Effect of Capital Structure on Stock Returns of Manufacturing and Allied Firms Listed at the Nairobi Securities Exchange

Abstract

Capital structure plays an important role in firm’s stock return provided it is utilized efficiently and in an effective manner at its optimal level. However, the questions of what constitutes an optimal capital structure remains unanswered and the most controversial issue in the finance circles. There is no agreement on the nature of effects of capital structure on the returns from both the theoretical and different empirical studies. The information asymmetry proposition of Myers and Majluf (1984) proposes a negative correlation because companies regardless of their market position would rely on the retained earnings for expansion instead of costly external finance. On the other hand, MM’s tax/ interest shield proposition predicts a positive relationship since at higher income level, corporation would want to utilize more debt finance in their capital structure in order to shield their profits from taxation The aim of this study was to ascertain the effect of capital structure on stock returns of manufacturing and allied firms listed at the NSE. The population for the study was all the 9 manufacturing and allied companies listed at the NSE. The independent variables for the study were capital structure as measured by debt ratio, profitability as measured by return on equity, liquidity as measured by current ratio and firm size as measured by natural logarithm of total assets. Stock return was the dependent variable and was measured by movement in share prices and dividend issued. Secondary data was collected for a period of 10 years (January 2007 to December 2016) on an annual basis. The study employed a descriptive cross-sectional research design and a multiple linear regression model was used to analyze the relationship between the variables. Data analysis was undertaken using the statistical package for social sciences. The results of the study produced R-square value of 0.175 which means that about 17.5 percent of the variation in stock returns of manufacturing and allied firms listed at the NSE can be explained by the four selected independent variables while 82.5 percent in the variation of stock returns of manufacturing and allied firms listed at the NSE was associated with other factors not covered in this research. The study also found that the independent variables had a weak correlation with stock returns of manufacturing and allied firms listed at the NSE (R=0.418). ANOVA results show that the F statistic was significant at 5% level with a p=0.000. Therefore the model was fit to explain the relationship between the selected variables. The results further revealed that profitability and liquidity produced positive and statistically significant values for this study. Capital structure produced negative but statistically significant values while firm size was found to be a statistically insignificant determinant of stock returns of manufacturing and allied firms listed at the NSE. This study recommends when firms are setting their capital structure they should strike a balance between the tax savings benefit of debt and bankruptcy costs associated with borrowing. High levels of debt has been found to reduce stock returns of listed manufacturing and allied firms from the findings of this study and so firm managers should maintain debt in levels that do not impact negatively on stock returns to ensure the goal of maximizing shareholders’ wealth is attained.