Financial Constraints, Capital Structure And Investment

Abstract

Evidence of financial constraints and its effects on firm’s real decision in countries with advanced capital markets implies that the situation might be severe in countries with less developed capital markets. Despite this possibility, there is a dearth of evidence on the severity of financial constraints and its effects in Kenya. Against this backdrop, this study examined firm capital structure and investment and analysed the role of financial constraints in this context in Kenya. To this end, three specific objectives were addressed, each by an essay, using data from all manufacturing firms that were listed on Nairobi Securities Exchange between 1999 and 2016. The data was collected from published annual financial statements that companies filed at Capital Market Authority. The first essay analysed the determinants of financial constraints in Kenya. Size-age measure was found to perform better than measures of financial constraints based on endogenous switching regression and has high correlation with experienced financial constraints. Thus, size and age of the firms are the main determinants of financial constraints in Kenya. The endogenous switching regression based classifications were found to be sensitive to the choice of the starting values, and the specification of the outcome equation and the selection equation. They were inefficient and produced inconsistent sub-samples. About 67 percent of the firm-years in the manufacturing sector suffer from financial constraints. The second essay investigated the effects of financial constraints on firm capital structure. The goal of this essay was implemented in two ways. First, a financial constraints dummy variable was interacted with the determinants of capital structure. Second, incremental F ð€€€test was used to test for the differences in the financing behaviour across financial constraint regimes. Pecking order theory does not hold, however, financing behaviour varies across financial constraint regimes. The third essay investigated the effects of financial constraints on firm investment. The study used investment Euler equation and Tobin Q to examine whether constrained and unconstrained firms invested differently, in terms of what drives investment. Secondly, real exchange rate shock was used to analyse firm’s investment response to shock in the presence of financial constraints. The empirical strategy was to compare investment rate immediately before and after the shock for firms under different degrees of financial constraints. Financial constraints negatively affect investment and firm’s response to shock depends on financial constraint status. Overall, financial constraints affect young and small firms causing them firms to forego external capital, underinvest, and alter their response to a positive shock. Policy should aim at easing constraints on access to capital by broadening the scope of assets that can be pledged as collateral and instituting policies to reduce costs associated with verification of private information, and contract enforcement including legal charge such as by creation of a central depository for collateral. Furthermore, to minimize policy related distortions, financial constraints should be taken into consideration in designing the level of interventions. Keywords: Financial constraints, manufacturing, investment, capital structure, endogenous switching regression. JEL classification: D82; D92; E22, G31, G32, G33, L60.