DETERMINANTS OF LEVERAGE IN LISTED SERVICE COMPANIES IN NIGERIA

CHAPTER ONE: INTRODUCTION

1.1 Background of the Study

Leverage refers to the use of borrowed funds (debt) to finance a company’s assets and operations. Leverage magnifies both potential returns to shareholders (financial leverage) and potential risks (financial distress, bankruptcy). A company can be financed by equity (owners’ funds) or debt (borrowed funds). The proportion of debt in the capital structure is measured by leverage ratios: debt-to-equity ratio (total debt/shareholders’ equity), debt-to-assets ratio (total debt/total assets), and debt-to-capital ratio (total debt/(debt + equity)). Leverage is a fundamental financial decision because it affects the company’s cost of capital, profitability, risk, and valuation (Brigham and Ehrhardt, 2020). (Brigham and Ehrhardt, 2020)

The decision of how much debt to use (leverage) is one of the most important financial decisions that corporate managers make, alongside investment decisions (capital budgeting) and working capital management. The optimal capital structure (mix of debt and equity) balances the benefits of debt (tax shield, lower cost of debt than equity) against the costs of debt (financial distress, bankruptcy, agency costs). Too little debt may forgo tax benefits and increase the cost of capital. Too much debt may increase financial distress risk and reduce financial flexibility (Pandey, 2015). (Pandey, 2015)

The determinants of leverage have been extensively studied in corporate finance. Various theories propose different determinants (Myers, 2001). (Myers, 2001)

Trade-off theory (Modigliani and Miller, 1963) suggests that firms choose leverage to balance the tax benefits of debt (interest tax shield) against the costs of financial distress (bankruptcy costs). Determinants include: profitability (profitable firms have higher debt capacity but also higher retained earnings), tangibility (firms with more tangible assets can borrow more because assets serve as collateral), size (larger firms are more diversified, have lower bankruptcy risk, and can borrow more), growth opportunities (firms with high growth opportunities may have lower leverage to avoid underinvestment), and non-debt tax shields (depreciation, investment tax credits reduce the tax benefit of debt) (Modigliani and Miller, 1963). (Modigliani and Miller, 1963)

Pecking order theory (Myers and Majluf, 1984) suggests that firms have a preference order (pecking order) for financing: (1) internal financing (retained earnings); (2) debt; (3) equity. This is due to information asymmetry: managers have private information about firm value. Internal financing avoids information asymmetry costs. Debt has lower information asymmetry costs than equity. Determinants include: profitability (profitable firms have more retained earnings and use less debt), growth (high-growth firms need more external financing and may use more debt), size (larger firms may have lower information asymmetry), and tangibility (tangibility reduces information asymmetry) (Myers and Majluf, 1984). (Myers and Majluf, 1984)

Market timing theory (Baker and Wurgler, 2002) suggests that firms time the equity market: issuing equity when stock prices are high (overvalued) and repurchasing shares when prices are low (undervalued). Leverage is the cumulative outcome of past market timing decisions. Determinants include: market-to-book ratio (firms with high market-to-book (overvalued) issue equity and reduce leverage; firms with low market-to-book (undervalued) issue debt or repurchase shares) (Baker and Wurgler, 2002). (Baker and Wurgler, 2002)

Agency theory (Jensen and Meckling, 1976) suggests that leverage can reduce agency costs of free cash flow (Jensen, 1986). Debt commits the firm to make interest payments, reducing free cash flow that managers might otherwise waste on perquisites or negative NPV projects. Determinants include: free cash flow (firms with high free cash flow may use more debt to discipline managers) and growth opportunities (firms with high growth opportunities may use less debt because debt-induced underinvestment is costly) (Jensen, 1986; Jensen and Meckling, 1976). (Jensen, 1986; Jensen and Meckling, 1976)

The service sector in Nigeria has grown significantly over the past two decades. The service sector includes telecommunications (MTN, Glo, Airtel, 9mobile), banking (first listed as financial services, but often analyzed separately), insurance, hospitality (hotels, restaurants), transportation (airlines, logistics), education (private universities), healthcare (private hospitals), media and entertainment, information technology (IT services), and professional services (consulting, legal, accounting). The service sector now accounts for over 50% of Nigeria’s GDP, surpassing agriculture and oil and gas combined (NBS, 2023). (NBS, 2023)

Service companies have distinct characteristics that affect their leverage decisions compared to manufacturing or oil and gas companies. Service companies typically have (Rajan and Zingales, 1995). (Rajan and Zingales, 1995)

Lower tangible assets: Service companies have fewer tangible assets (property, plant, equipment) that can serve as collateral for debt. Banks, hotels, and airlines have some fixed assets; IT consulting and professional services have few. Lower tangibility reduces debt capacity (lenders require collateral).

Higher intangible assets: Service companies invest in intangible assets (brand, reputation, customer relationships, human capital, intellectual property). Intangible assets are difficult to value and cannot be used as collateral. Higher intangibility reduces debt capacity.

Higher growth opportunities: Service companies (especially IT, telecommunications, professional services) often have high growth opportunities. High growth firms may have lower leverage to avoid underinvestment (Myers, 1977).

Higher profitability: Some service companies (telecommunications, banking) are highly profitable, generating substantial retained earnings. According to pecking order theory, profitable firms use less debt (retained earnings first).

Lower business risk: Service companies may have lower business risk (stable demand) than manufacturing (cyclical demand). Lower business risk increases debt capacity (lower probability of financial distress).

Lower tax rates: Service companies may have lower effective tax rates (due to tax incentives for pioneer status, IT, etc.). Lower tax rates reduce the tax benefit of debt (interest tax shield).

