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STUDY ON THE RELATIONSHIP BETWEEN CAPITAL
STRUCTURE AND FINANCIAL PERFORMANCE OF THE
MANUFACTURING COMPANIES LISTED ON THE NAIROBI
STOCK EXCHANGE
BY
THOMAS GITARI NJENGA
UNITED STATES INTERNATIONAL UNIVERSITY
AFRICA
SUMMER, 2014
STUDY ON THE RELATIONSHIP BETWEEN CAPITAL
STRUCTURE AND FINANCIAL PERFORMANCE OF THE
MANUFACTURING COMPANIES LISTED ON THE NAIROBI
STOCK EXCHANGE
BY
THOMAS GITARI NJENGA
A Project Report Submitted to the Chandaria School of Business in Partial
Fulfillment of the Requirement for the Degree of Masters in Business
Administration (MBA)
UNITED STATES INTERNATIONAL UNIVERSITY-
AFRICA
SUMMER, 2014
ii
STUDENT’S DECLARATION
I, the undersigned, declare that this is my original work and has not been submitted to any
other college, institution, or university other than the United States International
University in Nairobi for academic credit.
Signed:_____________________________ Date:_________________________
Thomas Gitari Njenga (ID: 632307 )
This project has been presented for examination with my approval as the appointed
supervisor.
Signed:______________________________ Date:_________________________
Dr. Amos G. Njuguna
Signed:______________________________ Date:_________________________
Dean, Chandaria School of Business
iii
COPYRIGHT
All rights reserved. No part of this report may be photocopied, recorded or otherwise
reproduced, stored in a retrieval system or transmitted in any electronic or mechanical
means without prior permission of the copyright owner.
Thomas Gitari Njenga Copyright © 2014
iv
ABSTRACT
The purpose of the study was to assess the relationship between Capital structure and
financial performance and position of manufacturing companies quoted on the Nairobi
Securities Exchange. The study sought to answer the following questions: What are the
components of capital structure? Is there a relationship between capital structure and
financial performance? Is there a relationship between capital structure and assets .Lastly,
what is the effect of capital structure on the profitability.
The research used descriptive research design to describe the relationship of the variables
in order to justify the research findings. The data that was examined for the purpose of the
study was only secondary data obtained from the Capital Markets Authorities of Kenya
and Kenya Association of Manufacturers. The population of the study was from the
manufacturing firms quoted on the Nairobi Securities Exchange Market. The study used
purposive and random sampling technique to select a sample from the nine manufacturing
firms companies quoted on the Nairobi Securities Exchange.
The research model used was Debt Equity ratio as the independent variable, whereas
dependent variables were the following ratios: Return on Assets, Return on Equity and
Profitability ratios such as the Pre – Tax profit ratio and the After Tax profit ratio. The
financial ratios were calculated by use of Microsoft Excell spreadsheets using data
obtained from the five year period (2006- 2012) financial statements of the selected
companies. Then data analysis was done by use of; graphs, tables, trend analysis and
regression.
The study has shown that the major components of capital structure are debt and equity.
Secondly, the results of the study showed that there is no significant statistical
relationship between capital structure and assets of the manufactured companies quoted.
Lastly, the results of the study showed that there is no significant statistical relationship
between capital structure and financial profitability of the manufacturing firms quoted on
the Nairobi Securities Exchange.
v
ACKNOWLEDGEMENT
First and foremost I would like to thank God the Almighty for giving me the knowledge,
strength and intelligent to complete my studies. Apart from my God and my own efforts,
the success of my project depends largely on the encouragement and guidelines of many
others.
I wish to express my deep sense of gratitude to my supervisor, Dr Amos Njuguna for his
able guidance and useful suggestions, which helped me in completing this project in time.
Last , but not least, I would like to express my heartfelt thanks to my beloved late Mum,
my family and friends for their prayers and support, to my school friends and my
classmates for their help and wishes for the successful completion of this project.
vi
TABLE OF CONTENTS
STUDENT’S DECLARATION ....................................................................................... ii
COPYRIGHT ................................................................................................................... iii
ABSTRACT ...................................................................................................................... iv
ACKNOWLEDGEMENT .................................................................................................v
TABLE OF CONTENTS ................................................................................................ vi
LIST OF TABLES ......................................................................................................... viii
LIST OF FIGURES ...........................................................................................................x
CHAPTER ONE ................................................................................................................1
1.0 INTRODUCTION ........................................................................................................1
1.1 Background of the Study ...............................................................................................1
1.2 Statement of the Problem ...............................................................................................5
1.3 Purpose of the Study ......................................................................................................6
1.4 Research Questions ........................................................................................................6
1.5 Significance of the Study ...............................................................................................6
1.6 Scope of the Study .........................................................................................................7
1.7 Definition of Terms........................................................................................................8
1.8 Chapter Summary ..........................................................................................................9
CHAPTER TWO .............................................................................................................10
2.0 LITERATURE REVIEW ..........................................................................................10
2.1 Introduction ..................................................................................................................10
2.2 Components of Capital Structure .................................................................................10
2.3 Effect of Capital Structure on Assets. ..........................................................................16
2.4 Effect of Capital Structure on a Firm‟s Performance/Profitability. .............................19
2.5 Chapter Summary ........................................................................................................22
CHAPTER THREE .........................................................................................................23
3.0 RESEARCH METHODOLOGY .............................................................................23
3.1 Introduction ..................................................................................................................23
3.2 Research Design...........................................................................................................23
3.3 Population and Sampling Design .................................................................................24
3.4 Data Collection Methods .............................................................................................25
3.5 Data Analysis Methods ................................................................................................25
vii
3.6 Chapter Summary ........................................................................................................26
CHAPTER FOUR ............................................................................................................27
4.0 RESULTS AND FINDINGS .....................................................................................27
4.1 Introduction ..................................................................................................................27
4.2 General Information .....................................................................................................27
4.3 Components of Capital Structure .................................................................................30
4.4 Relationship between Capital Structure on Assets.......................................................34
4.5 Capital Structure Relationship with Performance ........................................................45
4.6 Regression Analysis .....................................................................................................58
4.7 Chapter Summary ........................................................................................................62
CHAPTER FIVE .............................................................................................................64
5.0 DISCUSSION, CONCLUSIONS AND RECOMMENDATIONS ........................64
5.1 Introduction ..................................................................................................................64
5.2 Summary ......................................................................................................................64
5.3 Discussion ....................................................................................................................65
5.4 Conclusion ...................................................................................................................70
5.5 Recommendations. .......................................................................................................71
REFERENCES .................................................................................................................73
APPENDICES: .................................................................................................................81
APPENDIX 1: BOC KENYA DATA COLLECTION INSTRUNMENT ( 2006 - 2012
) IN KSH '000' ..................................................................................................................81
APPENDIX 2: EABL DATA COLLECTION INSTRUMENT ( 2006 - 2012 ) IN
KSH '000' ..........................................................................................................................82
APPENDIX 3: EVEREADY DATA COLLECTION INSTRUNMENT ( 2006 - 2012
) IN KSH '000' ..................................................................................................................83
APPENDIX4: MUMIAS DATA COLLECTION INSTRUMENT ( 2006 - 2012 ) IN
KSH '000' ..........................................................................................................................84
APPENDIX 5: UNGA GROUP DATA COLLECTION INSTRUMENT ( 2006 -
2012 ) in KSH '000' ..........................................................................................................85
viii
LIST OF TABLES
Table 4.1 Manufacturing Companies & their Nature of Operations ................................. 28
Table 4.2 Manufacturing Companies Annual Average Turnover in KSH „000‟ (2006
– 2012)................................................................................................................................28
Table 4.3 Manufacturing Companies Average After Tax Profit in KSH „000‟ (
2006 – 2012) ...................................................................................................................... 29
Table 4.4 Manufacturing Companies Average Assets ( 2006 – 2012) in KSH „000‟ ...... 29
Table 4.5 Manufacturing Companies Average Net worth ( 2006 – 2012) in KSH „000‟. 30
Table 4.6 BOC KENYA Debt Equity Ratio ...................................................................... 35
Table 4.7 BOC KENYA Return on Assets Ratio .............................................................. 35
Table 4.8: EABL Debt Equity Ratio .................................................................................. 36
Table 4.9: EABL Return on Assets Ratio .......................................................................... 37
Table 4. 10: Eveready Debt Equity Ratio .......................................................................... 38
Table 4. 11: Eveready Return on Assets Ratio .................................................................. 39
Table 4. 12: Mumias Debt Equity Ratio ............................................................................ 40
Table 4. 13: Mumias Return on Assets Ratio .................................................................... 41
Table 4. 14: Unga Group Debt Equity Ratio ..................................................................... 42
Table 4. 15: Unga Group Return on Assets Ratio ............................................................. 43
Table 4.16 Weighted Average Debt Equity Ratios & Return on Assets Ratios
Analysis..............................................................................................................................45
Table 4. 17: BOC Return on Equity Ratio ......................................................................... 46
Table 4. 18: BOC Kenya Pre – Tax and After Tax Ratios ................................................ 46
Table 4.19: EABL Return on Equity Ratio ........................................................................ 48
Table 4.20: EABL Pre – Tax and After – Tax Profit Ratios.............................................. 48
Table 4.21: Eveready Return on Equity Ratio analysis ..................................................... 50
Table 4. 22: Eveready Pre- Tax and After – Tax Profit Ratios.......................................... 50
Table 4. 23: Mumias Sugar Company Return on Equity Ratio ......................................... 52
Table 4. 24: Mumias Sugar Company Pre – Tax and After – Tax Profit Ratio................. 52
Table 4. 25: Unga Group Return on Equity Ratios ............................................................ 54
Table 4. 26: Unga Group Pre – Tax and After tax profit ratios ......................................... 54
Table 4.27 Weighted Average Debt Equity Ratios & Return on Equity Ratios Analysis . 56
Table 4.28 Weighted Average Debt Equity Ratios & Pre Tax Profit Ratio Analysis. .... 57
Table 4.29 Weighted Average Debt Equity Ratios & Pre Tax Profit Ratios Analysis ..... 58
Table 4.30 Debt Equity and Return on Assets Model Summary ....................................... 59
ix
Table 4.31 Debt Equity Ratio and Return on Assets Anova.............................................. 59
Table 4.32 Debt Equity Ratio and Return on Equity Model Summary ............................. 60
Table 4.33 Debt Equity Ratio and Return on Equity Anova ............................................. 60
Table 4.34 Debt Equity Ratio and Pre – Tax Profit Model Summary .............................. 61
Table 4.35 Debt Equity Ratio and Pre – Tax Profit Anova ............................................... 61
Table 4.36 Debt Equity Ratio and After – Tax Profit Ratio Model Summary .................. 62
Table 4.37 Debt Equity Ratio and After Tax Anova ......................................................... 62
x
LIST OF FIGURES
Figure 4.1 Debt Levels for the Manufacturing Companies (2006 – 2012) ........................ 31
Figure 4.2 Equity Levels for the Manufacturing Firms (2006 – 2012) ............................. 32
Figure 4.3 Share Capital of the Manufacturing Companies (2006 – 2012) ....................... 33
Figure 4.4 Retained Earnings for the Manufacturing Companies (2006 – 2012) .............. 34
Figure 4. 5: BOC Debt Equity and Return on Assets Ratios Trend Analysis ................... 36
Figure 4. 6: EABL Debt Equity and Return on Assets Ratios Trend Analysis ................. 38
Figure 4. 7: Eveready Debt Equity and Return on Assets Ratios Trend Analysis ............. 40
Figure 4. 8: Mumias Debt Equity and Return on Assets Ratios Trend Analysis .............. 42
Figure 4. 9: Unga Group Debt Equity and Return on Assets Ratios Trend Analysis ........ 44
Figure 4. 10: BOC Debt Equity and Return on Equity Ratios Trend Analysis ................. 47
Figure 4. 11: BOC Debt Equity and Profit (Pre Tax & After Tax) Ratios Trend analysis 47
Figure 4. 12: EABL Debt Equity and Return on Equity Ratios Trend Analysis ............... 49
Figure 4. 13: EABL Debt Equity Ratio and Profit (Pre Tax & After Tax) Analysis......... 49
Figure 4. 14: Eveready Debt Equity and Return on Equity Ratios Trend analysis. .......... 51
Figure 4.15: Eveready Debt Equity and (Pre Tax & After Tax) Ratios Trend analysis .... 51
Figure 4. 16: Mumias Debt Equity Ratio and Return on Equity Ratios Trend Analysis .. 53
Figure 4. 17: Mumias Debt Equity Ratio and Profit (Pre Tax & After Tax) analysis ....... 53
Figure 4. 18: Unga Group Debt Equity and Return on Equity Ratios Trend analysis ....... 55
Figure 4.19: Unga Group Debt Equity and (Pre Tax &After Tax) Ratios Trend Analysis55
1
CHAPTER ONE
1.0 INTRODUCTION
1.1 Background of the Study
According to Myers (2001) there is no universal theory of debt-equity choice but there are
vital conditional theories such as, the tradeoff theory that says firms seek debt levels that
balance the tax advantages of additional debt against the costs of possible financial
distress. The tradeoff theory predicts moderate borrowing by tax-paying firms. Secondly
there is the pecking order theory that says the firm will borrow, rather than issue equity,
when internal cash flow is not sufficient to fund capital expenditures. Thus the amount of
debt will reflect the firm's cumulative need for external funds.
Lastly the free cash flow theory that says dangerously high debt levels will increase
value, despite the threat of financial distress, when a firm's operating cash flow
significantly exceeds its profitable investment opportunities. The free cash flow theory is
designed for mature firms that are prone to overinvest.
However, a study by Modigliani (1958) proved that the choice between debt and equity
financing has no material effects on the value of the firm or on the cost or availability of
capital. The study assumed perfect and frictionless capital markets, in which financial
innovation would quickly extinguish any deviation from their predicted equilibrium.
Manufacturing industry in Kenya is one that has companies with different proportions of
capital structure and this has an impact on their financial profitability and performance.
The manufacturing industry is a wide industry that dealing with the
changing/transformation of raw materials through a process aimed to finished goods for
sale. The study has dealt much on the large manufacturing companies which according to
the Kenya Statistical Abstract (2004) are firms with more than fifty employees.
Manufacturing firms that are quoted on the securities exchange have more access to funds
from the public hence their borrowing ability increases their leverage which in turn
influences the capital structure proportions of debt and equity. According to Faulkender
2
and Petersen (2006), firms without access to the public debt markets are more restricted
in their ability to borrow and therefore have lower leverage.
Manufacturing companies capital structure invested in assets determines the financial
position of the companies in terms of liquidity. Shleifer and Vishny (1992) argue that
more liquid assets should be financed with debt more often because banks and public debt
markets incur lower costs from financing these debts in turns means that higher asset
liquidity increases the amount of capital the companies can borrow.
Morellec (2001) argues that the effect of asset liquidity on leverage is dependent on
whether there are restrictions on asset disposition .Assets that have higher liquidity, their
sales are more likely because of the lower costs of selling them. In turn, asset sales reduce
the size and value of a firm‟s assets upon closure and therefore are bad for creditors.
