The Relationship Between Capital Structure and Stock Returns of Firms Quoted in the Nairobi Securities Exchange

Abstract

The study’s objective was to determine the relationship between capital structure and stock returns of firms quoted in the Nairobi Securities Exchange. The researcher adopted an empirical research design. In this case, data was gathered relating to capital structure and stock returns of firms quoted in the Nairobi Securities Exchange over a three year period between 2011 and 2013. The target population for this study therefore comprised of all 50 presently listed companies in the Nairobi securities Exchange’s main segment. However, banking and insurances companies were excluded from the study because their capital is regulated by Central Bank of Kenya and Insurance Regulatory Authority respectively. This study collected secondary data relating to stock returns and firm’s capital structure of the listed companies at the Nairobi Stock Exchange for the period between 2011 and 2013. Secondary data was collected from the annual reports of the publicly listed companies. Data analysis method was based on Pearson correlation analysis and a multiple regression model conducted on Statistical Package for Social Sciences (SPSS) on the accounting based measures of firm’s capital structure used in this study. Analysis of firm’s stock return was performed using one year stock returns (Y) based on the market share prices, while capital structure was measured using the following variables: Leverage ratio (X1 = Total market Debt/market Equity); Firm size (X2 = natural log of sales); Cash generation capacity (X3 = Earnings before interest tax depreciation and amortization); Operating leverage (X4= change in EBITDA divided by change in sales); Industry dummy variable (X5). Adjusted R Square value and Analysis of Variance (ANOVA) was used to test the significance of the model. The Pearson product-moment correlation coefficient (PPMCC or PCC) was used as a measure of the correlation (linear dependence) between stock price return as the dependent variable and other variables as the independent variables, giving a value between +1 and −1 inclusive for each tested variable. The researcher then presented the findings using appropriate piecharts, graphs and tables. Research findings indicated that stock returns increase with increase in the company’s leverage ratio of firms listed in the NSE and is consistence with the theoretical review. It can therefore be concluded that management of such firms should aim at maintaining high leverage ratio which will in turn drive an increase in stock returns which will be favorable for the firm’s shareholders. Findings indicated that although the increase in firm size results in a decrease in stock returns, this relationship is not significant for publicly listed companies in the NSE. It can therefore be concluded that management of firms listed in the NSE should not be too concerned with the firm size as it is not significant in determining stock returns. Findings also indicated that firm profitability has no significant impact on stock returns for firms listed in the NSE. Findings further indicated that that an increase in operating leverage increases the firm’s stock returns. It can therefore be concluded that management of firms listed in the NSE should target higher operating leverage in order to increase stock returns. The study recommended that on the effect of policy and decision making of the board with regard to stock returns, it is recommended that the board of directors of companies quoted in the NSE should set up policies that link firm performance to stock returns both in the short term and long term to further reinforce the executive alignment to stockholders’ wealth maximization.