Modigliani and Miller theory review



2.1.   Introduction


This chapter presents a review of the literature available on the firm-specific factors such as profitability, firm growth, firm size and firm risk and how they affect the capital structure of insurance companies.

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The chapter is organized as follows: theoretical review, conceptual framework, empirical review, critical review, research gaps and finally, the summary of the chapter is presented.


2.2.   Theoretical review


The theoretical context of the analysis focuses a lot on the impact of the firm’s specific factors on the structure of the capital model. The following are some of the hypotheses relevant to this research: the M & M theory, the Trade-off theory, the pecking-order model and agency theory.


2.2.1   Modigliani and Miller theory


According to this model, capital structure has no significance on an enterprise’s value as long as there are no bankruptcy costs or corporate taxes in ideal market conditions. The ratio of liabilities to equity does not affect the capital expense of the company. Its properties solely determine an enterprise’s value, so it can’t be altered by managing capital structure. Recommendations advanced by M & M and in 1958 and 1963 exists who, utilizing monetary hypothesis, set up the unique Modigliani and Miller proposition I and II, also known as MMI and MMII.

The first proposition of MM1 was based on the following assumptions: capital markets are flawless and perfect, and no single person has the power to influence commodity costs. With the arbitrage incentive and opportunity, all assets are priced efficiently.

Second, there are no agency expenses, meaning that the incentives of shareholders, employees, and creditors are properly aligned. Third, no taxes are levied. The taxation effect is negligible and does not affect this model. Fourth, there are no bankruptcy or transaction costs, which are legitimate and endorsing costs associated with value issues.

Fifth, for obligation issues, this can be the contracts forced by loan bosses, just as the potential lawful and managerial costs that might be brought about amid bankruptcy procedures when budgetary hazard is excessively high. 6th, standard financial specialists can acquire at a similar rate as firms; that is, no one market member is of such a size to have the option to impact the expense and accessibility of obligation money. Individual adapting is said to be a substitute for corporate equipping.

In conclusion, there is a perception that there is no data asymmetry amongst market participants, meaning that any standard financial professional has the same information as the company’s management about the company’s potential speculation opportunities. Financial experts are said to act rationally, make similar predictions about future events, and are uninterested in taking risks.

According to MM I, changes in an organization’s capital structure have no long-haul consequences for its reasonable worth, consequently in addition to the market estimation of an enterprise.


             Cost of equity

      Cost of capital


                                                                                                        The total cost of capital

                                                                                                                 Cost of debt


                               Level of borrowing


                     Figure 2.1: Modigliani and Miller proposition I


Modigliani and Miller (1958) “The Cost of Capital, Corporation Finance and the Theory of Investment”


Figure 2.1 illustrates the Modigliani and Miller Proposition I, which assumes that the overall cost of capital of a firm will remain constant at various levels of gearing.

The firm’s financial risk increases as it takes on larger amounts of less risky debt funding. Standard investors will now need a more thorough re-evaluation of how much they should be compensated for this increase in financial risk. The increased return required by ordinary investors negates the benefit of any less costly debt financing and results in the usual cost of borrowing.

After much criticism of their proposition, I, Modigliani and Miller revised their thinking and put forth their second proposition in 1963. The second proposition (MM II) relaxes the assumption of no taxes and considers that interest payable on debt is tax-deductible.




                Cost of equity

       Cost of capital


           The total cost of capital



                                                                                                                      Cost of debt


           Level of borrowing


Figure 2.2: Modigliani and Miller proposition II

Source: Modigliani and Miller (1963). “Corporate income taxes and the cost of capital: a correction.”


Figure 2.2 illustrates MM II, whereas debt financing increases, the overall cost of capital decreases. Interest on debt is an allowable expense when determining a company’s tax liability and lowers the tax burden. Thus it has the effect of shielding corporate profits, which is a benefit to the ordinary shareholder. As the degree of debt obligation increments, so too does the tax benefits, which counterbalances a portion of the risk that the common investor would require as per MM I. As the increases in the required return by ordinary shareholders is lower than the benefits of debt, the overall cost of capital decreases as the level of borrowing increases. In the absence of bankruptcy costs and financial distress implications, MM II promotes high levels of debt financing due to the after-tax cost of debt being lower than the cost of equity and decreasing the overall cost of capital to the firm. One can conclude that to continue in this manner, the optimal level of capital is at a 100% level of gearing (Atrill, 2009).

Miller (1988) revised MM II to take into account the effects of personal taxes and corporate taxes. In essence, Miller stated that due to returns on stocks being taxed at relatively lower rates to returns on bonds/debt, an investor would be willing to accept a lower pre-return from stocks relative to the pre-tax return on bonds/debt. He pointed out two key findings. First, the deductibility of interest for tax purposes makes the use of debt financing favourable for a firm. Secondly, the lower tax rates on returns from equity for the investor lowers the cost of equity and makes equity financing more favourable for the firm. These two statements are directly opposed to each other and leave one with the question, which is a better method of financing to use, debt or equity? Miller proved that although the presence of personal taxes lowers the cost of equity financing, it does not completely offset the savings from the lower cost of debt financing.


There is, however, a fundamental difference between debt financing and equity financing in the real world with corporate taxes. Dividends paid to shareholders come from the after-tax profit. By contrast, interest paid to bondholders comes out of the before-tax profits. Modigliani and Miller (1963) suggest that a value-maximizing firm can obtain a target capital structure in the presence of corporate taxes. In other words, if the market is not perfect, and this is the case with insurance firms operating in Kenya, as a result of, say, the existence of taxes, or of underdeveloped financial markets, or the inefficient case, firms must consider the costs entailed by these imperfections. A proper decision on the capital structure can be helpful to minimize these costs.


The Miller and Modigliani theory is considered critical for this study because it provides the background of the capital structure debate. Their first seminal paper (1958) made their first proposition which kicked of the capital structure debate. Then after much criticism, they came up with the second position (1963). Many of the study’s that studied the theory of capital structure either supported the first proposition or the second.

2.2.2   The trade-off theory


This model was developed as a result of debates surrounding the theorem developed by M & M. introduction of corporate tax to the original M & M proposition led to the creation of the debt benefit. It shielded earnings from taxation. Kraus and Litzenberger (1973), the proponents of this theory, assert that optimal leverage represents the trade-off between the paybacks of tax shield inherent in liability and the charges associated with bankruptcy. Myers (1984), on the other hand, reveals that if a firm is following this theory, it ought to set debt to value ratio as it gears towards its target.

Merit discussion, according to Myer evokes a myriad of discussion that includes thetarget not being observable directly. Still, instead, it could be imputed from the evidencedependingontheadditionofastructure.

Bradley et al. (1984) observe that the tax structure which is assumed is not realistic as it is implied. For example, the dynamic aspects of the tax code are or presented properly in the single-period model but the model contains essential elements of the United States tax codes. The nature of the risk-neutral investors enables them to face progressive tax rates from bonds on the end period. Capital and dividends are usually taxed at a constant rate that is single. The investors are prompted to invest in security offers that offer after-tax deals given their risk neutrality nature. The firm is bound to face marginal tax rates at the end of the period wealth, and it is in a position to deduct principal payments and iterates as long as the investor makes payments. Shields to debt taxes do not exist; thus, if a firm fails to fulfil the promises of the debt payment, the deadweight costs are incurred, causing the pie to shrink.

If a firm relies heavily on debt, there is a risk of escalating financial distress, leading to liquidation, which could be detrimental to equity and debt holders. Expenses associated with bankruptcy have a detrimental impact on a company’s value, outweighing the benefits of borrowing.

Despite the difficulty in the measurement of the indirect costs, they have been proven to be of utmost significance. Lots of verifiable tests have revealed that direct costs are relatively smaller compared to indirect costs. Warner (1977) studied the profitability of 11 rail firms to enable him to come up with the methodology to measure and devaluate costs related to bankruptcy. He warns that costs should not be overlooked because they seem negligible in the implementation of capital structure policies. However, it is fair to conclude that the implied straight costs of bankruptcy are lower in the case of the companies that are said to be under scrutiny than debt on savings. (p.345).

The importance of agency theory lies in highlighting management function in enterprise choice of arrangement of capital and to help understand the adjustments that must happen to arrive at optimal leverage. This theory, in addition, provides knowledge on the entrenched interest that motivates the various stakeholders of the firm, finally, how agency cost impacts the enterprise choice of capital structure that fundamentally leads the exploration.

