The Relationship Between Cost of Capital and Leverage for Companies Quoted on the Nairobi Stock Exchange

Abstract

In the Study an attempt is made to determine the effect of leverage on cost of capital at the Nairobi Stock Exchange. The first hypothesized relationship between cost of capital and leverage is that the cost of capital can decline with use of debt up to an optimum level where the value of the company is maximum. The Implication is that the value of a firm depends on capital structure. The other view is that the value of a firm does not depend on how it is financed. What matters is the earning power of the assets employed by the company and the risk attaching to these earnings. This is the famous capital structure decisions. The study covers the period 1990 to 2001 and relied on information contained in the annual reports. Multiple regression is used for the analysis of the data. The results show that generally size and fisk are particularly important while the other variables viz: leverage, growth, dividend payout ratio and liquidity also impact on the cost of capital. The effect of leverage on cost of capital varies from company to company. In some companies, cost of capital declines with leverage while for others, it is an increasing function. This is attributable to the differences in the debt contracts that are written by these companies. The variations can be seen in the cost of debt paid by the companies. If the cost of debt is higher than the overall cost of capital, then increase in leverage leads to increase in the cost of capital. If cost of debt is lower than the overall cost of capital, then the cost of capital declines with leverage.