Factors That Influence the Capital Structure Decision of the Firm

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ABSTRACT The capital structure decisions are influenced by various factors. Different researchers obtained different conclusions on what the important determinants of capital structure are. The main objective of this study is to ascertain the factors that significantly influence capital structure decisions. The factors tested are: The firm’s age, size, growth, tangibility, profitability, business risk and non-debt tax shield. From my analysis all these factors were found to be significant but at varying levels, with profitability and company growth as the most significant.

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TABLE OF CONTENTS

Declarationii Acknowledgementiii Abstractiv Table of Contents v CHAPTER 1. 1. 0 INTRODUCTION………………………………..... …. ………………….. ……………1 1. 1 BACKGROUND……………………………………………. …….. …..................... 1 1. 2 STATEMENT OF THE PROBLEM………………………………………... …….. 2 1. 3 OBJECTIVE OF THE STUDY ……... ……………………... ………………….. …3 1. 4 IMPORTANCE OF THE STUDY …... ……….. ………………………………....... 4 CHAPTER 2 2. 0 LITERATURE REVIEW ………………………………………. ……. …….. ……5 2. 1 INTRODUCTION ………………………………………………. …. ……………. 5 2. 2 THE CHOICE BETWEEN DEBT AND EQUITY …………….. ……………….. 6 2. 3 CAPITAL STRUCTURE THEORIES ……………………………. …….. ……. 6 2. 3. 1 THE VALUE OF THE FIRM GIVEN CORPORATE TAXES ONLY....... ….. 6 2. 3. 2 THE VALUE OF THE FIRM IN A WORLD WITH BOTH CORPORATE AND PERSONALTAXES……………………. ………………….. …. …11 2. 3. 3 INTRODUCING RISK: A SYNTHESIS OF CAPM AND MM........ ………13 2. 3. 4 THE COST OF CAPITAL WITH RISKY DEBT ………………………….... 1 6 2. 3 5 THE MATURITY STRUCTURE OF DEBT………,,…….

…17 2. 4 OPTIMAL CAPITAL STRUCTURE………………………….. ……….. 18 2. 4. 1 POSSIBLE REASON FOR AN OPTIMAL MIX OF DEBT AND EQUITY …………………………………………………………. 19 CHAPTER 3 3. 0 RESEARCH METHODOLOGY AND DESIGN ……………………….. ………23 3. POPULATION …………………………………………………………….. ………23 3. 2 SAMPLE ……………………………………………………………………………23 3. 3 DATA COLLECTION METHOD ………………………………………. ………23 3. 5 DATA ANALYSIS METHOD …………………………. …………………. …….. 24 CHAPTER 4 4. 0 DATA ANALYSIS AND INTERPRETATION…………... ……………………. 26 4. 1 INTRODUCTION……………………………………... …………………………26 4. 2 ANALYSIS OF FINDINGS………………………………………………….. ….. 27 4. 1. 1 TANGIBLITY…………………………………………………. ………. 27 4. 2. 2NON-DEBT TAX SHIELD…………………………………. …………27 4. 2. 3BUSINESS RISK (EARNING VOLATILITY)………………. ….. …. 27 4. 2. 4A FIRM’S SIZE……………………………………………………. ….. 27 4. 2. GROWTH………………………………………………………………. 28 4. 2. 6PROFITABILITY…………………………………………….. ………. 28 CHAPTER 5 5. 0 SUMMARY AND CONCLUSION…………………………………………....... 29 5. 1 LIMITATION OF THE STUDY………………………………………………... 29 5. 2 RECOMMENDATIONS…………………………………………………………30 5. 3 RECOMMENDATION FOR FURTHER RESEARCH………………………. 31 APPENDIX 1……………………………………………………………………………32 APPENDIX 2……………………………………………………………………………33 APPENDIX 3……………………………………………………………………………35 LIST OF TABLES……………………………………………………………………... 39 LIST OF FIGURES……………………………………………………………………. 39 REFERENCES…………………………………………………………………………40 CHAPTER ONE 1. 0INTRODUCTION 1. BACKGROUND The term capital structure has been defined in different ways by different authors.

Weston and Copeland (1988) defines capital structure as the firm’s mix of debt and equity financing that affects the cost of capital that is it explains how the cost of capital is related to shareholder’s wealth and shows how to extend the cost of capital concept to the situation where projects do not all have the same risk. Brealey and Myers (1984), for example define capital structure as the firm’s mix of different securities. Emery Gray W. explains capital structure decision as choice between debt and equity.

The decision affects the common stockholders’ expected rate of return, how their rate of return changes or varies in response to changes in economic conditions and risk of financial distress as well. The decision of whether to finance an enterprise with Long-term debt or Equity sources is what the capital structure decision comprises of. Studies highlighted have found that the decision is based on certain factors, Omondi (1996). This decision affects the common stockholder's expected return, how their rate of return varies in response to changes in economic conditions, and the risk of financial distress.

The debt-equity capital structure also affects creditors because their security is enhanced when the company obtains financing from investor whose position is junior to them and vice-versa. Finally, this decision affects managers who may lose their jobs if they choose a capital structure that provides too little return or too much risk. The choice between equity and debt has no effect on the company and market value of its common stock in a perfect financial market with symmetric information; however, it may have an effect under other conditions. If use of debt affects cost of capital then an optimal capital structure exists.

This is the mix of debt and equity that simultaneously maximizes a firm’s value and minimizes the overall cost of capital. From various studies carried out, there is still no clarity whether firm’s have target debt rations, Weston and Copeland (1988). Based on findings by Kamere (1987): stability of future cash flows, the level of interest rates, the firm’s asset structure, the firm’s tax advantage of debt and the maturity of debt are all important factors in deciding a firm’s capital structure. Other factors tested by Kamere were Age, which proved to have a very low correlation co-efficient of 0. 748 and Size of the firm, which also had a low co-efficient of 0. 2727. The study is done with the factors that influence the capital structure decision of the management of public company. Omondi (1996) analyzed the following factors: industrial class, asset structure, profitability, size, interest charges, and changes in cash flow, age, and ownership. He concluded that there are disparities in the factors that influence capital structure within the following sectors: Agricultural, Industrial and Allied, Commercial and Allied and Financial and Investment Sectors.