Figure 2.3: Optimal debt ratio


Source from: Stewart C. Myers (1984) “The Capital Structure Puzzle”


According to the figure, managers of all-equity companies” can increase firm value by replacing equity with debt, thus generating more tax-saving. Without the cost of financial distress, managers would maximize firm value by maximizing debt, a situation represented by the upper curve. We have to note that it is not in linear because of the cost of adjustment. The lower curve illustrates how financial distress alters this conclusion. There are several pieces of research based on the existence of a capital structure. Graham and Harvey (2001) surveyed 392 CFOs about the cost of capital, capital budgeting and capital structure. They find moderate support that most firms have target debt ratios and follow the trade-off theory.

Companies appear to choose financing instruments as if they have target levels of debt in mind. More importantly, the results are consistent with the notion that these target debt levels are themselves a function of company size, bankruptcy risk, and asset composition Marsh, (1982). In contrast to previous studies based on time-series analysis of macro-data, Bradley, Jarrell and Kim (1984) used cross-sectional, firm-specific data to investigate the behaviour of 20-year average firm leverage ratios for 851 firms coving 25 two-digit SIC industries. The strong finding of intra-industry similarities in firm leverage ratios and persistent inter-industry differences, together with the highly significant inverse relation between firm leverage and earning volatility, supports the modern balancing theory of capital structure. In addition, Wald (1999) conducted a cross-country comparison and examined the factors correlated with capital structure. The result stated significant differences between firms. Specifically, differences appear in the correlation between the long-term debt/ asset ratio and the firm’s riskiness, profitability, size and growth. The findings of this study suggest different choices in capital structure across countries and legal institutions. This supports the trade-off theory in that different corporations operating different business environment have different target debt ratio. However, there are costs, and therefore delays, in adjusting to the optimum. Firms cannot immediately offset random events that bump them away from their capital structure targets. That is why they always see the random difference in actual debt ratios among firms with the same target debt ratio. Furthermore, due to market imperfections, firms can adjust only partially to their long term financial targets. According to Jalilvand and Harris (1984), large firms seem to adjust faster to the target level of long-term debt than do small firms.


Target debt ratio varies from country to country, industry to industry, and firm to firm. As far as firm-specific factors are concerned, the nature of the asset base, the stability of the cash flow, and the quality of management will all be relevant. Static trade-off theory suggests that companies with safe, tangible assets and plenty of taxable income to shield should have high target ratios. Unprofitable companies with risky, intangible assets should rely primarily on equity financing (Brealy et al, 2006). However, empirical studies suggest that the trade-off model seems to have a relatively low R2 (Myers, 1984). Actual debt ratio vary widely across similar firms, and an odd fact about real-life capital structure is that the most profitable companies commonly borrow the least (Titman & Wessel, 1988; Rajan & Zingales, 1995; Faa & French, 2002; Wald, 1999), where the trade-off theory predicts exactly the reverse and fails to explain. Sarkar and Zapatero (2003) conduct an empirical study with a firm sample in the S&P 500 Index. Their paper shows that mean reversion in the earnings process can reconcile the trade-off theory of capital structure with empirical evidence. They re-formulate the trade-off theory with mean-reverting earnings. Contrary to the traditional trade-off theory but consistent with empirical regularities, their model predicts a negative relationship between wages and target leverage ratio when payments are mean-reverting. It also demonstrates that the speed of earnings reversion plays an essential role in determining the capital structure and the earning-leverage and volatility-leverage relationships.

An essential purpose of the trade-off theory is to explain that corporations are usually financed partly with debt and partly with equity. It states that there is an advantage to financing with debt, the tax benefits of debt. There is a cost of financing with debt, the costs of financial distress including bankruptcy costs of debt and non-bankruptcy costs The marginal benefit of further increases in debt declines as debt increases. In contrast, the marginal cost increases, so that a firm that is optimizing its overall value will focus on this trade-off when choosing how much debt and equity to use for financing. This theory was considered essential to this study to help explain how insurance companies finance its operations using debt and equity.


2.2.3   Pecking order theory


Pecking-order was as a result of the study of Donaldson (1961) on the financing choices of a sample of large organizations. The primary argument of this model is that organizations like better inner bases of finance to outer bases

Should there be need of external financing, firms ought to issue the security that is safest is required, meaning that they start with the priorities such as the debt then the rest follows which include securities and equity. The study reveals two types of debt that is internal and external thus making it difficult. Any firm that observes debt ratios shows that it’s dire need for external finances. He observes that “management strongly favoured internal generation as a source of new funds even to the exclusion of external funds except for occasional unavoidable “bulges” in the need for funds” (pp 67). The key idea of pecking order theory is that managers raise new finance in a particular sequence (Myers, 1984):


Firms prefer external finances and adapt their target dividend payout ratios to their investment opportunities, although dividends are sticky and target payout ratios are only gradually adjusted to shifts in the extent of valuable investment opportunities.


Sticky dividend policies, plus unpredictable fluctuations in profitability and investment opportunities, mean that internally generated cash flow may be more or less than investment outlays. If it is less, the firm first draws down its cash balance or marketable security portfolio.

If external finance is required, firms issue the safest security first. That is, they start with debt, then possibly hybrid securities such as convertible bonds, then perhaps equity as a last resort. In this story, there is no well-defined target debt-equity mix, because there are two kinds of equity, internal and external, one at the top of the pecking order and one at the bottom. Each firm’s observed debt ratio reflects its cumulative requirement for external finance.


Pecking order theory starts with asymmetric information, which indicates that managers know more about their companies’ prospects, risks and values than do outside investors. Asymmetric information can in practice explain the dominance of debt financing over equity issues. The most of external financing comes from debt, even in the case of highly information efficient market. However, none of this says that firms ought to heavily relay on debt financing. In fact, a firm with ample internally generated funds does not have to sell any kind of security (Brealey et al, 2006)


The pecking order is considered as a descriptive reasonable empirical model of corporate leverage. When practical figures are given, the heavy reliance on internal finance and debt is clear. For all non-financial corporations over the decade 1979-1982, internally generated cash covered, on average, 62% of capital expenditures, including investment in inventory and other current assets. Brealy and Myers” studies (1984) provide evidence that the bulk of required external financing came from borrowing. Net new stock issues were never more than 6% of external financing. These statistical figures make pecking order theory to seem reasonable and at least provide a description of typical behaviour. Also, Shyam-Sunder and Myers (1999) find strong support for this model with a sample of 157 firms over the period 1971 to 1989. This is a persuasive and influential result. However, a few months after, their work was cited by Chirinko and Singha (2000), who argue that empirical evidence can evaluate neither the pecking order nor static trade-off models. Alternative tests are needed that can identify the determinants of capital structure and can discriminate among competing hypotheses.

One has to be concerned that the pecking order theory assumes that the managers act in the interest of existing shareholders, with the objective to maximize their value. However, this is not always the case, especially in the aspect of agency cost. Many academics are reviewing their work and considering new problems as a result of agency costs. Donaldson (1969) acknowledges that the financial decisions made by the firm he studies before were not directed towards maximizing shareholders wealth, and those scholars, e.g. Berle and Means (1932) and Berle (1954), trying to explain those decisions have to restart by recognizing the “managerial view” of corporate finance. Myer and Majluf (1984) demonstrate the possible conflict between interests of managers and shareholders. Problems can particularly arise when a firm’s manager accumulates too much financial slack that they become immune to market discipline. Myers (1984) critically states that pecking order hypothesizes cannot explain everything. There are plenty of examples of firms issuing stock when they could issue debt. In 2003, Frank and Goyal constructed a study on financing behaviour of publicly traded American firms over the 1971 to 1988 period. According to their empirical results, firm’s internal financing, on average, is not sufficient to cover investment spending. As a result, most companies in their sample use significant external financing. In addition, it is widely found that debt financing does not dominate equity financing. Net equity issues track the financing deficit quite closely, while net debt does not do so.

The funding deficit does not include the existing component of long-term debt. Both of these facts run counter to what pecking order theory suggests. This could be due to the fact that they included small businesses in their sample, which are hardly following the pecking order.


Furthermore, pecking order theory fails to explain the influence of taxes, financial distress, security issuance costs, agency costs, or the set of investment opportunities available to a firm upon that firm’s actual capital structure. It cannot explain why financing tactics are developed to avoid the consequences of managers’ superior information.

