Fluent Essays

From: Elkana Kimeli <[email protected]> Date: 14 Jul 2018 13:19 Subject: Proposal To: Allan Lusenji <[email protected]> Cc: You have done the complete research yet we only needed to do up to chapter three only. Remove chapter four and five. Justify your text, number your sections and subsections. Do not indent inside the first sentence of your paragraphs, let them start at the edge of the page like the other sentences. Attachments area Running head: BUSINESS MANAGEMENT RESEARCH 1 BUSINESS MANAGEMENT RESEARCH PROJECT remove, page numbers be at the bottom of the page 23 THE RELATIONSHIP BETWEEN CAPITAL STRUCTURE AND FINANCIAL PERFORMANCE OF BANKS LISTED AT THE NAIROBI SECURITIES EXCHANGE BY ALLAN A LUSENJI A RESEARCH REPORT SUBMITTED TO MASINDE MULIRO UNIVERSITY IN PARTIAL FULFILLMENT OF THE REQUIREMENTS OF THE AWARD OF A DEGREE OF BACHELOR OF COMMERCE AT MASINDE MULIRO UNIVERSITY MAY 2018 DECLARATION – new page This research project is my original work and has not been presented to any other institution or University Sign_________________ Date ______________ ALLAN A LUSENJI BCM/B/04-56702/2016 This research project has been submitted for examination with our approval as the university supervisor. Sign_________________ Date _______________ MR: ELKANA KIMELI Lecturer School of Business, MASINDE MULIRO UNIVERSITY Contents – how about the preliminary pages? 2 2 3 3 4 5 6 8 8 8 10 10 10 11 11 13 13 14 14 14 14 14 14 16 16 16 16 16 17 17 17 19 19 19 27 29 29 29 29 30 31 CHAPTER ONE: INTRODUCTION 1.0 Introduction This chapter provides the background information about relationship between capital structure and financial performance of banks, the problem statement, objectives of the study, research questions, significance of the study and the scope of the study. 1.1 Background of the Study Capital refers to structure as the way in which a firm finances its operations which can either be through debt or equity capital or a combination of both. Financial Performance is the blue print of the financial affairs of a concern and it reveals the organization’s ability to translate its financial resources into mission related activities (Brigham, & Houston, 2005). The importance of financing decisions cannot be over emphasized since many of the factors that contribute to business failure can be addressed using strategies and financial decisions that drive growth and the achievement of organizational objectives. The finance factor is the main cause of financial distress. Financing decisions result in a given capital structure and suboptimal financing decisions can lead to firm’s failure (Abor, 2007). A great dilemma for management and investors alike is whether there exists an optimal capital structure. The objective of all financing decisions is wealth maximization and the immediate way of measuring the quality of any financing decision is to examine the effect of such a decision on the firm’s performance. High performance is more than high returns. It is the ability to generate high returns for the level of risk assumed by a firm. Credit risk, liquidity risk, market risk and so on are some of the risks firms assume in order to earn optimal returns. High performing institutions are those that manage and control their risk the best by employing effective trade-off between risk and returns. Firms are constantly looking for ways to achieve high performance and therefore a lot of theories have been formulated and studies conducted by firms in efforts to determine the factors that influence performance of firms (Abor, 2007). A set of these theories and studies identify capital structure as one of the factors affecting a firm’s performance on one hand and on the other hand these theories and studies contradict the view that Capital structure does affect a firm’s performance arguing that capital structure is irrelevant to a firm’s performance (Hamilton, 2010). The capital structure of a firm is basically the way a firm finances its assets through some combination of debt and equity that a firm deems as appropriate to enhance its operations. Capital Structure – number your subsections A firm’s capital structure refers to the way a firm finances its assets though equity, debt or a combination of both. As financial capital is an uncertain but critical resource for all firms, suppliers of finance are able to exert control over firms. Debt and equity are the two major classes, with debt holders and equity holders representing the two types of investors in the firm. Each of these is associated with different levels of risk, benefits, and control. It is the way the corporation finances its assets through some combination of equity, debt, or hybrid securities (Holmes, 2003). A mix of a companys long-term debt, specific short-term debt, common equity and preferred equity is instrumental in determining the capital structure of a firm. The capital structure is how a firm finances its overall operations and growth by using different sources of funds. Debt comes in the form of bond issues or long-term notes payable, while equity is classified as common stock, preferred stock or retained earnings. According to Hovakimian, Hovakimian, & Tehranian, 2004) , the Consensus is that “leverage increase with fixed assets, non-debt tax shields, investment Opportunities, and firm size, and decreases with volatility, advertising expenditure, the probability Of bankruptcy, profitability, and uniqueness of the product.” Block, & McMillan, (2005) state that Asset structure; non-debt tax shields, growth, uniqueness, industry classification, size, earnings Volatility and profitability are factors that may affect leverage according to different theories of Capital structure. Still, other authors such as Abor, (2007) may provide another set of potential determinants of capital Structure. Financial Performance – number subsections A firm’s