Capital Structure Determinants: The Case for Kenyan Banks
CAPITAL STRUCTURE DETERMINANTS
THE CASE OF THE KENYAN BANKING INDUSTRY
TABLE OF CONTENTS
1. INTRODUCTION
Capital structure refers to the mix of debt and equity which a firm uses to finance its operations. Many theories have been formulated with regard to whether there exists an optimal capital structure mix and the role the various determinants of capital structure play in deciding the mix. The Modern theory of capital structure began with Modigliani and Miller in 1958 (Harris and Raviv, 1991) where they 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 and they assumed perfect and frictionless capital markets. (Myers, 2001) There have been a lot of theoretical contributions to the Modigliani & Miller work.
A number of theories such as the Trade-off Theory, the Pecking Order Theory and the Agency Theory have thus been developed in the attempt to explain the financing decision of companies and if an optimal capital structure exists. The trade-off theory states that the optimal debt ratio is set by balancing the trade-off between the benefits (such as interest debt tax shield) and costs (such as bankruptcy costs) of debt. The pecking order theory proposes that due to information asymmetry and to avoid public scrutiny, companies prefer internal funding to external funding (Myers & Majluf, 1984). The Agency Cost Theory on the other hand predicts the capital structure choice is based on the existence of agency cost. This theory investigates the relationship between the manager of the firm, and the outside equity and debt holders. Generally a higher debt level ensures that the management is more disciplined (Jensen & Meckling, 1976). However, most of these theories differ in their relative emphasis on and interpretation of these factors according to Myers. (2001)
Empirical research to support or disapprove these theories
THE CASE OF THE KENYAN BANKING INDUSTRY
TABLE OF CONTENTS
1. INTRODUCTION
Capital structure refers to the mix of debt and equity which a firm uses to finance its operations. Many theories have been formulated with regard to whether there exists an optimal capital structure mix and the role the various determinants of capital structure play in deciding the mix. The Modern theory of capital structure began with Modigliani and Miller in 1958 (Harris and Raviv, 1991) where they 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 and they assumed perfect and frictionless capital markets. (Myers, 2001) There have been a lot of theoretical contributions to the Modigliani & Miller work.
A number of theories such as the Trade-off Theory, the Pecking Order Theory and the Agency Theory have thus been developed in the attempt to explain the financing decision of companies and if an optimal capital structure exists. The trade-off theory states that the optimal debt ratio is set by balancing the trade-off between the benefits (such as interest debt tax shield) and costs (such as bankruptcy costs) of debt. The pecking order theory proposes that due to information asymmetry and to avoid public scrutiny, companies prefer internal funding to external funding (Myers & Majluf, 1984). The Agency Cost Theory on the other hand predicts the capital structure choice is based on the existence of agency cost. This theory investigates the relationship between the manager of the firm, and the outside equity and debt holders. Generally a higher debt level ensures that the management is more disciplined (Jensen & Meckling, 1976). However, most of these theories differ in their relative emphasis on and interpretation of these factors according to Myers. (2001)
Empirical research to support or disapprove these theories
References: Basel III: A Global Regulatory Framework for more Resilient Banks and Banking System. (2010). Retrieved on 21st April 2013, from http://www.bis.org/publ/bcbs189_dec2010.htm Brealey, R Deesomsak, R., Paudyal, K., and Pescetto, G., 2004. The determinants of capital structure: evidence from the Asia Pacific region, Journal of Multinational Financial Management. Retrieved 20 May, 2013 from Jstor Database. Goyal, V. K. & Frank, M. Z., 2003. Testing the pecking order theory of capital structure. Journal of Financial Economics, Volume 67, pp. 217-248. Gropp, R. & Heider, F. (2009). The determinants of bank capital structure. Working paper series no. 1096. Retrieved 20 April, 2013 from http://www.ecb.europa.eu Jensen, M., & Meckling, W Lemmon, M., Roberts, M. & Zender, J. (2008) Back to the beginning: Persistence and the cross-section of corporate capital structure, Journal of Finance 63. Retrieved 20 April, 2013, from Jstor database. Marques, O. & Santos, C. (2003). Capital structure policy and determinants. Evidence from Portuguese banking industry. Modigliani, F. & Miller, M. (1958). The cost of capital, corporation finance and the theory of investment’, the American Economic Review, vol. 48, pp. 261-297. Retrieved 20 April, 2013, from Jstor database. Myers, S. & Majluf, N. (1984). Corporate financing and investment decisions when firm have information that investors do not have, Journal of Financial Economics, Vol. 13, pp. 187-221. Retrieved 20 April, 2013, from Jstor database. Myers,C.S (2001) The Capital Structure. Journal of Economic Perspectives, volume 15,(pp. 81-102). Retrieved on 19th April 2013 ,from jstor database Nyamora, I.(2013) Shibru W. (2012). Determinants of capital structure: An Empirical Study on Ethiopian Banking Industry. Unpublished master’s thesis, Addis Ababa University, Addis Ababa. Rajan, R. G. & Zingales, L., 1995. What Do We Know about Capital Structure? Some Evidence from International Data. The Journal of Finance, 50(5), pp. 1421-1460. Titman,S & Wessels,R.(1988) Determinants of Capital Structure Choice. Journal of Finance, volume 43, (pp. 1-19). Retrieved on 19th April 2013,from jstor database Welch, I