Pecking order theory is considered important to this study because it explains why the most profitable firms generally borrow less- not because they have low target debt ratios but because they do not need outside money. Less profitable firms issue debt because they do not have sufficient internal funds for their capital investment and because debt financing is preferred to equity financing under the pecking order theory. More importantly, this theory demonstrates the inverse relationship between profitability and financial leverage within the industry. Suppose firms generally invest to keep up with the growth of their industries. Then rates of investment will be similar within an industry. Given sticky dividend policy, the least profitable firms will have less internal funds and will end up with borrowing more. Profitability is one of the independent variables of this study.


2.2.4   Agency cost theory


Agency hypothesis concentrated on the costs which are made because of divergence of interest between investors, company directors and bondholders as indicated by Jensen and Meckling (1976). Furthermore, the problem of debt motivates entrepreneurs.

Major contributors of the costs of agency are highlighted as: costs of agency that emerge because of the conflicts between company directors and equity-holders and costs of agency that emerge because of the conflict between equity holders and bondholders. The subsequent discussions present equity holders versus directors’ encounters and equity-holder and bondholder conflicts in an orderly manner.

Conflicts between equity holders and directors arise as a result of the separation of proprietorship and power. When directors do not own 100 percent of the corporation, they are only entitled to a small portion of the profits generated by their efforts. They must, however, bear the entire cost of these exercises. The clashes between the investors and administrators take a few unmistakable forms.


As per Jensen and Meckling (1976), directors want to utilize less exertion and have more noteworthy perquisite levels, for example, rich office and corporate planes, not quite the same as the investor’s enthusiasm of firm esteem augmentation. In this case, increasing the value of the chiefs’ property would align the needs of investors and supervisors. On the other side, by ensuring that managers value the venture consistently, increasing the degree of responsibility often mitigates the loss caused by conflicts between investors and executives. Since directors are obligated to pay out revenue, reducing their free income reduces their ability to do so.. As indicated by Masulis (1988) clash may emerge in light of the fact that supervisors may lean toward momentary undertakings, which produce results early and upgrade their notoriety rapidly, as opposed to progressively beneficial long-haul ventures.


Harris and Raviv (1991) assert that managers desire to remain in their positions, so the try their best to minimize chances of losing those positions. Changes in corporate control increase the likelihood of losing jobs, so executives can resist takeovers, regardless of the impact on equity-holder capital. On working choices, administrators and investors may likewise have various inclinations: Harris and Raviv (1991) saw that managers will normally wish to keep working the firm regardless of whether liquidation is favored by investors.

The topic of over speculation is a particular example of the disagreements between investors and supervisors. In this case, executives are motivated to develop their company beyond its optimal size while also acknowledging low-NPV projects. Dispensing liability reduces office problems that arise from administrative behavior that is motivated by competing interests among investors and administrators. For instance, the over investment issue alleviated through enterprise commitment in paying out money thus it keeps administrators from putting resources into negative NPV ventures. Jensen (1986) alludes to the non-optional nature of debt as the role of debt in discipline. As Hunsaker (1999) found that bankruptcy risk in increased by rising debts, along these lines constrains the board’s utilization of perquisites. Furthermore, issue convertible debt likewise controls directors’ conduct since they allow supervisors to partake in a company’s benefits if there should be an occurrence of good execution and along these lines decreases the expenses in monitoring.

Equity-holders versus bondholder conflict: The common thread running through these arguments is that the equity holders or their agents decide on options for transferring wealth from bondholders to equity holders. Positively, bondholders may demand a higher profit for their bonds or liabilities. Distinctive crucial origins of debt holders and equity holders clashes have been distinguished in the organization cost investigations; the immediate wealth exchange from bond-holders to investors (Smith and Warner, 1979) equity-holders can build their wealth to the detriment of bond- holders’ interests by expanding the profit in form of dividends; the issuance of debt with higher need will confiscate wealth from existing bond-holders.

Resource substitution is another origin of the contentions (Jensen and Meckling,1976). When marking liability contracts, bondholders request a loan cost based on the riskiness of the company’s venture exercises. While liability contracts gives investors a motivating force to put resources into unsafe undertakings supposing that it succeeds the profits over the assumed worth of liability will be possessed by investors and if there should arise an occurrence of disappointment, the result is for the most part conceived by bondholders due to investors’ restricted risk. Exceeding gains emanating from projects that are risky reduce the attractiveness of the projects that are deemed lesser risky to the shareholders. This happens due to the ability of the projects that re regarded a safe to pay bondholders. Higher risk premium will be requested by bond holders in case they anticipate substitution incentives of the projects regarded as safe by those seen as risky. Shareholders incur the extra costs since they own the enterprise.


Underinvestment problem is another agency problem that results in shareholder- bondholder conflicts Myers (1977): Underinvestment problem mostly incurs in financial distress. The extension of debt decreases the shareholders incentives to invest in new projects (even the projects with high growth opportunities will be passed through) because the profits from these projects will be exhausted in debt repayment. One way to minimize these conflicts is that firms with high growth opportunities should have lower leverage. The conflicts can also be mitigated by adjusting the properties of the debt contracts, for example, the adjustment can be done by including covenants such as adding limits on the dividends payment or setting restrictions on the disposition of assets. Alternatively, debt can be secured by collateralization of tangible assets in the debt contracts.

The common thread running through these arguments is that the equity holders or their agents decide on options for transferring wealth from bondholders to equity-holders. Positively, bondholders may demand a higher profit for their bonds or liabilities if they are aware of the circumstances in which these wealth seizures will occur. This theory is important to the study because it describes how conflicts of interest among different stakeholders, such as shareholders, managers, and bondholders, result in agency costs, and how the trade-off between these agency costs determines the optimal capital structure that balances the interests of all stakeholders. Management control whose motivations and effects form the central subject of this theory was adopted as the moderating variable of this study.


2.3   Conceptual framework


According to Mugenda and Mugenda (1999), a conceptual framework is a hypothesized model identifying relationships between the dependent variable and independent variables. The current study has a causal relationship, Sekaran (2010) investigated existence of causal     relationship when both the independent and dependent variables are present and with each unit of increase or decrease in the independent variable there is a decrease or increase in the dependent variable. Profitability, growth opportunity, firm size and firm risk have been listed in literature as variables that influence the choice of capital structure in firms; management control has also been listed as having moderating influence on the choice of capital structure by firms. The study tested these factors to come out with findings as documented in this thesis.







Independent variables

Moderating variable

Dependent variable



Figure 2.4: Conceptual framework



2.4   Empirical literature review


Empirical literature review is a focused search of published works, such as periodicals and books, that discuss theory and present empirical findings relevant to the topic at hand (Zikmund et al., 2010).

A literature review is a thorough examination of previous studies into a particular subject.

It should be broad in nature, covering decades, if not centuries, of content, but it should also be focused. , concentrating solely on scholarship specifically related to the research in question (Kaifeng & Miller, 2008).

Literature analysis helps a researcher to put his or her research into an analytical and historical context by using a structured approach to previous scholarship.

To put it another way, a literature review assists the author in stating why their study is important (Kaifeng & Miller, 2008).



2.4.1   Capital structure


The term capital structure refers to the mix of different types of securities (long-term debt, common stock, preferred stock) issued by a company to finance its assets Song (2005). A company is said to be unlevered as long as it has no debt, while a firm with debt in its capital structure is said to be leveraged. Song (2005) notes that there exist two major leverage terms: operational leverage and financial leverage. While operational leverage is related to a company’s fixed operating costs, financial leverage is related to fixed debt costs. Loosely speaking, operating leverage increases the business (or the operating) risk, while financial leverage increases the financial risk. Total leverage is then given by a firm’s use of both fixed operating costs and debt costs, implying that a firm’s total risk equals business risk plus financial risk. In this study of capital structure and its determinants, with leverage, we mean financial leverage, or its synonym gearing.


The firms” capital structure, or financial leverage, constitutes this study’s dependent variable. Since hundreds of articles have been written about capital structure and its





determinants since the 1958 paper by MM, One must be conscious that various capital structure measures exist, and that each capital structure measure can be measured in a range of methods.

There are roughly two types of leverage measures: those based on market value of equity and those based on booked value of equity (Loof, 2003). For instance, Titman and Wessels (1988) discussed six measures of financial leverage in their study of capital structure choice: long-term, short-term, and convertible debt divided by market and book values of equity respectively. It is normal, however, for analytical studies to use only leverage measures in terms of book values rather than market values of equity due to data limitations, as is the case in Titman and Wessel’s research (1998). Since market data isn’t available for this analysis, I’ll have to calculate leverage solely in terms of only the booked values.