Imposing restrictions on the firm's assets prevents asset sales and increases expected asset
value in liquidation for creditors.
According to Kenya Association of Manufacturers (2012) the manufacturing sector is
mainly agro-based and characterized by relatively low value addition, employment, and
capacity utilization and export volumes partly due to weak linkages to other sectors. In
addition 95% of Kenya‟s manufactured goods are basic products such as beverages, food,
building materials and basic materials. Only 5% of the manufactured goods are things like
pharmaceuticals which are in skill – intensive activities.
The growth pattern for the manufacturing industry in Kenya has not been stable. From
2007- 2011 a span of five years the best growth year was 2007, according to Economic
Survey, (2008) the manufacturing industry grew at 6.2% and this was attributed to
increased exports of manufactured products and growth in business investment. The key
drivers to this were food, beverage, tobacco, petroleum & other chemicals ( Economic
Survey, 2008)
The external environment factors have an impact on the growth of manufacturing
industries in Kenya, for instance after the election in December 2008 there was post
election violence that led to disruption of raw materials and temporary closure of the
manufacturing industries. Growth in the manufacturing sector fell to 3.6% from 6.2% in
3
2007. The key manufacturing companies affected were food, beverage and tobacco since
their combined valued added contracted by 1.7% in 2008 compared to an expansion of
9.3% in 2007 (Economic Survey, 2009)
Weather also affects the manufacturing industry performance a lot, because favourable
weather conditions ensure reliable power supply that bolsters electric power generation
since electric power is a key component in the manufacturing industry. In 2010 the
manufacturing sector grew by 4.4% compared to 2.0% in 2009 since there was reliable
power supplies as a result of favourable weather conditions that enhanced electric power
generation (Economic Survey, 2011)
Legal factors also contribute a lot to the financial performance of firms especially those in
the manufacturing industry. In 2010 there were favorable tax policies, including the
removal of duty on capital equipments and some raw materials (Economic Survey, 2011)
this contributed to the manufacturing sector growing by 4.4% in the year 2010.
The government activities also have an impact on the performance of manufacturing
companies this can be seen through things such as tax policies by the government.In the
year 2010 the government of Kenya introduced favourable tax policies to the
manufacturing industry which saw the removal of duty on capital equipments and some
raw materials.According to the Economic Survey (2011) this also led to an increased
growth in the manufacturing sector.
Economic factors such as the interest rates and foreign exchange rates have a direct
relationship with the performance of manufacturing companies in Kenya. In 2011 there
was the free fall in the Kenya shilling which saw the shilling depreciate its value to major
world currencies. According to Economic Survey (2012), the manufacturing sector grew
by 3.3% compared to 4.4% in 2010.This growth was undermined mostly by the
depreciating Kenya Shilling which increased the cost of imported intermediary inputs and
unfavourable weather conditions that led to reduced availability of raw materials.
In 2012 the sector grew by only 3.1% compared to 3.3% in 2011, high cost of production,
competition from imports, high cost of credit and political uncertainty are some of the
major reasons for that growth , ( Kenya Association of Manufacturers, 2013)
4
Kenya manufacturing sector is large since it serves both the local market and exports to
the East African region. The manufacturing sector mostly comprises of subsidiaries of
multi-national corporations which contributed approximately 13% of the Gross Domestic
Product (GDP) in 2004 .However with improved power supply, increased agro
processing products, favourable tax reforms and tax incentives, vigorous export
promotion and trade incentives through expanded markets of AGOA, COMESA and
East African Community (EAC) the sector grew by 1.4 % per cent in 2004 as compared
to 1.2% in 2003 (PWC Kenya, 2012).
The rising levels of poverty aggravated by the general slowdown of the economy has
continued to inhibit growth in the demand of locally manufactured goods, this has
resulted to a high demand shift in favour of relatively cheaper imported manufactured
products. In addition, the high cost of energy has led to high prices of locally
manufactured products thereby limiting their competitiveness in the regional markets and
hampering the sector's capacity utilisation. This resulted to a growth of 2.0% in the
manufacturing as compared to a growth of 3.6% in 2008. ( Economic Survey, 2010).
However, Kenya‟s manufacturing sector being the most developed in the East Africa
region has a greater opportunity to take advantage of and that is the recent introduction of
the EAC Customs Union which brings about: enlarged market size, economies of scale,
and increased intraregional trade (PWC Kenya, 2012)
Corporate governance plays a big role since effective and effecient management leads to
a good financial performance and position of a company.Countries like Kenya which are
developing, more industries in the private sector of the economy are come up with the
objective to produce and supply the needed goods, create employment, generate revenues
for the state and also raise the living standards of the people. Al-Attar, Hussain, and Zuo
(2008) stated that, it is essential for the corporate sector to be very effectively and
efficiently managed in order to attain both the national and corporate objectives.
Over the past few years the manufacturing industry has been improving with companies
like Crown Berger, British American Tobacco (BAT) and Toyota (K) ltd amongst other
companies reporting increased profit margins. Good capital structure management can be
attributed to the increased profits. This has also resulted to an increase in the number of
5
manufacturing companies thus enabling competition and in the end increased quality of
production by the manufacturing companies (Kibuthu, 2005).
The manufacturing industry has also seen firms collapse, for example Webuye Pan Paper
due to financial problems which were tied up to capital structure. Other firms have had
financial difficulties have been able to remain on the manufacturing industry, like Kenya
Co-operative Creameries (KCC) and Eveready East African limited. This has led to the
two companies making losses and had to downsize employee numbers (Onyango, 2008).
1.2 Statement of the Problem
There has been a lot of research study on the capital structure as a subject but little has
been done on the relationship between capital structure and the financial performance and
position of manufacturing companies which are quoted on the Nairobi Securities
Exchange market. According to Ross, Westerfield and Jordan (2002) increasing the
amount of debt in proportion to equity increases the riskiness of a firm. The riskiness in
turn may affect the performance of a firm.
One of the research gaps that brought about this study is linking performance of
manufacturing companies to capital structure since there is variation of companies in
terms of their capital structure composition and studies have shown that there is no
optimal capital structure composition of equity and debt (Ross, 2002)
From these there was a need to further the studies by showing whether there capital
structure has an impact on the financial performance and position of manufacturing
companies quoted on the Nairobi Securities Exchange market. The study has analyzed
components of capital structure is, the effect of capital structure on asset, the effect of
capital structure on profitability.
The relationship between the debt level of a firm and its financial performance is a vital
issue which is unsolved issue in the finance field. Theoretical and empirical studies try to
define the determinants of capital structure but research investigating the relationship
between capital structure and firm‟s level of performance are limited. Again there are no
previous studies in Kenya investigating the role of debt in this relationship; therefore this
research has attempted to fill in this gap.
6
However as mentioned before the first research question on components of capital
structure is covered empirically by previous studies. The last two research questions are
covered empirically by statistical analysis of financial statements of manufacturing firms
quoted on the Nairobi Securities Exchange. The study used selected quoted
manufacturing companies‟ financial statements for past seven years: 2006, 2007, 2008,
2009, 2010, 2011 and 2012.
1.3 Purpose of the Study
The purpose of the study was to examine the relationship between capital structure and
the financial performance and position of manufacturing companies quoted on the
Nairobi Securities Exchange market.
1.4 Research Questions
The specific research questions used to achieve the general objective of the study were:
1.4.1 What are the components of capital structure?
1.4.2 Is there a relationship between capital structure and assets of the listed
manufacturing companies?
1.4.3 Is there a relationship between capital structure and profitability of the listed
manufacturing companies?
1.5 Significance of the Study
The study filled in the knowledge gap on the relationship between capital structure and
financial performance. The study will be of benefit to the manufacturing industry at large
and especially to the following key stakeholders in the sector:
1.5.1 Managers
The findings of the research will equip the top level managers, such as the managing
directors, and general managers of manufacturing companies with skills of analyzing the
relationship between capital structure and financial performance. This will in turn enable
them to make informed decisions pertaining to the capital structure, decisions that will
trigger good financial performance and position.
7
1.5.2 Manufacturing Firms
The study will be useful to the manufacturing companies at large, both small and big
companies. This will form a basis for strategy by the companies when it comes to capital
structure thus position the companies in the industry in a way that will enhance good
financial performance reflected by: suppliers and customers‟ goodwill, new businesses,
quality products and healthy competition.
1.5.3 Employees
Capital structure is the engine of a company and the knowledge of it is essential to the
employees so that they can be able to know how the changes on capital structure
influence the financial performance of a company. Again the employees have the chance
to go up ladder and maybe end up in managerial positions that will require such
knowledge.
1.5.4 Investors
The study will be useful to the current and prospective investors interested in the
manufacturing companies quoted on the Nairobi Securities Exchange since they will be
able to have knowledge on capital structure relationship with financial performance of the
listed manufacturing companies.
1.5.5 Scholars
The research will help upcoming researchers and scholars to come up with more ways of
evaluating capital structure impact on the financial performance and position of a
company. This study will help build a foundation in a vital area of study that will give
benefits to all the stakeholders
1.6 Scope of the Study
The study focuses on the large manufacturing companies especially those that are located
in Nairobi. The manufacturing firms that the study covers are the ones listed on the
Nairobi Securities Exchange. The major objective of companies is financial performance
reflected mostly by increased profits. Capital structure is vital when it comes to financial
performance and position of the manufacturing companies.
8
1.7 Definition of Terms
1.7.1 Capital Structure
Capital structure is the way a firm finances its sources of funds for investment mostly
through assets by use of debt and equity combination (Saad, 2010). According to
Ahmadpour and Yahyazadehfar, (2010) Capital Structure is combination of debt and
equity that makes up the sources of corporate assets. Most of the research on capital
structure, argue that capital is the proportions of debt vs. equity observed on the right-
hand sides of corporations' balance sheets (C.Myers, 2001).
1.7.2 Financial Leverage
According to Ward and Price (2006), financial leverage is the proportion of capital that is
financed by debt as opposed to own equity. Hence the higher the leverage, the higher the
amount of debt in the capital structure of a firm.
1.7.3 Equity
It‟s the contribution that shareholders make to a company in order for it to be operational,
basically it‟s the owners of the business capital contribution. It is the ownership interest
of shareholders that is the common and preferred stockholders. Equity is the total assets
minus total liabilities thus the net worth (Stephen A.Ross, 2001)
1.7.4 Debt
This is a liability whereby a firm borrows a certain amount of money at an interest. This
is based on an agreement with the obligation to repay at a particular time. (Stephen
A.Ross, 2001)
1.7.5 Debt Equity Ratio
This ratio gives the measure of how much a firm‟s capital structure is funded through
debt and how much is funded through owner‟s equity (i.e. shareholders, owner‟s equity
etc.). Debt equity ratio is calculated by dividing total liabilities by total equity. Debt
equity ratio greater than 1 means that the firm has less equity than total liabilities, ratio
greater than 0 but less than 1 means that the firm has more equity than total liabilities
(Aged Care Benchmarking, 2011).
9
1.7.6 Return on Assets
This ratio is also known as Return on Investment and it tells how effective a firm is
earning on assets employed. This ratio is calculated by dividing net profit by total assets.
Total assets are used in an attempt to measure total investment by a firm, the higher the
ratio the better since it provides an indication of future growth (Mahdi, 2009)
1.7.7 Return on Equity
Return on Equity measures the return that a firm is making on the funds invested in the
capital structure. It is calculated by dividing net income by shareholder‟s equity. The
higher the ratio, a firm is said to be capable of generating cash internally (Mahdi, 2009).
1.8 Chapter Summary
Chapter one has given a general overview and background of the study. It has discussed
in detail the statement of the problem, the purpose of the study, research questions,
significance and scope of the study. The next chapter shall give more literature on capital
structure impact on financial performance and position of the manufacturing firms.
References shall be made on past studies and academic writings.
10
CHAPTER TWO
2.0 LITERATURE REVIEW
2.1 Introduction
The literature in this topic is about capital structure, its components and how it impacts on
the financial performance of manufacturing companies. Section 2.2 looks at the capital
structure, its components and the various theories of capital structure. Section 2.3 is about
other components of capital structure. Section 2.4 explores capital structure relationship
with assets. Section 2.5 is about the effect of capital structure on performance/profitability
of firms. All the sections try to address to the specific research questions and fulfil the
general objective of the study. The last section is section 2.6 will summarizes the whole
chapter.
2.2 Components of Capital Structure
Capital structure comprises of debt and equity, the proportions of debt and equity depend
with a firm and usually vary in different firms. Cheng (2009) studied the effect of
financing mix in capital structure on operating performance. Findings from the study
indicate that firms should not solely reply on a single source of financing either debt or
equity while firms are advised to incorporate both two sources to raise capital.
The empirical literature on corporate capital structure started with the Modigliani and
Miller (1958) capital structure irrelevance proposition. In the subsequent years,
researchers have developed a number of theories that have discussed about the relevance
of capital structure choice for determination of firm financial performance and position.
Out of all the theories two most important and dominant theories of capital structure
include the trade-off and pecking order theories (Harris, 1991) but the study will also be
looking at two more others that is the agency theory and the life stage theory. According
to Gracia and Mira (2008) in their study based on Spanish Small and Medium Sized
Enterprises (SMEs) they found out that both trade-off and pecking order models are
useful in explaining the capital structure.
11
The trade-off theory based its research on taxes (Modigliani and Miller,1963), bankruptcy
and financial distress costs (Warner, 1977) suggests that firms have a unique optimal
capital structure that balances between the tax advantage of debt financing and the costs
of financial distress and bankruptcy.
The tradeoff theory has it that firms seek to have debt that balances the tax advantages of
additional debt against the costs of possible financial distress. Whereas the pecking order
theory says that a firm borrows, rather than issue equity, especially when internal cash
flow is not sufficient to fund capital expenditures. Thus the amount of debt to be
borrowed is reflected by the firm's cumulative need for external funds (C.Myers, 2001)
There has been a long debate on trade-off versus pecking order theory of capital structure,
however according to Fama and French, (2005) it is probably time to stop running
empirical horse races between them as stand-alone stories for capital structure. Perhaps it
is best to regard the two models as stable mates with each having elements of truth that
help explain some aspects of financing decisions.
The researchers on latter phase capital structure studies have tried to estimate the speed at
which companies try to reach the optimal or target capital structure. The adjustment speed
depends on the costs of adjusting the leverage. The research based on the estimation of
speed of adjustment to target capital structure has been termed as dynamic trade-off
theory; this research has been quite extensive (Mahakud, 2012).
2.2.1 Debt
Debt is the long term and short term borrowing that a firm has; mostly the long term
borrowing is used to finance the capital structure of a firm and is at an interest which is
pegged on to the agreement between the lenders and the firm, on the obligation of the
firm to repay at a particular time (Ross, 2001).
When it comes to debt, according to Myers and Majluf (1984) theory of pecking order,
debt is considered as the last resort after a firm has realized that its internal financing that
its equity and retained earnings are not enough. According to Mahakud and Jitendra,
(2012) under pecking order there is no optimal capital structure since the observed debt
ratio is the cumulative outcome of the pecking order financing behavior overtime.
