Tax and Capital Structure: the Case of Listed Companies in Kenya.

Abstract

This paper looks at the impact of tax on the capital structure of companies listed on the Nairobi Stock Exchange (NSE). The study adopts the static trade-off theory (STO) of capital structure given that this theory incorporates the impact of taxes on capital structure. The main motivation for the study is the Modigliani-Miller (M-M) argument that in the presence of corporate taxes, the firm's value is positively related to its debt. Hence it addresses the question of whether the capital structure of companies change following a change in the tax rate. Panel data analysis of a sample of 20 listed non-financial companies is used to determine the impact of tax on capital structure covering the period 1993 to 2001. The main proxies for the tax effect considered include the marginal effective tax rate, and non-debt tax shields as depreciation and the tax loss carry forward. The marginal tax rate is proxied using the average effective tax rate. We include variables likely to determine the capital structure of firms such as liquidity, tangibility, growth opportunities, profitability, dividend yield and size of the firm to control for their effects. We use the Hausman test to identify the best model and the fixed effects model is found to be the best in estimating this situation. The results show that the tax rate is significant in determining the leverage of firms but shows unexpected (negative) sign. Non-debt tax shield variable is found to be insignificant in determining the leverage of these firms. Profitability, tangibility and growth opportunities are found to be significant in explaining the capital structure of these firms. The firms are also found to adjust their leverage to the target debt ratio while in the process incurring positive adjustment costs. This implies that the firms will not at any time fully adjust to the target debt level due to the presence of the adjustment costs. Other factors found to be relevant in determining the capital structure in the study are tangibility, growth and profitability.