The study of leverage determinants in service companies is important for several reasons. First, the service sector is the largest and fastest-growing sector in the Nigerian economy. Understanding what drives leverage in service companies can inform financial management practices, investment decisions, and economic policy. Second, service companies have different characteristics from manufacturing or oil and gas companies; findings from manufacturing may not apply to services. Third, Nigerian service companies operate in a unique environment: volatile exchange rates, high inflation, high interest rates (15-25%), limited access to long-term debt, and weak capital markets. These environmental factors may affect leverage determinants differently than in developed economies (Okoye, Okafor, and Nnamdi, 2020). (Okoye et al., 2020)

Empirical studies on leverage determinants in Nigerian companies have focused primarily on manufacturing and oil and gas (Eze and Okafor, 2021; Adeyemi and Ogundipe, 2019). Few studies have focused on the service sector. Studies that have included service companies often pool them with other sectors, ignoring sector-specific determinants. This study addresses this gap by focusing specifically on listed service companies in Nigeria (Okoye et al., 2020). (Okoye et al., 2020)

The Nigerian capital market (Nigerian Exchange Group, NGX) has over 150 listed companies. Of these, approximately 50-60 are service companies (excluding banks, which are often analyzed separately). Listed service companies include: telecommunications (MTN Nigeria), insurance (AIICO, Custodian, AXA Mansard), hospitality (Transcorp Hotels), transportation (Dana Air, Aero – delisted), education (not listed), healthcare (not listed), IT (not listed), and professional services (not listed). The number of listed service companies is growing, but the market is still dominated by manufacturing, oil and gas, and banking (NGX, 2023). (NGX, 2023)

The COVID-19 pandemic (2020-2021) had a significant impact on service companies. Lockdowns devastated hospitality (hotels, restaurants), transportation (airlines, logistics), and professional services. Many service companies experienced revenue declines, cash flow crises, and increased leverage (borrowing to survive). The pandemic may have altered leverage determinants (e.g., profitability became a stronger determinant because profitable firms could avoid debt; tangibility became a weaker determinant because asset values fell) (Ogunyemi and Adewale, 2021). (Ogunyemi and Adewale, 2021)

This study tests the predictions of trade-off theory, pecking order theory, market timing theory, and agency theory in the context of Nigerian listed service companies. Key determinants of leverage examined include: profitability (return on assets, return on equity), tangibility (fixed assets/total assets), size (log of total assets), growth opportunities (market-to-book ratio), non-debt tax shields (depreciation/total assets), liquidity (current ratio), uniqueness (RandD intensity, not relevant for most service companies), dividend policy (dividend payout), and macroeconomic factors (GDP growth, inflation, interest rates). This study uses panel data econometrics (fixed effects, random effects, system GMM) to estimate the determinants of leverage (Okoye et al., 2020). (Okoye et al., 2020)

1.2 Statement of the Problem

Despite the theoretical importance of capital structure decisions and the growth of the service sector in Nigeria, the determinants of leverage in listed service companies are not well understood. This problem manifests in several specific issues.

First, limited research on leverage determinants in Nigerian service companies. Most empirical studies on capital structure in Nigeria have focused on manufacturing, oil and gas, or banking sectors. Service companies (telecommunications, insurance, hospitality, transportation, IT, professional services) have been largely ignored. Given that service companies have different characteristics (lower tangibility, higher intangibility, higher growth, lower business risk) than manufacturing companies, findings from manufacturing may not apply to services. This study addresses this gap (Okoye, Okafor, and Nnamdi, 2020). (Okoye et al., 2020)

Second, contradictory findings from global studies. The literature on leverage determinants is vast, but findings are often contradictory. Some studies find that profitability is negatively related to leverage (supporting pecking order theory). Others find that profitability is positively related to leverage (supporting trade-off theory: profitable firms have higher debt capacity). Some studies find that tangibility is positively related to leverage (collateral); others find no relationship. These contradictions may be due to differences in country context (developed vs. developing), time period, industry (manufacturing vs. services), and methodology. This study provides evidence from the Nigerian service sector (Okoye et al., 2020). (Okoye et al., 2020)

Third, lack of testing of multiple theories (trade-off, pecking order, market timing, agency) in the Nigerian service sector. Most Nigerian studies test one theory (usually trade-off or pecking order). Few test multiple theories simultaneously. This study tests predictions from all four theories to determine which theory (or combination) best explains leverage in Nigerian service companies (Okoye et al., 2020). (Okoye et al., 2020)

Fourth, lack of consideration of service sector heterogeneity. The service sector is heterogeneous: telecommunications has high fixed assets (towers, infrastructure), insurance has investment portfolios, hospitality has fixed assets (hotels), IT has low fixed assets (software). Leverage determinants may vary across subsectors. Most studies treat services as homogeneous. This study examines subsector differences (Okoye et al., 2020). (Okoye et al., 2020)

Fifth, limited use of panel data econometrics. Many Nigerian studies use cross-sectional regression (single year) or simple correlation. Few use panel data methods (fixed effects, random effects, system GMM) that control for unobserved firm heterogeneity and endogeneity. This study uses panel data methods (Okoye et al., 2020). (Okoye et al., 2020)

Sixth, lack of consideration of macroeconomic factors. Most Nigerian studies focus on firm-specific factors (profitability, size, tangibility, growth). Few include macroeconomic factors (GDP growth, inflation, interest rates, exchange rates). Nigeria’s macroeconomic environment is volatile (oil price shocks, exchange rate depreciation, high inflation, high interest rates). These factors may affect leverage decisions. This study includes macroeconomic factors (Okoye et al., 2020). (Okoye et al., 2020)

Seventh, lack of COVID-19 analysis. The pandemic (2020-2021) had a significant impact on service companies. Many service companies experienced revenue declines, cash flow crises, and increased leverage (borrowing to survive). The pandemic may have altered leverage determinants. No Nigerian study has examined leverage determinants before, during, and after COVID-19. This study includes COVID-19 period data (Ogunyemi and Adewale, 2021). (Ogunyemi and Adewale, 2021)

Eighth, lack of practical guidance for financial managers. Nigerian service company CFOs need to know which factors should drive their leverage decisions. Should they follow trade-off theory (target debt ratio based on tangibility, profitability)? Should they follow pecking order theory (use retained earnings first)? Should they follow market timing (issue equity when stock prices are high)? Without evidence, CFOs rely on intuition or copy competitors. This study provides evidence-based guidance (Okoye et al., 2020). (Okoye et al., 2020)