12
Ni and Yu (2008), in their study “Testing Pecking-Order Theory” also found little support
for pecking order theory amongst the Chinese listed firms in 2004. They concluded that
large companies in China usually follow the pecking order hypothesis whereas small and
medium companies do not.
The tradeoff theory of capital structure predicts that firms will choose their mix of debt
and equity to balance the costs and benefits of debt. Tax benefits and control of free cash
flow problems are argued to push firms to use more debt. The theory describes a firm‟s
optimal capital structure as the mix of financing that equates the marginal costs and
benefits of debt (F.Zender, 2010).
The size of the firm determines capital structure on the basis of external financing mostly
debt financing this is due to the fact that large companies have an access to the stock
exchange market since meeting the requirements for being listed is kind of easier
compared to small firms. The study is in agreement with Wang,(2011) in his study of
firms in the manufacturing industry in Pakistan where he argued that large firms have a
lower agency cost since they have a lesser volatile cash flow and can easily access the
capital markets.
Debt offers firms a tax shield, therefore this makes firms to pursue higher levels of debt in
order to gain the maximum tax benefit and in the end increase their profitability. On the
other hand, high levels of debt increases the possibility of a firm going into bankruptcy.
(Myers S. , 2001).
In the agency theory of capital structure, Jensen (1986) and Stulz (1990) add to the
discussion on the mitigation of manager-shareholder conflict by stating that because of
debt a firm is committed to pay out its cash thus reduce cash available for management in
terms of personal use. Thus mitigation of conflict agency conflict becomes necessary and
constitutes advantages of debt financing.
When it comes to increased levels of debt by a firm, managers should be very careful so
as to mitigate the risk factor which may lead to bankruptcy. According to Leland and Pyle
(1977) they propose that managers will take debt-equity ratio as a signal, by the fact that
high leverage implies higher bankruptcy risk.
13
According to Grossman and Hart (1982), there are a number of benefits by using debt,
most notable one being on agency conflict whereby bankruptcy is expensive for managers
concerned with maintaining control of a firm. This ensures that the firm‟s capital structure
is effectively used so as to avoid bankruptcy and what ends up in the long run is better
financial performance and position of a firm.
According to Frielinghaus, Mostert and Firer, (2005) organizations are like living
organisms in that they undergo through various stages of life, from birth to death. At each
particular life stage organizations have typical behaviours. They assert that that more debt
should be utilised by firms as they mature from birth. However they also acknowledge
that little has been done to test this theory empirically. Hovakimiam, Opler and Titman
(2001) are also in agreement with this theory by stating that firms should use higher debt
to fund assets but this should be progressively as the firm matures through its life stages.
As firms grow they usually have low or high growth opportunities, because of this firms
require financing mostly debt. According to Datta, Iskhandar and Raman (2005) firms
that have high growth opportunities have more debt in their capital structure.
2.2.2 Equity
According to Stephen A. Ross, (2001) equity is the contribution of the shareholders that
starts up a firm and enables it to be in operation. In other words it‟s the component of
capital derived by total capital minus debt meaning that it‟s the owners of the firm capital
contribution. It is the ownership interest of shareholders that is the common and preferred
stockholders.
More equity is required in starting up a firm but as the business is growing ability to
access debt financing also increases. This is consistent with Kimki, (1997) study on
“intergenerational succession in small family business: borrowing constraints and optimal
timing of success.”
A study on debt – equity choice by Armen Hovakimian, Tim Opler and Sheridan Titman
(2001) showed that firms usually increase their equity depending on financial
performance in that profitable firms have high equity – less debt and on the other hand
14
firms that have high stock prices relative to their past stock price, they are more likely to
seek more equity than debt and may even end up repurchasing debt.
Firms have different growth patterns, there are those that have high growth opportunities,
others have low or no growth opportunities at all .According to Jensen (1986) firms with
great investment opportunities have lower debt levels meaning that they employ more
equity to debt.
Equity point of view from the pecking order theory of capital structure by Myers and
Majluf (1984) is that firms follow a pecking order of incremental financing choice that
prioritizes internal funds at the top. Internal funds is own equity that includes retained
earnings, according to this theory the most important component of capital structure
financing is equity debt comes in when equity is not enough.
Seifert and Gonenc (2008) in their study titled, “The international evidence on pecking
order hypotheses” they found little support for pecking order behaviour in the US, UK
and Germany for the period 1980 to 2004. This was largely attributed to the information
asymmetry due to widespread ownership of stock whereby insiders know more than
outsiders especially the investors. They also found evidence supporting pecking order
behaviour in Japan during the 1980s and 1990s
According to a study by F. Zender (2010) on debt capacity and tests of capital structure,
bankruptcy and other agency costs provide firms with incentives to use less debt hence
more equity and this is contrary to the trade off theory that encourages firms to use debt
after analyzing the cost and benefits of debt.
Agency theory study on Capital Structure, started by Jensen and Meckling (1976) who
were advancing work by Fama and Miller (1972) has it that the management has a long
term impact on owners equity since they might be tempted to pursue personal incentives
instead of maximizing shareholders value (Myers, 2001).
The second type of agency conflict noted by Jensen and Meckling (1976) is the conflict
between debt holders and equity holders. On the debt contract agreement between equity
holders and debt holders is investing in the firm through turning of the debt into equity. If
15
the firms perform well financially with a return above that of the cost of debt then equity
holders benefit whereas if the firm financial performance is below the cost of debt then
the debt holders bear loss.
A firm‟s growth influences the capital structure in terms of the needs of the firm which in
turn dictate whether debt or equity, firms with expected growth are not supposed to
collaterize their assets hence more equity than debt and this is true in relation to a study
by Rajan and Zingales (1995) which noted that firms with expected growth should be
equity financed than debt financed.
2.2.3 Other Components of Capital Structure
There are other components of capital structure that add up to the capital structure of a
company and the major ones include: share capital, share premium, revenues reserves,
capital reserves and retained earnings amongst others.
2.2.3.1 Share Capital
According to Investopedia (2014) Share capital is the funds raised by a company issuance
of shares in return for cash or other considerations and is usually composed of both
common and preferred shares.
2.2.3.2 Share Premium
Share premium is the excess amount received by a firm over the par value of its shares,
(Business Dictionary, 2014). According to Investopedia (2014) share premium is simply
the amount of money a shareholder pays more than the cost of the share.
2.2.3.3 Revenue Reserves
This is a portion of business profits retained by a company for investment in future
growth, these funds are not re- distributed to the share holders as special dividends, (
Business Dictionary, 2014). Revenue reserve is for strengthening the financial position of
a company, replacing depreciated assets, meeting liabilities and conducting Research and
Development for the company.
16
2.2.3.4 Capital Reserves
This are the reserves set aside by a company for long term capital investments or any
other large and anticipated expense that may be incurred in the future, ( Investopedia ,
2014). This fund enables a company to have adequate financing to at least finance
partially or wholly a project. The funds are permanently invested and not paid as
dividends.
This fund may be from subsidies, donations or even part of the retained earnings set aside
for capital reserve.
2.2.3.5 Retained Earnings
This is the percentage of net earnings not paid out as dividends but retained by a company
to be either re-invested by purchase of a capital asset or pay company obligations such as
debt, (Investopedia, 2014). These earnings are kept aside in order to invest in viable areas
with growth opportunities for a company for example new machinery, research and
development.
According to Business Dictionary (2014) this earnings are usually reduced by losses since
they are accumulated earnings.
2.3 Effect of Capital Structure on Assets.
According to Hussy, R (1999) assets may be fixed or current, tangible or intangible.
Assets can be used to tell how the firm is effective in terms of income generation given
the assets base the firm has. The ratio that is used to tell us how a find this effectiveness is
the Return on Assets which is obtained after dividing net profit by total tax, the higher the
ratio the higher the chances are for the firm future‟s prospective growth (Mahdi, 2009)
According to (Rayan, 2008) assets are an important component of capital structure and
they depend to a greater degree on the liquidation value.Then when it comes to assets,it
depends on what type of assets since there is tangible assets and intangible assets,tangible
assets can support higher level of debt than intangible assets (Myers, 1977) .
Christian Riis Flor, (2008) states that as the firm increases its capital structure the assets
also grow at the rate that that the capital structure is growing. Debt renegotiation
continues when there is current production and capital optimization through effective
17
utilization of assets. If changes in earnings are more correlated to the changes in asset
value, then there is a negative effect on debt and equity values because implicit collateral
is less valuable. Therefore firm owners should invest in assets whose changes are less
correlated. This implies that higher correlation implies that debt renegotiation is more
likely to result in an asset sale.
Titman and Wessels (1988) study does not indicate a relationship between a firm‟s assets
and leverage but a study of international data by Rajan and Zingales (1995) has evidence
that tangible assets are positively correlated with leverage in the G7 countries. Firms
with asset value that have higher growth rate then the debt and the equity value are all
higher. Stock owners prefer to invest in assets whose future value is less correlated to the
current profitability and debt renegotiation is less likely to result in asset sale when this
correlation is low (Flor, 2008)
Capital structure and assets are tied down to the liquidity of assets; optimal leverage by a
firm is attained by having more liquid assets (R.Vishny, 1992) . According to Williamson
(1988) assets that are more liquid should be financed by the debt component of capital
structure because banks and public debt markets incur lower costs from financing these
assets. This in turn increases the amount of capital that firms can borrow as well as the
optimal leverage.
Information is key to asset liquidity and leverage, according to Harris and Raviv (1990)
financial performance of a firm forms the basis for investors to obtain information about a
firm‟s ability to pay its debts. This enables the investors to minimize the risk of their
investment by balancing with the assets liquidity of a firm (Sibilkov, 2007)
However asset liquidity may not increase leverage because this depends on whether there
are restrictions placed on asset disposition. Selling assets that have higher liquidity is
more likely because of the lower costs of selling them and the higher liquidation values.
When assets are sold they reduce the size of the firm and are not good for creditors.
Therefore imposing restrictions on the assets prevents their sale thus increasing their
liquidity value to creditors Morellec (2001).This means that the assets serve as collateral
for debt which changes the capital structure proportions.
18
Myers and Rajan (1988) argue that the effect of asset liquidity on leverage becomes
positive when managers do not have the discretion over the assets of the firm. Due to this,
risk reduces when assets are being used as collateral for debt. But on the other hand if
managers have discretion over the firm‟s assets then the assets liquidity becomes negative
due to increased risk by the managers discretion over the assets since they can sell them.
Various research studies have found that it is difficult to measure the liquidity of assets
but Schlingemann, Stulz, and Walkling (2002) came up with a new measure of asset
liquidity, called “the liquidity index.” The liquidity index is estimated in two steps. First,
the industry liquidity which is as a result of the industry liquidity indices of weighted by
the total book value of assets. The assumption in the liquidity index is that assets liquidity
at the firm level depends on industry conditions; Shleifer and Vishny (1992) support this
claim.
However the difference between asset liquidity at the industry level and at the firm level
makes the liquidity index biased and according to Valeriy Sibilkov (2007) an industry
level measure of asset liquidity is conservative in nature.
After analyzing Shleifer and Vishny (1992) liquidity index, it is clear that industries with
high turnover have higher liquidity meaning that a firm‟s sales turnover are positively
correlated to asset liquidity, giving this measure a shortcoming. Despite the shortcoming
of the asset liquidity measure, it has many theoretical and applicability advantages over
other liquidity measures. Alderson and Bekter (1995) usually use one minus the ratio of
managerial estimates of the value of assets as a measure of liquidation costs. These
estimates are subjective and greatly biased. Almeida and Campello (2007) measure asset
specificity as the proportion of used equipment purchases to total equipment purchases in
an industry. However this asset specificity ratio declines when new equipment purchases
increase despite this purchases generating greater demand for assets and higher assets and
high asset liquidity in the industry.
The study will analyze the relationship between structure and assets by using Debt equity
ratio as the independent variable and Return on Assets as the dependent variable.
19
2.4 Effect of Capital Structure on a Firm’s Performance/Profitability.
Capital structure and financial performance relationship over the years has received
attention in the finance literature .Different researchers have tried to answer the question
of how capital structure relates to corporate governance which in turn affects financial
performance of firms (Pratheepkanth, 2011)
Corporate governance is key to the financial performance of a company because it brings
a control mechanism into the structure of a firm and according to Huson and Nazrul
(2008) the relationship between ownership structure and company performance is an
issue of interest among various people such as the academicians, investors and policy
makers especially in understanding role of corporate governance in financial
performance.
Different studies on capital structure and financial performance have been done, the most
notable ones being studies on the relationship between increased use of debt in capital
structure and financial performance. Studies like: Roden and Lewellen, (1995); Ghosh et
al., (2000); Hadlock and James, (2002), Deesomask et al, (2004); Berger and Bonaccorsi
di Patti, (2006), Huang and Song, (2006); Chakraborty, (2010) showed positive
relationship.
There are studies that showed weak or no relationship between leverage and financial
performance of companies, this include: Friend and Lang, (1988), Fama and French,
(1998), Gleason et al., (2000); Simerly and Li, (2000); Booth et al., 2001. A study by
Zeitun and Tian (2007) on Jordan firms found that debt level is negatively related with
performance. Where as a study by El-Sayed Ebaid, (2009) based on a sample of non-
financial Egyptian listed firms from 1997 to 2005 indicated that capital structure choice
has a weak-to-no impact on a firm's performance.
However according to Myers, (2001) and Eldomiaty, (2007) capital structure is not the
only measure of financial performance and financial decisions by a firm.These factors
incude things such as competition by similar businesses,business strategy amongs other
factors (Jermias, 2008)
20
Modgiliani and Miller (1958) came up with various conditions that capital structure is
relevant or irrelevant to the financial performance of firms. Some of the conditions
include taxes, interest rates and are used in decisions related to capital structure and more
so when it comes to financial leverage by firms.
The performance of a firm is highly dependent on the capital structure; the capital
structure is of great importance to both the managers of the firms and the providers of
capital funds. This is because if a wrong mix of capital structure components that is debt
and equity then the performance and survival of the firm may be seriously affected
(Onalapo, 2010) Capital structure relationship with financial performance is on the hands
of the managers of a firm. The firm manager‟s primary duty is to manage the firm in a
way that maximizes shareholder‟s wealth which has to be reflected by increased profits
and cash flows (Elliot, 2002)
However Jensen and Meckling (1976) argued that a conflict between shareholders and
lenders of funds is favourable to the shareholders in that they can venture into risky
investments when the capital structure is leans on more debt. The financial performance
of a firm is what enables the shareholders and managers to pay the debt plus interest but if
the performance is bad it‟s the lenders of the funds who incur the highest loss.
Profitability of a firm is as a result of the capital structure decisions that a firm comes up,
this decisions whether short term or long term affect the profitability of a firm while at the
same time increase the risk of the firm investment ventures. This is due to the fact that
capital structure comprises of debt and equity, debt increases the risk of future earnings
while enabling a firm to expect high returns (Muzir, 2011)
Managers of a firm prefer to use more debt to fund the business operations, according to
(Modigliani and Miller, 1963) tax shield due to interest expense is considered to be one of
the most important determinant of capital structure decision and is thought to motivate
firms to use more debt.
