ABSTRACT
The decision of capital structure is important for any firm. It is challenging for a company to identify the correct variations of debt and equity. To create a conducive environment for business in the nation, the government has invested heavily and as a result, various firms have performed well.Conversely, many firms are experiencing downward performance while others have even been delisted from the NSE within the last seven years. Therefore, the main objective of this study was to examine the relationship between capital structure and profitability of 37 selected firms listed at the NSE while controlling for moderating variables that included sales growth, firm size, and asset tangibility. Financial services firmslisted between 2009 and 2013 and suspended counters were excluded from the study. The researcher utilized the pecking order theory of capital structure that states that firms have a specific hierarchy they follow to finance their activities. A longitudinal research design, using secondarydataderived from firms’ annual audited reports and information from NSE handbooks were used in this study. Descriptive and inferential statistics were used to examine the relationship between capital structure and the profitability of firms listed at the NSE. Data was cleaned and run through the Statistical Package for Social Sciences (SPSS) version 24by analyzing one hundred and eight observations out of a possible 185 by eliminating missing data, outliers that would have made the model inconsistent for all the listed non-financial firms for the study period. This was done to regularize and to ensure that the analysis would reveal results that were more accurate. Descriptive statistics revealed thatfirms performed relatively well as compared to the industry average as measured by ROCEconsidering the economic and political climate in Kenya at the time was not favorable. The results also suggested that firms in Kenya were more reliant on short-term debt than long-term debt. For equity structure, the results revealed that firms preferred internal equity to external equity and that this was consistent through the period. The relative slow growth was brought about by the stagnant economic condition at the time. The results indicated that firms also retained most of their assets in fixed form. Pearson correlation results revealed that firm’s profitability measured by ROCE was significant and positively correlated with internal equity. Long-term debt was inversely correlated with ROCE and significant. Short-term debt was found to have a negative statistical significance relationship with profitability whereas external equity was found not to have a statistically significant relationship with profitability. Asset tangibility on the other hand was not statistically significant related to ROCE. Results also revealed that sales growth had a significant relationship with profitability while firm size was statistically insignificant in determining profitability of firms.The multiple regression model summary revealed that the model was well suited to explain the relationship between capital structure and profitability of firms listed at the NSE. It was concluded that non-financial firms listed in NSE are more reliant on equity financing than debt financing. The study recommended that Kenyan firms should use more internal equity to ascertain profitability as it does not involve costs of acquisition compared with external equity and debt finance.
CHAPTER ONE
INTRODUCTION
Background of the Study
Two major sources are available for firms willing to raise funds for their activities. These sources are internal and external sources (Siro, 2013). The internal source refers to the funds generated from within an enterprise which are mostly retained earnings. It results from the success enterprises earn from their activities. Firms will at the same time look outside to source for their needed funds to enhance their activities. Any funds not sourced from within the earnings of their activities are called external financing (Siro, 2013).
The external funding will be by increasing the number of co-owners of a business or outright borrowing in form of a loan. Issuance of equity helps in sourcing for funds. This can be through external financing leading to increment in the number of owners where its holders are entitled to dividends when surplus is declared and after meeting the mandatory requirements. Siro (2013) postulates at the same time, the equity holders exercise a greater decision control over the firm because they bear the larger share of risk. On the other hand, outright borrowings by a company make her a creditor to the lenders. This will be through issuance of debentures, bonds or other forms of debt instruments. The holders of this are entitled to a fixed amount of interest to be paid before the equity of shareholders and have lesser control over decisions in the organization.
Although most of the existing capital structure studies have been carried out in developed financial markets, some studies have examined the relationship between capital structure and financial performance of firms in developing countries. Abdul (2012) conducted a study to determine the relationship between capital structure decisions and the performance of firms in Pakistan. The study concluded that financial leverage has a significant negative relationship with firm performance as measured by return on assets (ROA), return on equity (ROE), gross profit margin (GPM) and Tobin’s Q (method of estimating the fair value of the firm). The relationship between financial leverage and firm performance as measured by the return on equity (ROE) was negative but not statistically significant.
In another study, Javed and Akhtar (2012) explored the relationship between capital structure and financial performance. They concluded that there is a positive relationship between financial leverage, financial performance, growth and size of the companies. The study, which focused on the Karachi Stock Exchange in Pakistan, used correlation and regression tests on financial data. The findings of the study are consistent with the agency theory. This study however isolated other financing decisions and focused only on financial leverage. Saeedi and Mahmoodi (2011) examined the relationship between capital structure and performance of listed firms in the Tehran Stock Exchange.
According to the study, market measures of performance are positively related to capital structure and whereas ROA is positively related to capital structure, no significant relationship exists between ROE and capital structure. Kyereboah-Coleman (2007) found that a high debt level is positively related to performance of micro-finance institutions in sub-Saharan Africa. In contrast, country-specific studies in Africa appear to consistently report a negative relationship between capital structure and firm performance i.e.Abor (2007) for South Africa and Ghana, Amidu (2007) for Ghana and Onaolapo and Kajola (2012) for Nigeria. However, Ebaid (2009) found a weak-to-no-effect of capital structure on firm performance in Egypt.
In Kenya, Kodongo, Mokoaleli-MokoteliandMaina (2014) investigated the relationship between leverage and the financial performance of listed firms in Kenya. The results suggested that leverage significantly and negatively affects the profitability of listed firms in Kenya. They further documented that leverage has no effect on firm value. The results were robust to alternative panel specifications and held for both small size and large-size firms. Mwangi, Makau and Kosimbei (2014) investigated the relationship between capital structure and performance of non-financial companies listed at the Nairobi Securities Exchange. In their study, they utilized the Feasible Generalized Least Square (FGLS) regression. The results suggested that financial leverage had a statistically significant negative relationship with performance as measured by return on assets (ROA) and return on equity (ROE). According to the results, they recommended that managers of listed non-financial companies should reduce the reliance on long-term debt as a source of finance.Kaumbuthu (2011) did a study to establish the relationship between capital structure and return on equity for industrial and allied sectors at the Nairobi Securities Exchange during the period 2004 to 2008. Capital structure was measured using debt- equity ratio while performance focused on return on equity. By applying regression analysis, the study found a negative relationship between debt-equity ratio and ROE for the industrial and allied sectors.
