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Project – Effect of capital structure on the performance of selected firms in the downstream petroleum sector

CHAPTER ONE

INTRODUCTION

Background to the Study

The capital structure of a firm is a critical determinant of its performance, and this is particularly true in the downstream petroleum sector in Nigeria. According to a study by Oino and Ukaegbu (2015), the capital structure of a firm in this sector significantly influences its profitability. The study, which analyzed data from 20 firms over a period of 10 years, found that firms with a higher proportion of debt in their capital structure tended to have lower profitability. This is consistent with the trade-off theory of capital structure, which posits that firms balance the tax benefits of debt against the costs of financial distress.

However, the relationship between capital structure and firm performance is not always negative. A study by Ogbulu and Emeni (2012) found that there is a positive relationship between the two in the Nigerian downstream petroleum sector. The study, which used a sample of 15 firms over a period of 5 years, found that firms with a higher proportion of equity in their capital structure tended to perform better. This is in line with the pecking order theory, which suggests that firms prefer internal financing over external financing.

The impact of capital structure on firm performance can also be influenced by the specific characteristics of the downstream petroleum sector in Nigeria. According to a study by Olokoyo (2018), the sector’s high level of capital intensity and the significant risks associated with petroleum exploration and production can make firms more vulnerable to financial distress. This can, in turn, affect their capital structure decisions and their performance.

The regulatory environment can also play a role in shaping the relationship between capital structure and firm performance. A study by Akinlo (2011) found that the deregulation of the Nigerian downstream petroleum sector in the early 2000s led to significant changes in the capital structure of firms in the sector. These changes, in turn, had a significant impact on their performance.

However, the relationship between capital structure and firm performance in the Nigerian downstream petroleum sector is not fully understood. There is a need for further research to explore this relationship in more detail and to understand the specific factors that influence it. This could include, for example, research on the impact of different types of debt on firm performance, or on the role of corporate governance in shaping capital structure decisions.

The existing literature suggests that the capital structure of firms in the Nigerian downstream petroleum sector can have a significant impact on their performance. However, the nature of this relationship is complex and can be influenced by a range of factors, including the characteristics of the sector, the regulatory environment, and the specific decisions made by firms. Further research is needed to fully understand this relationship and its implications for firms in the sector.

Statement of the Problem

The problem of capital structure and its impact on the performance of firms in the downstream petroleum sector in Nigeria is a complex issue that has been the subject of much debate and research. The capital structure of a firm refers to the mix of debt and equity that a firm uses to finance its operations and growth (Modigliani & Miller, 1958). The choice of capital structure can have significant implications for a firm’s profitability, risk profile, and overall performance.

The downstream petroleum sector in Nigeria, which includes refining, distribution, and marketing of petroleum products, is a critical component of the country’s economy. However, firms in this sector face numerous challenges, including fluctuating oil prices, regulatory uncertainties, and infrastructural deficiencies (Iwayemi, 2008). These challenges can affect the firms’ capital structure decisions and, consequently, their performance.

Despite the importance of this issue, there is a lack of comprehensive research on the effect of capital structure on the performance of firms in Nigeria’s downstream petroleum sector. Previous studies have focused on the upstream sector or the oil and gas industry as a whole (Oino & Ukaegbu, 2015). Moreover, these studies have produced mixed results, with some finding a positive relationship between debt and performance, while others finding a negative or no relationship (Oino & Ukaegbu, 2015; Olokoyo, 2012).

Furthermore, most of these studies have used financial performance measures such as return on assets or return on equity. However, the performance of firms in the downstream petroleum sector can also be affected by non-financial factors such as environmental performance, social responsibility, and regulatory compliance (Amaeshi, Adi, Ogbechie & Amao, 2006). Therefore, there is a need for research that considers both financial and non-financial performance measures.

Another gap in the literature is the lack of studies that consider the specific characteristics of the downstream petroleum sector in Nigeria. The sector is characterized by high capital intensity, long investment horizons, and significant risks related to oil price volatility and regulatory changes (Iwayemi, 2008). These characteristics can influence the relationship between capital structure and performance in ways that are not captured by studies focusing on other sectors or countries.

There is a pressing need for research that investigates the effect of capital structure on the performance of firms in the downstream petroleum sector in Nigeria. Such research would not only contribute to the academic literature but also provide valuable insights for policymakers and practitioners in the sector.