Firms return‟s may be low since there are firms that prefer to keep their leverage ratios
low so as to safeguard their profits from being used to pay interest payments associated
with debt. Size of the capital structure determines returns in terms of profits since a firm
21
with less capital structure cannot venture into high risk businesses that have high returns
(Sivaprasad, 2010)
Past research on American companies has shown that linking management and ownership
increases the company‟s profitability dramatically (Dolmat-Connel, 2002). The firm‟s
profitability is pegged onto the actions of the managers running the firm, if they are
efficient then they are able to minimize on the cost of capital and maximize the firm‟s
performance. This is dependent on the interest of the principals and the agents thus the
managers always tend to pursue own interests by spending the free cash flows available
rather than return it to the shareholders through dividend payments (Boodhoo, 2009)
According to Pinegar and Wilbricht (1989) the principal- agency conflict can be resolved
without increasing agency costs but by having a trade-off between equity and debt.
Lubatkin and Chatterjee (1994) argue that firm‟s efficiency can be attained by firms
increasing their debt to equity ratio because debt will ensure that excess cash flow is
returned to the shareholders rather than investing it in risky ventures. High leverage in
turn makes the managers to focus on business activities that will enable the firm to meet
its financial obligations.
However when a firm finances its capital structure by increasing debt then the cost of
capital increases which may bring about cash problems and if the situation aggravates
bankruptcy is bound to happen. This means that the firm has to ensure that its business
operations are bringing higher returns in terms of increased profits which may in turn
attract investors (Boodhoo, 2009)
The management of a firm prefers to invest profits in projects than pay out dividends to
the shareholders, this was advanced by Jensen (1989) Free Cash flow argument which
states that when top managers have free cash flows, they tend to invest it in projects with
negative Net Present Values instead that paying it out to shareholders as dividends. This
can be attributed to the fact that manager‟s salary increase with increase turnover thus
managers are motivated to increase the size of the firm even with investments that have
negative Net Present Value.
22
In order to assess the relationship between capital structure and profitability the study will
use Debt Equity Ratio as the independent variable whereas dependent variables will be
the Return on Equity and profitability ratios such as the: Pre Tax profit and After Tax
profit.
2.5 Chapter Summary
Chapter two has looked at the relevant literature on capital structure impact on the
performance of firms. The chapter has analyzed the major components of capital structure
that is debt and equity. Other components of capital structure have been analyzed. The
chapter has further presented a critical analysis of the various theories that explain debt
and equity plus how the two capital structure components relate to the performance of a
firm. Chapter has analyzed variables under study which are: capital structure relationship
with assets and capital structure relationship with performance/ profitability. After
Literature review chapter, the following chapter will be on research methodology to be
applied on study.
23
CHAPTER THREE
3.0 RESEARCH METHODOLOGY
3.1 Introduction
This chapter describes the research design methodology and procedures that was used to
carry out the study in order to find the solutions to the research questions in chapter one.
In section 3.2 the chapter will discuss the research design. Section 3.3 will be discussing
the population to be used in the study, also sample and sampling techniques will be
identified. Section 3.4 will be about data collection methods and section 3.5 will be on
data analysis. Lastly section 3.6 will be a summary of the whole chapter.
3.2 Research Design
A research design is the plan and structure of investigation so conceived to obtain
answers to research questions (Kerlinger 1986). According to Mugenda and Mugenda
(1999), a research design is an outline plan or scheme used to generate solutions to the
research problems. The plan is the overall program of the research and includes an outline
of what the researcher will do from writing of the hypothesis and their operational
implication for the final analysis of data.
One of the major goals of the firm is to maximize the wealth of the shareholders. One of
the major measures of this goal is the financial ratios (Prashant Gupta, 2011). The ratios
to be used in the study will be calculated from the secondary data which is financial
statements of seven years period (2008, 2009, 2010, 2011 and 2012) for selected quoted
manufacturing companies. The financial statements used were obtained from the Nairobi
Securities Exchange handbooks, companies‟ websites and Kenya Association of
Manufacturers.
Research design provides the framework to be used as a guide in collecting and analyzing
data (Coopers and Schindler, 2008). The research design used in this study is descriptive
in nature. Descriptive studies describe characteristics associated of the subject population
Schindler (2000). Descriptive design helps in finding out and measuring the relationships
among variables. The study used a framework of Debt Equity ratio as the independent
variable whereas Return on Assets ratio, Return on Equity ratio, Pre Tax profits ratio and
After Tax profit ratio were the dependent variables. After analysing the relationship
24
among the independent and dependent variables the study has thus provide
recommendations that are specific and relevant.
3.3 Population and Sampling Design
3.3.1 Population
According to Cooper and Schindler, (2003) population is total collection of elements
upon which inferences can be made. The population of the study consists of all the nine
listed manufacturing companies on the Nairobi Securities Exchange market. Mugenda
and Mugenda (1999), describe target population as the focus the researcher wants to
generalize the result of the study.
3.3.2 Sampling Design
3.3.2.1 Sampling Frame
According to Cooper and Schindler (2008) sampling frame is a list of elements from
which the sample is actually drawn and it is closely related to the population under study.
Sampling is selecting a proportionate representation from the total sample size which is
the population under study. Sampling enables: lower cost, accuracy of results, increased
speed of data collection, and availability of population elements. A representative sample
was selected from the list of the quoted manufacturing firms as stated by the Nairobi
Securities Exchange. This was to ensure that the sampling frame was current, complete
and relevant for the attainment of the study objectives.
3.3.2.2 Sampling Technique
According to Collins and Hussey (2006) sampling technique is a method used in selecting
elements from the population that will represent the population. Whether a particular
technique is of simple random type or different type, it depends on a variety of factors
such as object, scope and nature of the study (Hyers, 2006). For this study, non
probability sampling technique was used, that is, purposive random sampling. In this
study, a random sample of five manufacturing companies was taken from the population.
The selected sampling method ensured precise information that respond to the specific
research objectives thereby enhancing the credibility and reliability of the findings of this
study (Cooper and Schindler, 2003)
25
3.3.2.3 Sample Size
This is the selection of a subset of individuals from within a population to yield some
knowledge about the whole population, especially for the purposes of making predictions
based on statistical inference. According to Thietart, et al (2001) a sample size as the set
of elements from which data is collected. A good sample size should provide information
that is detailed and comprehensive.
Researchers rarely survey the entire population for two reasons (Adèr, Mellenbergh, &
Hand, 2008): the cost is too high, and the population is dynamic in that the individuals
making up the population may change over time. The three main advantages of sampling
are that the cost is lower, data collection is faster, and since the data set is smaller it is
possible to ensure homogeneity and to improve the accuracy and quality of the data.
Sample size is collected group of people or units you want to use to represent the
population. According to Denscombe (1998), the sample must be carefully selected to be
representative of the population. For this study, the sample size used was five
manufacturing companies listed on the Nairobi stock exchange that represent the nine
listed manufacturing companies
3.4 Data Collection Methods
Data is all the information that researchers‟ pursue in order to obtain findings and give
their possible observations (Mugenda and Mugenda 1999). Data is important in any
research because it holds all the hidden meaning of that information. Data collection
methods are the optional techniques that researchers use to obtain data that is relevant for
analysis. The researcher must choose the best option that will guarantee the most needed
information. According to this study, the researcher used secondary data the source being
from review of companies‟ profiles, financial reports, and journals, past research findings,
books, magazines and internet among others.
3.5 Data Analysis Methods
According to Cooper, Schneider (2001) data analysis is a research technique for the
objective, systematic and qualitative description of the manifest content of a
communication. Data analysis is the important part in any research because this is where
26
the truth unfolds itself. At this point, the researcher engages in a process of trying to make
data to have some meaning and be able to be understood by the interested parties. The
process has to have a model for data analysis that is sufficient for the kind of research
being pursued.
Data analysis was sought to determine the effect of capital structure on the financial
performance of manufacturing companies. The researcher examined the strength of
relationship between capital structure and financial performance and position of the
manufacturing firms quoted on the Nairobi Securities Exchange. Trend and regression
analysis was used then the analyzed data was interpreted, presented in tabular forms.
According to Denscombe (1998) descriptitive statistics involves a process of transforming
a mass of raw data into tables, charts, with frequency distribution and percentages, which
are a vital part of making sense of the data. The research data was be analyzed using
Microsoft Excell and regression analysis. The Analysis was presented using tables and
graphs to give a clear picture of the research findings at a glance.
3.6 Chapter Summary
The chapter has dealt with research methodologies that helped the researcher in gathering
and analyzing data in respect to the research questions. The chapter has discussed the
research design that was appropriate for this study. The population has been identified
hence the sample and sampling techniques has been arrived to. The most important of all,
the data collection and analysis methods have been identified to suite the study. The next
chapter is on the findings and analysis and it will show the results for this study.
27
CHAPTER FOUR
4.0 RESULTS AND FINDINGS
4.1 Introduction
This chapter presents the results and findings of the objectives of the study. The chapter is
broken into various parts; Part 4.2 presents the general information of the study while part
4.3 presents the components of capital structure by analyzing the five manufacturing
companies selected for the study. Part 4.4 presents the findings on the relationship
between capital structure and Return on Assets. In part 4.5 the chapter presents findings
on the relationship between capital structure and profitability by analyzing the effect of
capital structure on Return on Equity and on both pre – tax profit and after – tax profit.
Part 4.6 of the chapter presents regression analysis of the data with Debt – Equity ratio
being the independent variable whereas (Return on Assets ratio, Return on Equity ratio,
Pre-Tax Profit ratio and After Tax ratio) are the dependent variables used. Lastly, in part
4.7 the summary of the study is presented.
4.2 General Information
The purpose of the study was to determine the relationship between capital structure and
financial performance of manufacturing companies listed on the Nairobi Securities
Exchange. The study objectives were: the components of capital structure which was
dealt in literature review and are also analyzed in this chapter, the relationship between
capital structure and assets, the relationship between capital structure and profitability.
The manufacturing companies that were under examination were; BOC Kenya, East
African Breweries Limited, Eveready, Mumias Sugar Company and Unga Group. The
independent variable was the Debt Equity Ratio (DER) while the dependent variables
were; Return on Assets (ROA), Return on Equity (ROE), Pre-Tax Profit (PTP) and After-
Tax Profit (ATP) ratios.
4.2.1 Nature of Business
Table 4.1 below shows the companies under study (BOC Kenya, East African Breweries
Limited, Eveready, Mumias Sugar Company and Unga Group) and their nature of
operations in regards to the products they deal in.
28
Table 4.1 Manufacturing Companies & their Nature of Operations
COMPANY NATURE OF OPERATIONS
BOC Kenya Manufacturing & sale of industrial and
medical gases as well as wielding
products
East Africa Breweries Limited Manufacturing and selling of drinks, glass
containers, malt and barley.
Eveready Manufacturing and selling of Eveready
Dry Cells “D” size batteries in and
trading in an assortment of imported
Eveready flashlights, batteries, razors and
accessories.
Mumias Sugar Company Cultivation of sugarcane and
manufacturing of sugar as well as
providing support to sugarcane out-
growers.
Unga Group Milling of wheat and maize, the
manufacture of packaging materials and
animal nutrition product, and the
distribution of animal health products.
4.2.2 Turnover
The manufacturing companies used in this study have an annual turnover of not more
than 50 Billion Kenya Shillings. Table 4.2 below shows EABL has the highest turnover
of 41.4 Billion Kenya Shillings. Mumias Sugar Company is second after EABL and has
an annual average turnover of 13.2 Billion Kenya Shillings. BOC Kenya has the lowest
annual average turnover of 1.2 Billion Kenya Shillings.
Table 4.2 Manufacturing Companies Annual Average Turnover in KSH ‘000’
(2006 – 2012)
COMPANY AVERAGE TURNOVER ( 2006 - 2012 )
KSH'000
BOC KENYA 1,262,730
EABL 41,428,634
EVEREADY 1,723,745
MUMIAS 13,250,895
UNGA GROUP 10,970,204
29
4.2.2 Profits after Tax
From Table 4.3 below the manufacturing companies used for the study average after tax
profit is not more than 10 Billion Kenya Shillings. EABL has the highest Average profit
after tax with 8.6 Billion Kenya Shillings, the second one being Mumias with an average
annual after tax profit of 1.6 Billion shillings. The other companies have an average Profit
after Tax of not more than 300 Million Kenya Shillings; Eveready has the lowest annual
after tax profit with 41.8 Million Kenya Shillings.
Table 4.3 Manufacturing Companies Average After Tax Profit in KSH ‘000’
( 2006 – 2012)
COMPANY AVERAGE PROFIT AFTER TAX
(2006 – 2012) KSH’ 000
BOC KENYA 182,161
EABL 8,682,834
EVEREADY 41,840
MUMIAS 1,608,903
UNGA GROUP 254,639
4.2.4 Assets
The manufacturing Companies used in the study have an asset base of not more than 40
Billion Kenya Shillings. From Table 4.4 below EABL has the highest assets base of 38.2
Billion Kenya Shillings whereas Eveready has the lowest with 1 Billion Kenya Shillings.
Table 4.4 Manufacturing Companies Average Assets ( 2006 – 2012) in KSH ‘000’
COMPANY AVERAGE ASSET ( 2006 – 2012 )
KSH’ 000’
BOC KENYA 1,919,496
EABL 38,214,129
EVEREADY 1,040,099
MUMIAS 17,761,058
UNGA GROUP 4,974,026
30
4.2.3 Net worth
When it comes to the net worth of the manufacturing companies, EABL has the highest
average net worth of 20.6 Billion Kenya shillings and from Table 4.5 below Eveready has
the lowest average net worth of 382.7 Million Kenya Shillings.
Table 4.5 Manufacturing Companies Average Net worth ( 2006 – 2012) in KSH
‘000’
COMPANY AVERAGE NETWORTH ( 2006 – 2012
) KSH’ 000
BOC KENYA 1,423,518
EABL 20,661,504
EVEREADY 382,739
MUMIAS 10,903,889
UNGA GROUP 3,103,551
4.3 Components of Capital Structure
4.3.1 Debt
This is the long term and short term borrowing that the companies under the research
study have. The research has taken into account both short term borrowing and long term
borrowing and therefore have used total liabilities.
From Figure 4.1 below EABL is the company that is using the highest debt level which
has been increasing over the years 2006 – 2012, whereas the other companies have been
increasing and decreasing their debt levels. BOC Kenya has been using the lowest debt
levels when compared with the other companies from 2006 – 2012.
31
Figure 4.1 Debt Levels for the Manufacturing Companies (2006 – 2012)
4.3.2 Equity
Equity is the contribution of the shareholders that started up the manufacturing firms and
enable them to be in operation. In other words it‟s the owners of the firm capital
contribution.
From figure 4.2 below EABL has the highest Equity over the years apart from 2011,
Mumias has been increasing its equity from 2006 – 2011 then the equity decreased in
2012. Eveready has been having the lowest equity over the years as compared to the other
companies in the period of 2006 – 2012.