financial performance, in the view of the shareholder, is measured by how better off the shareholder is at the end of a period, than he was at the beginning and this can be determined using ratios derived from financial statements; mainly the balance sheet and income statement, or using data on stock market prices (Hutchinson, 1995). These ratios give an indication of whether the firm is achieving the owners’ objectives of making them wealthier, and can be used to compare a firm’s ratios with other firms or to find trends of performance over time. Abor (2007) states that adequate performance measure ought to give an account of all the consequences of investments on the wealth of shareholders. The main objective of shareholders in investing in a business is to increase their wealth. Thus the measurement of performance of the business must give an indication of how wealthier the shareholder, has become as a result of the investment over a specific time. The limitations on financial statements in explaining firm value underline the fact that the source of economic value is no longer the production of material goods, but the creation of intellectual capital. Intellectual capital includes human capital and structural capital wrapped up in customers, processes, databases, brands, and systems, and has been playing an increasingly important role in creating corporate sustainable competitive advantages. The use of financial ratios for business analysis is common, and hence, almost cliché. Ratio analysis techniques can be considered a business analysis paradigm as an established point of view (Jensen, 2006). Considering these facts, encouraging industry operators to apply the techniques of ratio analysis to assess their performance requires a simple framework that compresses a large amount of data into a small set of performance indicators. These performance indicators must include intangible, non-financial elements that are often critically important to operators. The firm’s debt ratio is the proportion of the firm’s debt in relation to the total equity finance in the company’s capital structure. This key ratio is famously known as an indicator of the company’s long term solvency position and 8 also indicator of the financial risk position of the company. It’s obtained by dividing the total company debt with the total shareholders’ funds. Gross profit is the difference between revenue and cost of goods sold. Gross Margin is the ratio of gross profit to revenue (Abor, 2007). Depends on situation or decision analyzed both or one of these two performance indicators can be more suitable. For merchandising decisions in company with large assortment of products gross profit expressed in money terms needs to be used when measuring financial result on the level of all product assortments or on the level of big product group Brigham, & Houston, (2005). This allows seeing what the overall financial result without digging into details is. Relationship between Capital Structure and Financial Performance Fischer, Heinkel, & Zechner, (2009) in their scholarly works argued that, financial leverage had a positive effect on the firm’s return on equity provided that earnings’ power of the firm’s assets exceeds the average interest cost of debt to the firm. Brigham, & Houston, (2005) also found significantly positive relationship between debt ratio and measures of profitability. Chen, (2004) also identified positive association between debt and profitability but for industries. In his study of leveraged buyouts, Donaldson, (2005) established a significantly positive relation between profitability and total debt as a percentage of the total buyout-financing package. However, some studies have shown that debt has a negative effect on firm profitability. Brigham, & Houston, (2005), for instance argue that the use of excessive debt creates agency problems among shareholders and creditors and that could result in negative relationship between leverage and profitability. Abor, (2007) found in their Indian study that leverage has a negative effect on performance. In another study, Fischer, Heinkel, & Zechner, (2009) examined the relation between capital structure and performance by comparing Polish and Hungarian firms to a large sample of firms in industrialized countries (Kitaka, 2013). He used panel data analysis to investigate the relation between total debt and performance as well as between different sources of debt namely, bank loans, and trade credits and firms’ performance measured by profitability (Abor, 2007). His results show a significant and negative effect for most countries. He found that the type of debt, bank loans or trade credit is not of major importance, what matters is debt in general. Nairobi securities exchange – number subsections The Nairobi Securities Exchange, which was formed in 1954 as a voluntary organization of stockbrokers, is now one of the most active capital markets in Africa. The administration of the Nairobi Securities Exchange is located on Tosica five storey building located at Westlands road Nairobi (Hall, Hutchinson, & Michaelas, 2008). As a capital market institution, the Nairobi Securities Exchange plays an important role in the process of economic development. It helps mobilize domestic savings thereby bringing about the reallocation of financial resources from dormant to active agents (Fischer, Heinkel, & Zechner, 2009) Long-term investments are made liquid, as the transfer of securities between shareholders is facilitated. The Nairobi Securities Exchange has also enabled banks to engage local participation in their equity, thereby giving Kenyans a chance to own shares. Banks can also raise extra finance essential for expansion and development. To raise funds, a new issuer (bank) publishes a prospectus, which gives all pertinent particulars about the operations and future prospects and