The relationship between leverage and market to book value ratio: evidence from firms listed at the Nairobi securities exchange

Abstract

Market to book ratio has been used to measure the premium that an investor is paying for the assets of a company. It is a ratio of market value to the assets of the firm compared to the book value of the same assets. On the other hand, leverage is an indication of the level of debt usage compared to equity in the firms‟ financing structure. The empirical work that has been carried out to determine the relationship between leverage and market to book ratio has focused on the market to book ratio being used as a proxy for growth options. Lower target leverage ratios have been maintained by firms to mitigate the underinvestment problem when future opportunities arise as per the trade-off Theory. The relationship between historical market-to-book ratio and current leverage is consistent with partial adjustment model of leverage. This study focussed on establishing the extent of the relationship between leverage and market to book ratio with evidence from firms listed at the Kenya‟s Nairobi Securities Exchange. Regression analysis on data from a sample of 36 companies listed at the Exchange for five years period from 2006 to 2010 was conducted to examine the variables leverage and Market to Book Ratio while controlling for Profitability, Growth of the firm, Size, Liquidity of the firm, Tangibility and Non-debt tax shield. The study revealed that leverage of the firm can be accounted for by market value to book ratio. A strong negative relationship between leverage and Market to Book Ratio was established from the results of the regression analysis employed in the study. Market to book ratio therefore is one of the variables which needs to be taken into account as firms decide on the target leverage. The positive relationship with leverage was established among the following control variables; growth of the firm, size of the firm, liquidity of the firm and tangibility of the firm. Any positive change on these variables is therefore going to lead to an increase in the leverage positions. The reasons for this may be because growth will lead to increased demand for external funds, size will encourage the firm to borrow, liquidity has the impact of leading to favorable credit assessments and tangibility has the role of providing assets for collateral.