Capital Structure
Azhagaiah and Gavoury (2011) suggest that for a purely equity financed firm; the whole of its after-tax cash flows (profit) is a benefit to the shareholders in form of dividends and retained earnings. However, firms with certain percentage of debts in their capital structure shall devote a portion of the profit after tax to servicing such debt. Capital structure decision is therefore very critical and fundamental in the life of a business. This is not only to maximize profit to the shareholders but also due to the impact such a decision has both on sustainability and its ability to satisfy external objectives. The capital structure theory is seen as an essential element to the administration of a firm wishing to raise funds for finance. It addresses the means of finance available to an enterprise. In addition, the best mix of such sources is that which can reduce the overall cost of capital and maximizes returns on acquisition (Azhagaiah&Gavoury, 2011). The success of any business therefore lies in its management's efforts to identify this optimum capital for smoothness, sustainability, and prosperity in line with her overall goals and objectives.
The main body of finance literature suggests that the continuing evolution of corporate finance reveals some divergence between finance practice and theory. This divergence has stimulated increased interest and research into the global aspects of corporate finance in order to establish the reasons for this anomaly and the common ground upon which theory can be modified and consistently applied to add value to the functioning of firms.
The reasons for the discrepancy between finance theories and practices vary and can be attributed to the legal underpinnings of finance as embodied in the differing laws and institutions of each country and to differences in each country’s economic and other. From the African perspective, such differences can be explained by the effect of emerging markets and their influence on the economic, social and legal patterns that impact significantly on the financial development patterns of countries. There is a lack of knowledge on the ground of the applicability of a wide range of financial theories. As a result, firms within the developing world tend to ignore such applications because of their complexity (Kasozi, 2009).
Firm Profitability
Profit is the primary objective of any business enterprise (Nimalathasan, 2009). Heavy capital investment is necessary for the success of all business enterprises. Profit is usually a long-termobjective, which measures not only the success of the product and business enterprise, but also of the development of the market for it. It is determined by matching revenues against the associated costs. The only costs placed against revenue, are those which have a contribution in the generation of such revenue. An enterprise should earn profits to survive and grow over a long period.
Sometimes, the terms 'Profit" and 'Profitability' are used interchangeably. However, in real sense, there is a difference between the two. Profit is an absolute term, whereas, profitability is a relative concept. However, they are closely related and mutually interdependent, having distinct roles in business. Profit refers to the total income earned by the enterprise during the specified period, while profitability refers to the operational efficiency of the enterprise. It is the ability of the enterprise to make profit on sales and the ability of enterprise to get sufficient return on the capital and employees used in the business operation (Harward& Upton, 2007).
Almajali, Alamro and Al-Soub (2012) argue that there are various measures of financial performance. For instance, return on sales reveals how much a company earns in relation to its sales, return on assets explain a firm’s ability to make use of its assets and return on equity reveals what return investors take for their investments. Company’s performance can be evaluated in three dimensions. The first dimension is company’s productivity, or processing inputs into outputs efficiently. The second is profitability dimension, or the level of which company’s earnings are bigger than its costs. The third dimension is market premium, or the level at which company’s market value is exceeds its book value. The owners and management of a firm, inter alia, are interested in its financial soundness. The owners invest their funds in the firm with an expectation of at least a reasonable return, if not high returns. Similarly, management of a firm naturally shows interest in improving its operational efficiency. The operational efficiency of the firm and reasonable rate of return on owner’s capital ultimately depend on the profit earned by it. So, the crucial importance of profits of a firm need not be over stressed. Profits are necessary to run the firm in a healthy atmosphere and to defend it from rival business firms. The structural composition of the capital of a company or organization will have an impact on its profit earning capacity (Reddy, 2012).
Empirically, Zeitun and Tian (2007) investigated the effect which capital structure has on corporate performance using a panel data sample representing of 167 Jordanian companies during 1989-2003. The study showed that a firm’s capital structure has significantly negative impact on the firm’s performance measures, in both the accounting and market measures. In Sri Lanka, Puwanenthiren (2011) carried out an investigation on capital structure and financial performance of some selected companies in Colombo Stock Exchange 2005-2009. Capital structure was surrogated by debt while performance was proxied by gross profit, net profit, return on investment or capital employed and returns on assets. The results showed the relationship between capital structure and financial performance is negative.
Mwangiet al. (2014) investigated the relationship between capital structure and performance of non-financial companies listed at the NSE. In their study they utilized the Feasible Generalized Least Square (FGLS) regression and applied panel data models (random effects).The results indicated that there was a significant positive relationship between total current liabilities to total assets and performance of non-financial companies listed at the NSE as measured by ROA. The positive coefficient indicated that as more current liabilities were utilized to finance assets performance as measured by ROA improved. Mwangi (2010) did a study on capital structure of firms listed at the Nairobi Stock Exchange and tried to look on the relationship between capital structure and financial performance. Data was collected using structured questionnaires. The study identified that a strong positive relationship exists between leverage, return on equity, liquidity and return on investment existed. This hypothesis is also supported by a number of studies; to them the benefits of debt financing are less than its negative aspects, so firms will always prefer to fund investments from internal sources.
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Item Type: Kenyan Topic | Size: 94 pages | Chapters: 1-5
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