states the price of the issue. Nairobi Securities Exchange also enhances the inflow of international capital (Abor, 2007). They can also be useful tools for privatization programmes. It is generally accepted that banks declaring stock distributions of 25 per cent or greater consider them as stock splits which, therefore, have no effect on retained earnings. Stock distributions of less than 25 per cent are considered as stock dividends that reduce the retained earnings account. In Kenya, the establishment and licensing of Investment Companies is done by the Capital Markets Authority (CMA). These firms are registered as Collective Investment Schemes (CIS) each mandated to operate investment based on the license granted. Kenya represents over 50\% of the economic power of the East African countries, with the most active securities exchange, Nairobi Securities Exchange (Kennerley 2002). Even with the growth in the number of investment firms, the uptake of these investment opportunities has been wanting. The volume of funds channeled to funds in comparison to other securities, questions the knowledge of the operations of funds, investor confidence and knowledge of the different investment vehicles available. The listed collective schemes are managed by investment companies. In Kenya there are three investment companies listed in the Nairobi Securities Exchange (Abor, 2007). This indicates that such investments are professionally managed and the returns derived should mimic the market trends. The Investment companies listed at are Centum Investment, Olympia Capital Holdings and Trans Century Ltd. The three investment firms are considered among the largest listed Investment Companies in the East African region and together with their subsidiaries are engaged in the business of investment across private equity, construction industry and infrastructure and quoted private equity asset classes. The Nairobi Securities Exchange has also enabled the investment companies to engage local participation in their equity, thereby giving Kenyans a chance to own shares (Abor, 2007). Companies can also raise extra finance essential for expansion and development. To raise funds, a new issuer publishes a prospectus, which gives all pertinent particulars about the operations and future prospects and states the price of the issue. NSE also enhances the inflow of international capital. They can also be useful tools for privatization programmes. It is generally accepted that investment firms declaring stock distributions of 25 per cent or greater consider them as stock splits which, therefore, have no effect on retained earnings. Stock distributions of less than 25 per cent are considered as stock dividends that reduce the retained earnings account (Kennerley, 2002). 1.2 Statement of the problem A bank’s capital structure refers to the mix of its financial liabilities. It has long been an important issue from the strategic management standpoint since it is linked with a firm’s ability to meet the demands of various stakeholders (Brigham, & Houston, 2005). Debt and equity are the two major classes of liabilities, with debt holders and equity holders representing the two types of investors in the bank. Each of these is associated with different levels of risk, benefits, and control. While debt holders exert lower control, they earn a fixed rate of return and are protected by contractual obligations with respect to their investment. Equity holders are the residual claimants, bearing most of the risk and have greater control over decisions (Gachoka, 2005). An appropriate capital structure is a critical decision for any business organization. The decision is important not only because of the need to maximize returns to various organizational constituencies, but also because of the impact such a decision have on an organization’s ability to deal with its competitive environment. Following the work of Abor, (2007), much research has been carried out in corporate finance to determine the influence of a business’s choice of capital structure on performance. The difficulty facing companies when structuring their finance is to determine its impact on performance, as the performance of the business is crucial to the value of the firm and consequently, its survival. Managers have numerous opportunities to exercise their discretion with respect to capital structure decisions. The capital structure employed may not be meant for value maximization of the firm but for protection of the manager’s interest especially in organizations where corporate decisions are dictated by managers and shares of the company closely held (Brigham, & Houston, 2005). Even where shares are not closely held, owners of equity are generally large in number and an average shareholder controls a minute proportion of the shares of the firm. This gives rise to the tendency for such a shareholder to take less interest in the monitoring of managers who left to themselves pursue interest different from owners of equity. In the past three years in Kenyan market in general, there is a significant reduction in the interest rate but it has not made any deference in the cost of borrowing. Try looking for any write ups. 2011 in particular the cost of funds increased significantly in the Kenyan debt market, this was as result of inflation that triggered monetary policy committee to increase the interest rates in the banking industry that spilled to the borrowers. The cost of funds thus affected bank’s financial performance, increased prices of real estate properties. There are a number of studies that have been done on capital structure and financial performance ; Gachoki, (2005) effect of capital structure change on share prices for firm quoted at the NSE, (Brigham, & Houston, 2005) the relationship between capital structure & profitability of micro finance institutions in