The Effect of Capital Structure on Share Price on Listed Firms In
Kenya. A Case of Banking Listed Firms
BY;
BENARD LUTA
DAYSTAR UNIVERSITY
P.O BOX
NAIROBI
PROPOSAL PRESENTED TO;
DAYSTAR UNIVERSITY
NOVEMBER, 2014.
DECLARATION
This proposal is my original work and has not been presented for a degree in any other university
Signature……………………………………………………. Date…………………………………………….
Student: BENARD LUTA
This proposal has been submitted for examination with my approval as University Supervisor.
Signature………………………………………………….. Date……………………………………………
TABLE OF CONTENTS
Title Page……………………………………………………………………………………I
Declaration………………………………………………………………………………… ii
Table of content…………………………………………………………………………….iv
Abstract …………………………………………………………………………………….v
CHAPTER ONE: INTRODUCTION…………………………………………….……. 1
1.1 Research Background…………………………………………………………………. 1
1.2 Research Problem Statement………………………………………………………….. 3
1.3 Research Objectives…………………………………………………………………… 3
1.4 Research Questions……………………………………………………………………3
1.5 Justification of the study…………………………………………………………….….4
1.6 Research Scope ……………………………………………………………………….. 4
1.7 Research hypothesis…………………………………………………………………….4
CHAPTER TWO: LITERATURE REVIEW………………………………………… 5
2.1 Introduction ……………………………………………………………………………5
2.2 Theoretical Review…………………………………………………………………….5
2.3 Empirical Review………………………………………………………………………9
CHAPTER THREE RESEARCH METHODOLOGY…………………………10
3.1 Research design……………….…………………………………………………10
3.2 Population ……………………………………………………………………….10
3.3 Sampling frame…………..……………………………………………………… 11
3.4 Sample and sampling technique………………………………………………… 11
3.5 Instruments…………………………………………………………………….. 12
3.6 Data collection procedure……………………………………………………… 12
3.7 Pilot test………………………………………………………………………… 13
3.8 Data processing and analysis…………………………………………………… 13
REFERENCES…………………………………………………………………….. 14
APENDICES………………………………………………………………………. 15
Abstract
This study is aimed at analyzing the effects of changes in capital structure on the stock price of listed banks in Kenya. Managers are always worried about the implications of their capital structure choices on stock price and market value. Conducting this research will solve this problem since it will create awareness to managers concerning the effect of their capital structure decisions on stock price. The major objective of this project is to investigate the relationship between changes in capital structure and stock price of listed banks in Kenya.
Ratio analysis is one of the major techniques that can be used to analyze the capital structure of a company. The study will therefore use debt to equity ratio, debt to asset ratio, and interest coverage ratios as the independent variables. The stock price will be use as the dependent variable. This study will be based on the banking sector in Kenya. Four banking companies actively trading in the Nairobi Securities Exchange will be selected. Data concerning these companies will be collected for a period of between the years 2008 to 2012. Secondary data will be collected from financial statements of the selected companies while stock prices will be collected from Nairobi Securities Exchange (NSE). The study will apply descriptive statistics, simple and multiple regression analysis during data analysis. This will assist in finding out the relationship between change in Capital structure and stock prices of listed banks in Kenya.
CHAPTER 1: INTRODUCTION
1.1 Background
The study aims at finding out the relationship between change in capital structure and stock price of listed banks in Kenya. According to (Brigham, E. F., & Houston, J. F. 1998),a manager’s major role is to maximize the shareholders wealth. There is therefore, the need to analyze the change in the share price, as this will serve as a clear indicator of shareholders value. Essentially, shareholder wealth is the number of shares outstanding times the market price per share. Thus, there is need to study factors affecting change in share price. One of the factors that affect share price of a company is change in capital structure.
Banks are examples of institutions that provide financial services to both low-income and high-income clients. The institutions are therefore a major contributor towards financial intermediation. In order for these institutions to increase customer and shareholder value, it’s important to study the factors that may lead to value creation. One of these factors includes the capital structure components such as equity or debt. Firms that do not pay close attention to these variables may end up with lower returns in future.
