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A STUDY ON THE IMPACT OF CAPITAL STRUCTURE ON PERFORMANCE OF COMMERCIAL BANKS IN KENYA BY ROBERT NDUNG’U NDUTA – 16/00143 SUBMITTED IN PARTIAL FULFILLMENT OF THE REQUIREMENTS FOR THE FINAL YEAR RESEARCH PROJECT OF THE BACHELOR OF COMMERCE DEGREE KCA UNIVERSITY JULY

April 22, 2019 0 Comment

A STUDY ON THE IMPACT OF CAPITAL STRUCTURE ON PERFORMANCE OF COMMERCIAL BANKS IN KENYA

BY
ROBERT NDUNG’U NDUTA – 16/00143

SUBMITTED IN PARTIAL FULFILLMENT OF THE REQUIREMENTS FOR THE FINAL YEAR RESEARCH PROJECT OF THE BACHELOR OF COMMERCE DEGREE KCA UNIVERSITY

JULY, 2018

CHAPTER ONE
INTRODUCTION
1.1 BACKGROUND TO THE STUDY
The banking sector of developing economies like Kenya plays a signi?cant role in the economic acceleration process of the countries, as such it is necessary to understand the factors impacting its performance.
Capital structure denotes the mode of ?nance, usually a blend of the loan and equity capital, through which a ?rm is ?nanced. According to Diamond ; Rajan (2000) the capital structure of banks is largely determined by the asset side of the statement of financial position. It has been an interesting issue for many researchers, wherein they attempted to delineate the connection between capital structure and the performance of ?rms. The decision of how a ?rm will be ?nanced is subjected to both the managers of the ?rms and fund suppliers. If ?nancing is done by employing an incorrect combination of debt and equity, a negative effect is seen in the performance and even endurance of a ?rm. Thus, in order to maximize the ?rm value, managers need to carefully consider the capital structure decision, which is a complex task, as the use of leverage varies from one ?rm to another. Therefore, what managers usually do is try to achieve the best combination of debt and equity in their capital structure. In this context, there have been several studies that tried to inspect the af?liation of capital structure with the performance of ?rms. Modigliani and Miller (1958) stated that, under perfectly competitive capital market conditions, the ?rm value is free from the in?uence of capital structure decisions.
Capital structure is based on three sources of financing. These are issuing shares, borrowing or by using retained earnings. Each source of financing has its own importance. The study of Shaheen and Malik (2012) contributed that for all long term and short term needs, firms use debt financing tool. The study of Sheikh and Wang (2013) contributed that the firms’ priority to use debt is due to the negative relation of firms’ performance with the capital structure of the firm negative relationship between capital structure and performance indicates that agency issues may lead the firms to use higher than appropriate levels of debt in their capital structure. Capital structure varies from industry to industry. Empirical evidences from the world proves that the capital structures are industry specific ,for example, according to Amjed (2011), particular industry follows a particular hierarchy for choosing the capital structure.
1.2 STATEMENT OF THE PROBLEM
The bank performance which constitutes the core of the financial sector, plays a critical role in transmitting monetary policy impulses to the entire economic system, capital structure plays a significant role in the success of an enterprise. A good capital structure enables a banking company enterprise to go ahead successfully on its path and attain gradual growth. The capital structure of banks is, however, still a relatively under-explored area in Kenya. Currently, there is no clear understanding on how banks choose their capital structure and what factors influence their corporate financing behavior. As such the need for research on the relationship between capital structure and bank performance is vital.
Various studies, both locally and internationally have observed the impacts of capital structure on the performance of a ?rm. The mixed evidence derived from the studies drove the need to explore and establish the in?uence of capital structure decision on ?rm performance. Kuria (2013), for example researched the effect of capital structure on the financial performance of commercial banks, conducted on 35 commercial banks in Kenya in operation in Kenya for the five years (2008 to 2012). The finding of the analysis concluded that there is no significant relationship between the capital structure and the financial performance of commercial banks in Kenya. Rouf (2015), by using the data from 2008–2011, conducted a study on non-?nancial companies and observed a signi?cant negative relation of capital structure with Return on Asset (ROA) and Return on Sales (ROS). Hossain and Hossain (2015), by using the data of manufacturing companies over the period of 2002–2011, investigated the antecedents of capital structure in Bangladesh. In a similar study, which excluded the performance of bank sector, Hasan et al. (2014) studied whether Bangladeshi ?rms are affected by capital structure. Chowdhury and Chowdhury (2010) studied the association of ?rm value with capital structure choice. They used data only over the period of 1994–2003 for non-?nancial ?rms and ignored banking sector performance.
Orua (2009) in her study of the relationship between capital structure and financial performance of micro finance in Kenya restricted her study on micro finance institutions. Kamau (2009) also carried out a research on effects of change in capital structure on performance of companies quoted in Nairobi Stock Exchange. Nyata (2009) also carried out a study on relationship between capital structure earnings growth and price earnings ratio of firms in NSE. In all these studies, the scholars have concentrated much on firms listed in the NSE which includes some banks. From the above discussions, it is evident that, there are few studies seeking a relationship between the capital structure and the performance of banks. Therefore this study will concentrate on the impact of capital structure on commercial banks in Kenya.
1.3 OBJECTIVE OF THE STUDY
The main objective of this study is to examine the relationship between capital structure and bank performance by estimating the contribution of capital structure investment to banks performance as measured by financial ratios.
Specific objectives
To determine the effect of debt on financial performance of commercial banks in Kenya
To assess the effect of internal equity on financial performance of commercial banks in Kenya
To determine the effect of external equity on financial performance of commercial banks in Kenya
To assess the effect of preference share on financial performance of commercial banks in Kenya.

