THE EFFECT OF CAPITAL STRUCTURE ON PROFITABILITY OF FINANCIAL FIRMS LISTED AT NAIROBI STOCK EXCHANGE

THE EFFECT OF CAPITAL STRUCTURE ON PROFITABILITY OF FINANCIAL FIRMS LISTED AT NAIROBI STOCK EXCHANGE

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ABSTRACT
Capital is the financing for a business and is made up of, primarily, owners’ funding and funding from lenders. The combination of the sources of business funding is referred to, as the capital structure of that business. Capital structure is thus the mix of company’s long term debt, specific short term debt, common equity and preferred equity; that is, how a firm finances its overall operations and growth using different sources of funding. This is composed of equity (rights issue) and debt financing (credit market through corporate bonds etc). This research sought to investigate the effect of capital structure on profitability of financial firms listed at Nairobi Stock Exchange during the period 2008-2012. The success of financial institutions in Kenya’s dynamic business environment depend on their ability to effectively determine the optimum and appropriate capital mix that is necessary to ensure that the shareholders get returns. It is worth noting that financial institutions depend on their ability to identify, assess, monitor and manage risks in a sound and sophisticated way. In order to assess and manage risks, financial firms must have effective ways of determining the appropriate amount of capital that is necessary to absorb unexpected losses arising from their market, credit and operational risk exposures. The sector has recorded double-digit growth in profits for most of the past decade, when the economic growth has averaged at about five per cent. Factors such as amount of debt, the risks associated with indebtedness, interest rates and debt equity combination could affect the financial performance of firms. This research investigated the effect of capital structure on financial performance in relation to these factors. In respect of the above objectives of the study, data was collected by a review of documents, annual reports of the companies and the Nairobi Stock Exchange reports. Data collected was analysed using Statistical Packages for Social Sciences (SPSS) which gave descriptive analysis. The data was then be summarised and presented using tables. The study revealed that capital structure is inversely related to performance as revealed by the regression results of debt and return on equity. The results show that the mean values of debt/equity ratio and debt to total funds were 591.52% and 86.9% respectively. The mean value of debt/equity ratio suggests that debt is 5.915 times higher than equity capital. The debt/equity ratio is normally safe up to 2. It shows the fact that listed financial institutions in Kenya depend more on debt rather than equity capital. The mean value of debt to total funds ratio indicates 86.9% of the total capital of listed banks in Kenya is made up of debt. This has re-emphasized the fact that banks are highly levered institutions. The co-efficient values were found to be negative for the association between debt to equity and interest. This reveals that an increase in the level of debt finance increases the interest payments thus resulting in a decline in profitability. Arising from this observation it can be postulated that capital structure choice among listed financial firms support the pecking order theory that firms prefer raising capital, first from retained earnings, second from debt, and third from issuing new equity. The study noted that banks generally play a crucial role in the economic development of every country. One critical decision banks face is the debt-equity choice. Among others, this choice is necessary for the profit determination of firms. What this means is that banks that are able to make their financing decisions prudently would have a competitive advantage in the industry and make superior profits. However, it is essential to recognize that this decision can only be wisely taken if banks know how debt policy influences their profitability.
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TABLE OF CONTENTS
DECLARATION .............................................................................................................. ii
DEDICATION ................................................................................................................. iii
ACKNOWLEDGEMENT ............................................................................................... iv
ABSTRACT ....................................................................................................................... v
TABLE OF CONTENTS ................................................................................................ vi
LIST OF TABLES ........................................................................................................... ix
CHAPTER ONE ............................................................................................................... 1
1.0 INTRODUTION ......................................................................................................... 1
1.1 Background of the Study .............................................................................................. 1
1.2 Statement of the Problem ............................................................................................. 2
1.3 Objectives of the Study ................................................................................................ 3
1.3.1 General Objective ................................................................................................... 3
1.3.2 Specific Objectives ................................................................................................. 3
1.4 Research Questions ...................................................................................................... 3
1.5 Significance of Study ................................................................................................... 4
1.6 Scope of the study ........................................................................................................ 4
CHAPTER TWO .............................................................................................................. 5
2.0 LITERATURE REVIEW .......................................................................................... 5
2.1 Introduction .................................................................................................................. 5
2.2 Capital Structure Defined ............................................................................................. 5
2.3 Theories of Capital Structure ........................................................................................ 6
2.3.1 Modigliani Miller Irrelevance Theory ................................................................... 6
2.3.1.1 Criticisms and Improvements of the theory ........................................................ 7
2.3.2 Pecking order theory .............................................................................................. 7
2.3.3 Trade Off Theory ................................................................................................... 8
2.3.4 Agency Costs Theory ............................................................................................. 9
2.3.5 Information signaling theory ................................................................................ 10