Kenya; Gachoki, B. (2005) the relationship between capital structure and financial performance of SMEs in Nairobi, (Abor, 2007), a test of relationship between capital structure and agency costs. Findings appear to suggest that there is a significant impact of capital structure on company performance after controlling for company specific characteristics such as company size, non-duality, leverage and growth. The finding is of significant for investors and policy marker which will serve as a guiding for better investment decision. No study has been done on the relationship between capital structure and financial performance on listed banks in Nairobi security exchange. This study therefore seeks to fill in this gap by investigating capital structure on financial performance with specific reference to listed banks in Nairobi security exchange. Objective of the Study The focus of this study is to establish the relationship between Capital Structure and Performance of the banks listed at the Nairobi securities exchange. The following specific objectives will guide the study: i. To determine the effect of debt financing to the return on capital equity. ii. To determine the effect of shareholder’s equity on financial performance Research questions i. The following research questions in relation to listed banks in Kenya will be a guide to the research: ii. To what extent does capital structure affect on the bank’s financial performance? iii. How does debt influence financial performance? iv. How does shareholder’s equity influence financial performance Significance of Research The findings of this study will benefit Investors in the listed investment firms, shareholders of the listed investment firms, academicians and financial researchers and the management of investment firms. The more the knowledge about a phenomena one has the better equipped they are to face the challenges of the future. Effects of capital structure, how it is affected by a firms return and how a change on it can affect the firm’s value will be a welcome weapon to facing the challenges of better management, capital appreciation and shareholder wealth maximization. Current and prospective investors in these firms will be able to understand better the capital structure of the firms they have invested in or seek to invest in and its impact on the firm’s financial performance, how its change impacts on the firm’s value and if the firms return can cause it to change its capital structure and what the consequences of such a choice would be. This will further inform their investment decisions lowering the risks of investing blindly. The researcher hopes that the findings from the study shall be useful to the business community since it will throw more light on the role that capital structure has in determining financial performance. Shareholders will understand more about the capital structure, firm’s value and firm’s returns and how they are related and in turn affect each other. This will help them in making informed decisions at the Annual General Meetings while being faced with issues of capital structure changes and firms value determination. Capital structure is a wide study where a lot of research had been done. Yet, there is no empirical evidence that it has been exhaustively covered and that all options that relate to it have been researched and reviewed. Thus, additional information based on concrete evidence will be a welcome additive to the existing scope of knowledge. CHAPTER TWO: LITERATURE REVIEW Introduction This chapter examines the literature relevant to the study. It follows the conceptual framework, incorporate scholarly works and theories. The rationale of the study is to ascertain the role capital structure plays in determining financial performance. The literature under review was obtained from journal articles, websites and text. Components of capital structure Different firms have different capital structures. Firms have an option of either equity or debt to finance their assets. Gachoka, (2005) argues that businesses have only two options in which they can raise money; either through debt or equity. However, Brigham, & Houston, (2005) concluded that the choice between equity and debt financing options has no effect on the overall value of the firm. The debt component in the capital structure consist borrowed funds which include both short-term and long-term debts (Kitaka, 2013). Debt is the aggregate of all interest bearing liabilities of a firm, long term as well as short term. Use of debt in a firm always leads to agency costs (Block, & McMillan, 2005). A firm would maximize its value if its assets are fully financed by debt where interest on debt is tax allowable. However, if interest on debt is not tax allowable, the owners of the firm may be indifferent whether to use debt or equity, Abor, 2007) argues that where debt is used as a financing option, the creditors are paid back their principal amount and interest on debt which is fixed amounts according to the contract between the lender and the borrower. Failure to pay principal amount and interest may lead to legal actions by the firm’s creditors (Brigham, & Houston, 2005). Increased debt financing leads to increase in fixed legal payments to creditors in form of principal and interest which may lead to liquidity problems making the firm unable to effectively pay principal and interest when due. However, increased debt in the capital structure of a firm may lead to increased value of the firm due to tax benefits, Abor, (2007) argues that to reduce the risk associated with debt, the firm may opt for equity as a source of finance more than debt financing to finance expected investment opportunities that are likely to spur growth opportunities. This will positively reflect on the performance of the firm. On the other hand, equity component includes common