Researchers have raised serious problems of lacking market data in an empirical study of determinants of capital structure choice. Several scholars who have researched capital structure choice have argued that both book and market values should be used at the same time. The reason for this is that the information signaled in book value and market value is informative in different aspects (Loof, 2003). In contrast to this, Titman and Wessels (1988) refers to an earlier study by Bowman (1980), which demonstrated that the cross-sectional correlation between the book value and market value of debt is very large. Furthermore, Brealey and Myers (2003) argued that using only book values isn’t a big deal because market value includes the value of intangible assets created by things like research and development, staff education, and advertising, among other things. These types of assets are difficult to sell, and the value of intangible assets can vanish entirely if the business goes bankrupt. As a result, misspecification due to the use of book value measures can be minor, or even totally unessential.


Irrespective of market or book value, there still exists the problem of choosing an appropriate leverage measure as the dependent variable. Indeed, in an important paper by Rajan and Zingales (1995), they argue that the choice of the most relevant measure





depends on the objective of the analysis. Though, they conclude “the effects of past financing decisions are probably best represented by the ratio of total debt over capital (defined as total debt plus equity). Table 1 below lists the different measures of leverage and each measures pros and cons, discussed in Rajan and Zingales (1995). In the discussion of different leverage measures, it is important consider the following statement by Harris and Raviv (1991, p. 331) in order to compare different empirical studies:


“The interpretation of the results must be tempered by an awareness of the difficulties involved in measuring both leverage and the explanatory variables of interest. In measuring leverage, one can include or exclude accounts payable, accounts receivable, cash, and other short-term debt. Some studies measure leverage as a ratio of book value of debt to book value of equity, others as book value of debt to market value of equity, still others as debt to market value of equity plus book value of debt. […] In addition to measurement problems, there are the usual problems with interpreting statistical results”.





Table 2.1: Different measures of leverage and their corresponding pros and cons



Leverage measure                                                       Pros (+) and cons (-)



  • Total liabilities




Total assets

+ The broadest definition of leverage; proxy for what is left for shareholders in case of liquidation.


-Not a good indication of whether the firm is at risk of default in the near future. May overstate leverage since total liabilities includes items like accounts payable, untaxed reserves etc.




  • Total debt / Total assets


  • Total debt / Net assets


  • Total debt   / equity).



+ Does not include liabilities like untaxed reserves or accounts payable (for transaction purposes); more appropriate measure of leverage than (1) above.


− Affected by level of trade credit5 (i.e. unpaid bills; makes up bulk of accounts payable).

+ Not influenced by trade credit. (Net assets = total assets − accounts payable − other liabilities


– Still affected by factors that have nothing to do with financing, e.g. assets held against pension liabilities

+Probably the best representation of past financing decisions (capital = total debt +


− Measure of the risk that equity holders will not be able to make fixed payments and will have to give up control





  • EBIT /


Interest expense



  • EBITDA /


Interest expense

+ Appropriate measure if investments equal in magnitude to depreciation needed to keep the firm a going concern


– Based in assumption that short-term liabilities like accounts payable and short-term debt will be rolled over. Very sensitive to income fluctuations

+ Measure of the risk that equity holders will not be able to make fixed payments and will have to give up control.


Appropriate if no such investments as in (5) are needed.



– Same as for (5).

Note: EBIT = Earnings Before Interest and Taxes. EBITDA = EBIT + Depreciation. Source: Rajan and Zingales (1995).


Here in Kenya several studies have been in the field of capital structure, these studies have used different measures of financial leverage but most of them have used book values only. For instance Musili (2005) in his study of capital structure choice used total debt ratio computed from book values as the measure of financial leverage.  Kinyua (2014) studied the relationship between capital structure and profitability of listed non-financial firms in Kenya, and used long-term debt to equity and short-term debt to equity as measures of leverage. The research adopted a descriptive research design and target population of this study comprised of all the 40 listed non-financial firms.


Due to Kenya’s limited number of non-financial businesses, a census was conducted and included primary data from annual financial reports. The data was analyzed using regression. And descriptive data analysis methods.

The long-term liability to equity indicated an inverse relationship to profitability at -5.70%, with an adjusted coefficient of determination of 97.80%. The study also found that the firm’s profitability (measured by return on equity) was positively correlated with the short-term debt at 18.10% and long-term debt (LP/PL) at 56.20%.


Onsomu (2014) examined the relationship between capital structure and agency costs of firms listed at the Nairobi Security Exchange.  The study used efficiency cost ratio as a proxy for agency costs, Long term debt to equity as a proxy for capital structure and two other variables that affects agency costs; this are information asymmetry as measured by market value/Book value per share and ownership concentration measured by corporate ownership/Equity. The historical data for these were obtained from the Nairobi Securities Exchange and the Capital Markets Authority data banks. The correlation research design was used in the study. The study covered a target population of all companies quoted at Nairobi Securities Exchange between 1st January 2009 and 30th December 2013. The research used secondary data from Nairobi Security Exchange. The key findings revealed that there was a positive correlation between capital structure and agency costs. The main conclusion from our analysis is that indeed capital structure determines agency costs. Given the evidence from this research, it’s evident that capital structure positively affects agency costs of listed firms at the Nairobi Securities Exchange.

This research established three indicators of financial leverage for the purpose of the study after carefully analyzing previous empirical works: short-term debt ratio, long-term debt ratio, and total debt ratio.

Since the majority of insurance companies are not listed on the Nairobi Securities Exchange, it was difficult to obtain market values for the financial leverage measures and all of the independent variables.


2.4.2   The influence of firm profitability on capital structure


Since essentially the goal in business element is to make benefits, productivity has been the most significant issue contemplated over the past numerous years of research in finance. Normally, benefit is estimated as far as profit for the capital put into the business or profit for the incomes created amid a given period, Abor (2005). Various evaluators of profits have been tried in past investigations and found to impact capital structure.

An examination directed by Capon et al. (1990) examined 320 experimental investigations availed to the public in the range of 1921 and 2007 that utilized the meta-scientific procedure to outline the factual outcomes in the writing on industry, firm, and business success. This investigation uncovered that the kinds of measures used to catch rate of profitability included profit for equity, return on capital, return on resources, sales returns, and income before interest and taxation(EBIT). These profits illustrate productivity measures to evaluate the enterprise’s gainfulness. Along these lines, this examination operationalized three aspects as proportions of firm productivity rate of profit for resources, rate of profit for capital and income before tax and interest..


A study conducted by Capon et al. (1990) reviewed 320 empirical studies (165 in economics and industrial organization literature, and 155 in the management literature) published between 1921 and 2007 that used the meta-analytical technique to summarize the statistical results in the literature on industry, firm, and business performance. This study revealed that the types of measures used to capture return on investment included return on equity, return on capital, return on assets, return on sales, and earnings before interest and taxes (EBIT). These returns represent the profitability measures to assess the firm’sprofitability. Therefore, this research operationalized three constructs as measures of firm profitability rate of return on assets (ROA), rate of return on capital (ROCE) and earnings before interest and taxes (EBIT).

The pecking order theory, based on works by Myers and Majluf (1984) argued that firms follow a pecking-order in the choice of financing their activities. Roughly, this theory states that firms prefer internal funds rather than external funds. If external finance is required, the first choice is to issue debt, then possibly with hybrid securities such as convertible bonds, then eventually equity as a last resort (Brealey & Myers, 1991). In the pecking order model, higher earnings should result in less book leverage. Firms prefer raising capital, first from retained earnings, second from debt, and third from issuing new equity. This behaviour is due to the costs associated with new equity issues in the presence of information asymmetries. Debt typically grows when investment exceeds retained earnings and fall when investment is less than retained earnings. Accordingly, the pecking order model predicts a negative relationship between book leverage and profitability. The pecking order theory predicts that firms with a lot of profits and few investments have little debt. Since the market value increases with profitability, the negative relationship between book leverage and profitability also holds for market leverage. This relationship is one of the most systematic findings in the empirical literature.


Mendell et al. (2006) investigates financing practices across firms in the forest products industry by studying the relationship between debt and taxes hypothesized in finance theory. In testing the theoretical relationship between profitability and capital structure for 20 publicly traded forest industry firms for the years 1994-2003, using panel data methodology, the study established a negative relationship between profitability and debt, thus supporting the position held by the proponents of pecking order theory.