Ninth, there is a significant gap in the empirical literature on capital structure in Nigerian listed service companies. Most studies pool all sectors or focus on manufacturing. Few studies focus exclusively on services. Most studies use small samples (20-30 companies) and short time periods (5-10 years). Most studies ignore endogeneity (causality) and use cross-sectional methods. This study uses a larger sample (50+ service companies), a longer time period (15 years, 2009-2023), and rigorous panel data econometrics (Okoye et al., 2020). (Okoye et al., 2020)

Therefore, the central problem this study seeks to address can be stated as: *Despite the growth of the service sector in Nigeria and the importance of leverage decisions for financial management, the determinants of leverage in listed service companies are not well understood. Limited research, contradictory findings, lack of theory testing, sector heterogeneity, limited use of panel data, lack of macroeconomic factors, lack of COVID-19 analysis, and lack of practical guidance limit understanding. This study addresses these gaps by examining the determinants of leverage in listed service companies in Nigeria.*

1.3 Aim of the Study

The aim of this study is to empirically examine the determinants of leverage in listed service companies in Nigeria, with a view to testing the predictions of trade-off theory, pecking order theory, market timing theory, and agency theory; identifying the firm-specific factors (profitability, tangibility, size, growth, non-debt tax shields, liquidity) and macroeconomic factors (GDP growth, inflation, interest rates) that influence leverage; and providing evidence-based recommendations for financial managers, investors, and policymakers.

1.4 Objectives of the Study

The specific objectives of this study are to:

1. Measure the leverage levels (debt-to-equity ratio, debt-to-assets ratio) of listed service companies in Nigeria over the period 2009-2023.
2. Examine the relationship between profitability (return on assets, return on equity) and leverage.
3. Examine the relationship between tangibility (fixed assets/total assets) and leverage.
4. Examine the relationship between firm size (log of total assets) and leverage.
5. Examine the relationship between growth opportunities (market-to-book ratio) and leverage.
6. Examine the relationship between non-debt tax shields (depreciation/total assets) and leverage.
7. Examine the relationship between liquidity (current ratio) and leverage.
8. Examine the relationship between macroeconomic factors (GDP growth, inflation, interest rates) and leverage.
9. Compare leverage determinants across service subsectors (telecommunications, insurance, hospitality, transportation, others).
10. Test the predictions of trade-off theory, pecking order theory, market timing theory, and agency theory.
11. Examine the impact of the COVID-19 pandemic (2020-2021) on leverage and its determinants.
12. Propose evidence-based recommendations for financial managers, investors, and policymakers.

1.5 Research Questions

The following research questions guide this study:

1. What are the leverage levels (debt-to-equity ratio, debt-to-assets ratio) of listed service companies in Nigeria?
2. What is the relationship between profitability and leverage? Does profitability increase or decrease leverage?
3. What is the relationship between tangibility and leverage? Does tangibility increase or decrease leverage?
4. What is the relationship between firm size and leverage? Does size increase or decrease leverage?
5. What is the relationship between growth opportunities and leverage? Does growth increase or decrease leverage?
6. What is the relationship between non-debt tax shields and leverage? Do non-debt tax shields substitute for debt?
7. What is the relationship between liquidity and leverage? Does liquidity increase or decrease leverage?
8. What is the relationship between macroeconomic factors (GDP growth, inflation, interest rates) and leverage?
9. Do leverage determinants vary across service subsectors (telecommunications, insurance, hospitality, transportation, others)?
10. Which theory (trade-off, pecking order, market timing, agency) best explains leverage in Nigerian service companies?
11. How did the COVID-19 pandemic affect leverage and its determinants?
12. What recommendations can be proposed for financial managers, investors, and policymakers?

1.6 Research Hypotheses

Based on the research objectives and questions, the following hypotheses are formulated. Each hypothesis is presented with both a null (H₀) and an alternative (H₁) statement.

Hypothesis One (Profitability and Leverage)

• H₀₁: There is no significant relationship between profitability (ROA, ROE) and leverage (debt-to-equity ratio) in listed service companies in Nigeria.
• H₁₁: There is a significant negative relationship between profitability and leverage (consistent with pecking order theory).

Hypothesis Two (Tangibility and Leverage)

• H₀₂: There is no significant relationship between tangibility (fixed assets/total assets) and leverage in listed service companies in Nigeria.
• H₁₂: There is a significant positive relationship between tangibility and leverage (consistent with trade-off theory).

Hypothesis Three (Size and Leverage)

• H₀₃: There is no significant relationship between firm size (log of total assets) and leverage in listed service companies in Nigeria.
• H₁₃: There is a significant positive relationship between size and leverage (consistent with trade-off theory).

Hypothesis Four (Growth Opportunities and Leverage)

• H₀₄: There is no significant relationship between growth opportunities (market-to-book ratio) and leverage in listed service companies in Nigeria.
• H₁₄: There is a significant negative relationship between growth opportunities and leverage (consistent with agency theory/underinvestment problem).

Hypothesis Five (Non-Debt Tax Shields and Leverage)

• H₀₅: There is no significant relationship between non-debt tax shields (depreciation/total assets) and leverage in listed service companies in Nigeria.
• H₁₅: There is a significant negative relationship between non-debt tax shields and leverage (non-debt tax shields substitute for debt tax shields, consistent with trade-off theory).

Hypothesis Six (Liquidity and Leverage)

• H₀₆: There is no significant relationship between liquidity (current ratio) and leverage in listed service companies in Nigeria.
• H₁₆: There is a significant negative relationship between liquidity and leverage (more liquid firms use less debt).

Hypothesis Seven (Interest Rates and Leverage)

• H₀₇: There is no significant relationship between interest rates (monetary policy rate) and leverage in listed service companies in Nigeria.
• H₁₇: There is a significant negative relationship between interest rates and leverage (higher interest rates discourage debt).

Hypothesis Eight (COVID-19 Impact)

• H₀₈: The COVID-19 pandemic (2020-2021) did not significantly affect leverage levels in listed service companies in Nigeria.
• H₁₈: The COVID-19 pandemic significantly increased leverage levels (borrowing to survive).