The capital structure of the banking institutions has become a global issue in the field of finance. Since one of the major objectives of a firm is to maximize shareholders’ wealth, the question of how best to finance these organizations is a key issue. This study therefore examines the existing sources of funding for the banks, and explores how changes in in such sources could affect the share price. This paper is related to work by Estrella, Park, and Peristiani (2000) that tested how alternative capital ratios fared in predicting U.S. bank failures in the early 1990s, and found that a leverage ratio performs just as well as a risk-adjusted measure of capital. Berger and Bouwman (2009) explored the relationship between bank capital and different aspects of banks performance in crises and tranquil times for U.S. banks. Crises included both banking crises and stock market crashes. The studies conducted by such researchers in the U.S banking sector provided a clear indication that banks an optimum capital level that ensures wealth maximization
Studies on the impact of capital structure on a firm’s share price have in most cases been carried out in developed economies on large and listed firms. Several research questions remain unresolved in the banking industry in Kenya where information asymmetry is severe. Since the seminal contribution by Modigliani and Miller (1958), several subsequent studies show that a firm with high leverage tends to have a capital structure that translates into a better performance, and this leads to creation of shareholder value. The basic MM principles are applicable to lending institutions, but only after accounting for the fundamental differences in how lenders and corporations operate. This has acted as one of the motivating factors towards conducting this research.
Previous studies have indicated that the earnings per share (EPS) increase with an increase in debt-to-equity ratio. There have also been attempts to maintain an optimal capital structure. This is a combination of both equity and debt that maximizes not only earnings but also the stock price of the company. It is, therefore, evident that there is need to study the relationship between change in capital structure and the stock price. This may provide a company with the necessary knowledge to determine the optimal capital structure that maximizes its earnings and stock price.
1.2 Statement of the problem
Share price determination is a contradictory task, affected by lots of factors. However, some only few studies have conducted in developing countries like Kenya. The perspective of this paper is to determine the preferred sources of financing by Kenyan listed firms and in particular the banking sector. The banking sector is unique because of the huge demand for their services in the country and this is an opportunity to examine the effect of change in debt-equity ratio on stock price of the listed banks that are experiencing growth and huge capital investments.
1.3 Statement of objectives.
The General objective of the study is to investigate the relationship between changes in capital structure and stock price of listed banks in Kenya. The specific objectives include;
To study the effect of change in debt-equity ratio on stock price of the listed banks in Kenya
To study the effect of change in debt-to-asset ratio on the stock price of listed banks in Kenya
To study the effect of change in interest coverage ratio on the stock price of listed banks in Kenya.
1.4 Research questions
Is there any change in the debt equity ratio of the listed banks in Kenya?
Is there any effect of change in the interest coverage ratio on the stock price of the listed banks in Kenya?
What is the effect of change in debt-asset ratio on the stock price of the listed banks in Kenya?
What is the effect of change in interest coverage ratio on the stock price of the listed banks in Kenya?
1.5 Justification
This study will be conducted because there is need to understand the effects of funding sources on the share price of listed banks in Kenya. Understanding their effects and dynamics will help in proper management of different sources of funds in order to enhance growth and shareholders’ maximization. Thus, the investors will use the findings of this research to make appropriate decisions. For example, investors may decide to either buy the shares or sell the shares based on the information provided by this research.
1.6 Scope
The scope of this study will be limited to the listed banks in Kenya. The banks include: Barclays Bank of Kenya, CFC Stanbic Holdings Ltd, Diamond Trust Bank of Kenya, Housing Finance Co. Ltd, Kenya Commercial Bank Ltd, the National Bank of Kenya, NIC Bank Ltd, Standard Chartered Bank Ltd, Equity Bank Ltd, and the Co-operative Bank of Kenya. The reason these banks appear in this list because they belong to a category of the best performing institutions in the Nairobi Securities Exchange.
1.7 Hypothesis
This study hypothesizes that changes in the capital structure components such as debt or equity funding instruments can affect the market stock price of listed banks in Kenya.
CHAPER 2: LITERETURE REVIEW
2.1 Introduction
Literature review estimates solutions to the problem being investigated and gives highlights on the theoretical explanation of the problem. It also provides the previous research studies that had been conducted about the same problem. Such studies may have been done by either organizations or individuals and documented in sources such as journals, reports, magazines, books or papers
The main aim of the literature review is to avoid circumstances in which more people research on the same subject that had been tackled by the earlier researchers. This chapter illustrates the research gaps, theoretical review and conceptual review of research parameters.