He also quoted other studies done such as Williamson (1963) who found some evidence that firm’s that had growth opportunities tended to have lower leverage policies. This suggested that growth of the firm might be an important factor in the determination of capital structure. Marsh (1982) studied 748 issues of equity and debt by U. K. Companies between 1959 and 1970 to see how companies select between financing instruments and found that firms are heavily influenced by market conditions and the past history of security prices in choosing between debt and equity.

The study also presented evidence that the choice seemed to be made as if certain debt level were borne in mind. Julilvand and Harris (1984) in a study of U. S Corporations obtained results which suggested that financial decisions are interdependent and firm’s size, interest rate conditions and stock price levels affect speeds of adjustment to capital structure suggesting that they do influence it. 1. 2STATEMENT OF THE PROBLEM A firm should consider certain factors in determining its capital structure decision. As cited in the introduction, there are disparities in the factors that influence capital structure.

However, there is some consensus to some extent on certain variables. These are profitability, business risk, asset tangibility, growth, size and non-debt tax shield. This study seeks to find out which factors are put into consideration when coming up with a capital structure for a firm of firms Studies done by Kamere (1987) and Omondi (1996) concluded that turnover, growth asset structure and age are determinants capital structure in Kenya. This study however, had some limitations on the statistical model that was used.

It does not give the magnitude and direction of the determinants of capital structure hence it is of limited use in predicting capital structure. A similar study was done by Odinga (2003) who set to find out the relationship between capital structure and hypothesized influential variables such as asset tangibility, growth, size, business risk, profitability and non-debt tax shield. These earlier studies set a stage for the need to identify the direction and magnitude of factors that impact capital structure. 1. 3OBJECTIVE OF THE STUDY Factors that influence the capital structure decision of the firm •Which of the factors have the greatest influence on the capital structure decision 1. 4 IMPORTANCE OF THE STUDY •To companies in general to know how other companies make their financial decisions and what influence them. •To financial consultant in advising companies on how to design their capital structures in relation (the) to the factors. •To the management of companies in choosing which mode of financing. •To scholars students who may wish to use the information in this study for further research. CHAPTER TWO 2. 0LITERATURE REVIEW 2. 1 INTRODUCTION The financial management is charged with the decision of selecting an optimal capital structure i. e. the optimal mix of debt and equity This is a difficult task because the he has to choose a decision that will maximize their returns and enhance the market value of the firm whilst at the same time minimizing the risk or the cost of capital. The capital decision is influenced by the following internal and external factors: Legal and political environment; and the economic environment and social environment.

The firm can be financed by shareholder capital, retained earnings borrowed funds. Ploughing back of profits in the form of proposed dividends is also an available source of funds to the company. The firm can also use debt as a source of funds. However, they must pay a fixed cost on the debt as interest. Large amounts of debts increase the risk of the firm and thus reducing the earning capacity of the firm. Nevertheless one advantage of using debt is that the interest charged is deducted before tax and could increase the value of the firm.

This study will look at the factors influencing the choice of debt and equity, the capital structure advanced by various authors and how other market imperfection influence this decisions. The study will also show how capital structure decisions are related to the investment decision. We will examine the capital structure decision in various firms and the implications for resource from the literature reviewed 2. 2THE CHOICE BETWEEN DEBT AND EQUITY At the point where earnings per share (EPS) are believed to be higher with leverage than without it, it is generally believed that leverage is beneficial.

Ross and Westerfield (2002). However leverage also creates risk. Thus a risk averse investor may prefer the all equity firm while a risk neutral investor (or less risk averse) may prefer a greater degree of leverage. The Debt – Equity (Capital Structure) decision also affects the creditors because their security is enhanced when the company obtains financing from investors whose position is junior to them and visa versa. This decision affects managers who may lose their jobs if they choose a capital structure that provides too little return or too mush risk -Emery (2000).

However, Miller and Modigliani have a convincing argument that a firm cannot change the total value of its outstanding securities by changing the proportions of its capital structure. 2. 3 CAPITAL STRUCTURE THEORIES 2. 3. 1 THE VALUE OF THE FIRM GIVEN CORPORATE TAXES ONLY 2. 3. 1. 1 Value of the Levered Firm Modigliani and Miller (1956, 1963) wrote the seminal paper on cost of capital, corporate valuation, and capital structure the assumed that: - •Capital structures are frictionless. •Individuals can borrow and lend at the risk free rate. •There are no costs to bankruptcy. Firms only issue two types of claims; risk free debt and (risky) equity. •All firms are assumed to be in the same risk class. •Corporate taxes are the only form of government levy. •All cash flows streams are perpetuities (i. e. no growth) •Corporate insiders and outsiders have same information (i. e. no signaling opportunities) •Managers always maximize shareholder’s wealth. The assumptions require more clarification. What is meant by all firms have the same risk class. The implication is that the expected risky future net operating cash flow varies, at most, a scale factor. CFi = CFi CF = the risky net cash flow from operations. a constant scale factor. This implies that the expected future cash flows from the two firms or projects are perfectly correlated. If two streams of cash flows differ by, at most, a scale factor, they will have same distributions of returns, same risk, and will require same expected return. Suppose the asset of a firm return the same distribution of net operating cash flow each period for an infinite number of periods. We can value the after tax stream of cash flow by discounting its expected value at the applied risk adjusted risk Value of an unlevered firm. Vu = E (FCF) P Vu = present value of an unlevered firm.

E (FCF) = perpetual free cash flow after taxes P = discount rate. Given perpetual cash flow value of an unlevered firm can be written in either two different ways. Vu = E (FCF) or E (NOI) (1-Tc) (income after taxes) P P If firm issue debt the after tax cash flow must be split up between debt and shareholders. Value of a levered firm is the sum of discounted value of two types of cash flow that it provides. VL = E (NOI) (1-Tc) + kdDTc P Kb KdD = perpetual stream of risk-free payment to bondholders Kb = is current before tax market required rate of return for the risk-free stream.

