Effect of Financial Performance on Capital Structure of Listed Manufacturing Companies in Kenya

International Journal of Research and Innovation in Social Science (IJRISS) | Volume V, Issue II, February 2021 | ISSN 2454–6186

Effect of Financial Performance on Capital Structure of Listed Manufacturing Companies in Kenya

Olanrewaju Isola Fatoki*, Fredrick Wafula, Gabriel Waweru
College of Business, KCA University, Nairobi, Kenya
Corresponding Author*

Abstract: This paper examines the portability of the reverse causality hypothesis between financial performance and capital structure of listed manufacturing firms in Kenya. Most research carried out in East Africa, Kenya inclusive shunned the likely effect of performance on capital therefore, to achieve this objective, financial performance was proxy by return on assets and return on equity while the capital structure was measured by total debt ratio and debt to equity ratios. The data employed covered 7 companies for the period from 2010 to 2016. While the Panel Vector Auto regression was applied and analysed using EVIEWS 10, the Wald granger causality test was carried out to determine the possibility of causality between the variables. The result reveals that past performance does not have a significant effect on the capital structure as measure by total debt ratio while it was established that capital structure composition of the firms affects their financial performance as measured by return on assets and return on equity. However, employing the debt-equity ratio as a measure of capital structure, it was established that a bi-directional relationship exists between DER and ROA while it was the opposite in the case of ROE. The study, therefore, concludes that the behaviour of the listed manufacturing firms in their choice of capital structure composition reflects both the efficiency risk and franchise value hypotheses. It, therefore, recommends that firms should strive more for returns to enhance the value of the firm to maximize the wealth of the shareholders.

Keywords: Capital Structure; Financial Performance; TDR; DER; ROA; ROE; Reverse Causality Hypothesis

I. INTRODUCTION

Investors and potential investors will be obliged to invest their hard-earned savings in a company that promised to make a return that will change their wealth position at a point in time. However, as sound as this objective is, it will be elusive if the hard-earned resources are not combined for optimum utilization. The essence of capital structure decision is to ensure the right combination of financing resources that will yield maximum return without necessarily hampering the interest of stakeholders
Since the seminal work of Modigliani and Miller (1958, 1963) on the relevance and irrelevance of capital structure, researchers incorporate financial theory have always been interested in the causal effect of capital structure on financial performance and value of the firm. The classical thinking from the theories propounded since then was premised on a causal relationship that capital structure choice determines or affect performance thereby impact on the value of the firm (Kraus & Litzenberger, 1973; Meckling & Jensen, 1976

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