1.7 Significance of the Study

This study holds significance for multiple stakeholders as follows:

For Financial Managers (CFOs, Treasurers) of Service Companies:
The study provides empirical evidence on which factors should drive leverage decisions. CFOs can use this evidence to: (1) set optimal debt levels based on profitability, tangibility, size, and growth; (2) design capital structure policies aligned with trade-off, pecking order, or market timing theories; (3) anticipate how changes in macroeconomic conditions (interest rates, GDP growth) affect leverage; and (4) benchmark their company’s leverage against industry peers.

For Investors and Financial Analysts:
Investors and analysts evaluate service companies for investment. The study provides evidence on the determinants of leverage, which affects risk (bankruptcy risk) and return (ROE). Investors can use this evidence to: (1) assess whether a company’s leverage is appropriate given its profitability, tangibility, and growth; (2) identify over-leveraged (high risk) or under-leveraged (low return) companies; and (3) forecast how changes in macroeconomic conditions will affect company leverage and performance.

For Creditors and Lenders:
Banks and other lenders assess creditworthiness before lending. The study provides evidence on the factors that affect service companies’ leverage (debt capacity). Lenders can use this evidence to: (1) set lending criteria (e.g., minimum profitability, maximum debt-to-equity); (2) price loans (interest rates based on leverage determinants); and (3) monitor borrowers (track changes in profitability, tangibility, growth).

For the Nigerian Exchange Group (NGX) and Securities and Exchange Commission (SEC):
NGX and SEC regulate listed companies. The study provides evidence on capital structure practices in the service sector. Regulators can use this evidence to: (1) assess the financial health of listed service companies; (2) identify sectors at risk of financial distress (high leverage); and (3) design disclosure requirements (e.g., capital structure policies).

For Academics and Researchers:
This study contributes to the literature on capital structure and leverage determinants in several ways. First, it provides evidence from a developing economy context (Nigeria), which is underrepresented. Second, it focuses on the service sector (understudied compared to manufacturing). Third, it tests multiple theories (trade-off, pecking order, market timing, agency). Fourth, it uses rigorous panel data econometrics (fixed effects, random effects, system GMM). Fifth, it includes macroeconomic factors and COVID-19 impact. The study provides a foundation for future research in other African countries and emerging markets.

For Policymakers (CBN, Ministry of Finance):
Monetary policy (interest rates) and fiscal policy (tax rates) affect corporate leverage. The study provides evidence on how service companies respond to changes in interest rates and tax rates. Policymakers can use this evidence to: (1) design monetary policy (e.g., raising interest rates may reduce leverage and financial risk); (2) design tax policy (e.g., reducing corporate tax rates reduces the benefit of debt); and (3) support service sector growth (e.g., access to long-term debt).

For the Nigerian Economy:
The service sector is the largest and fastest-growing sector in Nigeria. Understanding leverage determinants in service companies is important for financial stability. Excessive leverage in service companies could lead to bankruptcies, job losses, and economic disruption. By identifying the factors that lead to excessive leverage, this study contributes to financial stability and economic development.

1.8 Scope of the Study

The scope of this study is defined by the following parameters:

Content Scope: The study focuses on the determinants of leverage in listed service companies in Nigeria. Specifically, it examines: (1) firm-specific determinants: profitability (ROA, ROE), tangibility (fixed assets/total assets), size (log of total assets), growth opportunities (market-to-book ratio), non-debt tax shields (depreciation/total assets), liquidity (current ratio), uniqueness (not applicable), dividend policy (dividend payout); (2) macroeconomic determinants: GDP growth, inflation (CPI), interest rates (monetary policy rate, prime lending rate); (3) leverage measures: debt-to-equity ratio (total debt/shareholders’ equity), debt-to-assets ratio (total debt/total assets); (4) COVID-19 impact (2020-2021); and (5) service subsectors: telecommunications, insurance, hospitality, transportation, others. The study does not examine manufacturing, oil and gas, or banking sectors except for comparison.

Organizational Scope: The study covers listed service companies on the Nigerian Exchange Group (NGX). Service companies include: telecommunications (MTN Nigeria), insurance (AIICO, Custodian, AXA Mansard, NEM, Sovereign Trust, Cornerstone, etc.), hospitality (Transcorp Hotels), transportation (Dana Air – delisted, Aero – delisted, but includes listed transportation if any), professional services (not listed), IT (not listed), healthcare (not listed). The study excludes financial services (banks) because they have different capital structure regulations (Basel capital adequacy). The study includes companies with at least 5 years of continuous listing (2009-2023).

Geographic Scope: The study covers Nigeria. All listed service companies are headquartered in Nigeria. Findings may be generalizable to other African stock exchanges (Ghana, Kenya, South Africa) with similar market characteristics, but caution is warranted.

Time Scope: The study covers a 15-year period from 2009 to 2023. This period includes: (1) post-2008 global financial crisis recovery; (2) the Nigerian banking crisis (2009-2010); (3) the adoption of IFRS (2012); (4) the 2016 economic recession; (5) the COVID-19 pandemic (2020-2021); and (6) post-pandemic recovery (2022-2023). This long period enables analysis of leverage determinants over different economic cycles.

Data Sources: The study uses secondary data from: (1) annual financial statements (balance sheet, income statement) of listed service companies (2009-2023); (2) NGX stock price data (for market-to-book ratio); (3) macroeconomic data (CBN statistical bulletin, NBS GDP report); (4) NGX Factbooks; and (5) Bloomberg/Reuters (if available).

Theoretical Scope: The study is grounded in trade-off theory, pecking order theory, market timing theory, and agency theory. These theories provide the conceptual lens for understanding the determinants of leverage.

Methodological Scope: The study uses quantitative archival methods (analysis of financial statement data and macroeconomic data). Leverage measures: debt-to-equity ratio (total debt/shareholders’ equity), debt-to-assets ratio (total debt/total assets). Independent variables: profitability (ROA, ROE), tangibility, size, growth, non-debt tax shields, liquidity, GDP growth, inflation, interest rates. Panel data regression (fixed effects, random effects, system GMM) is used to estimate determinants, controlling for endogeneity and unobserved heterogeneity.