Market value for bonds B is B = KdD Kb VL = Vu + TcB It says in the absence of any market imperfections including corporate taxes (i. e. if Tc = 0) the value of the firm is completely independent of the type of financing used for its projects therefore without taxes: VL = Vu, if Tc = 0 MM1: The market value of any firm is independent of its capital structure and is given by capitalizing its expected return at the rate p, appropriate to its risk class. To support their position they used first arbitrage pricing argument. 2. 3. 1. 2 Weighted Average Cost of Capital

We can determine cost of capital by using the fact that shareholders will require the rate of return on new projects to be greater than opportunity cost of the funds supplied by them and bondholders. Change in the value of levered firm with respect to a new investment is given as:- VL = (1-Tc) E (NOI) + Tc B P I T For a project to be acceptable to the original shareholders it must increase their wealth. Therefore: S = VL - 1 ; 0 I I NB: The requirement that the changes in original shareholders wealth be positive i. e. S / I ; 0 are a behavioral assumption by MM.

They were assuming that: - ?Managers do exactly what shareholders wish ?Managers and shareholders always have the same information. With the above assumptions we can determine WACC: (1 -Tc) E (NOI) ; P (1 - Tc B) I I Left side - after tax change in net operating cash flows brought about by new investment Right side- opportunity cost applicable to project. The value of the levered firm reaches a maximum when there is 100% debt financing (as long as all of debt is risk free). 2. 3. 1. 3 Two Definitions of Market Value Weights First are the leverage ratio changes in the marginal or average debt?

Secondly, is the ratio to be measured value leverage, replacement value leverage or reproduction leverage? The last two definitions as we shall see are both market value. Book value can be ruled out immediately as being meaningless as there is no relationship whatsoever between book value concepts (e. g. R/E) and the economic value of equity. By replacement value we mean the economic cost of putting a project in place. In MM formulation, replacement cost is the market value of the investment under consideration. Reproduction value is change in value in the total present value of the stream of goods and services expected from the project.

Noting that the difference between them is the NPV of the project that is it can compare the two concepts: - NPV = V - I For a marginal project, where NPV =0, replacement cost and reproduction value are equal. Haley and Schall (1973, pp 306-311) introduce an alternative cost of capital definition where the 'target' leverage is the ratio of debt to reproduction value as shown below: WACC = p (1 – Tc) B V Value of the firm is higher if we use the reproduction value definition of leverage but in the case of heterogeneous expectations there is no solution to the problem.

Hence, we favor the original argument of MM that long-run target debt to value ratio is close to dB/dI i. e. use of the replacement value definition. 2. 3. 1. 4 Cost of Equity How do we determine the cost of the two components of WACC i. e. debt and equity? The cost of debt is the risk -free rate, at least given the assumptions of this model. The cost of equity is the change in the return to equity holders with respect to the change in their investment (S + S). The return to equity holders is the net cash flow after interest and taxes- NI. Therefore their rate of return is NI/(S + S). Cost of equity, ks = NI / S is written as,

Ks = p + (1 - Tc) (p - Kb) B S The implication is that opportunity cost of capital to shareholders increases linearly with change in the market value ratio of debt to equity. If the firm has no debt in its capital structure, the levered cost of capital is equal to the cost of equity, ks for an all-equity firm, p. 2. 3. 2 VALUE OF THE FIRM IN A WORLD WITH BOTH PERSONAL AND CORPORATE TAXES. 2. 3. 2. 1Assuming all firms has identical effective tax rates. In the original model gain from leverage . G is the difference between the value of the levered and unlevered firms, which is the product of the corporate taxes into the model.

Assume for the moment that there are only two types of personal tax rates, the rate on income received from holding shares, Tps and the rate on income from bonds, Tpb. The expected after-tax stream of cash flows to shareholders of an all equity firm would be: (NOI)(1 - Tc)(1 - Tps) By discounting the perpetual stream at the cost of equity for an all equity firm we have the value of the unlevered firm. Vu = E (NOI) (1 - Tc) (1 - Tps) P Alternatively, if the firm has both bonds and shares outstanding, the earnings stream is partitioned into two parts.

Cash flows to shareholders after corporate and personal taxes and payments to bondholders after personal taxes. The sum of the discounted streams of cash flows is the value of the levered firm. VL = E (NOI) (1 - Tc) (1 - Tps) + KdD {(1 - TpB) - (1 - Tc) (1 - Tps)} Pp Miller's argument has important implications for capital structure. First, the gain to leverage may be much smaller than previously thought. Consequently, optimal capital structure may be explained by a trade off between a small gain to leverage and relatively small costs such as expected bankruptcy costs.

Secondly, the observed market equilibrium interest rate is seen to be a before tax rate, that is, "grossed-up" so that most or the entire interest rate tax shield is lost. Finally, Millers theory implies there is an equilibrium amount of aggregate debt outstanding in the economy that is determined by relative corporate and personal tax rates 2. 3. 2. 2 Assuming that firms have different marginal effective tax rates DeAngelo and Masulis (1980) extend Miller's work by analyzing the effect of tax shields other than interest payments on debt.

They are able to demonstrate the existence of an optimal (non-zero) corporate use of debt while still maintaining the assumptions of zero bankruptcy costs. It is reasonable to expect depreciation expenses and investment tax credits to serve as tax shield substitutes for internal expenses. DeAngelo and Masulis model predicts that firms will select a level of debt that is much related to the level of available tax shield substitutes. They further show that if there are positive trade-off between marginal expected benefit of internal tax shield and marginal expected cost of bankruptcy. 2. 3. 3 INTRODUCING RISK: A SYNTHESIS OF MM AND CAPM.

The CAPM provides a natural theory for the pricing of risk when combined with the cost of capital definition derived by MM (1958, 1963); it provides a unified approach to the cost of capital. The work we shall describe was 1st published by Hamada (1969) and synthesized by Rubinstein (1973). CAPM can be written as: E (RJ) = Rf + (E (Rm) - Rf) Bj Where E (RJ) = expected rate of return on asset j, RF = the (constant) risk free rate E (Rm) = the expected rate of return on the market portfolio Bj = COV (RJ, Rm)/Var (Rm) The figure illustrates the difference between the original MM cost of capital and the CAPM.

