The relationship between the firm’s capital structure and the systematic risk of common stocks: an empirical study of companies quoted on the Nairobi stock exchange

Abstract

The issue of risk is of great importance to anyone interested in finance either as an investor or a finance manager. This is so because while the main objective of any investment is for its return, it has been established that this return is partly depended on the risk level associated with that investment. That is, the higher the risk the higher is the expected return, and vice versa. This being the case however, it has been established further that investors can diversify away part of this risk. The part of risk which they cannot diversify away is the systematic risk and this is what concerns them most. Among the factors thought to influence the risk of a security is the capital structure of the firm issuing the security. This study then attempts to establish whether there is a relationship between the firm’s capital structure and the systematic risk of its common stocks for companies quoted on the Nairobi Stock Exchange (NSE). This study relies heavily on the theory of capital structure as espoused by Modigliani and Miller (MM theory 1958). It involves the computation of annual returns of the companies having debt and then annual returns of these same companies assuming that they do not have debt in their capital structure. These two sets of annual returns are then regressed against the observed market returns for the same period to determine the levered and unlevered estimates of systematic risk (beta). The study concludes that there is no relationship between the firm’s capital structure and the systematic risk of its common stocks. While there appears to be a difference between the means of the levered and un-levered estimates of beta, this difference is not statistically significant to lead to a conclusion to the contrary. However, these conclusions are limited to the extent of the validity of the assumptions made in the study and the respective limitations that the study encountered.