Chen et al. (2009) studied the insurance companies of Taiwan, to know the relationship among profitability, operational risk, and capital structure. Factor analysis and path analysis methodologies were used to examine correlation among the capital structure, operational risk, and profitability. A sample of listed insurance companies in America was also taken. The result of the research was that firms” values are not related with capital structure, a close relationship was shown among operational risk, profitability and capital structure. Capital structure is negatively related with profitability if equity ratio increases or reserve-to-liability ratio decreases which result in higher profits.


Eriotis et al. (2000) explored the connection between proportion of equity and enterprise gainfulness. In the investigation, the dimension of the firm in speculation and its level of market control were evaluated. The raw figures of different enterprises of 1995-96 were taken into study. It was seen through the examination that the money related structure assumes a key job in an enterprises equity proportion. An association’s productivity relies upon obligation to-value proportion. The debt-to- equity proportion fluctuates from firm to firm. It is the choice of the proportion which makes effective monetary technique and for this reason, a few firms pick a high rate equity proportion and the others rely upon lower rate equity proportion. It was seen from the investigation of different enterprises that the proportion  has a negative association with an association’s productivity. The investigation further uncovered that the organizations that fund their speculation on their value engage much benefit in contrast with the organizations that account their operations through obtained capital.


Ebaid (2009) examined the connection between the diverse debt values with organization’s success. Multiple relapse procedure was utilized to discover the effect of debt strategy on an organization’s success. Discoveries of the investigation uncover that liabilities are contrarily related by profit from assets Capital structure including total debt isn’t fundamentally related with Return on Equity and Gross overall revenue (ROE and ROA). Discoveries of the investigation uncover that ROA and firm execution are contrarily related.

Serrasqueiro and Marcia (2009) directed an examination to investigate the organization capital structure. In the investigation, the aftereffect of Portuguese organizations is inspected which demonstrates a negative and measurably huge connection between the benefit of recorded Portuguese organizations and their dimension of obligation. The aftereffects of the investigation further demonstrate that there is incredible impact of substantial quality of advantages, size and gainfulness on the structure of Portuguese organizations. Discoveries of the examination propose that most firms depend on inside wellspring of financing or bank obligation to satisfy their financing needs in less created capital markets.

Nonetheless, in the trade off hypothesis structure, a contrary inference is normal. At the point when firms are gainful, they ought to incline toward obligation to profit by the taxation shield. Built on trade-off hypothesis perspective, increasingly beneficial firms are presented to bring down dangers of insolvency and have more prominent motivation to utilize obligation to misuse intrigue taxation shields. As per the trade-off hypothesis, organization costs, assessments, and liquidation costs push increasingly gainful firms toward higher book leverage. To begin with, expected insolvency costs decay when benefit increments. Second, the deductibility of corporate intrigue installments initiates progressively gainful firms to fund with liability. At last, higher influence controls cause issues by constraining administrators to pay out a greater amount of the company’s overabundance money. The trade-off hypothesis predicts that influence increments with benefit. Since the market esteem likewise increments with gainfulness, this positive connection does not really apply for market influence. A few researchers have discovered positive connection among gainfulness and capital structure.



Gill et al. (2011) seeks to extend Abor’s (2005)

Findings on the impact of capital structure on profitability by analyzing the impact of capital structure of profitability of the American service and manufacturing companies

A sample of 272 American firms listed on New York Stock Exchange for a period of 3 years from 2005 – 2007 was selected. The correlations and regression analyses were used to estimate the functions relating to profitability (measured by return on equity) with measures of capital structure. The findings show a positive relationship between short-term debt to total assets and profitability, as well as total debt to total assets and profitability.

The findings of this analysis also indicate that in the manufacturing sector, there is a positive relationship between short-term debt to total assets and profitability, long-term debt to total assets and profitability, and total debt to total assets and profitability.


Abor (2005) investigated the relationship between the capital structure and profitability of listed firms on Ghana Stock Exchange (GSE). Data was taken for this study between 1998 and 2002. Twenty-five listed firms qualified for this study. Regression analysis methodology was used in the assessment of functions involving the return on equity (ROE) with measure of capital structure. The result of the research is that capital structure is related to the marketing, because different firms issue different securities in many different combinations, which maximize the market value. Huge return and profitable firms always use more short-term debt. Short term debt is an important part of total debt, and usually firms use 85% of short-term loan against long-term debt. Long- term debt and return on equity have negative relationship; total debt and return on equity are positively related.


Madan (2007) investigated the relationship between the capital structure and the overall performance of Indian firms and also assessed the capital structure. Study further assessed how different debt-equity combinations play an important part in a firm’s overall performance and expansion. The findings revealed that both lower and higher gearing ratios are not enviable for the firms. Companies which operate at break-even point also use debt in capital structure to insure the profits. Indian firms use 30/70 or 40/60 percent of debt and equity combination, other need is fulfilled through the reserves, capital and surplus.


Most of the empirical studies done on the relationship between profitability and capital structure tend to follow either the trade-off or pecking order propositions. However, the results appear inconclusive and diverse in different environments and industries.


2.4.3   The influence of firm growth on capital structure


Firm growth will very strongly influence capital structure decisions of the managers as they struggle to identify cheaper sources of funds that will help them finance their expanding operations Abor (2005). The most cost effective source of finance will be retained earnings but in most cases, this source will not be adequate and therefore the firm usually results to external sources. The common indicators for growth according to many researchers include increase in the size of market share in the industry, increase in the size of physical assets and increase in sales. Titman and Wessels (1988) used market-to-book ratio as a proxy for growth opportunities. Odinga (2003) used percentage change in total sales to measure growth. However, Drobetz and Fix (2003) measured growth as a percentage increase in total assets. Kuria (2010), Turere (2012) and Muema (2013) used the same measure.


According to the pecking order theory hypothesis, a firm will use first internally generated funds which may not be sufficient for a growing firm. The next option for the growing firms is to use debt financing which implies that a growing firm will have a high leverage (Drobetz & Fix, 2003). Applying pecking order arguments, growing firms place a greater demand on the internally generated funds of the firm. Consequently, firms with relatively high growth will tend to issue less security subject to information asymmetries, i.e. short-term debt. This should lead to firms with relatively higher growth having more leverage.

The same relationship is supported by the trade-off theory, too. According to this theory, growth causes firms to shift financing from new equity to debt, as they need more funds to reduce the agency problem. Following the trade-off theory, for companies with growth opportunities, the use of debt is limited as in the case of bankruptcy, the value of growth opportunities will be close to zero. Growth opportunities are a particular case of intangible assets (Myers, 1984; Williamson, 1988; Harris & Raviv, 1990).


Theoretically, growth opportunity negatively relates with the firm’scapital structure. Particularly, growth rate indicates a high equity financing and a low debt financing. On the one hand, firms with low, negative growth rate, tend to employ debt to limit agency costs of managerial discretion and discipline the firm’s managerial attitudes (Jensen, 1986). On the other hand, using leverage means increasing the debt’s agency cost. This cost causes two issues. Firstly, it increases the overall cost of capital, and secondly, it transfers the wealth from stockholders to debt holders since the stockholders bear this agency cost. Therefore, high-growth firms may not issue debt to pursue their investments, particularly the firms with high leverage (Myer, 1977).


This theoretical assumption is supported by many empirical works (Booth et al., 2001; Kim & Sorensen, 1986; Rajan & Zingales 1995; Wald, 1999). However, there are several dissents. Notably, Kester proves the opposite direction (Kester, 1986). Different conclusions partly may result from different proxies employed to examine the growth rate. Growth opportunity’s definition can be as a five-year average of sales growth (Wald, 1999), market-to-book ration of equity (Booth et al., 2001).


Nguyen (2014) in his examination intended to look at the legitimacy of five picked determinants chosen by the creator, to be specific, development rate, association’s size, productivity, liquidity and intrigue inclusion ability, inside the extent of Finnish innovation firms. The organizations which are recorded in the innovation segment list in OMX Helsinki Stock Exchange are chosen as the object of the exploration. The examination utilized the quantitative research structure, which is a mix of deductive methodology, quantitative strategy and exploratory research. The information was gathered from both essential and optional sources. The essential source is predominantly the money related reports of 17 firms amid the time of 2008 – 2012. Then, the optional source is acquired from books and diaries. The finding factually affirmed an emphatically irrelevant connection between development rate and capital structure.

