The effect of capital structure on the profitability of energy utility companies in Kenya

Abstract

Capital structure plays an important role in firms financial performance provided it is utilized efficiently and in an effective manner at its optimal level.However, the questions of what constitute 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 profitability from both the theoretical and different empirical studies. The information asymmetry proposition of Myers and Majluf 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. This study sought to determine the effect of capital structure on profitability of energy utility companies in Kenya. The population for the study was all the 17 energy utility firms in Kenya while the sample consisted of the three major players: KPLC, KenGen and Ketraco. The independent variable was capital structure as measured by debt ratio. The control variables were firm size as measured by natural logarithm of total assets and liquidity as measured by the current ratio. Profitability was the dependent variable which the study sought to explain and it was measured by Return on Equity (ROE). Secondary data was collected for a period of 7 years (2009 to 2016) on semi-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. Statistical package for social sciences version 21 was used for data analysis purposes. The results of the study produced R-square value of 0.046 which means that about 4.6 percent of the variation in profitability of energy utility companies in Kenya can be explained by the three selected independent variables while 95.4 percent in the variation was associated with other factors not covered in this research. The study also found that the independent variables had a weak correlation with profitability of utility companies (R=0.214). ANOVA results show that the F statistic was insignificant at 5% level with a p=0.560. Therefore the model was not fit to explain profitability of energy utility companies in Kenya. The results further revealed that individually, capital structure, firm size and liquidity were statistically insignificant determinants of profitability of energy utility companies in Kenya. This study recommends that 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 impact positively on profitability of energy utility firms from the findings of this study and so firm managers should maintain debt in levels that impacts positively on profitability to ensure the goal of maximizing shareholders’ wealth is attained.