2.3.6 Free cash flow theory ........................................................................................... 11
2.3.7 Life Cycle Theory ................................................................................................ 11
2.3.8 Contemporary Capital Structure Theories ........................................................... 11
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2.4 Debt Financing ........................................................................................................... 12
2.4.1 Measurement of Indebtedness .............................................................................. 12
2.4.2 Debt and Shareholders’ Returns ........................................................................... 13
2.4.3 Debt and Risk ....................................................................................................... 14
2.4.4 Debt and Dividends .............................................................................................. 16
2.4.5 Debt and Share Value ........................................................................................... 17
2.4.6 Debt and Interest rates .......................................................................................... 17
2.4.7 Debt and Agency Costs ........................................................................................ 17
2.4.8 Factors Influencing Debt Financing ..................................................................... 18
2.4.8.1 Advantages of Debt Financing .......................................................................... 19
2.4.8.2 Disadvantages of Debt Financing ..................................................................... 19
2.5 Factors affecting firms choice of capital structure ..................................................... 20
2.6 Firm Performance and its Measurement ..................................................................... 21
2.7 Empirical Literature .................................................................................................... 22
2.8 Conclusion from Literature Review ........................................................................... 25
2.9 Conceptual framework ............................................................................................... 26
CHAPTER THREE ........................................................................................................ 28
3.0 METHODOLOGY ................................................................................................... 28
3.1 Introduction ................................................................................................................ 28
3.2 Research Design ......................................................................................................... 28
3.4 Data Sources and instruments .................................................................................... 28
3.5 Measurement of Variables .......................................................................................... 29
3.5.1 Indebtedness ......................................................................................................... 29
3.5.2 Firm Performance ................................................................................................. 29
3.6 Data Processing and Analysis .................................................................................... 29
CHAPTER FOUR ........................................................................................................... 31
4.0 DATA FINDINGS AND ANALYSIS ...................................................................... 31
4.1 Introduction ................................................................................................................ 31
4.2 Descriptive Statistics .................................................................................................. 31
4.2.1 Debt ratio .............................................................................................................. 31
4.2.2 Gearing ratio ......................................................................................................... 32
4.2.3 Return on Equity .................................................................................................. 33
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4.2.4: Interest rates ........................................................................................................ 33
4.2.5 Variables Analysis ............................................................................................... 34
4.2.6 Regression model ................................................................................................. 34
CHAPTER FIVE ............................................................................................................ 36
5.0 SUMMARY OF FINDINGS, CONCLUSIONS AND RECOMMENDATIONS 36
5.1 Introduction ................................................................................................................ 36
5.2 Summary of Findings ................................................................................................. 36
5.3 Conclusion .................................................................................................................. 37
5.4 Recommendations ...................................................................................................... 37
5.5 Areas for Further Studies ............................................................................................ 38
REFERENCES ................................................................................................................ 39
APPENDICES ................................................................................................................. 43
Appendix 1: Proposal Budget ........................................................................................... 43
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LIST OF TABLES
Table 4.1: Debt Ratio…………………………………………………….………….32
Table 4.2: Gearing ratio…………………………………………………….….…….33
Table 4.3 Return on Equity………………………………………………….………34
Table 4.4 Interest rates………………………………………………………………34
Table 4.5 Variables Analysis………………………………………………….……..35
Table 4.6 Regression Analysis………………………………...……….……………35
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CHAPTER ONE
1.0 INTRODUTION
This chapter discusses the background of the study, giving an overview on the effect of capital structure on profitability of financial firms listed at Nairobi Stock Exchange. It further discusses the statement of the problem, objectives of the study, research questions, the significance of the study, scope of the proposed study and the limitations of the study.
1.1 Background of the Study
The capital structure decision is crucial for any business organization in any sector or economy. It is usually difficult for business firms to identify the right combination of debt and equity. The decision is important because of the need to maximize returns to various organizational constituencies. It is also important because of the impact such a decision has on a firm's ability to deal with its competitive environment. A firm can choose among many alternative capital structures. It can choose to either issue a large amount of debt or very little debt. It can arrange lease financing, use warrants, issue convertible bonds, sign forward contracts or trade bond swaps. It can issue many distinct securities in countless combinations, however, it attempts to find the particular combination that maximizes its overall market value.