Ilyas (2007) using panel data methodology conducted research in Pakistan but found the arrangement of capital in the businesses have negative relationship with leverage. Gurcharan (2010) analyzed the enterprises in Indonesia, Philippine, and Thailand. The effect of nondebt tax shield, profitability, size and growth opportunities on capital structure decisions were examined in that work with elements GDP growth rate and inflation. The result for firm specific factors revealed that viability and progression prospects were undesirably correlated to market debt to total assets ratio in all countries, but was statistically significant for three of the countries. Non-debt tax shield negatively affected the stated leverage ratio, but was statistically significant in only one country. However, a similar study conducted by Nyang’oro (2003) produced contradicting results.

Abor and Biekpe (2005) explored on large unlisted firms together with small and medium enterprises (SME) in Ghana using panel data analysis for the period 1998- 2003. They found that listed and large unlisted firms had higher debt ratios as compared to SMEs. The results further showed that total debt constituted more than 50%. Growth was insignificant in influencing decisions on capital arrangement in Ghana.


The delineated explorations follow either the trade-off or pecking order propositions. However, the empirical findings of some studies appear to contradict the theoretical stand points perhaps because of use of diverse proxies of growth.


2.4.4   The influence of firm size on capital structure


According to (Muema, 2013) sales  are considered a sound measure in size measurements.

So the natural logarithm of sales is taken to measure the size as used in some previous studies. Myers and Majluf (1984), Turere (2012) and Muema (2013) used the same measure. For the purpose of this research, the size of the firm will be measured by taking the natural logarithm of the assets as this measure “smoothens” the variation in the figure over the periods of time.


According to trade-off theory, First, large firms do not regard direct bankruptcy costs as an active variable in determining the degree of leverage since these costs are set by constitution and account for a smaller proportion of the overall firm’s value, according to the trade-off principle.

Furthermore, since larger businesses are more diversified, they are less likely to go bankrupt (Titman & Wessels, 1988). Following this, one might anticipate a favorable relationship between a firm’s size and leverage.

According to the trade-off principle, the size of a company has an inverse relationship with the likelihood of bankruptcy.

As a result, scale and leverage have a positive relationship.


Second, contrary to first view, Rajan and Zingales (1995) argued that there was less asymmetrical information about the larger firms. This reduced the chances of undervaluation of the new equity issue and thus encouraged the large firms to use equity financing. This means that there is negative relationship between size and leverage of a firm. Following Rajan and Zingales (1995), we expect a negative relationship between size and leverage of the firm. Therefore, the pecking order theory of the capital structure predicts a negative relationship between leverage and size, as larger firms exhibit increasing preference for equity relative to debt. Meanwhile, previous research also has different results with some researchers following trade-off and others supporting pecking order predictions.


Ramalho and Silva (2009), using regression analysis, established the empirical evidence based on large firms and found that conditional on having debt, firm size is negatively related to the proportion of long-term debt in capital structure of Portuguese SMEs. They divided the sample into micro, small, medium and large firms and found that the relationship between leverage and firm size is statistically significant and negative for small and medium non-zero leverage firms.


Firm size is linked to capital structure for many theoretical reasons, including economies of scale in reducing knowledge asymmetry, scale in transaction costs, and market access.

Smaller businesses are less transparent in terms of information than larger businesses, so the costs of resolving information asymmetry with lenders are higher for small businesses.

The transaction costs associated with a particular form of financing can also influence financing decisions. Titman and Wessels found that transaction costs are a function of scale. Hence, relatively high transaction costs may effectively make some financing options unavailable for smaller firms. For instance, public debt issuance is generally not an alternative to obtain external financing for smaller firms, as scale is required for such debt issuance. These theoretical reasons suggest that smaller firms should have lower debt levels.


According to Strebulaey and Kurshey (2006), the results of a positive relationship between leverage and firm size may bew contaminated by the presence of zero-leverage firms


Strebulaev and Kurshev (2006) argued that the results of a positive relationship between leverage and firm size may be contaminated by the presence of zero-leverage firms, which are also the smallest in terms of size. They find that, controlling for unlevered firms, the relationship between firm size and leverage becomes slightly but significantly negative. Strebulaev and Kurshev (2006) provided a theoretical clarification for the opposite effects of firm size on leverage. Due to fixed costs of external financing, smaller firms choose to refinance less frequently than larger firms because they are more affected by these fixed costs in relative terms. Hence, small firms choose to operate at a higher leverage level at a refinancing moment to compensate for less frequent rebalancing. This argument explains why smaller firms, if they have some debt, are more levered than larger firms. In addition, as the time period between restructurings is longer for small firms, on average, they have lower leverage ratios.


Serrasqueiro and Marcia (2009) using panel data methodology, conducted a study to analyze the company capital structure. In the study the result of Portuguese companies is examined which shows a negative and statistically significant relationship between the firm size of listed Portuguese companies and their level of debt. The results of the study further show that there is great influence of tangibility of assets and profitability on the structure of Portuguese companies. Findings of the study suggest that most firms rely on internal source of financing or bank debt to fulfil their financing needs in less developed capital markets.


Gleason et al. (2000), using panel data from retailers in 14 European countries, which are grouped into 4 cultural clusters, it is shown that capital structures for retailers vary by cultural clusters. This result holds in the presence of control variables. Using logarithms of total assets as an absolute measure of firm size, it is shown that capital structure influences firm size, although not exclusively. A negative relationship between capital structure and firm size suggests that large firms tend to borrow less. This is inconsistent with the position held by the trade-off theory that suggests high leverage for large firms.


Hung et al. (2002) investigated the inter-relationship between firm specific characteristics and capital structure. The study comprised all financial firms in Hong Kong. Regression analysis was applied on panel data to get the results. The results showed that capital structure is positively related with log of assets and have negative relationship with profitability. This particular observation was found to be consistent with the trade-off theory and pecking order theory.


Raheman et al. (2007) found a significant capital structure relationship with firm size for non-financial firms listed on Islamabad Stock Exchange. The study population included all the listed non- financial firms, the study used multiple regression analysis and correlation analysis to measure the relationship between firm size and capital structure. The results obtained indicated a positive relationship between firm size and capital structure. These results are consistent with the proposition of the trade-off theory.


Strebulaev (2005) studied Russian firms using panel data methodology and found out that Firm size is strongly positively related to capital structure. A number of intuitive explanations can be put forward to account for this stylized fact, but none have been considered theoretically. The analysis of dynamic economy demonstrates that in cross- section, the relationship between leverage and size is positive and thus fixed costs of financing contribute to the explanation of the stylized size-leverage relationship. However, the relationship changes the sign when we control for the presence of unlevered firms.


Fareed (2014) study investigated the effect of firm specific factors on capital structure decision (leverage) for a sample of 19 firms of power and energy sector of Pakistan. The secondary data is extracted from the “Balance sheet analysis” for the period of 2001- 2012 of the 19 firms which are listed on the Karachi stock exchange. Generalized least square method, correlation analysis were employed on panel data and results revealed that Firm size and firm growth are both positively related with leverage and also significant. Our results also show that large firms do long term financing through debt as compared to small firms of power and energy sector.


Anila (2013) attempted to explore the impact of firm specific factors on capital structure decision for a sample of 65 non- listed firms, which operate in Albania over the period

2008-2011. In this study three capital structure measures were used: short –term debt to total assets (STDA), long- term debt to total assets (LTDA) and total debt to total assets (TDTA) as dependent variables and four dependent variables: tangibility(TANG), liquidity (LIQ), profitability(ROA=return on assets) and size (SIZE). The investigation used panel data procedure and the data was taken from balance sheets and included only accounting measures on the firm’s leverage. This study found that size (natural logarithm of total assets) has a significant impact on leverage. Also empirical evidence revealed a significant positive relation of size to leverage. Results revealed that long term debt to total assets and total debt to total assets ratios are significantly different across Albanian industries.


2.4.5   The influence of firm risk on capital structure


Based on the basic concepts of the capital structure, firm managers make decisions on what type of funds and at what levels in terms of magnitude will lead to the overall minimization of the costs associated with procuring these funds. Therefore, the demand and supply of funds affect the capital structure, but at the same time, the risk associated with the firm’s cash flows affects the capital structure. In other words, the more the volatility of the cash flows of the firm, the more will be the impact of this risk on the firm’s ability to raise debt and/or equity. Titman and Wessels (1988) pointed out that “a firm’s target debt level is a decreasing function of the volatility of earnings (p.6)”. Other authors who confirmed this relationship include (Bradley, Jarrell, & Kim, 1984). Moreover, the costs associated with the funds will be affected as a result of the volatility of cash flows. Therefore, it can be stated that the capital structure decisions are based on the impact of the external environment on the firm and the strategies the firms use to insure that the value of the firm is maximized. For the purpose of this study, standard deviation of operating income, standard deviation of sales and solvency ratio were adopted as proxies of firm risk.