Assuming that all projects within the firm had the same business or operating risk. The WACC for the firm (implicitly) does not change as a function of systematic risk. This assumption, of course, must be modified because firms differ in risk. (Source Copeland, Thomas and Fred J. Weston, (1988) “Financial theory and Corporate Policy, Third Edition; New York: Addison-Wesley Publishing Company) 2. 3. 3. 1 The Cost of Capital The table shows expressions for the cost of debt, Kb, unlevered equity, p, levered equity, Ke, and the weighted average cost of capital both in MM and CAPM.

MM assumed , for convenience, that corporate debt is risk-free i. e. its price is insensitive to changes in interest rates and either that it has no default risk or that default risk is completely diversifiable(Bb=0) Type of capital CAPM Definition M-M Definition Debt Kb = RF + [E (Rm) - RF] Bb Kb = RF, Bb = 0 Unlevered equity p = RF+ [E (Rm) - RF] Bu p=p Levered equity Ks =RF + [E (Rm) - RF] Bl Ks = p + (p - kb) (1 -Tc) B S WACC for the firmwacc=kb (1-Tc) B + ks S

B+S B+S WACC = p (1 - Tc B B+S 2. 3. 3. 2 The Cost of Capital for Projects with Different Risks. A very difficult problem is to decide what to do if the project risk is different from that of the firm. Project must be evaluated at a cost of capital that reflects the systematic risk of its operating cash flows as well as the financial leverage appropriate for the project. Estimate of the correct opportunity cost of capital are derived from a thorough understanding of the MM cost of capital and CAPM. 2. 3. 3. 3 Seperability of Investment and Financing Decision

What implications do the dependency required rate of return and on the project wacc on the relationship between investment and financing decisions i. e. how independent is one of the other? To clarify the issue we shall investigate two different suppositions: a) If the WACC is invariant to changes in the firm's capital structure i. e. if WACC = p because Tc = 0) then the investment and financing decision are completely separable. This might actually be the case if Miller's (1977) paper is empirically valid. The implication is that we can use NOI when estimating the appropriate cut off rate for capital budgeting decisions.

In other words it is unnecessary to consider financial leverage of the firm. Under the above assumptions, it is irrelevant. b) If there is really a gain from leverage, as would have been suggested by MM theory i. e. if Tc = 0, or if the DeAngelo - Masulis (1980) extension of Miller’s (1977) paper is empirically valid. Then the value of the project is not independent of the capital structure assumed for it. However assuming that an optimum capital structure exists and assuming all projects are financed at the optimum we may treat the investment decision as if it were separable from financing decision.

But if projects carry the ability to change the optimal capital structure and some projects have more debt capacity than other. Then investment and financing decisions can't even be handled as if they were independent. 2. 3. 4 THE COST OF CAPITAL WITH RISKY DEBT 2. 3. 4. 1The Effect of Risky Debt in the Absence of Bankruptcy Costs. The functional theorem set form by the MM is that given complete and perfect capital market, it does not make any difference how one splits up the streams of operating cash flows.

The percentage of debt or equity does not change the total value of the cash streams provided by the productive investment of the firm. The value of the firm should be equal; to the discounted cash flows from investment. Stiglitz (1969) first proves this result using a state preference framework and Ruben stein (1973) proved it using a mean-variance approach. If we designate the return or risky debt as Rbj, its expected return is: E (Rbj) = RF + [E (Rm) - RF] Bbj By introducing risky debt we obtain the same MM result as: VL = V u + TcB

Therefore the introduction of risky debt cannot by itself be used to explain the existence of an optimal capital structure. 2. 3 4. 2 the Cost of Risky Debt- Option Pricing Model Even though risky debt without bankruptcy costs does not alter the basic MM result, we are still interested in knowing how the cost of risky debt is affected by changes in capital structure. The simple algebraic approach that follows was proved by Hussar (1981) and combines the option pricing model (OPM), CAPM and MM theorems. They are all consistent with one another. Assumptions: - A.

Firm issues zero coupons bonds that prohibit any capital distributions until after the Bonds mature. B. No transaction costs or taxes, so that the value of the firm is unaffected by its capital Structure. C. There is a known non-stochastic risk-free rate of interest D. There is homogeneous expectations about the stochastic process that describes the Value of the firm's assets. The realization that equity and debt in a firm can be conceptualized as options allows us to use insights on option pricing theory. 2. 3 5 THE MATURITY STRUCTURE OF DEBT.

Optimal capital structure refers not only to the ratio of debt to equity but also to the maturity structure of debt. There are three approaches to answering the maturity statement problem. Morris (1976) suggests that short-term debt or variable debt can reduce risk to shareholders and thereby increase equity value if the covariance between net operating income and expected future interest rate is positive. This cross-hedging argument is further strengthened if it increases debt capacity by reducing risk of bankruptcy and thereby allowing a greater gain from leverage.

The second approach to optimal debt maturity on agency cost is that by Myers (1977) Barme, Haugen and Senbet (1980) who argue that if shareholder's claim on the assets of a levered firm is similar to a call option, then shareholders have an incentive to undertake riskier projects because their call options value is greater than when the assets of the firm has higher variance. The theory suggests that firms with many investment opportunities may prefer to use short-term debt (or callable debt). Brick and Ravid (1985) provide a tax-based explanation as the third approach.

They support the term structure of interest rate is not flat and there is a gain to leverage in the Miller's (1977) sense. That is a long-term maturity is optimal because coupons on long-term bonds are currently higher than coupons on short-term bonds and the tax benefit of debt is accelerated. If it is not the case, the gain to leverage is negative and the results are reversed. SUMMARY OF CAPITAL STRUCTURE THEORIES The cost of capital is seen to be a rate of return whose definition requires a project to improve the wealth position of the current shareholders of the firm.

