The effect of capital structure on the cost of capital of firms listed at the Nairobi securities exchange

Abstract

Capital structure has been a subject of interest to many researchers over a long period of time because of its importance in financial decision making. As a matter fact, the amount of debt or equity a company holds significantly determines its survival in the long run. While keeping in mind that the overall objective of the firm is to maximize shareholder wealth and thus increase value, a firm is said to create value when it generates a return greater than its cost of capital. The cost of capital is therefore an important factor in determining a firm’s value. According to Modigliani and Miller, a firm’s cost of capital is said to be independent of its capital structure under the assumption of a perfect market which only exists in theory. To determine whether this theory holds true, this study sought to examine the effect of capital structure on the cost of capital of firms listed at the Nairobi Securities Exchange. The study reviewed literature on capital structure and determinants of a firm’s cost of capital. The size of the firm was found to be a determinant of cost of capital and was measured as the value of total assets held by a firm. Capital structure was measured as the leverage ratio of total debt over total equity while the cost of capital was measured as the weighted average cost of capital. The relationship between capital structure and the cost of capital was explained using regression analysis. The study found that there existed a positive relationship between capital structure, the cost of capital and size of the firm such that an increase in capital structure and size of the firm resulted in an increase in the cost of capital at statistically significant levels. The study concluded that an increase in the leverage ratio will lead to an increase in the cost of capital, while a decrease in leverage will correspond to a decrease in the cost of capital of firms listed on the NSE.