1.4 RESEARCH QUESTIONS
a) Does debt have effect on financial performance of commercial banks?
b) What are the determinants of capital structure?
c) Does external equity have effect on financial performance of commercial banks?
d) Does internal equity have an effect on financial performance of commercial banks?
e) Do preference shares have an effect on financial performance of commercial banks?

1.5 JUSTIFICATION OF STUDY
The findings of this study can be used to develop policies, practices and strategies that would enable commercial banks attain higher levels of financial performance.

CHAPTER TWO
LITERATURE REVIEW
2.1 INTRODUCTION
Capital structure refers to the use of finance by utilizing different proportions of various sources of debt and shareholders’ equities for the benefit of the firm, whether it is measuring in terms of profitability or valuation of the firm. Now a days, the selection of capital structure determines on the basis of cost and benefit analysis between the sources of financing.
2.2 THEORETICAL REVIEW
This section seeks to explain the various theories relevant in capital structure and financial performance. The most renowned theories of capital structure like MM theory, pecking order theory, static trade-off theory, agency theory, the theory of free cash flows and many other conditional theories are designed by the researchers for the beneficial financing decisions.
Modigliani and Miller (1958) state that, by taking the effect of tax advantage on debt that the ?rm value can be increased by incorporating more debt into the capital structure and thus the optimal capital structure of a ?rm should be made up of a hundred percent of debt. However, it is arguable whether these assumptions hold in the real world; thus, several theories, for instance, the static trade-off theory, pecking order theory and theory of agency cost, emerged to explain the connection of capital structure decisions with the ?rm performance.

2.2.1 TRADE-OFF THEORY
The argument over the assumptions of Modigliani and Miller (1958) results in the static trade-off theory, which states that, with the incorporation of tax into the Modigliani and Miller (1958) theorem, the advantage for the use of debt capital, if practically possible, can be applied to protect earnings from high taxes. According to Brigham and Houston (2004), the optimal capital structure of a ?rm, from which the ?rm value will increase and the cost of capital will decrease, is determined by the trade-off of the bene?ts of using debt, known as tax savings and the costs of debt such as agency costs. Furthermore, the trade-off theory states that ?rms having more physical assets should employ additional debt capital, as these physical assets would be collateral. In addition, the intangible asset value is more prone to depreciate in the case of ?nancial suffering. Focusing on the unequal treatment of tax in debt ?nancing and equity ?nancing, Schepens (2016) argued that more equal treatment of debt and equity signi?cantly increases bank capital ratios, driven by an increase in common equity, which ultimately impacts the capital choice of banks.
2.2.2 PECKING ORDER THEORY
Myers (1977) developed a capital structure theory, known as the pecking order theory, which believes in no optimal capital structure and suggests that very ?rm has a preferred hierarchy for the ?nancing decisions and usually prefers the internal ?nancing rather than acquiring funds from out side the organization. However, ?nancing from outside sources is required when all in-house funds are employed. According to Muritala (2012), in such a case, ?rms will prefer debt over equity.