2.2 Theoretical review
In this section we review theories such as the trade off, agency, and pecking order theories of capital structure and relate the same to listed banks in Kenya. One of the most important financial decisions confronting a firm is the choice between debt and equity. The seminal paper dealing with irrelevance of debt in capital structure for determining firm value by Modigliani-Miller (1958) included a number of assumptions—one of which was absence of corporate tax. Subsequently, when Modigliani-Miller (1963) factored corporate tax in the model, it was found that theoretically the value of a firm should increase with debt because of higher interest tax shield. But monotonic increase of debt for higher tax shield increases bankruptcy cost especially when profitability of the firm is low and fluctuating. This leads to ‘trade off’ theory of capital structure that postulates an optimum debt level or target level, where the marginal increase of present value of tax saving is just offset by the same amount of bankruptcy cost. Although we may not be able to determine the exact debt target level objectively in the listed banks, trade off theory explains that there is a limit to debt financing and the target debt may vary from one bankto another depending on profitability, among many of other factors.
The capital structure of a firm plays a very important role in the determination of a firm’s value. This fact has been propagated by most finance theories. This, therefore, implies that changes in leverage of a firm result to changes in stock returns. This research will propose and test several hypotheses to explain the relationship between capital structure and stock price. Several researches done in the field of finance have revealed that the negative relationship is stronger for firms with very high leverage level. This is evident in the pecking order theory, which asserts that an increase in leverage reduces a firm’s debt capacity. This may lead to low rate of investment in the future.
It is evident that firms are most likely to issue equity when their market values are high, relative to the book value and their values in the past. Consequently, the current capital structure of a firm has a strong relationship with the past market values of equity. According to (Baker and Wurgler, 2002), capital structure is the cumulative of past attempts to time the equity market.The research will involve an empirical study that tests the relationship between leverage and the stock returns of a firm. The works of Modigliani-Miller (1958) assert that returns increase in leverage.
Using a the details from the listed banks in Kenya, the research will also revisit Welch’s (2004) findings that states that stock returns are the fundamental determinants of capital structure changes. Welch’s findings can provide a basis to believe that there is a relationship between changes in capital structure and the stock price of a company.
The alternative theory of finance known as ‘pecking order’ theory was developed by Myers (1984). It is based on the premise that in reality successful firms with high and consistent profitability rarely go for debt financing. The origin of pecking order theory is asymmetric information where managers know more about a firm’s prospect than the outside investors. The theory suggests that if the firm issues equity shares to finance a project, it has to issue shares at less than the prevailing market price. This signals that the shares are over-valued and the management is not confident to serve the debt if the project is financed by debt. Thus issue of shares is ‘bad news. On the contrary, if external borrowing is used to finance the project, it sends a signal that the management is confident of the future prospect of serving debt. Hence debt is preferred over shares in financing decision. If debt is issued, pricing of debt instrument remains a problem. To avoid controversy the management may wish to finance project by internal fund generation, i.e. by retained earnings. Thus, financing follows an order, first-retained earnings, then-debt and finally equity when debt capacity gets exhausted. This explains why the profitable firm uses less debt.
(Joe, 2008) finds that there is a significant negative effect of the change in a firm’s leverage ratio on its stock prices. This effect is stronger for firms with limited debt capacity. He also documented that firms with an increase in leverage ratio tend to have less future investment, even after controlling for growth option and target leverage. These findings are consistent with a dynamic view of the pecking-order theory that an increase in leverage reduces firms’ safe debt capacity and may lead to future underinvestment, thus reducing firm value.
2.3 Conceptual Framework
The theories on capital structure demonstrate the effect of capital gearing on WACC (Weighted Average Cost Of Capital) , the value of the business and shareholder’s wealth. The traditional theory encourages companies to take on debt so as to reduce WACC, since at low levels of gearing the increased cost of equity is not important. At high levels of gearing the returns expected by both shareholders and lenders increases pushing WACC higher. However, just before shareholders’ and lenders’ returns begin to increase, shareholders’ wealth is maximized and this is the point where WACC is at its minimum. The Modigliani and Miller (MM) view on capital structure is that when debt is introduced, shareholders would require a higher return. However, the low cost of debt compensates for the high expectation of shareholder’s returns therefore the effect on WACC is zero.