stock, preferred stock and other reserves including retained earnings. In equity financing, the firm is not under obligation to distribute its earnings to shareholders. Though the firm may opt to pay dividends or repurchase back its shares from the shareholders, the firm is under no obligation (Gachoka 2005). Firms that finance their investments using equity finance are more profitable than those firms that prefer borrowed funds to finance investments. (Block, & McMillan, 2005) argues that a firm must endeavor to achieve the optimal capital structure or the best mix of financing in order to maximize profitability, return on investments, and increase its value as well as reduce the overall cost of capital. A firm’s cost of capital is a function of its capital structure. Abor, (2007) argued that the choice of optimal capital structure would reduce the cost of capital and increase the shareholder’s wealth. The optimal capital structure is the mix of various components that yields the highest value of the firm. Theoretical Literature Review Theoretical literature review in this study will highlight the major capital structure theories. Capital structure theories were started by David 1979 when they wrote a paper on capital structure irrelevance theory from which other theories have emerged. Most of the research work done in capital structure has been conducted with data from developed countries (Block, & McMillan, 2005) Capital Structure Theory Capital structure puts into perspective the way in which a firm finances its operations. Apparently, this can either be through debt or equity capital or a combination of both David (1979). Capital structure theory as attributed to Modigliani and Miller concluded that it doesn’t matter how a firm finances its’ operations and that the value of a firm is independent of its’ capital structure making capital structure irrelevant. The study was based on the assumption that there were no brokerage costs, earnings before interest and tax were not affected by the use of debt and that investors could borrow at the same rate as corporations and lastly there was no information asymmetry. Although this statement didn’t reject the possible preference of a firm’s owner to a certain type of financing over others, it did affect the irrelevance of the value of the firm to the means of financing it given a perfect market (Abor, 2007). A number of theories were from then onward advanced to explain capital structure notable among which are the pecking order theory and trade off theory which have been often than not a centre of debate. Modigliani-Miller Theory (1958) The Modigliani-Miller theorem (of Franco Modigliani, Merton Miller) forms the basis for modern thinking on capital structure. The basic theorem states that, under a certain market price process (the classical random walk), in the absence of taxes, bankruptcy costs, and asymmetric information, and in an efficient market, the value of a firm is unaffected by how that firm is financed. It does not matter if the firms capital is raised by issuing stock or selling debt. It does not matter what the firms dividend policy is. Therefore, the Modigliani-Miller theorem is also often called the capital structure irrelevance principle. The theorem was originally proven under the assumption of no taxes. It is made up of two propositions which can also be extended to a situation with taxes (Abor, 2007). Consider two firms which are identical except for their financial structures. The first (Firm U) is unlevered that is, it is financed by equity only. The other (Firm L) is levered: it is financed partly by equity, and partly by debt. The Modigliani Miller theorem states that the value of the two firms is the same. Agency Costs Theory There are three types of agency costs which can help explain the relevance of capital structure. Asset substitution effect: As Debt to Equity ratio increases, management has an increased incentive to undertake risky (even negative NPV) projects. This is because if the project is successful, share holders get all the upside, whereas if it is unsuccessful, debt holders get all the downside. If the projects are undertaken, there is a chance of firm value decreasing and a wealth transfer from debt holders to share holders. Underinvestment problem: If debt is risky (e.g. in a growth company), the gain from the project will accrue to debt holders rather than shareholders. Thus, management has an incentive to reject positive NPV projects, even though they have the potential to increase firm value. Free cash flow: unless free cash flow is given back to investors, management has an incentive to destroy firm value through empire building and perks etc. Increasing leverage imposes financial discipline. Pecking Order Theory of capital structure The pecking order theory as developed by Myers (1984) stated that firms prefer internal sources of finance; they adapt their target dividend payout ratios to their investment opportunities although dividends and payout ratios are gradually adjusted to shifts in the extent of valuable investment opportunities. In addition, Myers (1984) stated that in the event that external finance is required, firms are most likely to issue the safest security first that is to say they start with debt then possibly convertible debt then equity comes as last resort. In summary, Myers’ argument was such that businesses adhere to a hierarchy of financing sources and prefer internal financing when available. Should external financing be required, debt would be preferred over equity. Pandey (2005) also concurred with Myers’ argument when he noted that managers always preferred to use internal finance and would only resort to issuing shares as a last resort. He went on to add that the pecking order theory was able to explain the negative inverse relationship between profitability and debt ratio within an …