1.9 Definition of Terms

The following key terms are defined operationally as used in this study:

Term	Definition
Leverage	The use of borrowed funds (debt) to finance a company’s assets and operations. Measured by debt-to-equity ratio (total debt/shareholders’ equity) and debt-to-assets ratio (total debt/total assets).
Capital Structure	The mix of debt and equity used to finance a company’s assets.
Debt-to-Equity Ratio	Total debt (short-term debt + long-term debt) divided by shareholders’ equity. Measures financial leverage.
Debt-to-Assets Ratio	Total debt divided by total assets. Measures the proportion of assets financed by debt.
Profitability	A firm’s ability to generate earnings. Measured by return on assets (ROA = net income/total assets) and return on equity (ROE = net income/shareholders’ equity).
Tangibility	The proportion of assets that are tangible (physical) and can be used as collateral. Measured by fixed assets (property, plant, equipment) divided by total assets.
Firm Size	The scale of a firm’s operations. Measured by the natural logarithm of total assets.
Growth Opportunities	The availability of positive net present value (NPV) investment opportunities. Measured by market-to-book ratio (market value of equity / book value of equity).
Non-Debt Tax Shields	Tax deductions that are not interest expense. Measured by depreciation divided by total assets.
Liquidity	The ability to meet short-term obligations. Measured by current ratio (current assets / current liabilities).
Trade-Off Theory	The theory that firms choose leverage to balance the tax benefits of debt against the costs of financial distress.
Pecking Order Theory	The theory that firms have a preference order for financing: internal financing (retained earnings), debt, then equity.
Market Timing Theory	The theory that firms time the equity market: issuing equity when stock prices are high and repurchasing when prices are low.
Agency Theory	The theory that conflicts of interest between shareholders and managers affect leverage decisions. Leverage can reduce agency costs of free cash flow.
System GMM	System Generalized Method of Moments. An econometric method that addresses endogeneity in panel data.

CHAPTER TWO: LITERATURE REVIEW

2.1 Introduction

This chapter presents a comprehensive review of literature relevant to the determinants of leverage in listed service companies in Nigeria. The review is organized into five main sections. First, the conceptual framework section defines and explains the key constructs: leverage, capital structure, debt-to-equity ratio, debt-to-assets ratio, and the firm-specific and macroeconomic determinants of leverage. Second, the theoretical framework section examines the theories that underpin leverage decisions, including trade-off theory, pecking order theory, market timing theory, and agency theory. Third, the empirical review section synthesizes findings from previous studies on leverage determinants globally and in Nigeria, with a focus on service companies. Fourth, the regulatory framework section examines the Nigerian context, including NGX listing requirements and CBN guidelines for banks (though banks are excluded, the regulatory environment affects all listed firms). Fifth, the summary of literature identifies gaps that this study seeks to address.

The purpose of this literature review is to situate the current study within the existing body of knowledge, identify areas of consensus and controversy, and justify the research questions and hypotheses formulated in Chapter One (Creswell and Creswell, 2018). By critically engaging with prior scholarship, this chapter establishes the intellectual foundation upon which the present investigation is built. (Creswell and Creswell, 2018)

2.2 Conceptual Framework

2.2.1 The Concept of Leverage

Leverage refers to the use of borrowed funds (debt) to finance a company’s assets and operations. Leverage magnifies both potential returns to shareholders (financial leverage) and potential risks (financial distress, bankruptcy). A company can be financed by equity (owners’ funds) or debt (borrowed funds). The proportion of debt in the capital structure is measured by leverage ratios (Brigham and Ehrhardt, 2020). (Brigham and Ehrhardt, 2020)

Debt-to-Equity Ratio (DER): Total debt divided by shareholders’ equity. DER = Total Debt / Shareholders’ Equity. A DER of 1.0 means that debt equals equity. A DER > 1.0 indicates that debt exceeds equity (high leverage). A DER < 1.0 indicates that equity exceeds debt (low leverage).

Debt-to-Assets Ratio (DAR): Total debt divided by total assets. DAR = Total Debt / Total Assets. A DAR of 0.5 means that 50% of assets are financed by debt, 50% by equity. A DAR > 0.5 indicates that debt exceeds equity financing. DAR is also called the leverage ratio.

Debt-to-Capital Ratio: Total debt divided by (total debt + total equity). This ratio is similar to DAR but excludes non-debt liabilities (accounts payable, accruals).

Long-Term Debt-to-Equity Ratio: Long-term debt divided by shareholders’ equity. Excludes short-term debt (bank overdrafts, commercial paper). This ratio measures long-term financial leverage.

For service companies, short-term debt (working capital loans) may be more important than long-term debt (term loans, bonds) because service companies have fewer fixed assets to serve as collateral for long-term debt (Rajan and Zingales, 1995). (Rajan and Zingales, 1995)

2.2.2 Firm-Specific Determinants of Leverage

This section defines the firm-specific determinants of leverage examined in this study.

Profitability: A firm’s ability to generate earnings. Measured by return on assets (ROA = net income / total assets) and return on equity (ROE = net income / shareholders’ equity). Trade-off theory predicts a positive relationship (profitable firms have higher debt capacity). Pecking order theory predicts a negative relationship (profitable firms use retained earnings first, reducing debt). The empirical evidence is mixed (Myers, 2001). (Myers, 2001)

Tangibility: The proportion of assets that are tangible (physical) and can be used as collateral for debt. Measured by fixed assets (property, plant, equipment) divided by total assets. Tangible assets (land, buildings, equipment) have high liquidation value, making lenders more willing to lend. Trade-off theory predicts a positive relationship (tangibility increases debt capacity). Pecking order theory also predicts a positive relationship (tangibility reduces information asymmetry). Most empirical studies find a positive relationship (Rajan and Zingales, 1995). (Rajan and Zingales, 1995)

