Determinants of Capital Structure: a Review of the Evidence

Abstract

One of the key unresolved issues in the field of finance is whether capital structure is a relevant input into the value of the firm. In addition, what are the key determinants of capital structure and why do these variables matter? This study was primarily a literature review in the area of firm capital structure with the ultimate aim of identifying researchable issues in the area of corporate capital structure choices in Kenya. The study found out that two main theories of capital structure have become predominant, that is the trade-off and pecking order theories; and to a lesser degree the free cash flow theory. Empirical testing of these theories has not yielded definite conclusions as to which of them is better at explaining observed firm capital structures. The bulk of the empirical research in the area of firm capital structure has focused on isolating the relationship between capital structure on the one hand and various explanatory variables such as; tangibility of assets, non-debt tax shields, rates of taxation, growth of firm and investment opportunities, uniqueness of firm's products, industry classification, size of firm, volatility of firm earnings, profitability of firm, bankruptcy costs, adjustment (financing) costs and country that firm is based in; on the other. The studies that have been conducted in Kenya on capital structure have mostly been at the masters degree level and they have focused on testing separately the main theories of capital structure and also the relationship between capital structure and various determinants. It does appear that a lot more empirical work requires to be carried out in the area of capital structure in Kenya. The study identified several empirically researchable issues in Kenya, primarily focusing on firms listed on the Nairobi Stock Exchange. One issue is testing the tradeoff, pecking order and free cash flow theories of capital structure. Another study would be to carry out an empirical assessment of the determinants of capital structure. Yet one could carry out an empirical assessment of the determinants of changes in capital structure. Finally assessing the functional nature of the relationship between the independent variables and each of the dependent variables can be carried out.