32
Figure 4.2 Equity Levels for the Manufacturing Firms (2006 – 2012)
4.3.2 Other Components of Capital Structure
The study will be analysing the other components of capital structure discussed in the
literature review in chapter two of the study. These includes: Share Capital, Share
Premium, Revenue Reserves, Capital Reserves and Retained Earnings.
4.3.2.1 Share Capital
From figure 4.3 below the manufacturing companies have maintained their share capital
from 2006 – 2012 apart from Mumias sugar Company which had a share capital of 1
Billion Kenya Shillings in 2006 & 2007, then tripled the share capital to 3 Billion Kenya
Shillings in the year 2008.Mumias maintained its tripled share capital from the year 2008
to the year 2012. BOC Kenya had the lowest share capital of 97.6 Million Kenya
Shillings as compared to the other companies used in the study.
33
Figure 4.3 Share Capital of the Manufacturing Companies (2006 – 2012)
4.3.2.2 Revenue Reserves
The manufacturing companies under study did not have revenue reserves for the period of
2006 – 2012. This means that they had not set aside funds for investment in future
growth.
4.3.2.3 Capital Reserves
The manufacturing companies under study did not have revenue reserves for the period of
2006 – 2012.This translates to no funds for long term capital investments or any other
large and anticipated expense that may be incurred.
4.3.2.4 Retained Earning
From Figure 4.4 below the manufacturing companies had retained earnings apart from
Unga Group which did not have retained earnings for the period of 2006 – 2012. EABL
had the highest Retained Earnings followed by Mumias Sugar Company. BOC Kenya
was third in Retained Earnings though it did not have had retained earnings in 2010. Unga
34
Group was the only Company not setting aside funds for viable future projects with
business growth.
Figure 4.4 Retained Earnings for the Manufacturing Companies (2006 – 2012)
4.4 Relationship between Capital Structure on Assets
4.4.1 BOC Debt Equity Ratio
Debt Equity Ratio measures how much a firm‟s capital structure is funded by debt and
how much is funded by owner‟s equity. Debt Equity Ratio is calculated by dividing total
liabilities by total equity. BOC Company that deals with gas had a Debt Equity Ratio of
25% in both 2006 and 2007, however in 2008 BOC increased its borrowing which
increased to 29% only to fall in 2009 to 23%. In 2010 BOC Debt Equity Ratio increased
to 25%. The Debt Equity Ratio increased to 27% both in 2011 & 2012. The Debt Equity
Ratio for BOC is illustrated in the table 4.6 below
35
Table 4.6 BOC KENYA Debt Equity Ratio
Year Debt Equity Ratio %
2006 25%
2007 25%
2008 29%
2009 23%
2010 25%
2011 27%
2012 27%
4.4.2 BOC Return on Assets Ratio
Return on Assets tells how effective a firm is earning on assets employed. This ratio is
calculated by dividing net profit by total assets.BOC Return on Assets was 13% in 2006,
increased to 14% then started dropping to 10% in 2008, 8% in 2009 and further dropped
to 4% in 2010. In 2011 Return on Assets increased to 8% then to 10% in 2012.
The Return on Assets for BOC is illustrated in table 4.7 below.
Table 4.7 BOC KENYA Return on Assets Ratio
Year Return on Assets Ratio %
2006 13%
2007 14%
2008 10%
2009 8%
2010 4%
2011 8%
2012 10%
4.4.3 BOC Debt Equity Ratio and Return On Assets
The trend analysis between BOC Debt Equity Ratio and Return on Assets is not
consistent meaning there is no relationship between the two ratios. When Debt Equity
Ratio was constant the Return on Assets increased, when Debt Equity Ratio increased
Return on Assets decreased and increased. This is depicted on Figure 4.5 below.
36
Figure 4. 5: BOC Debt Equity and Return on Assets Ratios Trend Analysis
4.4.4 East Africa Breweries Limited Debt Equity Ratio
East Africa Breweries Limited (EABL) is a company that manufactures beer and soft
drinks. The Debt Equity Ratio of EABL has been increasing gradually; 25% in 2006, 33%
in 2007, 33% in 2008, 34% in 2009, 38% in 2010, 46% in 2011 and 84% in 2012. EABL
Debt Equity ratio gradual increase between 2006 –2010 is illustrated in table 4.8 below
Table 4.8: EABL Debt Equity Ratio
Year Debt Equity Ratio %
2006 25%
2007 33%
2008 33%
2009 34%
2010 38%
2011 46%
2012 84%
37
4.4.5 East Africa Breweries Return on Assets Ratio
EABL Return on Assets fluctuated from 2006 to 2012, in 2006 it was 26% then dropped
to 24% in 2007, rose to 28% in 2008 then started falling up to 18% in 2011 only to rise to
20% in 2012..The Return on Earnings for EABL are illustrated in table 4.9 below
Table 4.9: EABL Return on Assets Ratio
Year Return on Assets Ratio %
2006 26%
2007 24%
2008 28%
2009 24%
2010 23%
2011 18%
2012 20%
4.4.6 East Africa Breweries Limited Debt Equity Ratio and Return on Assets
EABL Debt Equity Ratio and Return on Assets trend is showing no significant
relationship since EABL Debt Equity Ratio and Return on Assets Ratios are fluctuating in
different directions. When Debt Equity Ratio increased from 0.26 in 2006 to 0.33 in 2007
Return on Assets dropped from 0.25 in 2006 to 0.24 in 2007. When Debt Equity Ratio
remained constant at 0.33 in 2007 and 2008, return on Assets increased from 0.24 in 2007
to 0.28 in 2008. Lastly when Debt Equity Ratio increased from 0.46 in 2011 to 0.84 in
2012 Return on Assets also increased from 0.18 in 2011 to 0.20 in 2012.
This trend is illustrated in figure 4.6 below.
38
Figure 4. 6: EABL Debt Equity and Return on Assets Ratios Trend Analysis
4.4.7 Eveready Debt Equity Ratio
Eveready Debt Equity Ratios are above 50% meaning that the company capital structure
has a higher debt financing than own equity. In 2006 the ratio was 52%, increased to 63%
in 2007 only to reduce in 2008 to 56%.Eveready debt Equity ratio increased to 66% in
2010 from 60% in 2009. Then the Debt Equity Ratio further increased to 75% in 2011
only to drop to 67% in 2012. Eveready Debt Equity ratio is illustrated on Table 4.10
below.
Table 4. 10: Eveready Debt Equity Ratio
Year Debt Equity Ratio %
2006 52%
2007 63%
2008 56%
2009 60%
2010 66%
2011 75%
2012 67%
39
4.4.8 Eveready Return On Assets
Eveready Return on Assets has been on the downfall, it fell from 18% in 2006 to 11% in
2007,it fell further to 2% in 2008 then slightly rose 3% in 2009,only to fall again further
to 1% in 2010.The worst fall was to -12% in 2011 but there was an increase to 6% in
2012. All this is illustrated by table 4.11 below
Table 4. 11: Eveready Return on Assets Ratio
Year Return on Assets Ratio %
2006 18%
2007 11%
2008 2%
2009 3%
2010 1%
2011 -12%
2012 6%
4.4.9 Eveready Debt Equity Ratio and Return on Assets Analysis
There is no relationship between Eveready debt Equity Ratio and Return on Assets Ratio
since the ratios are fluctuating in different directions. The Debt Equity Ratio increased
from 0.52 in 2006 to 0.63 in 2007, the Return on Assets dropped from 0.18 in 2006 to
0.11 in 2007. When the Debt Equity Ratio fell from 0.63 in 2007 to 0.56 in 2008 the
Return on Assets Ratio also fell from 0.11 in 2007 to 0.02 in 2008.Eveready Debt Equity
Ratio increased from 0.66 in 2010 to 0.75 in 2011 the Return on Assets fell worse from
0.01 in 2010 to – 0.12 in 2011. This trend analysis is illustrated on figure 4.7 below.
40
Figure 4. 7: Eveready Debt Equity and Return on Assets Ratios Trend Analysis
4.4.10 Mumias Sugar Company Debt Equity Ratio
Mumias Sugar Company produces sugar and electricity amongst other products. The Debt
Equity ratio for Mumias Sugar Company fell from 35% in 2006, to 30% in 2007, and then
increased to 36% in 2008, 43% in 2009.In 2010 it fell to 40% and further fell to 38% in
2011 only to increase to 43% in 2012. These ratios fluctuations are illustrated on table
4.12 below.
Table 4. 12: Mumias Debt Equity Ratio
Year Debt Equity Ratio %
2006 35%
2007 30%
2008 36%
2009 43%
2010 40%
2011 38%
2012 43%
41
4.4.11 Mumias Sugar Company Return on Assets Ratio
Mumias Sugar Company Return on Assets has been on the decrease as seen by: 13% in
2006, 12% in 2007, and 9% in 2008. However the Return on Assets remained a constant
of 9% in 2008, 2009 and 2010. The Return on Assets for Mumias Sugar Company further
fell to 8% in 2011 and 7% in 2012. These changes in Mumias Debt Equity Ratio are
illustrated on table 4.13 below.
Table 4. 13: Mumias Return on Assets Ratio
Year Return on Assets Ratio %
2006 13%
2007 12%
2008 9%
2009 9%
2010 9%
2011 8%
2012 7%
4.4.12 Mumias Sugar Company Debt Equity Ratio and Return on Assets Ratio
The trend analysis on Mumias Sugar Company Debt Equity Ratio and Return on Assets
does not depict a relationship since in 2006 when the Debt Equity Ratio fell from 0.35 in
2006 to 0.30 in 2007 the Return on Assets also fell from 0.13 in 2006 to 0.12% .When
Debt Equity Ratio increased from 0.36% in 2008 to 0.43% in 2009 then fell to 0.38% in
2011 the Return on Assets Ratio remained constant at 0.09% in 2008, 2009 and 2010.
This trend is shown on figure 4.8 below.
42
Figure 4. 8: Mumias Debt Equity and Return on Assets Ratios Trend Analysis
4.4.13 Unga Group Debt Equity Ratio
Unga Group is a company that produces mostly flour .The Company Debt Equity ratio
was decreased from 39% in 2006 to 38%, in 2007 where it remained constant in 2008.
Then The Debt Equity Ratio increased to 43% in 2009 and remained constant in 2010. In
2011 it fell to 34% and increased in 2012 to 38%. This is shown on table 4.14 below.
Table 4. 14: Unga Group Debt Equity Ratio
Year Debt Equity Ratio %
2006 39%
2007 38%
2008 38%
2009 43%
2010 43%
2011 34%
2012 38%
43
4.4.14 Unga Group Return on Assets Ratio
Unga group Return on Assets Ratio increased by a small margin in 2007 at 4% from 2%
in 2006.However in 2008 it rose to 8% only to fall to 3% in 2009.In 2010 the Return on
Assets for Unga Group increased to 5% and further increased to 8% then fell to 5% in
2012.This increase and decrease of Unga Group is shown on table 4.15 below.
Table 4. 15: Unga Group Return on Assets Ratio
Year Return on Assets Ratio %
2006
2%
2007 4%
2008 8%
2009 3%
2010 5%
2011 8%
2012 5%
4.4.15 Unga Group Debt Equity Ratio and Return on Assets
From the trend analysis of Unga Group Debt Equity ratio and Return on Assets there is no
relationship between the two variables. When Debt Equity Ratio decreased from 0.39 in
2006 to 0.38 in 2007 Return On Assets increased from 0.02 in 2006 to 0.04 in 2007
whereas when Debt Equity Ratio remained consant at 0.38 in 2008 , Return on Assets
increased to 0.08 in 2008. When Debt Equity Ratio increased increased from 0.34 in 2011
to 0.38 in 2012 the Return on Assets Ratio fell from 0.08 in 2011 to 0.05 in 2012. This
relationship is depicted on figure 4.9 below
44
Figure 4. 9: Unga Group Debt Equity and Return on Assets Ratios Trend Analysis
4.4.16 Relationship between Debt Equity Ratio and Return on Assets
Table 4.16 below presents the relationship between Debt Equity Ratio and Return on
Assets. The study analyzed the trend of weighted average of Debt Equity Ratio in
comparison to that of weighted average of Return on Equity. The implication is that
manufacturing companies Debt Equity Ratio is not tied up to the Return on Assets
because when Average weighted Debt Equity ratio increases the Average weighted
Return on Assets increases and decreases.
45
Table 4.16 Weighted Average Debt Equity Ratios & Return on Assets Ratios
Analysis
COMPANY DEBT EQUITY RATIOS
2006 2007 2008 2009 2010 2011 2012 AVERAGE
BOC 0.25 0.25 0.29 0.23 0.25 0.27 0.27 0.26
EABL 0.25 0.33 0.33 0.34 0.38 0.46 0.84 0.42
EVEREADY 0.52 0.63 0.56 0.60 0.66 0.75 0.67 0.63
MUMIAS 0.35 0.12 0.09 0.09 0.09 0.08 0.07 0.38
UNGA
GROUP
0.39 0.38 0.38 0.43 0.43 0.34 0.38 0.38
AVERAGE
DER
0.35 0.35 0.39 0.41 0.40 0.44 0.52
RETURN ON ASSETS RATIOS
2006 2007 2008 2009 2010 2011 2012 AVERAGE
BOC 0.13 0.14 0.10 0.08 0.04 0.08 0.10 0.10
EABL 0.26 0.24 0.28 0.24 0.23 0.18 0.20 0.23
EVEREADY 0.18 0.11 0.02 0.03 0.01 0.12 0.06 0.04
MUMIAS 0.13 0.12 0.09 0.09 0.09 0.08 0.07 0.10
UNGA
GROUP
0.02 0.04 0.08 0.03 0.05 0.08 0.05 0.05
AVERAGE
ROA
0.14 0.13 0.11 0.09 0.08 0.06 0.10
4.5 Capital Structure Relationship with Performance
4.5.1 BOC Return on Equity
Return on Equity measures the return that a firm is making on the funds invested in the
capital structure. It is calculated by dividing net income by shareholder‟s equity. For BOC
the Return on Equity was 18% in 2006, increased slightly to 19% in 2007 then started
falling and in 2008 it was 14%,2009 at 10%. It fell to 5% in 2011 and increased to 11% in
2011 and 14% in 2012.Return on Earnings for BOC are shown in table 4.17 below.
46
Table 4. 17: BOC Return on Equity Ratio
Year Return on Equity Ratio %
2006 18%
2007 19%
2008 14%
2009 10%
2010 5%
2011 11%
2012 14%
4.5.2 BOC Pre – Tax and After Tax profit
Pre Tax Profit Ratio is the proportion of profit before tax in the total revenue of a firm
and is calculated by pre – Tax profit divided by revenue whereas After Tax Profit Ratio
is the after taxes profit proportion in the total revenue of a firm. From Table 4.18 below,
BOC Pre - Tax profit has been falling from 30% in 2006, 27% in 2007, 23% in 2008 and
18% in 2009, 10% in 2010. Pre –Tax Profit Ratio increased to 18% in 2011 and 22% in
2012. After - tax profit has also been decreasing and increasing proportionately with the
Pre- Tax profit.