In a world without taxes the value of the firm is independent of its capital structure. However there are several important extensions of the basic model. With introduction of corporate taxes the optimal capital structure becomes 100% debt. Finally, when personal taxes are introduced, the value of the firm is unaffected by the choice of financing leverage. Financing is irrelevant. 2. 4 OPTIMAL CAPITAL STRUCTURE This chapter looks at some possible explanations for why there might be such a thing as an "optimal capital structure" that contains both debt and equity. The first issue is the effect of bankruptcy costs.

Secondly, we consider the possibility that changes in the financial structure may be interpreted by the market place as signals of the future health of the firm. Thirdly, we discuss implication of the option pricing theory for the capital structure of the firm and for the valuation of risky debt. Finally, we discuss agency costs as determinants of capital structure. 2. 4. 1 Possible Reason for an Optimal Mix of Debt and Equity 2. 4 1. 1 Effects of Bankruptcy Costs. When we consider bankruptcy cost the value of the firm in bankruptcy is reduced by the fact that payments must be made to third parties other than ondholders or shareholders. Dead Weight losses associated with bankruptcy may cause the value of the firm to be less than the discounted value of the expected cash flow from operations. Baxter (1978), Stiglitz (1972), Kraus and Litzberger (1973) and Kim (1967) all suggest that this is a possibility. Warner (1977b) conducted a research on several railroad bankruptcies that occurred in 1933 and 1955. He found that direct costs are trivial, thus suggesting that bankruptcy causes direct costs that are less important for the capital structure vision of a large firm than of small firm.

Altman (1984) evidence suggest that bankruptcy costs (direct and indirect) are sufficiently large to give credibility to a theory of optimal capital structure based on the trade-off between gains from leverage, induced tax shields and expected bankruptcy costs. 2. 4. 1. 2 Signaling Hypothesis If we assume that financial markets are not fully aggregating in the sense that market prices don't reflect all information especially that, which isn’t publicly available, then it’s possible that managers may elect to use financial policy decisions to convey to the market.

Changes in capital structure are an obvious candidate for a signaling device. First application has been put forth by Ross (1977) who suggested that managers do signal an optimistic future for the firm in order to use a greater financial leverage. Another signaling paper by Leland and Pyle (1977) focuses on owners instead of managers. Majluf and Myers (1984) present a signaling model that combines investment and financing decisions, which is rich in empirical implications. 2. 4. 1. 3Option Pricing Implication for Capital Structure

Black and Scholes (19783) suggest that equity in a levered firm can be that of a call option. When shareholders issue bonds, its equivalent to selling the assets of the firm to the bondholders in return for cash and a call option. The theory of option pricing argues that, in a world with no transaction costs or taxes the wealth of shareholders increases with greater financial leverage. MM proposition argue under the same set of assumptions, the value of shareholders wealth is unaffected by changes in capital structure. 2. 4. 1. 4 Effect of Agency Costs on Capital Structure

Jensen and Meckling (1976) use agency cost to argue that the probability distributions of cash flows provided by the firm is not independent of its ownership structure and that this fact may be used to explain optimal leverage. First, there is an incentive problem associated with the issuance of new debt and agency cost of debt. They suggest that given increasing agency costs with higher proportion of equity in one hand and a higher proportion of debt on the other, there is an optimum combination of outside debt and equity that will be chosen because it minimizes agency cost.

In this way it is possible to argue for the existence of an optimal capital structure even in a world without taxes and bankruptcy costs. 2. 4. 1. 5 Contractual Methods of Reducing Agency Costs. Secured debt is collateralized by tangible assets owned by the firm. Leasing - leased assets are fully secures because they are literally the property of the lessor and can be repossessed in the event of default on the leased payments. Firms therefore have to make a choice in determining their target Debt – Equity ratio.

This choice is affected by a number of factors: Non-debt tax shield: If a company has (and will continue to have) taxable income, an increased reliance on debt will help reduce taxes paid by the company and increase taxes paid by the bondholder. If corporate rate taxes are higher than other bondholder tax rates, there is value from using debt. Tangibility: Financial Distress is risky with or without formal bankruptcy proceedings. The cost of financial distress depends on the assets the firm has.

For instance, if the firm has a large investment in land, buildings and other tangible assets, it will have smaller costs of financing distress than a firm with large investments in Research and development e. g. Pharmaceutical Firms. Business risk (Earning volatility): Firms with uncertainty of operating income have high probability of experiencing financial distress even without debt. Hence these firms opt to finance their investments with equity. For example the Pharmaceutical Firms have uncertain operating income because no one can predict whether today’s research will enerate new drugs, consequently these firms issue little debt, Ross Westerfield. and Jaffe, (2002) A firm’s size may also influence the capital structure for several reasons: There is a tendency for larger firms to be more diversified than smaller firms. As a result their cash issues and flows are less subject to fluctuations and hence have higher credit ratings for their debt issues and pay lower interest rates on their debt -Pinches and Ming, (March 1973). The effective reason here would seem to be the extent of diversification rather than the size in the sense of value of total assets and volume of sales.

Ferri and Jones who used the value of total assets and volume of sales as a measure of size found the hypothesis that there is a relationship between the use of debt and the size of a firm true in an empirical study, (Ferri et al op cit). The age of the business may influence its capital structure. Lenders prefer to lend to older firms, which are well established and have favourable records of cash flow. Management of older firms may also have more experience in understanding the market (that is pre-supposing the continuation of existing management).

Level of Interest: Equity is more preferred to debt when the level of interest is high in the economy but debt financing would be preferred when interest rates are low. When there is a temporary use in interest rates, short term financing may be prefers because taking on long term debt means that the firm continues to pay high interest rates one down unless the alternatives of pegging the actual rate is taken- Kamere (1987 June) Profitability: There are different views on the relationship between leverage and profitability.

In Weston and Copeland (1988), they quote Myers and Majluf (1984) who argue that firms prefer internal to external financing and the more profitable the firm, the greater the availability of internal capital, hence there should be a negative relationship between profitability and leverage. A different view holds that the choice of firm’s capital structure signals to outsiders, investors the information of insiders. In this case investors take larger debt levels as a signal of good performance of the firm and management confidence- {Ross (1977) Leyland and Pyle (1977)} about future performance.