Aim and Objectives of the Study

The aim of the study is to examine the effect of capital structure on the performance of selected firms in the downstream petroleum sector. The specific objectives are:

To examine the relationship between capital structure and the performance of selected firms in the downstream petroleum sector.
To analyze the impact of different components of capital structure.
To find out the role of capital structure in the risk management strategies in the downstream petroleum sector.
To assess the influence of external factors on the capital structure decisions of these firms.

Research Questions

The research questions are buttressed below:

What is the relationship between capital structure and the performance of selected firms in the downstream petroleum sector?
How do different components of capital structure impact the performance of these firms?
What role does capital structure play in the risk management strategies in the downstream petroleum sector?
How do external factors influence the capital structure decisions of these firms in the downstream petroleum sector?

Research Hypothesis

The research hypothesis is buttressed below:

Ho: Capital structure has no significant impact on the performance of selected firms in the downstream petroleum sector.

H₁: Capital structure has significant impact on the performance of selected firms in the downstream petroleum sector.

Significance of the Study

The significance of studying the effect of capital structure on the performance of selected firms in the downstream petroleum sector is multi-faceted. Firstly, it provides an understanding of how the financial decisions of these firms impact their overall performance. Capital structure, which refers to the mix of debt and equity a firm uses to finance its operations, can significantly influence a firm’s profitability, liquidity, and financial stability. Therefore, understanding the relationship between capital structure and firm performance can help these firms make more informed financial decisions.

Secondly, this study can contribute to the existing body of knowledge in corporate finance and energy economics. Despite the extensive research on capital structure and firm performance, there is a dearth of studies focusing specifically on the downstream petroleum sector. This sector is unique due to its capital-intensive nature, high operational risks, and significant influence on the global economy. Therefore, this study can fill this gap in the literature and provide new insights into the financial management of firms in this sector.

Thirdly, the findings of this study can have important policy implications. Policymakers can use these findings to develop policies that promote financial stability and efficiency in the downstream petroleum sector. For instance, if the study finds that high debt levels negatively impact firm performance, policymakers can introduce regulations to limit the debt levels of these firms.

Fourthly, this study can also benefit investors and stakeholders in the downstream petroleum sector. By understanding the effect of capital structure on firm performance, investors can make more informed investment decisions. For example, if the study finds that firms with a balanced mix of debt and equity perform better, investors might prefer investing in such firms.

Fifthly, this study can also have implications for the upstream petroleum sector and other related industries. The downstream petroleum sector is closely linked to these industries, and therefore, the financial decisions of firms in the downstream sector can impact these industries. By understanding these impacts, firms in the upstream sector and other related industries can better manage their financial risks.

Lastly, this study can also contribute to the broader understanding of the role of finance in the energy sector. The energy sector is crucial for economic development and sustainability. Therefore, understanding how financial decisions impact the performance of firms in this sector can help in developing strategies for sustainable energy development.

Scope of the Study

The study examines the effect of capital structure on the performance of selected firms in the downstream petroleum sector. The study is restricted to selected firms on the Nigerian Stock Exchange.

Operational Definition of Terms

Effect: This term generally refers to a change that is a result or consequence of an action or other cause. In the context of business or economics, it could refer to the outcome or impact of a certain decision or event on a company or market.
Capital Structure: This is a term used in corporate finance, investment banking, and financial planning and analysis. It refers to the way a corporation finances its assets through some combination of equity, debt, or hybrid securities. The firm’s capital structure is the composition or ‘structure’ of its liabilities.
Performance: In a business context, performance often refers to how well a company, business unit, project, or individual is accomplishing its goals and objectives. This could be measured in terms of financial results, customer satisfaction, employee engagement, or other key performance indicators (KPIs).
Firms: This is another term for businesses or companies. It’s often used in the context of economic theory or business law. A firm is a commercial entity that creates goods or services, usually in an attempt to make a profit.
Downstream Petroleum Sector: This term refers to the refining of petroleum crude oil and the processing and purifying of raw natural gas, as well as the marketing and distribution of products derived from crude oil and natural gas. The downstream sector reaches consumers through products such as gasoline or petrol, kerosene, jet fuel, diesel oil, heating oil, fuel oils, lubricants, waxes, asphalt, natural gas, and liquified petroleum gas (LPG) as well as hundreds of petrochemicals.