Table 4. 18: BOC Kenya Pre – Tax and After Tax Ratios
Year Pre – Tax Profit Ratio in
%
After Tax Profit Ratio in
%
2006 30% 20%
2007 27% 18%
2008 23% 16%
2009 18% 12%
2010 10% 7%
2011 18% 12%
2012 22% 15%
4.5.3 BOC Debt Equity Ratio – Return on Equity Trend Analysis
BOC Debt Equity Ratio – Return on Equity trend analysis does not show any relationship
since when BOC Debt Equity ratio is constant at 0.25 in 2006 and in 2007, the Return on
Equity increases from 0.18 in 2006 to 0.19 in 2007.When Debt Equity Ratio for BOC
increases the Return on Equity falls and when Debt Equity Ratio decreases the Return on
Equity decreases. This is illustrated on figure 4.10 below
47
Figure 4. 10: BOC Debt Equity and Return on Equity Ratios Trend Analysis
4.5.4 BOC Debt Equity Ratio – Pre –Tax and After Tax Profit analysis
From figure 4.11 below Debt Equity Ratio for BOC does not have a relationship with Pre
Tax and After Tax Ratios, when Debt Equity Ratio remains constant, Pre-Tax and After
Tax profit Ratios fall. When Debt Equity Ratio increases the Pre Tax and After Tax profit
ratios fall and when Debt Equity Ratio remains constant, the Profit Ratios increase.
Figure 4. 11: BOC Debt Equity and Profit (Pre Tax & After Tax) Ratios Trend
analysis
48
4.5.5 EABL Return on Equity
EABL Return on Equity increased from 34% in 2006 to 36% in 2007 and further
increased to 42% in 2008, fell in 2009 to 36% and slightly increased to 37% in 2010. In
2012 EABL Return on Equity sky rocked to 128% from 34% in 2011 as shown on table
4.19 below.
Table 4.19: EABL Return on Equity Ratio
Year Return on Equity Ratio %
2006 34%
2007 36%
2008 42%
2009 36%
2010 37%
2011 34%
2012 128%
4.5.6 EABL Pre- Tax and After Tax Profit
EABL Pre Tax profit has been fluctuating from 23% in 2006 dropped slightly to 22% in
2007 and increased to 38% in 2008 only to start falling to 35% in 2009, 33% in 2010,
27% in 2011 and further fell to 22% in 2012..The After tax profit for EABL is directly
related to Pre Tax profit and changes proportionately with change in the Pre- tax profit,
this can be seen on Table 4.20 below.
Table 4.20: EABL Pre – Tax and After – Tax Profit Ratios
Year Pre – Tax Profit Ratio in
%
After Tax Profit Ratio in
%
2006 23% 17%
2007 22% 16%
2008 38% 28%
2009 35% 25%
2010 33% 23%
2011 27% 20%
2012 22% 20%
4.5.7 EABL Debt Equity Ratio and Return on Equity analysis
There is no relationship between EABL Debt Equity Ratio and Return on Equity. EABL
initially when Debt Equity Ratio was increasing so was the Return on Equity but when
49
Debt Equity Ratio remained constant, the Return on Equity increased. When Debt Equity
Ratio increased again Return on Equity fell. This is illustrated on Figure 4.12 below
Figure 4. 12: EABL Debt Equity and Return on Equity Ratios Trend Analysis
4.5.8 EABL Debt Equity Ratio – Pre Tax and After Tax analysis
From figure 4.13 below, Debt Equity Ratio does not have any relationship with Pre – Tax
and After tax profit ratios because when Debt Equity ratio increases the Profit ratios
increase and decrease.
Figure 4. 13: EABL Debt Equity Ratio and Profit (Pre Tax & After Tax) Analysis
4.5.9 Eveready Return on Equity
Eveready Return on Equity ratios are so volatile, from 37% in 2006 to 29% in 2007, then
a further drop to 5% in 2008. In 2009 Return on Equity increased to 7% only to drop in
50
2010 to 2%. The worst drop was 2011 when Return on Equity dropped to - 49% but rose
to 19% in 2012. This volatility of Eveready is shown on table 4.21 below.
Table 4.21: Eveready Return on Equity Ratio analysis
Year Return on Equity Ratio %
2006 37%
2007 29%
2008 5%
2009 7%
2010 2%
2011 - 49%
2012 19%
4.5.10 Eveready Pre Tax and After Tax
Eveready Pre Tax profit and After Tax profit ratios were so volatile, like in 2006 the Pre –
Tax profit was 12%, dropped to 8% in 2007, further dropped to 2% in 2008 then slightly
increased to 3% in 2009 only to drop to 1% in 2010. The Pre Tax profit Ratio dropped
worse in 2011 to –13% but rose to 5% in 2012. The Pre Tax and After tax are directly
related and are changing proportionately and are depicted on table 4.22 below
Table 4. 22: Eveready Pre- Tax and After – Tax Profit Ratios
Year After Tax Profit Ratio in %
2006 8%
2007 6%
2008 1%
2009 2%
2010 1%
2011 -9%
2012 5%
4.5.11 Eveready Debt Equity Ratio and Return on Equity analysis
From figure 4.14 below, when Debt Equity Ratio increases, the Return on Equity
decreases but when the Debt Equity ratio decreases the Return on Equity decreases still.
From the figure below it can be seen that Eveready Debt Equity Ratio has a greater
impact on the Return on Equity.
51
Figure 4. 14: Eveready Debt Equity and Return on Equity Ratios Trend analysis
4.5.12 Eveready Debt Equity Ratio and Pre – Tax and After Tax analysis
Figure 4.15 below on the trend analysis shows no relationship between Debt Equity Ratio
and Profit Ratios ( Pre- Tax and After – Tax).As Debt Equity Ratios increases the Profits
decrease and increase and as Debt Equity Ratio decreases so does Pre Tax and After Tax
Profit ratios.
Figure 4.15: Eveready Debt Equity and (Pre Tax & After Tax) Ratios Trend
analysis
52
4.5.13 Mumias Sugar Company Return on Equity
Mumias Sugar Company Return on Equity has not been stable, it has been fluctuating, in
2006 it was 20% the following year it fell to 17% and in 2008 continued to fall to13% and
in 2009 it rose to 16% only to fall in 2010 to 14% then slightly fell to 13% in 2011 where
it remained constant in 2012.The fluctuations of Mumias Sugar company are on Table
4.23 below.
Table 4. 23: Mumias Sugar Company Return on Equity Ratio
Year Return on Equity Ratio %
2006 20%
2007 17%
2008 13%
2009 16%
2010 14%
2011 13%
2012 13%
4.5.14 Mumias Sugar Company Pre- Tax and After Tax
Mumias Sugar Company Pre- Tax profit has been decreasing from 2006 at 19%, to 18%
in 2007 then to 13% in 2008 and to 10% in 2009. Later increased to 14% in 2010, 17% in
2011 then dropped to 11% in 2012. The After Tax Profit has been proportionate with the
Pre – Tax but in 2009 the After Tax increased when the Pre tax fell. This relationship is
as on table 4.24
Table 4. 24: Mumias Sugar Company Pre – Tax and After – Tax Profit Ratio
Year Pre – Tax Profit Ratio in
%
After Tax Profit Ratio in
%
2006 19% 13%
2007 18% 13%
2008 13% 10%
2009 10% 14%
2010 14% 10%
2011 17% 12%
2012 11% 13%
53
4.5.15 Mumias Sugar Company Debt Equity Ratio and Return on Equity
From figure 4.16 Mumias Sugar Company Debt Equity Ratio has no relationship with
Return on Equity. When Debt Equity Ratio decreased so did the Return on Equity, when
Debt Equity Ratio increased Return on Equity decreased.
Figure 4. 16: Mumias Debt Equity Ratio and Return on Equity Ratios Trend
Analysis
4.5.16 Mumias Sugar Company Debt Equity Ratio and Profit (Pre Tax and After
Tax)
Mumias Debt Equity Ratio when decreasing the Profit ratios increase and decrease. When
the Debt Equity Ratio increases, the Profit ratios decrease and increase. Hence there is no
relationship between Debt Equity Ratio and profit as shown on Figure 4.17 below.
Figure 4. 17: Mumias Debt Equity Ratio and Profit (Pre Tax & After Tax) analysis
54
4.5.17 Unga Group Return on Equity
Unga Group Return on Equity increased from 3% in 2006 to 6% in 2007 then to 13% in
2008. In 2009 the Return on Equity dropped to 6%, increased to 7% in 2010 and 12% in
2011 then fell to 9% in 2012.Table 4.25 shows the changes in Unga Group Return on
Equity.
Table 4. 25: Unga Group Return on Equity Ratios
Year Return on Equity Ratio %
2006 3%
2007 6%
2008 13%
2009 6%
2010 7%
2011 12%
2012 9%
4.5.18 Unga Group Profit Ratios (Pre- Tax & After Tax)
Unga Group profits both Pre Tax and After Tax have been below 10%, in 2006 and 2007
the Pre Tax Profit was at 2% and increased to 6% in 2008 only to drop to 2% in 2009 and
slightly increase to 3% in 2010.The Pre –Tax Profit increased to 5% in 2011 then fell to
3% in 2012. The After Tax profit ratio is directly proportional to the Pre Tax profit ratio.
From table 4.26 below, when the profit ratios are low so is the tax effect.
Table 4. 26: Unga Group Pre – Tax and After tax profit ratios
Year Pre – Tax Profit Ratio in
%
After Tax Profit Ratio in
%
2006 2% 1%
2007 2% 2%
2008 6% 4%
2009 2% 2%
2010 3% 2%
2011 5% 3%
2012 3% 2%
4.5.19 Unga Group Debt Equity Ratio and Return on Equity analysis
Unga Group Debt Equity Ratio has no relationship with Return on Equity because when
the Debt Equity Ratio decreases Return on Equity increases and decreases. is depicted on
Figure 4.18
55
Figure 4. 18: Unga Group Debt Equity and Return on Equity Ratios Trend analysis
4.5.20 Unga Group Debt Equity Ratio and Profit (Pre Tax & After Tax) Analysis
From figure 4.19 below Unga Group Debt Equity Ratio has no relationship with Pre Tax
Profit Ratios and After Tax Profit Ratios, when the Debt Equity Ratio decreases the
profitability ratios increase and remain constant. Debt Equity Ratio increases, the Pre Tax
profit and After Tax profit ratios decrease. This is shown on Figure 4.19 which is below.
Figure 4.19: Unga Group Debt Equity and (Pre Tax &After Tax) Ratios Trend
Analysis
56
4.5.21 Relationship between Debt Equity Ratio and Return on Equity
From table 4.27 below there is no any relationship between Debt Equity Ratio and Return
on Equity since when the weighted average Debt Equity Ratio of the manufacturing
companies increases the weighted Average of Return on Equity increases and decreases.
Table 4.27 Weighted Average Debt Equity Ratios & Return on Equity Ratios
Analysis
COMPANY DEBT EQUITY RATIOS
2006 2007 2008 2009 2010 2011 2012 AVERAGE
BOC 0.25 0.25 0.29 0.23 0.25 0.27 0.27 0.26
EABL 0.25 0.33 0.33 0.34 0.38 0.46 0.84 0.42
EVEREADY 0.52 0.63 0.56 0.60 0.66 0.75 0.67 0.63
MUMIAS 0.35 0.12 0.09 0.09 0.09 0.08 0.07 0.38
UNGA
GROUP
0.39 0.38 0.38 0.43 0.43 0.34 0.38 0.38
AVERAGE
DER
0.35 0.35 0.39 0.41 0.40 0.44 0.52
RETURN ON EQUITY RATIOS
2006 2007 2008 2009 2010 2011 2012 AVERAGE
BOC 0.18 0.19 0.14 0.10 0.05 0.11 0.14 0.13
EABL 0.34 0.36 0.42 0.36 0.37 0.34 1.28 0.50
EVEREADY 0.37 0.29 0.05 0.07 0.02 - 0.49 0.19 0.07
MUMIAS 0.20 0.17 0.13 0.16 0.14 0.13 0.13 0.15
UNGA
GROUP
0.03 0.06 0.13 0.06 0.07 0.12 0.09 0.08
AVERAGE
ROE
0.22 0.21 0.17 0.15 0.13 0.04 0.36
4.5.22 Relationship between Debt Equity Ratio and Pre Tax profit
There is no relationship between Debt Equity Ratio and Pre Tax profit Ratios since when
the Average weighted Debt Equity Ratio increases the Average weighted Pre Tax Profit
increases, remains constant and decreases. This is illustrated on Table 4.28 below.
57
Table 4.28 Weighted Average Debt Equity Ratios & Pre Tax Profit Ratio
Analysis.
COMPANY DEBT EQUITY RATIOS
2006 2007 2008 2009 2010 2011 2012 AVERAGE
BOC 0.25 0.25 0.29 0.23 0.25 0.27 0.27 0.26
EABL 0.25 0.33 0.33 0.34 0.38 0.46 0.84 0.42
EVEREADY 0.52 0.63 0.56 0.60 0.66 0.75 0.67 0.63
MUMIAS 0.35 0.12 0.09 0.09 0.09 0.08 0.07 0.38
UNGA
GROUP
0.39 0.38 0.38 0.43 0.43 0.34 0.38 0.38
AVERAGE
DER
0.35 0.35 0.39 0.41 0.40 0.44 0.52
PRETAX PROFIT RATIOS
2006 2007 2008 2009 2010 2011 2012 AVERAGE
BOC 0.30 0.27 0.23 0.18 0.10 0.18 0.22 0.21
EABL 0.23 0.22 0.38 0.35 0.33 0.27 0.22 0.29
EVEREADY 0.12 0.08 0.02 0.03 0.01 - 0.13 0.05 0.02
MUMIAS 0.19 0.18 0.13 0.10 0.14 0.17 0.11 0.15
UNGA
GROUP
0.02 0.02 0.06 0.02 0.03 0.05 0.03 0.03
AVERAGE
PTP
0.17 0.16 0.16 0.14 0.12 0.11 0.13
4.5.23 Relationship between Debt Equity Ratio and After Tax profit
From table 4.29 below, there is no relationship between Debt Equity Ratio and After Tax
profit Ratio; this is because when the Average weighted Debt Equity Ratio increases the
average weighted After Tax Profit Ratio increases and decreases.