According to Nirmala (2011) that more debt content in the capital structure of a firm decreases, its share price rise and vice versa. This indicates that investors prefer firms with lower debt content, since increased use of debt by a firm lowers the earnings available for equity shareholders and investors become apprehensive about their returns. In developing countries control on the prices in the security markets along with government directed credit programmes to preferred sectors could have a significant impact on corporate financing patterns
Independent variablesDependent variable
Debt to equity ratio
Debt to total asset ratio stock price
Interest coverage ratio
The above mentioned ratios provide an insight about the proportion of debt to equity financing. The total debt to total asset ratio measures the percentage of assets financed with debt. A low percentage implies that the company is less dependent on leverage.
The total debt to total equity ratio measures debt financing as a percentage of total financing. This ratio provides a measurement of how much suppliers, lenders, and creditors have committed to the company versus what the shareholders have committed.
The Earnings Coverage ratio, on the other hand, measures the extent to which an entity can meet its fixed charges. The ratio is used to determine how easily a company can pay interest expenses on outstanding debt .When this ratio is lower the ratio, it is an indicator that the company is burdened by debt expense.
CHAPTER 3: METHODOLOGY
3.1 Research design
This research will take a correlation approach. According to Sekaran (2002:123), a correlation research involves collecting data to determine whether a relationship exists between two or more quantifiable variables.
Correlation techniques are generally intended to answer 3 questions:
Is there a relationship between the two variables?
If the answer is yes, what is the direction of the relationship? Is it a positive or negative relationship?
What is the magnitude of that relationship?
Observations will be made on the sampled listed banks at the beginning of the analysis and then every subsequent year over a 5-year period. Using the observational data, we can determine how the dependent variables relate to the independent variable. The changes in such variables provide an answer to the nature of the relationship.
Furthermore, since we are interested in the direction of the relationship between the dependent and independent variables, a simple retrospective directional analysis can be determined from the data obtained.
3.2 Population
A population is the entire group of people, items or cases from which the researcher will want to gather data from. The population of this study will consist of all the banks listed in the Nairobi Securities Exchange (NSE).
3.3 Sample
Ideally, one would want to study the entire population. However, it is usually impossible or unfeasible to do this and therefore one must settle for a sample. According to Black and Champion (1976), a sample is a portion of elements taken from a population, which is considered to be representative of the population.
The sample of the study will be collected randomly. However there will be consideration of the banks that were thriving well in the Nairobi Securities Exchange. The sample of the following banks will be selected:
Barclays bank ltd
Kenya Commercial bank ltd
National bank of Kenya
The Co-operative Bank of Kenya
3.4 Sampling frame
A sampling frame is a list, map, or other specification of sampling units in the population from which a sample may be selected (Sharon L. Lohr).For our case, the sampling frame will be a list of banking companies listed in the Nairobi Securities Exchange (NSE)
3.5 Sampling technique
The sampling technique will be convenient sampling. This is sampling technique that is made up of items that are easy to reach.
3.6 Research Instruments
The following research instruments will be utilized during the study;
The questionnaires
Interview schedules.
The questionnaires will be administered to bank managers. In order to give the respondents complete freedom of response, the questionnaires will be open-ended. Additionally, the study will use three types of ratios to investigate the effect of capital structure on the stock price. The ratios will include total debt ratio: total liabilities/total assets, debt to asset ratio: total debt/assets, and coverage ratio: operating profit/interest charges.
3.7 Data collection procedure
For the purpose of this research, and in order to achieve its objectives, data will be collected both from primary and secondary sources. The Secondary data will be obtained from the annual financial statements of the listed banks. Such financial statements will include the balance sheets and profit and loss accounts. The secondary sources will also include articles, books, the internet, and the NSE published reports.
Primary data will be collected in two ways. Firstly, a questionnaire survey will be conducted with the managers within the banks selected for the study. Secondly, interviews will also be carried out with selected experts who analyze the financial statements of the companies.
3.8 Pilot test
The questionnaires will be tried out in the field before the actual data collection process begins. This will be done to a selected sample, which is similar to the actual sample. The subjects in the actual sample will not be used to pre-test. During this process, subjects will be encouraged to make comments and suggestions concerning instructions, clarity of questions and relevance
3.9 Data processing and analysis
Data will first be edited for accuracy, consistency and completeness. It will then be arranged and coded using MS. Excel. After the analysis, data shall be presented using tables, graphs and pie charts.
Ratio analysis will be conducted for the selected four companies. This will be done for five year period, 2008-2012.The result of this analysis will be presented in a table to demonstrate the trend. Periods of maximum and minimum stock price values will be noted and the values of capital structure ratios will be compared against such values in order to determine the relationship.