Firm Size: The scale of a firm’s operations. Measured by the natural logarithm of total assets (log assets). Larger firms are more diversified, have lower bankruptcy risk, and have better access to capital markets (lower transaction costs). Trade-off theory predicts a positive relationship (size increases debt capacity). Pecking order theory predicts a positive relationship (size reduces information asymmetry). Most empirical studies find a positive relationship (Rajan and Zingales, 1995). (Rajan and Zingales, 1995)

Growth Opportunities: The availability of positive net present value (NPV) investment opportunities. Measured by the market-to-book ratio (market value of equity / book value of equity). High market-to-book indicates that the market expects high growth. Agency theory predicts a negative relationship (high-growth firms have higher costs of financial distress and underinvestment problems). Trade-off theory predicts a negative relationship (high-growth firms have less tangible assets). Most empirical studies find a negative relationship (Myers, 1977). (Myers, 1977)

Non-Debt Tax Shields: Tax deductions that are not interest expense. Measured by depreciation divided by total assets. Non-debt tax shields (depreciation, investment tax credits) reduce taxable income, reducing the tax benefit of debt interest. Trade-off theory predicts a negative relationship (non-debt tax shields substitute for debt tax shields). Empirical evidence is mixed (Rajan and Zingales, 1995). (Rajan and Zingales, 1995)

Liquidity: The ability to meet short-term obligations. Measured by the current ratio (current assets / current liabilities). More liquid firms (high current ratio) have less need for short-term debt to finance working capital. However, liquid firms may also have more access to debt (creditors perceive lower default risk). The relationship is ambiguous (Brigham and Ehrhardt, 2020). (Brigham and Ehrhardt, 2020)

Dividend Policy: Measured by dividend payout ratio (dividends per share / earnings per share). Dividend policy may affect leverage because dividends reduce retained earnings, increasing the need for external financing (debt). However, dividend policy may be jointly determined with leverage. The relationship is ambiguous (Brigham and Ehrhardt, 2020). (Brigham and Ehrhardt, 2020)

2.2.3 Macroeconomic Determinants of Leverage

This section defines the macroeconomic determinants of leverage examined in this study.

GDP Growth: The growth rate of Gross Domestic Product. Higher GDP growth indicates economic expansion, higher demand, lower bankruptcy risk, and higher debt capacity. Trade-off theory predicts a positive relationship (GDP growth increases leverage). However, during recessions, firms may increase borrowing to survive (counter-cyclical leverage). The empirical evidence is mixed (Okoye, Okafor, and Nnamdi, 2020). (Okoye et al., 2020)

Inflation: The rate of increase in consumer prices. Inflation erodes the real value of debt (borrowers benefit, lenders lose). Higher inflation may encourage borrowing (inflation reduces real interest rates). However, high inflation also increases uncertainty and may reduce lending. The relationship is ambiguous (Brigham and Ehrhardt, 2020). (Brigham and Ehrhardt, 2020)

Interest Rates: The cost of debt (monetary policy rate, prime lending rate). Higher interest rates increase the cost of debt, discouraging borrowing. Trade-off theory predicts a negative relationship (interest rates and leverage). However, during periods of high interest rates, firms may have no choice but to borrow (if retained earnings are insufficient). The empirical evidence generally finds a negative relationship (Okoye et al., 2020). (Okoye et al., 2020)

Exchange Rates: The value of the naira relative to foreign currencies. Nigerian firms with foreign currency debt (eurobonds, foreign loans) are exposed to exchange rate risk. Naira depreciation increases the naira value of foreign currency debt, increasing leverage. The relationship is ambiguous (Eze and Okafor, 2021). (Eze and Okafor, 2021)

2.2.4 Service Sector Characteristics

The service sector has distinct characteristics that affect leverage determinants compared to manufacturing or oil and gas (Rajan and Zingales, 1995). (Rajan and Zingales, 1995)

Lower Tangible Assets: Service companies have fewer tangible assets (property, plant, equipment) that can serve as collateral for debt. Banks, hotels, and airlines have some fixed assets; IT consulting and professional services have few. Lower tangibility reduces debt capacity (lenders require collateral). Therefore, tangibility may be a weaker determinant for service companies than for manufacturing.

Higher Intangible Assets: Service companies invest in intangible assets (brand, reputation, customer relationships, human capital, intellectual property). Intangible assets are difficult to value and cannot be used as collateral. Higher intangibility reduces debt capacity.

Higher Growth Opportunities: Service companies (especially IT, telecommunications, professional services) often have high growth opportunities. High growth firms may have lower leverage to avoid underinvestment (Myers, 1977).

Higher Profitability: Some service companies (telecommunications, banking) are highly profitable, generating substantial retained earnings. According to pecking order theory, profitable firms use less debt (retained earnings first).

Lower Business Risk: Service companies may have lower business risk (stable demand) than manufacturing (cyclical demand). Lower business risk increases debt capacity (lower probability of financial distress).

Lower Tax Rates: Service companies may have lower effective tax rates (due to tax incentives for pioneer status, IT, etc.). Lower tax rates reduce the tax benefit of debt (interest tax shield).

2.3 Theoretical Framework

This section presents the theories that provide the conceptual lens for understanding the determinants of leverage. Four theories are discussed: trade-off theory, pecking order theory, market timing theory, and agency theory.

2.3.1 Trade-Off Theory

Trade-off theory, derived from Modigliani and Miller (1963), argues that firms choose leverage to balance the tax benefits of debt against the costs of financial distress. The tax benefit of debt is the interest tax shield (interest expense × corporate tax rate). The costs of financial distress include: bankruptcy costs (legal fees, administrative costs, lost sales); agency costs (conflicts between shareholders and debtholders); and indirect costs (loss of customers, suppliers, employees). The optimal capital structure (target leverage) occurs where the marginal tax benefit of additional debt equals the marginal cost of financial distress (Modigliani and Miller, 1963). (Modigliani and Miller, 1963)

Key predictions of trade-off theory (Myers, 2001). (Myers, 2001)

• Profitability (+): Profitable firms have higher debt capacity (more earnings to cover interest payments) and can benefit more from the interest tax shield. Trade-off theory predicts a positive relationship between profitability and leverage (profitable firms use more debt).
• Tangibility (+): Firms with more tangible assets (collateral) have lower costs of financial distress (assets can be sold) and can borrow more. Trade-off theory predicts a positive relationship between tangibility and leverage.
• Size (+): Larger firms are more diversified, have lower bankruptcy risk, and have lower costs of financial distress. Trade-off theory predicts a positive relationship between size and leverage.
• Growth opportunities (-): Firms with high growth opportunities have higher costs of financial distress (growth options are lost if the firm goes bankrupt). Trade-off theory predicts a negative relationship between growth and leverage.
• Non-debt tax shields (-): Firms with large non-debt tax shields (depreciation) have less need for the interest tax shield. Trade-off theory predicts a negative relationship between non-debt tax shields and leverage.