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Table 4.29 Weighted Average Debt Equity Ratios & Pre Tax Profit Ratios Analysis
COMPANY DEBT EQUITY RATIOS
2006 2007 2008 2009 2010 2011 2012 AVERAGE
BOC 0.25 0.25 0.29 0.23 0.25 0.27 0.27 0.26
EABL 0.25 0.33 0.33 0.34 0.38 0.46 0.84 0.42
EVEREADY 0.52 0.63 0.56 0.60 0.66 0.75 0.67 0.63
MUMIAS 0.35 0.12 0.09 0.09 0.09 0.08 0.07 0.38
UNGA
GROUP
0.39 0.38 0.38 0.43 0.43 0.34 0.38 0.38
AVERAGE
DER
0.35 0.35 0.39 0.41 0.40 0.44 0.52
AFTER TAX PROFIT RATIOS
2006 2007 2008 2009 2010 2011 2012 AVERAGE
BOC 0.20 0.18 0.16 0.12 0.07 0.12 0.15 0.14
EABL 0.17 0.16 0.28 0.25 0.23 0.20 0.20 0.21
EVEREADY 0.08 0.06 0.01 0.02 0.01 - 0.09 0.05 0.02
MUMIAS 0.13 0.13 0.10 0.14 0.10 0.12 0.13 0.12
UNGA
GROUP
0.01 0.02 0.04 0.02 0.02 0.03 0.02 0.02
AVERAGE
ATP
0.12 0.11 0.12 0.11 0.09 0.08 0.11
4.6 Regression Analysis
Regression analysis is a statistical tool for the investigation of relationships between
variables. It shows to which direction the relationship between variables move. Usually,
the investigator seeks to ascertain the causal effect of one variable upon another, in the
study it is the relationship between Debt Equity Ratio with (Return on Assets, Return on
Equity, Pre –Tax Profit Ratio and After – Tax Profit Ratio).
The study assembled data on the underlying variables of interest and employed regression
to estimate the quantitative effect of the causal variables upon the variable that they
influence. The study also assessed the “statistical significance” of the estimated
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relationships, that is, the degree of confidence that the true relationship is close to the
estimated relationship.
4.6.1 Regression Analysis on Debt Equity Ratio and Return on Assets
The study sought to ascertain the causal effect of one variable upon another. Debt Equity
Ratio was the independent variable whereas Return on Assets was the dependent variable.
Table 4.30 Debt Equity and Return on Assets Model Summary
Model Summary
Model R R Square Adjusted R Square
Std. Error of the
Estimate
1 .547a .299 .159 .02563
a. Predictors: (Constant), Debt Equity Ratio
The table 4.30 above provided the R and R2 value. The R value was 0.547, which
represented the simple correlation and, therefore, indicated a high degree of correlation.
The R2 value indicated how much of the dependent variable, Return on Assets, can be
explained by the independent variable, Debt Equity Ratio. In this case, only 29.9% could
be explained, which is little.
Table 4.31 Debt Equity Ratio and Return on Assets Anova
ANOVAb
Model Sum of Squares df Mean Square F Sig.
1 Regression .001 1 .001 2.135 .204a
Residual .003 5 .001
Total .005 6
a. Predictors: (Constant), Debt Equity Ratio
b. Dependent Variable: Return On Assets
The ANOVA (Analysis of variance) table 4.31 indicated that the regression model does
not predict the outcome variable significantly well. This is shown when you Look at the
"Regression" row and on the Sig. Column which represents “Significance test”. This
indicates that the statistical significance of the regression model is not applicable. Here, P
is 0.204 which is more than 0.05 hence the model is bust and does not predict the
dependent variable.
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4.6.2 Regression on Debt Equity Ratio and Equity
The study did regression using Debt Equity Ratio as the independent variable whereas
Return on Equity was used as the dependant variable so as to ascertain whether there is a
significant relationship between the two variables.
Table 4.32 Debt Equity Ratio and Return on Equity Model Summary
Model Summary
Model R R Square Adjusted R Square
Std. Error of the
Estimate
1 .350a .123 -.053 .10083
a. Predictors: (Constant), Debt Equity Ratio
From table 4.32 above the R value was 0.350, which represented the simple correlation
and, therefore, indicated a little degree of correlation. The R2 value indicated how much
of the dependent variable, Return on Equity, can be explained by the independent
variable, Debt Equity Ratio. From the analysis only 12.3% could be explained, which is
little.
Table 4.33 Debt Equity Ratio and Return on Equity Anova
ANOVAb
Model Sum of Squares df Mean Square F Sig.
1 Regression .007 1 .007 .699 .441a
Residual .051 5 .010
Total .058 6
a. Predictors: (Constant), Debt Equity Ratio
b. Dependent Variable: Return On Equity
The ANOVA table indicated that the regression model does not predict the outcome
variable significantly well. This is shown by the “Significance test”. This indicates that
the statistical significance of the regression model is not applicable. Here, P is 0.441
which is more than 0.05 hence the model is bust and does not predict the dependent
variable.
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4.6.3 Regression Analysis on Debt Equity and Pre- Tax Profit
The study did regression using Debt Equity Ratio as the independent variable whereas Pre
– Tax Profit was used as the dependant variable. This was to ascertain whether there is a
significant relationship between the two variables.
Table 4.34 Debt Equity Ratio and Pre – Tax Profit Model Summary
Model Summary
Model R R Square Adjusted R Square
Std. Error of the
Estimate
1 .649a .421 .306 .01890
a. Predictors: (Constant), Debt Equity Ratio
The table 4.34 above the R value was 0.649, which represented the simple correlation
and, therefore, indicated a higher degree of correlation. The R2 value indicated how much
of the dependent variable, Pre – Tax Profit, can be explained by the independent variable,
Debt Equity Ratio. From the analysis only 42.1% could be explained, which is average.
Table 4.35 Debt Equity Ratio and Pre – Tax Profit Anova
ANOVAb
Model Sum of Squares df Mean Square F Sig.
1 Regression .001 1 .001 3.640 .115a
Residual .002 5 .000
Total .003 6
a. Predictors: (Constant), Debt Equity Ratio
b. Dependent Variable: Pre Tax Profit
The ANOVA table 4.35 indicated that the regression model does not predict the outcome
variable significantly well. This is shown by the “Significance test”. This indicates that
the statistical significance of the regression model is not applicable. Here, P is 0.115
which is more than 0.05 hence the model is bust and does not predict the dependent
variable.
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4.6.4 Regression Analysis on Debt Equity and After – Tax Profit
The study used Debt Equity Ratio as the independent variable whereas After – Tax Profit
was used as the dependant variable. This was to determine whether there is a significant
relationship between the two variables.
Table 4.36 Debt Equity Ratio and After – Tax Profit Ratio Model Summary
Model Summary
Model R R Square Adjusted R Square Std. Error of the Estimate
1 .290a .084 -.099 .01585
a. Predictors: (Constant), Debt Equity Ratio
The table 4.36 above the R value was 0.290, which represented the simple correlation
and, therefore, indicated a low degree of correlation. The R2 value indicated how much of
the dependent variable, After Tax Profit Ratio, can be explained by the independent
variable, Debt Equity Ratio. From the analysis only 8.4% could be explained, which is
low.
Table 4.37 Debt Equity Ratio and After Tax Anova
ANOVAb
Model Sum of Squares df Mean Square F Sig.
1 Regression .000 1 .000 .458 .529a
Residual .001 5 .000
Total .001 6
a. Predictors: (Constant), Debt Equity Ratio
b. Dependent Variable: After Tax Profit
The ANOVA table 4.37 indicated that the regression model does not predict the outcome
variable significantly well. The Significance test P is 0.529 is more than 0.05 hence the
model is bust and is not statistical significant.
4.7 Chapter Summary
The chapter analyzed and presented the findings of the objectives of the study. The
objectives analyzed were the ones covered using secondary data on the literature review.
The chapter has analyzed; components of capital structure, the relationship between
capital structure and assets and the relationship between capital structure and profitability
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both Pre-Tax and After-Tax profits. Different techniques were used including: ratios
analyses, trend analysis of the ratios, variation of the Average weighted ratios were used
to determine the relationships. The next chapter entails discussions, conclusions and
recommendations of the findings.
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CHAPTER FIVE
5.0 DISCUSSION, CONCLUSIONS AND RECOMMENDATIONS
5.1 Introduction
The previous chapter analyzed the data so as to come up with the findings. In this chapter
the findings are discussed and conclusions are drawn out of the discussions .Subsequently
the recommendations for improvement and further studies are suggested. The chapter is
broken into the following parts: Part 5.2 is the summary of the chapter, part 5.3 is the
discussion of the study, part 5.4 is the conclusions of the study and lastly part 5.5 is the
Recommendations for improvement and for further research
5.2 Summary
The summary of the findings are presented in this chapter. The purpose of the study was
to examine the relationship between capital structure and financial performance of the
manufacturing firms quoted on the Nairobi Securities Exchange. The study gave objective
answers to the following research questions: What are the components of capital
structure? What are the factors that determine capital structure of a firm? Is there a
relationship between capital structure and assets? Is there a relationship between capital
structure and profitability?
The study used a casual research design where data to be examined for the purpose of the
study was exclusively secondary data that was extracted from the archives of the
companies to be studied. The population of the study was the nine manufacturing
companies quoted on the Nairobi Securities Exchange. Purposive and random sampling
technique was used to select a sample of 5 companies. The data from annual financial
statements ranging from 2006 to 2012 was entered in Microsoft Excell then financial
ratios (Debt Equity Ratio, Return on Assets, Return on Equity, Pre – Tax Profit and After-
Tax) were calculated. The analysis was also done on Microsoft Excell where trend and
regression analysis was done and represented using line graphs and tables.
The study found out that Debt and equity are the major components of capital structure;
the two vary in terms of their contribution percentage to the capital structure. The study
after analyzing 5 manufacturing firms quoted in the Nairobi Securities Exchange, Debt
65
equity ratio varies from one company to the other meaning that there is no optimal capital
structure in terms of debt to equity combination. From the study it is evident high debt
levels are consistent with low financial performance in terms of profits, Eveready
company is a good example of that.
The study also found out that there other components of capital structure which include;
share capital, share premium, revenue reserves, capital reserves and retained earnings.
From the study companies with highest share capital are performing financially well
compared to those with low Share Capital.
When it comes to components such as revenue reserves and capital reserves the
companies in the study have not had any for the period of 2006 – 2012. However, the
companies have been having retained earnings. EABL having the highest retained
earnings compared to the others can partly explain the performance.
When it comes to capital structure and assets relationship, the study found out that there is
no significant relationship from analysed statistical data. However the study found out
that the two are tied up together in a way of impact on each other. Assets can determine
the capital structure in terms of being used as collateral for debt financing while on the
other hand capital structure may determine the type of assets the firm is to invest in.
The study found out that there is no significant statistical relationship between capital
structure and financial performance of firms but from the analysis of Pre tax profit and
after tax profit, the study has seen that tax has an important role to play in the capital
structure of firms. First is that firms with high debt to equity ratio there is a tax shield
benefit thus increased profitability and on the other hand tax reduces the profit of a firm
which some portion of it goes to the retained earnings that re – finance the capital
structure of a firm.
5.3 Discussion
5.3.1 Components of capital structure
The study has established that capital structure has two components namely debt and
equity. From the 5 companies used in the study each company has Debt and Equity as
their main component of Capital Structure. The way a firm balances the two components
66
is the bone of contention in capital structure since there is no ideal capital structure
because different firms have different capital structure needs.
The study has found out that the 5 companies used in the study are all using Debt &
Equity as their main source of capital structure. This is consistent with Cheng (2009) who
studied the effect of financing mix in capital structure on operating performance. Findings
from his study indicate that firms should not solely reply on a single source of financing
either debt or equity while firms are advised to incorporate both two sources to raise
capital.
The five companies used in the study are all listed on the Nairobi Securities Exchange
meaning that they can easily access funds especially debt since meeting the requirements
for being listed is kind of easier to the five companies used for study when compared to
small firms. The study is in agreement with Wang,(2011) in his study of firms in the
manufacturing industry in Pakistan where he argued that large firms have a lower agency
cost since they have a lesser volatile cash flow and can easily access the capital markets.
The 5 companies used in the study, the period of 2006 – 2012 used varying debt and
equity each year to finance their capital structure. Companies like Eveready used higher
debt than equity whereas companies like BOC Kenya used higher equity and less debt.
The study is in agreement with Modigliani and Miller (1958) the proponents of capital
structure that Debt and Equity varies is dependant with the trade off theories and pecking
order theories of capital structure.
According to Warner (1977) on the trade off theory explains that firm usually trade off
between tax advantages on debt financing and the cost of financial distress and
bankruptcy. According to C Myers (2001) on the pecking order theory a firm follows a
particular pattern of steps in capital financing, the first step being use of internal finances
such as retained earnings, if they are not enough the firm resorts to debt financing
meaning that internal financing is first priority over debt financing.
When the companies that had Retained Earnings were compared, Eveready had the
lowest average Retained Earnings for the period of 2006 – 2012. This contributed to the
company to have the highest Debt Equity Ratio for the period of 2006 – 2012. Therefore
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the study is in agreement with the pecking order theory by Myers and Majluf (1984)
whereby firms prioritize internal funds (retained earnings) as their source of financing
which if not enough firms resort to debt.
The study is in agreement with Fama and French (2005) that the pecking order & trade
off theories cannot stand alone each theory on its own, they have some facts on capital
structure which may be useful when it comes to capital structure financing. Firms need to
analyse the two theories and come up with a balance of the two theories that fits the firm
since firms are different.
High Debt Equity Ratio is a signal of higher bankruptcy risk. This finding is consistent
with Leland and Pyle (1977) who proposed that managers will take debt-equity ratio as a
signal, by the fact that high leverage implies higher bankruptcy risk.
5.3.2 Relationship between Capital Structure and Assets
According to Regression Analysis, there is no significant statistical relationship between
capital structure and assets of the manufacturing companies quoted on the Nairobi
Securities Exchange. This has been seen by the 5 companies that were used for the study
after analyzing their Debt Equity Ratios with Return on Assets during the period of 2006
– 2012. The study is consistent with Titman and Wessels (1988) study that does not
indicate a relationship between a firm‟s assets and leverage
There is a high degree of correlation between Debt Equity and Return on Assets though
there is no significant statistical relationship between the two variables. Assets are usually
used as collateral for borrowing debt by firms. When Assets are used as collateral a
number of things are considered. First consideration is how the asset is tangible because it
is believed that tangible assets are more liquid than intangible assets. Secondly how is the
liquidity level of the asset in terms of it being converted to cash because assets with high
liquidity assets increase a firm‟s accessibility to debt financing.
From the study, companies growing their capital structure over the years have also been
increasing their assets base proportionately with the capital structure. This is consistent
with Christian Riis Flor, (2008) study on “Capital structure and asset: effects of an
68
implicit collateral” which has it that as a firm grows especially its capital structure then its
assets base should grow proportionally with the capital structure since assets represent the
face value of a firm. The key to this proportionality is effective utilization of assets that
ensures there is capital optimization and this can give room to debt financing and even
debt renegotiation.
The study is consistent with Hussy, R (1999) study that assets can be used to tell how the
firm is effective in terms of income generation given the assets base the firm has, the
higher the ratio the higher the chances are for the firm future‟s prospective growth
(Mahdi, 2009).
Another perspective of capital structure is in terms of what the firm buys with its finance
when investing, firms can use their Debt- Equity finances to invest in income generating
assets with high liquidity. This in turn may impact the capital structure in two ways, one
the earnings from this income generating asset may be ploughed back in the firm
investments thus improving the capital structure of the firm. On the other hand a firm may
use this income generating as collateral for debt financing on the basis of their liquidity.