According to pecking order theory and the trade-off theory, earnings volatility is considered to be either the inherent business risk in the operations of a firm or a result of inefficient management practices. In either case, earnings volatility is proxy for the probability of financial distress and the firm will have to pay risk premium to outside fund providers. To reduce the cost of capital, a firm will first use internally generated funds and then outsider funds. This suggests that earnings volatility is negatively related with leverage. This is the combined prediction of the trade-off theory and pecking order theory. According to pecking order theory and the trade-off theory, income variability is a measure of business risk. Since higher variability in earnings indicates that the probability of bankruptcy increases, we can expect that firms with higher income variability have lower leverage. Therefore, the trade-off model allows the same prediction, but the reasoning is slightly different. More volatile cash flows increase the probability of default, implying a negative relationship between leverage and volatility of cash flows. As expected, the relationship between leverage and volatility is negative. This supports both the trade-off theory (more volatile cash flows increase the probability of default) and the pecking order theory (issuing equity is more costly for firms with volatile cash flows).


Halov (2009) using panel data methodology, established that the volatility of risk is an important factor in explaining capital structure choices of firms. This effect is over and above the traditional determinants of capital structure such as the current level of risk, size, market-to-book ratio, tangibility of assets and profitability. The study shows that both (1) the fraction of debt in total new external financing raised by the firm, and (2) the long term debt as a fraction of the assets of the firm, are decreasing in the volatility of risk of the firm. Moreover, this negative relationship is significantly stronger for firms that do not have a credit rating. These results are consistent with the theoretical reasons that we provide to explain the negative relationship between leverage and volatility of earnings.





Jacques and Nigro (1997) studied the relationship between changes in capital and changes in risk taking in the US subsequent to the adoption of Basel Committee’sminimum capital regulation in 1991. They found increases in book capital ratios and decreases in risk exposure consistent with the findings of Shrieves and Dahl, Bichsel and Blum (2002) conducted a similar analysis of non-US banks. Their study of Swiss banks provides strong evidence in favor of a positive relationship during the period of 1990- 2002


Raiyani (2011) in his study of the impact of financial risk on capital structure decisions in selected Indian industries, used definition of capital structure in scope of book value to market value and measures were assumed for financial performance. The research applied panel data of 59 companies listed on Stock Exchange of India in a 10-year time horizon (1997-2007). The data was collected from secondary sources. Industries of the study were selected based on ten years’ data availability and if the total assets value of the company were more than Rs. 100 crores, the statistical tools used for analyzing them vary from general descriptive analysis such as Mean, Standard Deviation, Coefficient of Variation, Compound Growth Rate to Linear Growth Rate. Also, parametric t-test for ascertaining the level of significance of both compound and linear growth rates and one way analysis of variance, simply called F-test across selected industry sectors were also used. Results of the study demonstrated that finance risk variables, particularly risk followed by volatility in ROE have significant effect on determining the additional variation in use of debt financing in business through long-term sources among firms


Kumars (2009) studied the impact of risk on capital structure of listed firms in Iran stock exchange. The study was an attempt to establish whether the firm risk impacts capital structure decisions. The research used 2 definitions, solvency ratio and operating income standard deviation, as measures of firm risk. The study applied panel data of 117 corporates in Tehran Stock Exchange (TSE) in a 5-year time horizon (2002- 2007).Results of our study demonstrated that firm risk influences firm’scapital





structure. The results indicated a negative relationship between firm risk and capital structure


Floquet and Biekpe (2009) study was an attempt to identify the nature of the relationship between capital structure and risk-taking in emerging market financial firms. A three- stage least squares (3SLS) method of estimation was applied to a modified version of the capital model developed by Shrieves and Dahl and a modified version of Kwan and Eisenbeis” efficiency model. The relationship between changes in capital structure and risk and absolute levels of capital and risk are examined for 2940 financial firms across 44 emerging market countries for the period of 1995 to 2003. Results show that no significant relationship exists between changes in capital and changes in risk, contrary to the positive relationship presented by developed market empirical evidence. A positive relationship between the absolute levels of capital and risk is, however, identified amongst emerging market financial firms. The evidence suggests that emerging market financial firms do not align capital and risk positively in the short term, but are able to make this alignment in the longer term.


Moral hazard bank behavior is indicative of a negative relationship between capital ratio and risk, as high risk-taking is combined with high leverage. Demirgüç-Kunt and Detragiache (2000) also found that moral hazard to be prevalent in countries where banking regulation and supervision are substandard, indicating the possible presence of these conditions in emerging markets. A study conducted by Godlewski (2005) is one of the few that address the relationship between the changes in capital and risk in an emerging market context. Although Godlewski identifies weak evidence of a negative relationship between the changes under specific conditions, the results suggest that no significant relationship exists amongst emerging market financial firms. A limited investigation into the relationship between the absolute levels of capital and risk was carried out by Altunbas et al. (2001) that examined the influence of bank efficiency on the capital and risk system. They provided evidence of a strong positive relationship amongst European financial firms.





Calem and Rob (1996) developed a dynamic model of a banking firm subject to moral hazard, using US bank empirical data for the years 1984 to 1993 and found a “U-shaped” relationship between changes in capital and changes in risk-taking. This is explained by the fact that well-capitalized financial firms invest in high-risk assets; less well- capitalized financial firms pursue a more conservative risk approach, while poorly capitalized financial firms attempt to maximize risk-taking. Iwatsubo (2003) supports this view with evidence of a significant non-linear relationship between capital ratio and risk for Japanese financial firms.


Research into the relationship between the capital structure and risk-taking of financial firms provides conflicting and inconclusive results. The literature indicates that the relationship between changes in capital structure and risk is influenced by the time period under investigation and the environmental conditions to which financial firms are exposed. The results from investigations into the relationship between the absolute levels of capital and risk have consistently produced a significant positive relationship. However, these studies are limited in number and geographic location.


2.4.6   The moderating effect of firm management control on capital structure


Researchers in corporate finance have focused considerable attention on the ways in which managerial self-interest affects managerial decisions. Jensen and Meckling (1976) pointed out that managers sometimes set debt below the level which is optimal for unaffiliated outside shareholders. This deviation from the optimal capital structure is primarily due to two important types of non-diversifiable risk in a firm. First, as discussed by Fama (1980), managers have substantial human capital investment in their firms. Second, managers typically have a large equity investment in their firms. Models of managers” (controlling shareholders”) behavior frequently account for their exposure to idiosyncratic firm risk.





Carvey and Hanka (1999) in the study “capital structure and corporate control: The effect of antitakeover statute on firm leverage” it was found that firms protected by ‘second generation” state antitakeover laws substantially reduce their use of debt, and that unprotected firms do the reverse. This result supports recent models in which the threat of hostile takeover motivates managers to take on debt they would otherwise avoid. An implication is that legal barriers to takeovers may increase corporate slack.


Hamid (1992) argued that the agency theory recognizes that the interests of managers and shareholders may conflict and that, left on their own, managers may make major financial policy decisions, such as the choice of a capital structure, that are suboptimal from the shareholders’ standpoint. The theory also suggests, however, that compensation contracts, managerial equity investment, and monitoring by the board of directors and major shareholders can reduce conflicts of interest between managers and shareholders. This research investigated the relationship between the firm’s capital structure and 1) executive incentive plans, 2) managerial equity investment, and 3) monitoring by the board of directors and major shareholders. This paper found a positive relationship between the firm’s leverage ratio and 1) percentage of executives’ total compensation in incentive plans, 2) percentage of equity owned by managers, 3) percentage of investment bankers on the board of directors, and 4) percentage of equity owned by large individual investors. These findings are consistent with the predictions of agency theory, suggesting, in turn, that capital structure models that ignore agency costs are incomplete


Ellul (2010) investigated the use of leverage as one channel through which control- motivated block-holders can defend their corporate control. Such block-holders face a trade-off between raising external finance and losing their control over the firm. Debt has an advantage over equity in solving this trade-off because it does not dilute the block holder’svoting power. The study used a sample of 5,975 firms from 38 countries over the period 1992-2006 and identified the presence of family block holders and long-term institutional investors which are the type of owners that should value corporate control





most. It was found that firms that are owned by these block holders have high leverage, after controlling for other capital structure determinants. This result cannot be explained by the use of debt to discipline firms owned by block-holders that may have higher managerial agency conflicts, overinvestment problems or empire-building concerns. Most importantly, it was found that leverage in these firms is used strategically and not indiscriminately given the higher risk of bankruptcy it poses: debt is mostly used when control is contestable and less when block-holders already have control enhancing mechanisms in place. The evidence is reinforced when analyzing the behavior of leverage around hostile takeovers and withdrawn takeover bids.