2.2.3 AGENCY COST THEORY
Considering that debt is a necessary factor, which creates differences in the goals of shareholders with managers, Jensen and Meckling (1976) developed the agency cost theory. The theory explains that the cash ?ow of a ?rm relies on its ownership formation. The authors suggested that there should be the best combination of debt and equity capital that could shrink total agency costs. In other words, prevailing agency cost determines how much debt should be introduced into the capital structure.
2.3 DETERMINANTS OF CAPITAL STRUCTURE
Variables help to determine financing sources called determinants of capital structure. These determinants proved by many researchers. Like, Najjar and Taylor (2008) found some determinants of capital structure as occur in developed markets, namely; profitability, firm size, growth rate, market-to-book ratio, asset structure, solvency and liquidity. The study of Amidu (2007) discussed that the banks have always been concerned with both solvency and liquidity.
Growth is the determinant of capital structure and it is related to the performance of the firm. Capital structure choices determine on the basis of capital structure. According to Graham (2009) equity issuance and returns may both be correlated with growth opportunities. The study of Rafiq et al. (2008) contributed that the correlation between growth and leverage is positive. Therefore, he concluded that due to the positive relation, study proved that internally generated funds (retained earnings) are not enough for financing requirement, so debt financing is the only source to achieve further growth opportunities.
Size of the firm is the controlling variable and also the determinant of capital structure. It impacts on financial leverage. According to many studies it is the most important determinant of capital structure. The study of Ezeoha (2008) further explored the impact of size on financial leverage. He concluded that in a particular company size depends on the development level of financial market.
2.4 EMPIRICAL STUDIES
Various foreign and local studies which have been carried out by other scholars in this field are discussed in this section.
Dehghanzadeh and Zeraatgari (2013) were evaluated in research to examine the relationship between capital structure with return on assets and return on equity of 193 companies listed in Tehran Stock Exchange for the period 2006 to 2011. The results show there is a negative significant relationship between the rate of return on assets and capital structure. This means that under normal conditions the choice of capital structure have effects on the rate of return on assets and companies with a higher rate of return on assets, take advantage of lower debt in its capital structure. Also, there is no significant relationship between capital structures with the rate of return on equity.
Sajjadi and colleagues (2010) were evaluated in research to investigate the effects of six factors: type of industry, company size, and company age of industry, capital to assets ratio, a leverage size and cost of advertising on the profitability of the companies listed in Tehran Stock Exchange. He for profit using the three criteria of return on assets, return on assets adjusted and return on equity and concluded that if the defined criteria of profitability, return on assets and return on assets adjusted, the variables such as the size, the ratio of debt to total assets and ratio of capital to assets influence on profitability. But type of industry, company age and advertising costs has not effect on profitability. Also, if the criterion of profitability to be considered return on investment, type of industry and company size has an effect on profitability. But the company age, the ratio of capital to assets, a leverage size and cost of advertising has not effect on profitability.
Ebaid (2009) examine the capital structure and corporate performance in the period 1997-2005 for Egypt. His main objective was to investigate the relationship between the level of debt and financial performance. He used three performance indicators of return on assets, return on equity and gross profit margin; he found that if the use of the return on assets index, short-term debt and total debt had a many negative impact on financial performance but long-term debt have not impact on financial performance. He also concluded that the use of indicators of the rate of return on assets, return on equity and gross profit margin, none of these debts will have little impact on financial performance.