5.3.3 Relationship between Capital Structure and Financial Performance.
The analysis of the study using Regression has shown that the degree of correlation
between Capital structure and Return on Equity is low and there is no significant
statistical relationship between capital structure and Return on Equity. When it comes to
profitability the degree of correlation between capital structure and Pre –Tax profit is
higher and lower on capital structure with After Tax Profit meaning that Tax has effect on
capital structure. There is also no significant statistical relationship between capital
structure and profitability.
The study has found out that there is no relationship between capital structure and the
financial performance of the manufacturing companies listed on the Nairobi Securities
Exchange. This is after analyzing Debt Equity Ratio with Return on Equity and
Profitability ratios of the 5 companies used in the study for the period of 2006 – 2012.
This was consistent with a study by El-Sayed Ebaid, (2009) based on a sample of non-
69
financial Egyptian listed firms from 1997 to 2005 which showed that capital structure
choice has a weak-to-no impact on a firm's performance.
From the study companies with the wrong mix of debt and equity have dismal
performance. For instance companies engaging high debt and less equity. This means
Eveready has the wrong combination of Debt & Equity thus dismal performance. The
study is consistent with (Onalapo, 2010) study that a wrong mix of capital structure
components that is debt and equity seriously affects the performance and the survival of
the firm.
On the other hand, the study has seen that the way a company manages its Debt and
Equity over the years determines the performance. This means that a well managed and
utilised Debt – Equity combination results to increased profits. This is in agreement with
(Elliot, 2002) study that a firm manager‟s primary duty is to manage the firm in a way
that maximizes shareholder‟s wealth which has to be reflected by increased profits and
cash flows.
Capital structure decisions in terms of Debt – Equity combination determines the returns
and risks. From the study decision of companies to use the high debt meaning that the
risks are also high and its evident from the financials that the profit ratios are also high.
The study is consistent with (Muzir, 2011) study that profitability of a firm is as a result
of the capital structure decisions, which whether short term or long term affect the
profitability of a firm while at the same time increase the risk of the firm investment. This
is due to the fact that capital structure comprises of debt and equity, debt increases the
risk of future earnings while enabling a firm to expect high returns.
In June 2011 Eveready had to transition out its Managing Director also acting as CEO
hoping the new one to improve the performance, all these had to do with corporate
governance. The study is in agreement with ( Pratheepkanth Puwanenthiren,2011) who
did a study on capital structure and financial performance on selected business companies
in Colombo Stock Exchange, Sri Lanka. Again the corporate governance of a firm is
highly interlinked with the ownership of the firm. Capital structure relationship with
financial performance is highly dependent on the actions of the managers of a firm. The
70
managers should ensure that they are maximizing shareholders wealth which is indicated
by increased profits.
The study concurs with (Muzir Erol, 2011) study on the “triangle relationship among
Turkey firms size, capital structure choice and financial performance” which has it that
firms which use more debt in capital structure increases the risk of future earnings while
at the same time increasing expectations of high returns.If the risk is not covered by
actual returns then the firm is bound to go bankrupt but if the firm ias able to cover the
risk with returns then it will have a good performance that could attract investors.
5.4 Conclusion
5.4.1 Components of Capital Structure
Capital structure has two major components namely debt and equity, there is no ideal
ratio combination of debt and equity; firms should be able to come up with ways that can
balance the two on the basis of profitability and bankruptcy avoidance. The best way is
balancing between the trade off theory and the pecking order theory since they have some
good elements in them. For instance from the pecking order, companies should use
internal finances such as retained earnings, if they are not enough they resort to debt
financing meaning that internal financing is first priority over debt financing.
From the study, listed companies have an easy access to funds as compared to other firms
which are not listed on the Nairobi Securities Exchange. Companies should maximise this
easy access to come up with an optimal Debt – Equity ratio that is profitable to a firm and
at the same time is less risky. Lastly firm managers should always take debt-equity ratio
as a signal of risk and bankruptcy. This is due to the fact that high leverage implies higher
bankruptcy risk.
5.4.2 Relationship between Capital Structure and Assets
Assets can be used as collateral for borrowing debt by firms thus increasing the capital
structure component of debt. At the same time a firm using assets as collateral should
consider tangibility of the assets and liquidity of the assets because the two determines
accessibility to debt financing.
71
Firms should ensure that as they grow their capital structure their assets base also grow
proportionally with the capital structure. This is because assets represent the face value of
a firm. The key to this proportionality is effective utilization of assets that ensures there is
capital optimization in viable income generating business ventures which can also create
an opportunity for debt financing and even debt renegotiation.
5.4.3 Relationship between Capital Structure and Financial Performance
Capital mix of Debt and Equity seriously affects the performance of a firm and its long
term survival in business. Firms should ensure that they get an optimal balance of Debt
and Equity that works well with the firm since each firm is different from others. Other
than an optimal mix of Debt Equity, the firms should effectively and efficiently use the
capital structure. This will ensure that performance in terms of profitability is enhanced
while at the same time risk is minimized.
Profitability of a firm is as a result of the capital structure decisions, which whether short
term or long term. The decisions affect the profitability of a firm, while at the same time
increase the risk of the firm investment. Firm managers should make good decisions in
regards to the capital structure of their firms. In relation to that corporate governance
comes handy especially in the relationship between capital structure and a firm‟s
performance.
5.5 Recommendations
5.5.1 Recommendation For Improvement
5.5.1.1 Components of Capital Structure
Firms should try and balance debt – equity proportions in their capital structure in a way
that provides benefits to the firm at minimal costs, this would be possible if firms applied
both pecking order and trade off theories of capital structure whereby according to the
pecking order theory firm‟s first use internal financing like retained earnings, if this is not
enough then they borrow considering the trade off theory which has it that firms should
consider cost and benefits of debt.
72
5.5.1.2 Relationship between Capital Structure and Assets
Firms should ensure that as they grow their capital structure and their assets
proportionally since assets represent the face value of a firm. Assets should be effectively
and efficiently used in viable income generating business ventures. At the same time
firms should use their assets as collateral for debt financing having put into consideration
assets tangibility and assets liquidity in a way that a firm is not vulnerable to bankruptcy
risks.
5.5.1.3 Relationship between Capital Structure and Financial Performance
Optimal mix of Debt Equity, coupled with efficiency and effectiveness on one hand and
corporate governance on the other hand will ensures a firm‟s performance in terms of
profitability is enhanced while at the same time risk is minimized. Other than good
corporate governance managers and owners of a firm ought to be well aware of both
internal and external factors that may influence the performance of a firm.
5.5.2 Recommendation for Further Research
Finally a study on establishing the optimal range for capital structure should be
undertaken so as to form a good basis for forming decisions relating to the capital
structure of firms.
73
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APPENDICES:
APPENDIX FOR DATA COLLECTION INSTRUMENT
APPENDIX 1: BOC KENYA DATA COLLECTION INSTRUNMENT ( 2006 - 2012 ) IN KSH '000'
2006 2007 2008 2009 2010 2011 2012
TURNOVER 1,109,584 1,505,018 1,283,832 1,285,373 1,155,379 1,205,372 1,294,550
PRE -TAX 333,705 399,769 295,179 231,682 114,685 214,948 286,692
NET PROFIT 225,940 267,556 200,409 153,907 79,337 150,604 197,374
TOTAL ASSETS 1,705,352 1,859,335 2,057,227 1,988,401 2,019,810 1,816,803 1,989,541
CURRENT LIABILITIES 364,315 396,672 - - 402,014 458,790 523,229
NON CURENT LIABILITIES 69,191 62,531 603,119 454,607 96,411 29,462 11,501
SHARE CAPITAL 97,627 97,627 97,627 97,627 97,627 97,627 97,627
SHARE PREMIUM 2,554 2,554 2,554 2,554 2,554 - -
RETAINED EARNINGS 972,756 1,063,626 1,142,888 1,099,853 - 1,082,817 1,147,418
REVENUE RESERVES - - - - - - -
CAPITAL RESERVES - - - - - - -
RESERVES 115,927 114,292 117,317 240,038 - 148,107 209,766
TOTAL LIABILITIES ( DEBT
) 433,506 459,203 603,119 454,607 498,425 488,252 534,730
EQUITY ( shareholders ) 1,271,846 1,400,132 1,454,108 1,533,794 1,521,385 1,328,551 1,454,811
TOTAL EQUITY 1,705,352 1,859,335 2,057,227 1,988,401 2,019,810 1,816,803 1,989,541
82
APPENDIX 2: EABL DATA COLLECTION INSTRUMENT ( 2006 - 2012 ) IN KSH '000'
2006 2007 2008 2009 2010 2011 2012
TURNOVER 37,449,324 47,272,753 32,488,112 34,407,715 37,965,334 44,895,037 55,522,166
PRE -TAX 8,577,049 10,635,771 12,316,332 11,989,258 12,568,087 12,258,989 12,253,049
NET PROFIT 6,410,042 7,528,891 9,184,385 8,609,185 8,837,560 9,023,660 11,186,113
TOTAL ASSETS 24,781,697 31,106,195 33,254,248 35,832,389 38,420,691 49,519,364 54,584,316
CURRENT LIABILITIES 4,290,427 8,203,822 8,867,918 9,432,296 11,684,390 15,509,186 22,483,782
NON CURENT
LIABILITIES 1,905,700 2,051,597 2,269,487 2,746,441 2,783,675 7,254,997 23,384,654
SHARE CAPITAL 1,317,957 1,317,957 1,581,547 1,581,547 1,581,547 1,581,547 1,581,547
SHARE PREMIUM 1,959,100 1,959,100 1,691,151 1,691,151 1,691,151 1,691,151 1,691,151
RETAINED EARNINGS 8,967,173 9,294,786 10,509,910 11,332,702 10,768,656 11,261,368 14,985,679
REVENUE RESERVES - - - - - - -
CAPITAL RESERVES - - - - - - -
RESERVES 1,912,538 1,842,027 1,730,299 1,691,151 - - 18,292,037
TOTAL LIABILITIES (
DEBT) 6,196,127 10,255,419 11,137,405 12,178,737 14,468,065 22,764,183 45,868,436
EQUITY ( shareholders ) 18,585,570 20,850,776 22,116,843 23,653,652 23,952,626 26,755,181 8,715,880
TOTAL EQUITY 24,781,697 31,106,195 33,254,248 35,832,389 38,420,691 49,519,364 54,584,316
83
APPENDIX 3: EVEREADY DATA COLLECTION INSTRUNMENT ( 2006 - 2012 ) IN KSH '000'
2006 2007 2008 2009 2010 2011 2012
TURNOVER 2,029,462 2,232,143 1,774,675 1,645,193 1,635,106 1,374,847 1,374,789
PRE -TAX 234,036 179,505 27,855 41,568 17,476 (173,208) 68,914
NET PROFIT 165,566 126,408 17,840 28,271 8,703 (123,994) 70,084
TOTAL ASSETS 919,006 1,189,317 837,329 997,672 1,169,732 1,016,908 1,150,729
CURRENT LIABILITIES 393,429 644,475 384,139 528,176 668,833 658,427 695,764
NON CURENT LIABILITIES 82,900 101,757 86,765 74,800 97,500 105,476 79,076
SHARE CAPITAL 210,000 210,000 210,000 210,000 210,000 210,000 210,000
SHARE PREMIUM - - - - - - -
RETAINED EARNINGS 106,677 138,585 156,425 184,696 193,399 69,405 139,489
REVENUE RESERVES - - - - - - -
CAPITAL RESERVES - - - - - - -
RESERVES - - - - - - -
TOTAL LIABILITIES (
DEBT ) 476,329 746,232 470,904 602,976 766,333 763,903 774,840
EQUITY ( shareholders ) 442,677 443,085 366,425 394,696 403,399 253,005 375,889
84
APPENDIX 4: MUMIAS DATA COLLECTION INSTRUMENT ( 2006 - 2012 ) IN KSH '000'
2006 2007 2008 2009 2010 2011 2012
TURNOVER 11,657,540 10,381,190 11,970,101 11,791,708 15,617,738 15,795,300 15,542,686
PRE -TAX 2,219,889 1,909,894 1,589,204 1,193,161 2,179,874 2,646,575 1,764,029
NET PROFIT 1,526,615 1,393,611 1,213,837 1,609,972 1,572,383 1,933,225 2,012,679
TOTAL ASSETS 11,871,506 11,916,869 14,152,576 17,475,715 18,334,110 23,176,516 27,400,113
CURRENT LIABILITIES 2,007,043 1,613,376 3,398,096 3,760,339 3,250,021 2,961,691 5,720,655
NON CURENT
LIABILITIES 2,155,414 1,965,833 1,712,983 3,675,907 4,084,237 5,738,818 5,955,772
SHARE CAPITAL 1,020,000 1,020,000 3,060,000 3,060,000 3,060,000 3,060,000 3,060,000
SHARE PREMIUM
-
- - - - - -
RETAINED EARNINGS 4,553,495 5,251,866 4,154,154 5,292,218 6,404,006 7,863,551 9,312,806
REVENUE RESERVES
-
- - - - - -
CAPITAL RESERVES
-
- - - - - -
RESERVES
-
- - - - - -
TOTAL LIABILITIES (
DEBT ) 4,162,457 3,579,209 5,111,079 7,436,246 7,334,258 8,700,509 11,676,427
EQUITY ( shareholders ) 7,709,049 8,337,660 9,041,497 10,039,469 10,999,852 14,476,007 15,723,686
TOTAL EQUITY 11,871,506 11,916,869 14,152,576 17,475,715 18,334,110 23,176,516 27,400,113
85
APPENDIX 5: UNGA GROUP DATA COLLECTION INSTRUMENT ( 2006 - 2012 ) in KSH '000'
2006 2007 2008 2009 2010 2011 2012
TURNOVER 7,305,958 7,675,347 9,450,824 11,643,639 11,524,454 13,214,442 15,976,763
PRE -TAX 142,427 156,665 564,016 260,439 335,101 631,070 512,569
NET PROFIT 64,601 133,610 373,661 185,192 236,173 441,043 348,195
TOTAL ASSETS 3,590,169 3,717,369 4,761,528 5,565,541 5,064,420 5,708,897 6,410,259
CURRENT LIABILITIES 1,304,461 1,347,809 1,538,044 2,085,012 1,344,363 1,618,796 1,967,953
NON CURENT
LIABILITIES 89,098 50,571 259,483 334,142 355,354 345,150 453,088
SHARE CAPITAL 315,454 315,454 315,454 378,535 378,535 378,535 378,535
SHARE PREMIUM 73,148 73,148 73,148 73,148 73,148 73,148 73,148
RETAINED EARNINGS - - - - - - -
REVENUE RESERVES - - - - - - -
CAPITAL RESERVES - - - - - - -
RESERVES 1,059,596 1,141,147 1,656,459 1,715,291 1,125,853 1,384,192 1,558,405
TOTAL LIABILITIES 1,393,559 1,398,380 1,797,527 2,419,154 1,699,717 1,963,946 2,421,041
EQUITY ( shareholders ) 2,196,610 2,318,989 2,964,001 3,146,387 3,364,703 3,744,951 3,989,218
TOTAL EQUITY 3,590,169 3,717,369 4,761,528 5,565,541 5,064,420 5,708,897 6,410,259