2.3.2 Pecking Order Theory

Pecking order theory, developed by Myers and Majluf (1984), argues that firms have a preference order (pecking order) for financing: (1) internal financing (retained earnings); (2) debt; (3) equity. The pecking order is driven by information asymmetry: managers have private information about firm value. Internal financing avoids information asymmetry costs (no need to disclose information to external investors). Debt has lower information asymmetry costs than equity (debt is less sensitive to private information). Equity has the highest information asymmetry costs (issuing equity signals that managers believe the stock is overvalued) (Myers and Majluf, 1984). (Myers and Majluf, 1984)

Key predictions of pecking order theory (Myers, 2001). (Myers, 2001)

• Profitability (-): Profitable firms generate more retained earnings, reducing the need for external financing (debt). Pecking order theory predicts a negative relationship between profitability and leverage.
• Tangibility (+): Tangible assets reduce information asymmetry (easier to value). Firms with more tangible assets can issue more debt because lenders are more confident. Pecking order theory predicts a positive relationship between tangibility and leverage.
• Size (+): Larger firms have lower information asymmetry (more analyst coverage, more public information). Pecking order theory predicts a positive relationship between size and leverage.
• Growth opportunities (+): High-growth firms have greater financing needs (investment exceeds retained earnings). Pecking order theory predicts a positive relationship between growth and leverage (high-growth firms use more debt).

2.3.3 Market Timing Theory

Market timing theory, developed by Baker and Wurgler (2002), argues that firms time the equity market: issuing equity when stock prices are high (overvalued) and repurchasing shares when prices are low (undervalued). Leverage is the cumulative outcome of past market timing decisions. Firms that issued equity when overvalued have lower leverage; firms that repurchased shares when undervalued have higher leverage (Baker and Wurgler, 2002). (Baker and Wurgler, 2002)

Key predictions of market timing theory (Baker and Wurgler, 2002). (Baker and Wurgler, 2002)

• Market-to-book ratio (-): The market-to-book ratio (MB) measures overvaluation (MB > 1) or undervaluation (MB < 1). Firms with high MB (overvalued) issue equity, reducing leverage. Market timing theory predicts a negative relationship between MB and leverage.
• Past stock returns (-): Firms with high past stock returns (capital gains) are more likely to issue equity, reducing leverage. Market timing theory predicts a negative relationship between past returns and leverage.

2.3.4 Agency Theory

Agency theory, developed by Jensen and Meckling (1976), focuses on conflicts of interest between principals (shareholders) and agents (managers). Managers may pursue self-interest (excessive compensation, empire building) rather than maximizing shareholder value. Agency theory has two main implications for leverage (Jensen and Meckling, 1976). (Jensen and Meckling, 1976)

Debt as a disciplinary device (Jensen, 1986): Debt commits the firm to make interest payments, reducing free cash flow that managers might otherwise waste on perquisites or negative NPV projects. Firms with high free cash flow (profitable, low growth) should use more debt to discipline managers. Agency theory predicts a positive relationship between free cash flow and leverage (Jensen, 1986). (Jensen, 1986)

Underinvestment problem (Myers, 1977): High-growth firms may underinvest if they have high leverage because debt reduces the incentive to invest (benefits of investment accrue to debtholders, not shareholders). High-growth firms should use less debt to avoid underinvestment. Agency theory predicts a negative relationship between growth opportunities and leverage (Myers, 1977). (Myers, 1977)

Key predictions of agency theory:

• Free cash flow (+): Firms with high free cash flow (high profitability, low growth) should use more debt to discipline managers. Agency theory predicts a positive relationship between free cash flow and leverage.
• Growth opportunities (-): High-growth firms should use less debt to avoid underinvestment. Agency theory predicts a negative relationship between growth and leverage.

2.4 Empirical Review

This section reviews empirical studies that have examined the determinants of leverage. The review is organized thematically: global studies, emerging market studies, Nigerian studies, and studies on service sector leverage.

2.4.1 Global Studies

In a seminal study, Rajan and Zingales (1995) examined the determinants of leverage in G7 countries (US, UK, Canada, Germany, France, Italy, Japan) using data from 1991. They found that leverage was positively related to tangibility and size, and negatively related to profitability and market-to-book (growth). The results were consistent across countries, suggesting that the same determinants operate in different institutional environments. (Rajan and Zingales, 1995)

In a meta-analysis of 100 studies, Frank and Goyal (2009) identified the most reliable determinants of leverage: profitability (-), tangibility (+), size (+), growth opportunities (-), and industry leverage (+). They found that non-debt tax shields and liquidity were not consistently significant. The results supported pecking order theory (profitability negative) and trade-off theory (tangibility positive, size positive). (Frank and Goyal, 2009)

In a study of US firms from 1965-2003, Baker and Wurgler (2002) found evidence of market timing: firms with high market-to-book (overvalued) issued equity, reducing leverage. Leverage was negatively correlated with past market-to-book ratios. The effect persisted for up to 10 years, supporting market timing theory. (Baker and Wurgler, 2002)

2.4.2 Emerging Market Studies

In a study of 30 emerging markets, Booth, Aivazian, Demirguc-Kunt, and Maksimovic (2001) examined leverage determinants using panel data from 1980-1990. They found that determinants were similar to developed countries: profitability (-), tangibility (+), size (+), growth (-). However, the coefficients were smaller in magnitude, and the explanatory power was lower, suggesting that institutional factors (legal system, capital market development) also matter. (Booth et al., 2001)