Abor (2007) in research on small and medium enterprises in Ghana and South Africa in the six-year period (2003-1998) came to these results that in both countries, the ratio of total debt and short-term debt ratio have significant and negative relationship with gross profit margin. Long-term debt ratio is a positive significant relationship with the gross profit margin. In Ghana, the total debt ratio, the ratio of long-term debt and short-term debt ratio is a negative significant relationship with the rate of return on assets. In South Africa, between the ratio of total debt, and ratio of long-term debt, with the rate of return on assets is a negative significant relationship and is a positive relation between the ratios of short- term debt with the rate of return on assets.
Mubeen Mujahid (2012) examined the impact of capital structure on bank performance. The study spread empirical work on capital structure of banks within country and foreign country. Multiple reversion models were useful to evaluation the relationship between capital structure and banking performance. Performance was measured by return on assets, return on equity and earnings per share. Determinants of capital structure contains long term debt to capital ratio, short term debt to capital ratio and total debt to capital ratio. Results of the study validated a positive relationship between factors of capital structure and performance of banking industry.
Amidu (2007) conducted a study to investigate the dynamics involved in the determination of the capital structure of the Ghana banks. The dependent variables used in this paper are the leverage (LEV) is total debts divided by total capital; short-term debt ratio (SHORT) is total short-term debt to capital while long-term debt ratio (LONG) is the total long-term debt divided by total capital. The explanatory variables include (PRE) profitability, (RSK) risk, and asset structure (AST), tax (TAX), size (SZE) and sales growth (GROW). The regression line model is use in this research and the result was a negative relationship between profitability and leverage. The results of prior studies show that higher profits increase the level of internal financing(Titman and Wessels 1988; and Barton 1989).Profitable banks accumulate internal reserves and this enables them to depend less on external funds. The results of this study show that profitability, corporate tax, growth, asset structure and bank size influence bank’s financing or capital structure decision. The significant finding of this study is that more than 87 percent of the banks, assets are financed by debts and out of this short-term debt appear to constitute more than three quarters of the capital of the banks. This highlights the importance of short-term debts over long-term debts in Ghanaian banks financing.
Pal and Soriya (2012) suggested that intellectual capital (IC) performance of Indian pharmaceutical and textile industry. The data was gathered from the 105 pharmaceutical companies and 102 textile companies. Dependent variables used in this study includes MB (market to book value), ROA (return on Asset), ATO (asset turnover ratio) and ROE (return on equity), independent variables are PC, DER, VAIC and sales. Correlation and regression analysis were conducted to find the results. The use of MB as the market valuation is also debatable because the market sentiments of the stakeholders may not always consider financial statements of the company. Yongvanich and Guthrie (2005) and Abeysekera and Guthrie (2005) classified intellectual capital into three components: external capital, internal capital and Human capital. Profitability measured by ROA clearly indicates that; profitability of the companies is reflected through intellectual capital performance. Findings of the study may be exercised by the managers to organize and utilize ‘intellectual capital’ to have additional profitable output. Return on equity is found to be positively influenced by ‘intellectual capital’ in case of pharmaceutical industry indicating that these firms are generating profits from every unit of shareholders’ equity. Staking and Babbel (1995) supported the hypothesis found by Modigliani and Miller. Jou (1999) found that value of a firm initially increasing with financial leverage and then falling with financial leverage.
The arguments of prior researchers have well-balanced views on the determination of capital structure and firm performance. This study attempts to seek the extant up to which capital structure has affected the corporate performance particularly banking sector of Kenya.