Capital structure study attempts to explain the mix of securities and financing sources used by companies to finance investments (Myers,2001). Capital structure is the way in which a firm finances its operations which can either, be through debt or equity capital or a combination of both, Brigham, (2004). Most firms usually seek to increase the amount of debt finance in their capital structure, in anticipation of improving their performance. The principle of increasing risk indicates that, with increased debt the potential for a decrease in gain is higher than the potential for an increase in gain and yet some firms use more debt than others and still perform better. Previous research on the relationship between the capital structure and the performance of firms, which is mostly in reference to the developed countries in Europe and America, has produced mixed results. Some authors propose that there exists an optimum capital structure that maximizes shareholder wealth, as a result of the return on their investment and basing on the trade-off theories of capital structure. Other authors on the other hand argue that there is no optimum capital structure and that the performance of a firm is not related to the structure of its financing. Wagacha (2001) in a survey of enterprise attitudes found that firms seemed to increase their borrowing after listing. For large listed firms the debt to equity ratios seemed to rise, while for the small firms they fell,
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indicating that market development favoured large listed firms. Financial performance of a firm is a subjective measure of how well a firm can use its’ assets to generate revenues. Erasmus (2008) noted that financial performance measures like profitability and liquidity among others provided a valuable tool to stakeholders to evaluate the past financial performance and the current position of a firm. Brigham and Gapenski (1996) argued that in theory, the Modigliani and Miller model was valid however in practice, bankruptcy costs did exist and that these costs were directly proportional to the debt levels in a firm. This conclusion implied a direct relationship between capital structure and financial performance of a firm.
1.2 Statement of the Problem
The success of financial institutions in Kenya’s dynamic business environment depend on them being able to effectively determine the optimum and appropriate capital mix that is necessary to ensure that the shareholders get good returns. Financial institutions depend on their ability to identify, assess, monitor and manage risks in a sound and sophisticated way. In order to assess and manage risks, banks must have effective ways of determining the appropriate amount of capital that is necessary to absorb unexpected losses arising from their market, credit and operational risk exposures. The continued good performance of the banking sector against a backdrop of an economy that is not performing well has raised more questions than answers. The banking sector has recorded growth in profits for most of the past decade, when the economic growth has not been performing well. Previous research work done in Kenya on capital structure include Rutto (2008) who studied the effect of capital structure change on share prices for firms quoted at Nairobi Stock exchange. Musyoka (2009) examined the relationship between capital structure and corporate governance of the firms listed at the Nairobi Stock Exchange. Etyang', (2012) studied the determinants of capital structure of private hospitals in Nairobi. Arising from the findings of Berger (2006), the capital structure employed by firms could be a reason influencing their financial performance trends, an issue that has not been given serious attention by previous researchers. It is on this basis that the researcher decided to investigate the effect of capital structure on financial performance of listed financial firms in Nairobi Stock Exchange.
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1.3 Objectives of the Study
1.3.1 General Objective
To investigate the effect of capital structure on financial performance of financial firms listed at Nairobi Stock Exchange
1.3.2 Specific Objectives
i) To ascertain the relationship between debt and performance of financial firms listed at Nairobi Stock Exchange (NSE).
ii) To determine the leverage risk of financial firms listed at Nairobi Stock Exchange (NSE).
iii) To scrutinize the effect of interest rates on capital structure of financial firms listed at Nairobi Stock Exchange (NSE).
iv) To determine the effect of debt-equity combinations on performance of financial firms listed at Nairobi Stock Exchange (NSE).
1.4 Research Questions
i) What is the relationship between debt and performance of financial firms listed on Nairobi Stock Exchange (NSE)?
ii) What are the risks facing firms using more debt finance than equity finance?
iii) What is the relationship between capital structure, interest rates and performance of financial firms listed on Nairobi Stock Exchange (NSE)?
iv) What is the ideal debt-equity combination that enhances the performance of financial firms listed on Nairobi Stock Exchange (NSE)?
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1.5 Significance of Study
This study sought to establish the effect of capital structure on financial performance of financial firms listed at Nairobi stock exchange. Its output will be significant in the following ways.
i) Managers of firms listed at the NSE have the sole obligation of maximizing shareholders wealth and may be able to use the output of this research to predict the possible outcomes of the changes the firm undertakes on capital structure
ii) The output of this study might help firms’ management be aware of the invisible cost of capital borne by their shareholders as a consequence of their capital financing decisions.
iii) The study may be of help to scholars and academicians who may wish to use its findings as a basis for further research on capital structure at NSE.
1.6 Scope of the study
There are sixty one (61) listed companies in Nairobi Stock Exchange distributed among ten (10) different sectors i.e Agricultural, Automobile & Accessories, Commercial & Services, Banking, Energy & Petroleum, Construction, Insurance, Investment, Manufacturing and Telecommunication & Technology. This study concentrated on the banking sector which has eleven companies.

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