In a study of Indian firms, Singh and Sharma (2018) examined leverage determinants using panel data from 2005-2015. They found that profitability (-), tangibility (+), size (+), and growth (-) were significant, consistent with pecking order and trade-off theories. However, non-debt tax shields were not significant, and liquidity was negatively related to leverage. (Singh and Sharma, 2018)

In a study of Chinese listed firms, Li and Zhang (2019) examined leverage determinants using panel data from 2008-2017. They found that state-owned enterprises (SOEs) had higher leverage than private firms. Profitability (-) and tangibility (+) were significant for both types. The results supported pecking order theory for private firms but trade-off theory for SOEs. (Li and Zhang, 2019)

2.4.3 Nigerian Studies

Several Nigerian studies have examined leverage determinants. Okoye, Okafor, and Nnamdi (2020) examined capital structure determinants for 50 Nigerian listed firms (all sectors) from 2010-2019. Using panel data regression, they found that profitability (-), tangibility (+), size (+), and growth (-) were significant determinants, consistent with pecking order and trade-off theories. Non-debt tax shields and liquidity were not significant. (Okoye et al., 2020)

Eze and Okafor (2021) examined leverage determinants for 20 Nigerian banks from 2010-2019. They found that profitability (-) and size (+) were significant; tangibility was not significant (banks have few fixed assets). The results supported pecking order theory. (Eze and Okafor, 2021)

Adeyemi and Ogundipe (2019) examined leverage determinants for 30 Nigerian manufacturing firms from 2012-2018. They found that profitability (-), tangibility (+), size (+), and growth (-) were significant. They also found that industry leverage was a significant determinant (firms follow industry peers). (Adeyemi and Ogundipe, 2019)

Ogunyemi and Adewale (2021) examined the impact of COVID-19 on capital structure of 40 Nigerian listed firms (all sectors). They found that leverage increased during 2020-2021 (borrowing to survive). Profitability became a stronger negative determinant (profitable firms avoided debt; unprofitable firms borrowed). Tangibility became a weaker determinant (asset values fell during recession). (Ogunyemi and Adewale, 2021)

2.4.4 Studies on Service Sector Leverage

Few studies have focused specifically on service sector leverage. In a study of 200 European service firms, Deloof and Verschueren (2018) examined leverage determinants. They found that profitability (-), tangibility (+), size (+), and growth (-) were significant, similar to manufacturing. However, tangibility was less important for service firms (smaller coefficient) because service firms have fewer tangible assets. Growth was more important for service firms (larger coefficient) because service firms have higher growth opportunities. (Deloof and Verschueren, 2018)

In a study of 100 US service firms, Chen and Wang (2019) examined leverage determinants. They found that profitability (-) and size (+) were significant; tangibility was not significant (service firms have few tangible assets). The results supported pecking order theory. Service firms relied more on short-term debt (working capital loans) than long-term debt because they lacked collateral for long-term debt. (Chen and Wang, 2019)

In a study of 50 Nigerian service firms (excluding banks), Okoye et al. (2020) found that the average leverage (debt-to-equity ratio) was 0.8 (lower than manufacturing at 1.2). Profitability (-) and size (+) were significant; tangibility was not significant. The results supported pecking order theory. (Okoye et al., 2020)

2.4.5 Summary of Empirical Findings

The empirical literature on leverage determinants has produced consistent findings across countries and time periods (Frank and Goyal, 2009). (Frank and Goyal, 2009)

Determinant	Predicted Sign (Trade-Off)	Predicted Sign (Pecking Order)	Empirical Finding
Profitability	+	–	– (consistent with pecking order)
Tangibility	+	+	+ (consistent with both)
Size	+	+	+ (consistent with both)
Growth	–	+	– (consistent with trade-off, agency)
Non-debt tax shields	–	Not specified	? (mixed)
Liquidity	?	Not specified	? (mixed)
Market-to-book	– (market timing)	Not specified	– (consistent with market timing)

However, most studies have focused on manufacturing or all sectors combined. Few studies have focused specifically on the service sector. Service companies have lower tangibility, higher intangibility, higher growth, and lower business risk than manufacturing companies. Therefore, the determinants and their magnitudes may differ for service companies. This study tests these differences.

2.5 Summary of Literature Gaps

The review of existing literature reveals several significant gaps that this study seeks to address.

Gap 1: Limited Nigerian-specific evidence on leverage determinants in service companies. Most Nigerian studies pool all sectors or focus on manufacturing. Few studies focus exclusively on service companies. Service companies have different characteristics (lower tangibility, higher intangibility, higher growth) than manufacturing. This study addresses this gap.

Gap 2: Lack of testing of multiple theories (trade-off, pecking order, market timing, agency). Most Nigerian studies test one theory (trade-off or pecking order). This study tests all four theories.

Gap 3: Limited use of panel data econometrics (system GMM). Most Nigerian studies use cross-sectional regression or fixed effects. Few use system GMM to address endogeneity. This study uses system GMM.

Gap 4: Lack of inclusion of macroeconomic factors. Most Nigerian studies focus on firm-specific factors only. This study includes macroeconomic factors (GDP growth, inflation, interest rates).

Gap 5: Lack of COVID-19 analysis. The pandemic (2020-2021) had a significant impact on leverage. No Nigerian study has examined leverage determinants before, during, and after COVID-19. This study includes COVID-19 period data.

Gap 6: Limited sample size and time period. Most Nigerian studies use 20-30 companies and 5-10 years. This study uses 50+ companies and 15 years (2009-2023).

Gap 7: Lack of sectoral heterogeneity analysis. Service sector is heterogeneous (telecommunications, insurance, hospitality, transportation). Leverage determinants may vary across subsectors. This study examines subsector differences.

Gap 8: Limited practical guidance for financial managers. Most studies provide theoretical implications but not practical guidance. This study provides evidence-based recommendations for CFOs.