Theoretical Framework

CHAPTER THREE
RESEARCH METHODOLOGY
3.1 Introduction
This chapter outlines the general methodology used to conduct the study. The study is conducted by using the methodologies adopted in earlier research work on this issue. As other studies have discussed these relationships, conceptual frame work of our study is based on deduction method and for analysis of data collected from secondary sources quantitative techniques were employed. Descriptive statistics, correlation matrix and regression models are generally used for analysis of data.
3.2 Research design
Empirical research method was used. It used panel data of ten years due to the advantage that it has. It helps to study the behaviour of each bank over time and across space, Baltagi, (2005). The reasons for using Empirical research methods is that empirical research method help integrating research and practice, and also educational process needs to progress, Mugenda and Mugenda, (2003). Empirical study design provide respect to contextual differences, help to build upon what is already known and provide opportunity to meet standards of professional research. This study is based on secondary data obtained from published statements of accounts of the licensed commercial banks in Kenya, CBK, IMF and World Bank publications for five years from 2011 to 2015.

3.3 Target Population
According to Bryman & Bell, (2011), population refers to the complete set of counts derived from objects possessing one or more common characteristics. In this study, the population consisted of all the commercial banks registered by the Central Bank of Kenya in Kenya. According to the central bank of Kenya, there are 43 licensed commercial banks in Kenya. In this study, the population considered the commercial banks which were in existence for the period of 2011 to 2015.

3.4 Samples and Sampling Procedure
According to the Central Bank of Kenya, there are 43 licensed commercial banks in Kenya. In this study, the population consisted of the banks which were in existence in the period of 2011 to 2015. Family bank was fully fledged a commercial Bank in 2006, Charter house Bank was closed in 2006 due to tax evasion and money laundering.

3.5 Data collection
This study is based on secondary data obtained from published statements of accounts of the licensed commercial banks in Kenya, CBK, IMF and World Bank publications for five years from 2011 to 2015, considering banks that were there for the mentioned last years. The data to be collected for each variable includes; for financial performance, the data that was collected for debt was the total amount of debt. The data collected for ordinary shares was the ordinary share capital. The data was collected for total retained earnings for each bank, and the data collected for the preference shares was the preference share capital.

3.6 Data Analysis Technique
Multiple regression analysis and correlation analysis was used to predict and explain the nature and significance of relationship between dependent and independent variables.
3.6.1 Variables
The independent variables consist of long-term debt, short-term debt, total debt and control variables consist of firm size, asset Growth and dependent variables are Return on Equity (ROE), Return on Asset (ROA) and earnings per share (EPS).
3.6.1.1 Long term Debt to Capital
Mesquita and Lara (2003) and Abor (2005) have used long term debt to capital (LTDTC) as a measure of capital structure and it is calculated by following formula.
3.6.1.2 Short term Debt to Capital Ratio
Abor (2005; 2007) said that short-term Debt to capital ratio (STDTC) is measured by dividing short-term debt withtotal capital.
3.6.1.3 Total Debt to Capital Ratio
For the purpose of study, this ratio is calculated by dividing total debt on capital.
3.6.1.4,Return on Assets
Return on Assets (ROA) measures the profitability of the firms and calculated as
3.6.1.5 Return on Equity
Return on Equity (ROE) is used to calculate a firm’s profitability by revealing how much profit a firm generates with money invested by shareholders and its formula is given below.
3.6.1.6 Earnings per Share
Earnings per share (EPR) measure shareholders profitability by revealing how much profit a share generate with money shareholders have invested and calculated by this formula.
3.6.1.7 Firm Size
To measure firm size (SIZE) different methods are used by scholars. According to Titman and Twite (2003) firm size is calculated as natural log of total book value of assets. In this study we will use the book value of the total assets to calculate the firm size (SIZE).
3.6.1.8 Assets Growth
Assets growth is used by many scholars in their studies and for the purpose of this research; it is calculated by the following formula.
The regression model of Bertha and Melody (2013) comprised Earnings Before Interest and Taxes (EBIT) as the dependent variable. The independent variables included Debt (D), Retained Earnings (RE), Ordinary Shares (OS), and Preference shares (PS).
Multiple regression models are used to find out the association between capital structure characteristics and firm performance in the context of Kenya. Three regression models are formulated to check the relationship between capital structure and banking performance. Our base models take the following form:
Y it = ? + ?X it + ? it
Where:
Y is the dependent variable.
? 0 is the intercept.
X is the independent variable.
? are the error terms.
i is the number of firms and
t is the number of time periods.

Return on asset
ROA =? 0 +? 1 STDTC +? 2 LTDTC + ? 3 TDTC + ? 4 SIZE +? 5 AG +?
Return on equity
ROE =? 0 +? 1 STDTC +? 2 LTDTC + ? 3 TDTC + ? 4 SIZE +? 5 AG +?
Earnings per Share
EPS =? 0+? 1 STDTC +? 2 LTDTC + ? 3 TDTC + ? 4 SIZE +? 5 AG +?