Effective Corporate Tax Rate and Firm Financing:an Analysis of the Listed Firms at Nairobi Stock Exchange

Abstract

Financing a firm is basically a mix of debt and equity which a firm deems appropriate to enhance its operations. Firm financing constitutes its capital structure, which decision is crucial for any business organization because of the need to maximize returns to various organizational constituents and also because of the impact such a decision has on a firm's ability to deal with its competitive environment. However, the tax paid by the firm affects the two, both debt and equity ratios. Thus, tax constitutes a potentially important consideration in financing decisions. The question is, how does effective corporate tax rate affect the financial leverage of corporations? Therefore, this study assessed how the corporate tax rate affects financing for firms listed at Nairobi Stock Exchange. Specifically the study aimed to establish the relationship between effective corporate tax rate and debt ratio for firms listed at Nairobi Stock Exchange between 2003 and 2007. To achieve this objective of the study both correlation matrix and regression analysis were used. A regression equation: X= a + rY + e, was specified and estimated; where X represents the debt ratio, Y represents the effective corporate tax rate, a is the intercept, and r is the correlation coefficient which measures of the strength of linear association between the two variables, i.e., X and Y. The result revealed that there was a negative correlation between effective corporate tax rate and the debt ratio. First, the correlation matrix coefficient was -0.217. This linear correlation was negative at 5% level of significance, indicating that there was negative relationship between effective corporate tax and debt ratio. Secondly, the regression result revealed that the coefficient between the effective corporate tax and debt ratio was -0.43. This indicated there was a negative relationship between effective corporate tax rate and debt ratio. The negative relationship supports the Pecking Order theory where firms prefer to use internal financing before resorting to external funds, mainly debt. The theory supports the negative relationship between tax ratio and the debt ratio as opposed to the Trade-off theory which supports a positive relationship between debt and tax ratio where the higher the tax ratio, the higher the debt ratio. Pecking order theory also explains negative intra-industry correlation between profitability and debt ratio, where the higher the profitability, the lower the debt ratio.