Company Growth: According to Agency theory, there is a negative relationship between growth and debt level. Weston and Copeland (1988) quotes Myers’ (1979) who argues that under investment problem suggest a negative relationship between growth and long-term debt. He concluded that managers at firms with valuable growth opportunities should choose low leverage. The implication for control may affect the Debt Equity ratio decision because heavily levered companies have less control than firms that rely on equity or have a less degree of equity.

The firm therefore has to carefully analyze its financial position and determine to what extent to employ either debt or equity of what mix would be most appropriate for their firm. No two firms are exactly alike and therefore the debt equity ratios may differ from company to company depending on the factors affecting it. CHAPTER 3 3. 0RESEARCH METHODOLOGY AND DESIGN 3. 1 Design The research study is an exploratory type. 3. 2Population The population of this study will comprise of all companies listed at the Nairobi Stock Exchange between the years beginning January 2000 to December 2004 (See Appendix 1). 3. 3 Sample

In order for a firm to be included in the sample it must have fulfilled the conditions of having been quoted in the NSE since 2000 to 2004. The firms in the finance and investment sector are left out because they do not have a clear debt structure. From the remaining firms we randomly chose ten (10) companies. This is to simplify data collection and due to accessibility of the information required. (See Appendix 2) 3. 4 Data Collection Method Secondary data was used in this study, colleted from annual reports of those listed companies and records maintained at the Nairobi Stock Exchange (NSE) (Appendix 3).

From the data, the variables used in this study include: - •Debt/leverage ratio—computed as total debt divided by total debt plus equity •Tangibility- computed as total assets less current assets divided by total assets •Profitability- is computed as earnings before tax divided by total assets •Business risk- is computed as the variance of operating income. •Growth- is the average percentage change in total assets from the previous to the current year •Size- is computed as the log of total assets •Non-debt tax shield – is calculated as the depreciation divided by total assets. . 5 Data Analysis Method This study employs multiple regressions as the tool for analysis. This model describes leverage as a function of all the determinant variables represented in a general linear model as: Y= ? 0 + ? 1X1 + ? 2X2 + ? 3X3 + ? 4X4 + ? 5X5 + ? 6X6 It describes how leverage (Y) will be related to any one of the independent variables (regressors) provided all others remain constants. Where; Y – is the leverage/debt ratio to be predicted (dependant) ? 0 – is the co-efficient of regression.

It predicts the relationship between the leverage and respective variable. This relationship is compared with the known theoretical relationship to prove or disapprove the theoretical explanation. X1 – represents tangibility as an independent variable (regressor) X2 – represents profitability as an independent variable (regressor) X3 – represents business risk as an independent variable (regressor) X4 – represents growth as an independent variable (regressor) X5 – represents non-debt tax shield as an independent variable (regressor)

X6 – represents size as an independent variable (regressor) ?1 – represents the change in leverage that accompanies a unit change in variable X1 – (marginal effect) while holding other variables constant ?2 – represents the marginal effect of variable X2 on leverage holding other Variables constant ?3 – represents the marginal effect of variable X3 on leverage holding other Variables constant ?4 – represents the marginal effect of variable X4 on leverage holding other Variables constant 5 – represents the marginal effect of variable X5 on leverage holding other Variables constant ?6 – represents the marginal effect of variable X6 on leverage holding other Variables constant Overall total change in leverage (Y) therefore can be computed as the sum of the individual changes of the variables. Y= ? 0 + ? 1X1 + ? 2X2 + ? 3X3 + ? 4X4 + ? 5X5 Then? Y= ? 1? X1 + ? 2? X2 + ? 3? X3 + ? 4X4 + ? 5X5 Following this analysis marginal effect on debt is computed for each variable.

Comparison is made and significance of each predictor variable tested. The test is to determine whether the value of a predictor variable is significantly different from zero. The marginal effect on leverage as a result of all the variables is computed and the significance of the effect tested to find out whether and to what extent they explain leverage. The t-test was used because the data is less than 30. t-statistics are computed using standard error that account for non-independence of the data collected (95% confidence level of estimate is used). T (N-K-1) = b/sb

Where; b is the regression co-efficient of the variables sb is the standard error of the regression co-efficient T is the statistic values N is the number of subjects K is the number of predictor variables The result in t is on N-K-1 degree of freedom. The t-statistic values are considered to be significant when the value is more closer to zero and less significant the further it is from zero. CHAPTER 4 4. 0DATA ANALYSIS AND INTERPRETATION 4. 1INTRODUCTION The following are results generated from analyzing data collected from financial statement from various companies.

The data was tested using multiple regression analysis to show the significance of each variable to the capital structure decisions. TABLE 4. 0 SUMMARY OF THE MODEL TABLE 4. 1 SIGNIFICANCE OF VARIABLES From Table 4. 1 we can conclude that the variables have a mean significance of 0. 289. This could be due to the fact that some variables are more significant than other variables. The order of significance of the variables that affect the capital structure decisions is as follows: profitability (0. 051), company growth (0. 082), size of company (0. 14), business risk (0. 315), non-debt tax shield (0. 671), and tangibility (0. 720). 4. 2ANALYSIS OF FINDINGS 4. 2. 1 Tangibility: From the results tangibility has a significance of 0. 720 and indication that it is significant but at the least level because it is the furthest from zero as compared to the others. We can conclude that firms do not put a lot of consideration on bankruptcy costs as they dwell on the going concern concept. 4. 2. 2Non-debt tax shield: The significance level was 0. 671 also at a low level of significance.

This arose from the fact that most firms preferred using equity to debt, meaning they would not consider non-debt tax shield that relies on the increase of debt. We can also derive an assumption that the bondholder taxes were higher than corporate taxes thus most companies opting for equity. 4. 2. 3Business Risk (Earning volatility): It has a significance level of . 315. This is an indication that it has a high level of significance compared to the two above mentioned. Firms issue little debt to hedge against uncertainty of operating income. . 2. 4A firm’s size: Significance Level: 0. 114 Ferri and Jones who used the value of total assets and volume of sales as a measure of size found the hypothesis that there is a relationship between the use of debt and the size of a firm true in an empirical study, (Weston and Copland, 1988) from the significance level 0. 114 we found that a firms size plays a significant role in the leverage decisions. 4. 2. 5Growth: There is a negative relationship between growth and debt level (Weston and Copeland (1988) quotes Myers’ (1979)).

