EFFECT OF STOCK LIQUIDITY ON A CAPITAL STRUCTURE OF A FIRM

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EFFECT OF STOCK LIQUIDITY ON A CAPITAL STRUCTURE OF A FIRM

(a case study of Nigeria Stock Exchange Commission)

ABSTRACT

 This project work explores the effect of liquidity on capital structure of a firm. The firms which have more liquid equity enjoys a lower cost of equity and may be motivated to have more equity and less debt in their capital structure. Study shows that asset liquidity increases the debt capacity of the firms or organization when bond covenants restrict the disposition of the asset. The results demonstrate that liquidity has least impact on capital structure but not the significant impact on capital structure of the firm. Liquidity must be taken into account when the companies want to get the additional capital from the outsiders. The easiest way to increase the capital is to issue the long term bonds because companies have ample time to return the amount of bond along with interest. When the firms increase the inventory level, this will lead to increase in leverage. When the firms increase the cash in hand and other current assets, this will lead to reduction in the short term and long term debts.

CHAPTER ONE

INTRODUCTION

1.1     BACKGROUND OF THE STUDY

Liquidity has long been an important issue for securities traded in financial markets. Even though, liquidity is easy to define in theoretical terms, but its empirical measurement in an accurate and reliable manner is difficult, except for markets that are relatively very liquid, such as U. S. markets. Stock liquidity is related to the ease with which the firm can raise external capital by issuing stock equity, or a liquid stock is one that can be bought and sold easily. Accordingly, increasing stock liquidity will decrease issuance costs and the cost of capital and increase firm value (Burtler, et, al. 2005; Frieder and Martell, 2006; Lipson and Mortal, 2010; and Udomsirikul, et, al, 2010).

Capital structure theories have examined many determinants of capital structure decisions such as size, profitability, information asymmetry, and growth opportunities to explain leverage. Liquidity as one of these determinants has been clearly absent from empirical studies of capital structure (Hovakimian, Opler, and Titman, 2001; and Fama and French, 2002). Only recently researchers especially from U.S have considered liquidity to be one of the determinants of capital structure decisions, and showed that companies with more liquid equity will tend to issue equity than those with less liquid equity, and they conclude that capital structure decisions are likely influenced by liquidity (Frieder and Martell, 2006; Lipson and Mortal, 2010; and Udomsirikul, et, al. 2010).

Udomsirikul, et, al. (2010) and Nai-kang (2009) are the only two recent studies regarding stock liquidity and capital structure that links market microstructure with corporate finance in an emerging market. The results of these studies were the same as US studies, they showed that firms with more liquid equity have lower leverage and prefer equity financing when raising capital. This paper will examine the link between liquidity and capital structure in the Jordanian market, one of the Middle East regions, especially because there were a limited number of published researches in this subject, and because firm ownership is highly concentrated in Jordan than most of the developed countries, and that high ownership concentration proved to be significantly affect liquidity (Kothare, 1997; Amihud, Mendelson, and Uno, 1999; Heflin and Shaw, 2000; Rubin, 2007; and Udomsirikul, et, al. (2010).

1.2     STATEMENT OF PROBLEM

As Nigeria Stock Exchange is growing, liquidity has major impact on capital structure decision making. When financial institutions want to provide finance in a particular company, they analyze the liquidity of that company in which they are investing.

1.3     OBJECTIVES OF THE STUDY

The main objective is to understand the effect of liquidity on leverage and firm value. Other objectives are:

1. The effect of liquidity in developing financial market, such as Nigeria Financial Market.
2. To make managers understands the impact of liquidity in making capital structure decisions.
3. To evaluate how much liquidity is important for any organization

1.4     RESEARCH QUESTION

1. Is there any effect of liquidity on leverage and firm value?
2. What are the effects of liquidity in developing financial market?
3. Do managers understand the impact of liquidity in making capital structure decision?
4. How is liquidity important to any organization?

1.5     STATEMENT OF HYPOTHESIS

H_o:    The liquidity ratios has no significant effect on capital structure ratios

H_i:     The liquidity ratios have significant effect on capital structure ratios

1.6     SIGNIFICANCE OF THE STUDY

This research helps corporate firms in Nigeria to maintain a balanced proportion of long-term debts in their capital structure mix and that both the financed system and corporate enterprise should endeavour to uphold a policy of maintaining adequate liquidity rating.

This research is of great importance which enables the researchers to know the significance this research project as one of the tools that help organization greatly in accomplishing their goals and objective. It exposes the reader to a vast knowledge and wealth of experience of past scholars.

1.7     SCOPE OF THE STUDY

Due to time and resources constraints the study at hand has been limited to Nigeria Stock Exchange Commission, Abuja.

1.8     DEFINITION OF TERM

Capital structure: The relative proportions of a company’s total capital made up by debt, common stock, and preferred stock.

Liquidity: Assets that can easily be converted into cash.

Profitability: The state or condition of yielding a financial profit or gain.

Firm: a group of people who form a commercial organization selling goods or services.

Inflation rate: The rate at which the general level of prices for goods and services is rising, and, subsequently, purchasing power is falling.

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