Anecdotal evidence has shown the importance of control motivations to block-holders. An example is a survey of 891 Italian firms sampled from the Mediocredito database. A major problem facing Italian firms is the lack of adequate financing. Bagella et al. (2001) reported that to the question on their availability for any equity dilution, more than 80% of CEOs answered that they are ready for “No Equity Dilution”. When they were asked whether they see any advantage from higher financial stability resulting from external finance, almost 52% saw no advantages.


A recent example of such control motivations was provided by Bertelsmann, the German media company, a family-owned company since 1835. In 2001 the Bertelsmann family sold 25.1% of its company to Groupe Bruxelles Lambert (GBL) in exchange for 29.9% share (and complete control) of RTL, a media company. The deal gave the right to GBL to list its stake in Bertlesmann publicly after five years. In 2006, to avoid such a public listing, the Bertelsmann family bought back the stake of GBL for some $5.75 billion through an issue of debt, and “for this luxury, Bertlesmann has more than doubled its existing debt…the media company is probably overpaying by around Euro 500 million. However, it avoids the scrutiny of stock analysts and the activism of hedge funds” (The Economist, 2006).





Institutional block-holding around the world and in the U.S, Stulz (2005) argues that controlling shareholders may pursue their own interests and their objectives are likely to have important repercussions on firms they invest in. Leverage is one such important firm decision that they can influence. The only two directly related empirical papers are those of Berger, Ofek and Yermack (1997) who looked at entrenched managers, and Litov and John (2006) who looked at corporate governance and managers” investment policies. Notably, Berger et al. (1997) found that, contrary to the control hypothesis, entrenched managers decrease firm’sleverage.


The results that family block-holders increase leverage strategically can also be consistent with alternative explanations. For example, Harvey et al. (2004) find that debt is mostly used by firms where managerial agency costs are highest. Firms owned by control-motivated block-holders are potential examples. The results in this paper show that control motivated block-holders are associated with higher leverage even in firms that do not suffer from overinvestment problems. This also means that the results are robust to the argument that such firms may have larger leverage to restrict empire building (Zwiebel, 1996). Debt and dividends can be substitutes when dealing with agency conflicts (Jensen, 1986). If dividends, instead of debt, are used to discipline managers” empire building, then internal finance will be depleted with a consequent higher reliance on external funding. In the case where equity is more expensive than debt, then higher leverage results, but in this case, it is not because of any control motivations. The study found no support for this hypothesis. From this evidence it was concluded that the control motivation hypothesis proves robust to different tests.


Existing theoretical literature argues that control motives can influence the mix of equity and debt. Harris and Raviv (1988), Israel (1991) and Stulz (1988) investigated the actions of entrenched managers and found that they can use the capital structure to gain voting power. Stulz (1988) concluded that “whether management controls too few or too many votes, the firm’scapital structure decision is relevant because of its effect on the distribution of voting rights” (page 27).





Control motivations should be tested against other hypotheses. Managers with high control motivations often hold undiversified portfolios with significant firm-specific risks. Applying the Fama (1980) and Masulis (1988) frameworks to the case of leverage in firms owned by undiversified control-motivated managers, we can hypothesize that lower leverage can be used to reduce firm-specific risk. Debt in firms with concentrated ownership can also be used as a disciplining device to solve agency conflicts, especially where legal protection is ineffective. Harvey et al. (2004) showed that debt serves as a governance mechanism in emerging markets because it either reins in the overinvestment problem or signals management’sunwillingness to engage in overinvestment. Their evidence is consistent with Jensen (1986, 1993), Flannery (1986), Stulz (1990), Diamond (1991), Hart and Moore (1995), and Zweibel (1996).


Cheng, Nagar and Rajan (2004) stated that in the context of firms with an owner- manager, most financiers insist on some form of protection, so that the final compromise reached in most financial contracts for small firms is one resembling a debt contract (or a venture capital contract), which protects the founder-manager’scontrol as long as the firm is performing adequately.


Holmen (2007) used direct estimates of the portfolio diversification of the largest shareholder in a firm to study the impact of shareholder diversification on the firm. For firms where the controlling shareholder is an individual, tests indicated that the owner- managers use debt, dual class shares and corporate control transactions (merger activity) to strategically trade-off corporate control and the drawback of poor portfolio diversification. However, for firms where the controlling shareholder is an institution, the results indicate that control, but not diversification, is important.


Most of the empirical studies done on the relationship between firm growth and capital structure tend to follow the agency theory proposition. However, the empirical findings of studies done in the developed world differ from those of the developing world, those done in developing world show that managers are motivated by fear of bankruptcy and





therefore are averse to debt finance while those managers in the developed world are motivated by fear of dilution of ownership take overs and therefore prefer debt finanace. The management of the individual firm will be expected to influence the capital structure decisions through the financial decisions that they make as they guide the operations of the firms. Some of the financial decisions that they make include short- term borrowing, setting the cash ratio of the firms, deciding the dividend policy of the firm and the retention ratio among other decisions. These decisions are bound to guide the capital structure decision taken by the individual firms. For the purpose of this research: retention ratio, dividend ratio and cash ratio were adopted as proxies for the firm management control.


2.5. Critique of the existing literature relevant to the study


The financial literature offers two competing models of financial decisions: the static trade-off and the pecking order theory. In the trade-off model, firms identify their target leverage by weighing the costs of financial distress and the tax benefits. At the target leverage level, the benefit of the last unit of debt just offsets the cost. In contrast, the pecking order theory arises due to the existence of asymmetric information and transaction costs. In this theory, firms raise funds in a particular sequence and follow two rules. Firstly, corporations prefer internal financing than external ones. Secondly, firms always issue the safest securities first.


According to reviewed literature, capital structure studies continue to draw mixed findings with different theories not reaching a consensus on capital structure determinants. It seems that one is competing against the other and they both seem reasonable to some extent. Scholars always try to run a race between them in order to find the circumstances in which one is superior to another (Myer & Majuf, 1984; Fama & French, 2002). They find that pecking order works best for large, mature companies that have access to public bond markets. This is not consistent with smaller, younger, growth firms, which are more likely to rely on equity instead of debt. Here the pecking





order theory stumbles (Shyam-Sunder & Myers, 1999; Lemmon & Zender, 2002; Frank & Goyal, 2003). The trade-off theory still retains some explanatory power once pecking order motives are accounted for.


Empirical studies also show no consensus since even studies conducted within the same locality arrive at different conclusions e.g. Ngugi (2008) and Nyangoro (2003). The review considered comparative studies between developed and developing studies as well as country specific African studies. While previous research focused mainly on firm specific factors, later studies have laid emphasis on institutional as well as macroeconomic environment to assess the effect of country specific factors. Another conclusion of the study is that capital structure measures remain the same across developed and developing countries. This implies that variables used in developed countries are also applicable in developing countries.


2.6   Summary


The above review has clearly shown that there are a number of factors other than regulations that influence capital structure of financial firms. The Target debt ratio varies from country to country, industry to industry, and firm to firm (Buferna et al., 2005). As far as studies on Kenya are concerned, there are numerous studies on the determinants of capital structure of listed non-financial firms. Little is known about the influence a firm management control may have as a moderating variable on the influence of profitability, firm “s size, firm’sgrowth and firm’srisk on capital structure, especially for the insurance companies in Kenya. Control motivations of firm management should be tested against other hypotheses, Harvey et al. (2004). This study seeks to explore how insurance firms set their capital structure and the influence of firm management control as a moderating factor on the capital structure decisions of the insurance companies in Kenya.



2.7   Research gaps


Literature suggests that debt requirements of a firm in one industry differ from a firm in another industry because the various industries experience different business environments (Titman & Wessels, 1988). As a result of the unique financial characteristics of insurance firms and the environment in which they operate and the massive collapse of eight insurance companies in the last decade ( IRA report, 2008), there is a strong ground for a separate study on the influence of firm specific factors on capital structure of insurance companies in Kenya.






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