Regression analysis will be used to determine the relationship between the dependent and independent variables. Values of correlation coefficient(r) will be calculated to determine the extent to which a variable depends on the independent variable.
References
Cai, Jie, & ZHANG, Zhe (Joe). (2008). Leverage Change, Debt Capacity, and Stock Prices.Institutional Knowledge at Singapore Management University.
Baker, H. K., & Martin, G. S. (2011).Capital structure & corporate financing decisions: Theory, evidence, and practice. Hoboken, N.J: John Wiley & Sons.
Brigham, E. F., & Houston, J. F. (1998).Fundamentals of financial management. Fort Worth: Dryden Press.
Feld, L. P., Heckemeyer, J. H., Overesch, M., UniversitätMünchen., Ifo-InstitutfürWirtschaftsforschung.,&CESifo. (2011). Capital structure choice and company taxation: A meta-study. Munich, Germany: CESifo, Center for Economic Studies &Ifo Institute for Economic Research.
Katagiri, M., & Nihon Ginkō.(2011). A macroeconomic approach to corporate capital structure. Tokyo: Institute for Monetary and Economic Studies, Bank of Japan.
Agarwal, Yamini. (2013). Capital Structure Decisions: Evaluating Risk and Uncertainty. John Wiley & Sons Inc.
CGAP. (2004). “Financial Institutions with a “Double Bottom Line”: Implications for the Future of Microfinance.” (The Consultative Group to Assist the Poor (CGAP): Occasional Paper
No. 8)
CGAP. (2004). “Financial Institutions with a “Double Bottom Line”: Implications for the Future of Microfinance.” (The Consultative Group to Assist the Poor (CGAP): Occasional Paper
No. 8)
Cohen, R. D. (2003). “The Optimal Capital Structure of Depository Institutions.”WILMOTT Magazine, 38-49.
APPEDNICES
Appendix 1:
Capital Structure Questionnaire
The capital structure of listed banks in Kenya
Please tick the appropriate space or fill in the blanks.
1. Name of the Bank: ___________________
(The name of the bank will only be for the identifiable purpose for this research.)
2. Please indicate the size of the bank by annual profits.
Under 100 million [ ] 101 – 1,000 million [ ]
5,001 – _10,000 million [ ] over 10,000 million [ ]
3. Is the bank concerned about the type of funding instrument in the operation?
Yes [ ] (Please answer question 4-9) No [ ] (Please go to question 10)
4. Who makes the decision concerning the type of funding instrument when new finance is required?
a. Financial director
b. The board of directors
c. Other (please specify) _______________
5. What is your firm’s level of the following sources of finance?
Equity Long-term debt
a. less than 20% [ ] [ ]
b. between 20-40% [ ] [ ]
c. between 40-60% [ ] [ ]
d. between 60-80% [ ] [ ]
e. more than 80% [ ] [ ]
6. Do you consider the bank’s capital structure optimal?
Yes [ ] No [ ] Do not know [ ]
7. Does the bank have a target level of the above financing sources?
Yes [ ] No [ ] Do not know [ ]
(If yes, what is your target level for each?) Equity ————–Long-term debt————–
8. Are you familiar with the following capital structure theories?( If yes, tick)
a. Pecking order theory [ ]
b. Trade-off theory [ ]
c. Modigliani and Miller [ ]
d. Market timing theory [ ]
e. Argument about Tax-based [ ]
f. Argument about Signaling [ ]
g. Argument about Agency cost [ ]
9. Have you considered any of the following theories affect the way you operate your
Company?
a. Pecking order theory [ ]
b. Trade-off theory [ ]
c. Modigliani and Miller [ ]
d. Market timing theory [ ]
e. Argument about Tax-based [ ]
f. Argument about Signaling [ ]
g. Argument about Agency cost [ ]
10. If your firm is not concerned about the type of financing instrument, please give the reason: ————————————–
And please specify what your capital structure is relied upon: ————————
Thank you for completing the survey
Appendix 2
TIME PLAN FOR THE PROJECT
ACTIVITY TIME (MONTHS)
Research Proposal Writing November (2014)
Approval of Research Proposal November (2014)
Administration of Questionnaires and interviews December (2013)
Data analysis and conclusionJanuary (2014)
Presentation and DefendingJanuary (2014)