We found a significance level of 0. 082. This has a high impact on the capital structure decision showing that managers at firms with valuable growth opportunities should choose low leverage. 4. 2. 6Profitability: Firms prefer internal to external financing and the more profitable the firm, the greater the availability of internal capital, hence there should be a negative relationship between profitability and leverage (Weston and Copeland (1988), they quote Myers and Majluf (1984)). Our findings hold this argument in that, at a significance level of 0. 51 profitability greatly influences capital structure decision. This was the lowest significance level we recorded showing that profitability greatly influences Capital Structure Decision. For example if a firm has high profits it would employ less debt. CHAPTER 5 5. 0SUMMARY AND CONCLUSION The purpose of the study was to determine which factors influence the capital structure decision of the firm and which of these factors have the greatest influence on the capital structure decision.

Our research project concluded that all the variables included in our study i. e. Business Risk, Size of the Firm, Tangibility, Non Debt Tax Shield, Profitability and Growth significantly influence the capital structure decision. However, we found that profitability and growth influenced leverage at a greater degree. Profitability had a significance level of . 051 while growth had a significance level of . 082. Our findings were consistent with Odinga’s research (2003) in that we both had similar significant variables but at varying levels.

Whilst he concluded that Profitability and Non Debt Tax Shield were the most significant variables we, on the other hand, found company growth and profitability to be the most significant factors. Age of a firm and level of interest are also factors that influence the capital structure decision even though they don’t feature on financial statements. Levels of interest are determined by the micro-economic factors in the environment. The age of the business gives an older firm a greater advantage to sourcing funds externally than young ones.. 5. LIMITATION OF THE STUDY We encountered the following limitations in the course of our study: i)Our data collection involved the use of secondary data. This meant that we were restricted to firms quoted in the NSE, as these were the only firms whose financial statements were accessible to us. We attempted to use financial data from other firms not quoted in the NSE, but encountered resistance when seeking to collect the reports. ii)We could not use a larger sample size than that chosen due to the time constraints and the extra costs involved.

We had to settle on a sample size of ten for convenience and simplicity. iii)The financial data was volatile; this is due to macro and micro economic factors that influence the variables. These include inflation, interest rates, demand and supply of funds and uncertain economic conditions. These would cause variation in the data collected that wouldn’t be reflected within the financial data itself. iv)Some of the firms did not have clear debt structures. We had difficulty identifying debt in finance and investment institutions. v)We conducted our analysis by the use of multiple regression.

We encountered difficulty using this method and had to employ help from outside to help us analyze our data and this added on to our expenses. 5. 2RECOMMENDATIONS From the research conducted on the factors affecting Capital Structure decisions, companies should put more consideration on Company Growth and Profitability in deciding on whether to use debt or equity. We realize that all the mentioned factors are significant (i. e. Business Risk, Size of the Firm, Tangibility, Non Debt Tax Shield, Profitability and Growth), however, these two factors influence the Capital Structure decisions at a greater degree.

Due to volatility of the finance environment some of the variables may be significant if other factors are put into consideration. For instance, if bondholder tax rates are lower than corporate tax rates then it would be advisable for the firms to use debt as this would give them a non-debt tax shield. This means they would have to reconsider their debt equity structure. 5. 3RECOMMENDATION FOR FURTHER RESEARCH My study included the use of secondary data. In future I would recommend that questionnaires should be conducted to the Financial Managers of the firms.

This would help provide input on what factors affect the capital structure decisions of the firms. I realize that firms have different factors that influence them depending on the different industries they are in. APPENDIX 1 1. Unilever Tea Kenya46. Limuru Tea Co. Ltd. 2. Kakuzi47. Standard Group Ltd 3. Rea Vipingo Plantations Ltd48. Kenya Orchads Ltd 4. Sasini Tea & Coffee Ltd 5. Commercial And Services 6. Car & General (K) Ltd 7. CMC Holdings Ltd 8. Hutchings Biemer 9. Kenya Airways Ltd 10. Marshalls (E. A. ) Ltd 11. Nation Media Group 12. TPS Ltd (Serena) 13. Uchumi Supermarket Ltd 14. Barclays Bank Ltd 15. C. F.

C Bank Ltd ord. 16. Diamond Trust Bank Kenya Ltd 17. Housing Finance Company Ltd 18. I. C. D. C Investments Co Ltd 19. Jubilee Insurance Co. Ltd 20. National Bank of Kenya Ltd 21. NIC Bank Ltd 22. Pan Africa Insurance Holdings Ltd 23. Standard Chartered Bank Ltd 24. Athi River Mining 25. B. O. C Kenya Ltd 26. Bamburi Cement Ltd 27. British American Tobacco Kenya Ltd 28. Carbacid Investments Ltd 29. Crown Berger Ltd 30. Olympia Capital Holdings ltd 31. E. A. Cables Ltd 32. E. A. Portland Cement Ltd 33. East African Breweries Ltd 34. Firestone Africa Ltd 35. Kenya Oil Co Ltd 36. Mumias Sugar Co. Ltd 37. Kenya Power & Lighting Ltd 8. Total Kenya Ltd 39. Unga Group Ltd 40. A. Baumann & Co. Ltd 41. City Trust Ltd 42. Eaagads Ltd 43. Express Ltd 44. Williamson Tea Kenya Ltd 45. Kapchorua Tea Co. Ltd APPENDIX 2 1. East African Breweries Ltd. 2. Kenya Airways Ltd 3. Nation Media Group 4. Brooke Bond Ltd. 5. East African Cables Ltd. 6. Rea Vipingo Plantation Ltd 7. Firestone Africa Ltd. 8. Marshalls (E. A) Ltd. 9. Total (k) Ltd 10. British American Tobacco Kenya Ltd. APPENDIX 3 BATKshs’000 Years 1999 2000 2001 2002 2003 2004 TA7,158,6907,156,5816,742,6076,313,7966,356,0696,121,887 CA3,834,8113,673,5383,244,4442,892,0312,803,7732,601,067 O.

