. The study has two dependent variable, business risk proxy by the variability in earnings before interest and tax (EBIT), and finance risk proxy using earnings before interest and tax (EBIT) and tax and earnings per share (EPS).

The research will be conducted for a period of 10 years between 2007 -2016 using 10 listed deposit money banks in Nigeria.

1.7       Significance of the Study

The study will add to existing literatures by exploring the determinants of business risk, the interaction between business and financial risk in listed deposit money banks, however financial firms have usually been neglected.

The result of this research will help banks to have knowledge on the effect of debt on risk, will also give investors knowledge as the bank they want to invest in if is profitable or not, the government are also not left cause they will have an insight regarding banks that are able to control their debts and those that don’t, in essence it will help to add knowledge to existing literatures and other researchers.

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