I1,861,106 707,867 975,6261,299,0081,737,853`1,676,470 EBT1,874,466 682,970 851,3431,310,4231,677,5951,750,602 DEPN 1 92,474 220,600 226,153 227,418 225,787 234,575 TL2,832,9782,530,8012,202,9862,155,2382,360862 TOTAL (K) TA 56,24910,073,4137,130,1786,108,9247,860,02910,548,789 CA 44,121 8,554,3894,559,9223,741,9545,599,391 8,218,765 OI 118,869 750,083 248,833 710,499 760,276 1,061826 EBT 8,567 333,498(318,899) 604,776 756,645 931,638 DEPN 125,289 142,289 192,887 191,987 212,944 193,203 TL ,428,9864,985,2752,688,8023,737,625 6,026,038 FIRESTONE TA2,848,922 2,740,308 2,824,352 2,548,682 2,482,833 2,986,444 CA1,645,180 1,649,734 1,775,398 1,464,840 1,480,680 1,975,269 O. I 628,246 419,627 446,177 325,086 248,747 421,309 EBT 576,945 396,412 448,879 310,837 255,709 400,473 DEPN 188,242 219,115 202,527 213,626 194,306 185,077 TL 728,119 769,842 559,251 573,252 974,154 REA VIPINGO

TA1,006,012 849,546 852,935 823,053 871,716 1,028,661 CA 370,603 277,036 290,349 265,067 311,711 396,106 OI 29,646 (30,591) 41,444 75,370 40,465 34,009 EBT (7,723) (46,292) 8,955 47,108 10,895 17,794 DEPN 63,654 64,768 65,208 64,494 40,083 34,009 TL 403,765 416,813 371,662 410,530 452,854 NATION (Shs M) TA2598. 429192922. 13613. 3917. 74049. 3 CA961. 71163. 61217. 72097. 12257. 92022. 9 EBT342. 2296. 1 390. 2 635. 2 872. 6 894. 7 OI360. 1325. 7 381. 5 576. 3 810. 2 826. 0 DEPN499. 4733. 5 930. 1 1178. 0 1417. 41974. 0 TL1,011. 1 816. 71,281. 81,167. 71,192. 5 BROOKE BOND TA6,105,8826,592,5326,168,8736,227,1634,816,0375,183,965 CA1,048,1301,487,5421,149,3941,419,2091,562,1501,708,583 EBT 343,146 664,664 32, 8031 217,603 83,479 555,056 OI 150,964 617,878 294,161 225,280 85,499 523,286

DEPN1,060,5421,211,1691,359,9231,495,262 419,248 600,342 TL 707,555 581,231 629,533 609,941 597,620 MARSHALLS TA1,409,1011,238,8861,255,2801,207,2371,035,055 979,446 CA 812,746 697,106 651,783 671,325 615,323 600,676 EBT(211,118)(104,028) (356,066) 1,799 22,080 73,348 OI(115,478) (14,156) 66,144 85,123 68,651 64,987 DEPN265,330 177,324 176,108 196,464 211,803 226,897 TL 938,554904,028 854,221 767,670 733,483 E. A BREWERIES

TA14,653,97414,001,9348,074,43810,943,06611,440,35911,518,044 CA 5,467,072 5,285,6374,831,978 6,847,586 2,836,798 3,478,551 EBT 1,506,962 1,793,6522,499,117 3,400,411 5,383,277 7,041,897 OI 1,752,460 1,973,6522,511,926 3,256,281 4,894,362 6,016,411 DEPN 678,221 748,597 758,168 721,459 687,458 732,218 TL 4,721,5655,005,372 5,656,715 4,706,515 5,511,917 KQ (Shs M) TA177112294023267221702425529279 CA60961225810691843663826371 EBT14252853204410595472075 OI9491683205912118392677 DEPN3914408228859181244 TL1533015342145071602720988

EAST AFRICAN CABLES TA 400,538 360,577 328,314 330,539 355,901 492,216 CA299,352 263,895 241,623 239,564 272,782 410,583 EBT32,842 46,698 24,112 (4,954) 14,022 178,815 OI17187 37,758 15,083 (8,262) 8,433 180,435 DEPN10,802 10,498 6,226 9,042 9,015 9,700 TL 55,297 31,350 62,656 84,068 154,562 Where: TA is Total Assets CA is Current Assets EBT is Earnings before Tax OI is Operating Income DEPN is Depreciation TL is Total Liabilities REFERENCES 1. Altman E. September, 1984) “A Further Empirical Investigation of the Bankruptcy Cost Question,” Journal of finance, pp 1067-1089. 2. Bierman H. Jr. (1975) “ The Capital Budgeting Decisions,” Macmillian 3. Brealey R. and Myers S. (1991) “Principles of Corporate Finance,” New York: McGraw Hill 4. Copeland, Thomas and Fred J. Weston, (1988) “Financial theory and Corporate Policy, Third Edition; New York: Addison-Wesley Publishing Company, 5. Denzil Watson and Anthony Head, “Corporate Finance Principles and Practices,” 2nd Edition. 6. Emery Gray W. , “Corporate Finance, Principles and Practice”; New York :Addison-Wesley Publishing Company, . Fisher I. “The theory of Interest,” Macmillian 1965 8. Franco Modigliani and M. H. Miller, (June 1958) “the Cost of Capital Corporation Finance and The Theory of Investment” American Economic Review pp. 261-297 9. H. H Markowitz (1959) “Portfolio Selection: Efficient Diversification of Investments,” 10. John Wiley 11. Nicholas I. Kamere (1987) Academic paper, “Some factors that influence the Capital 12. Structure of Public Companies in Kenya” Unpublished MBA Research Project University of Nairobi 13. Odinga (2003) Academic paper, “Determinants that affect the Capital 14.

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