Debt stations) although the number of the companies

Debt and Equity choice for funds in east africa
Abdifitah Mohamed Jama Deer

The main aim of my research is to get answer these questions

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1- What is the correlation if interest rate increase or decrease and capital structure in the
company in east African firms?
2- Not only East African country beyond these countries, what are the determinants of
capital structure choice of fund whole the continental
3- If we use all theoretical framework does help to explain all variances
The purpose of Research
In this research, I will use difference theories so as to reach empirical result of debt-equity
choice and my sample will be 80 east African Companies downstream (fuel stations) although
the number of the companies in these countries are more than 100.
I will focus in my research how the interest rate fluctuation and equity-debt are related last ten
years. The models that I will use are trade-off agency and pecking.


(Gaud, Hoesli, & Bender, 2007) their study and determination in related to these three factors
first finding is adjustment to the target ratio about debt, second one is performance about
operating and thirdly and final one is market efficiency in financing choice that are not
change when the laverage book is used and they tested some of European firm Hoestli &
Bender reported the main factors of CAPM policies in the EU is Debt ratio, Operating
Performance and marker Performance.
Their paper, the maturity was over 12 (years) when they examine the debt and equity choice
applying case of European companies more than five hundred.
This research paper is interested because of my topic choice debt and equity in Africa Gaud,
Hoestli & Bender also their research is European countries and they find when the managers
of the companies prefer to issue debt so as to increase dividends of shareholder that means
when the projects has profitable that is best debt disciplines of the managers.

The theory of the MM (Modigliani-Muller Theory)

Trade off Theory
The MM (1958) model is criticized, mainly because it has very unrealistic assumptions and
fails when taxes, bankruptcy costs, or asymmetric information were introduced. In their later
paper, MM (1963) introduced taxes to their model.
The amount of debt used is positively related with firm value this theory developed by (MM,
1963). Also we can say if manager use the theory about maximizes debt 100% choice of funds
by specified as linear function of debt and equity radio also where is positive relation with
firm value and debt. In this model, they assume that there is no bankruptcy cost. However,
there exists an offsetting cost of debt which avoids this extreme choice. There is an increasing
stress of bankruptcy with increasing usage of debt. Therefore, bankruptcy is the balancing

factor for the extreme situation shown by MM in 1963

Myers (1984) changed the concept of MM (1963) and static trade off theory. By claiming the
benefit of using tire off and debt and the financial distress that occurs in the likelihood of
bankruptcy and increase the use of debt. According to Myers (1984), its trading outlook has
been limited to the company’s limited credit rating and the establishment of the capital
structure of the company.

Pecking direct hypothesis

Agency viewpoint is emerged from moral hazard and conflict of interest between principal
and agent. It suggests that agents of a company have a tendency to take actions which are not
best for the company because the benefits are higher than costs as such costs are shared
between shareholders.

The literatures use symmetric date base on demand and suppler. If demand and suppler can
get to various data (not good) the inventory are more likely to be selected. In a setup like
Modigliani and Miller (1958), where efficient market hypothesis holds and all of the members
of the market has a chance to reach same information under equal conditions, there would not
exist any problem related with asymmetric information and all sources would be equally
preferable. However, in real world, because of the asymmetric information problems, firms
prefer to obtain financing from sources where there exist lowest amount of information
asymmetry problems.

The main idea behind the pecking order theory which is, normally, owner of an overvalued
company prefers to sell equity while owner of an undervalued company uses equity financing
only as a last resort only company shareholder have to know the true about how the managers
deal to maximize value of the stock in market by the company. However, an outsider can only
guess these values. Therefore, people react suspiciously when shareholder tries to sell equity.
Therefore, the announcement of an equity issue will decrease the value of shares of a company
(Ross, 1977). On the other hand, using retained earnings or riskless debt will not cause any
change in the value of the shares.

(Berens ; Cuny, 1995) states that a firm follows a preference order if it prefers internal
financing retained earnings to external financing and if it prefers debt to equity at external
financing. (Berens ; Cuny, 1995) also indicates that if it is possible, using a riskless debt
should be equally preferable as internal financing. However, if debt is available but risky, it
should be placed somewhere between retained earnings and equity which actually creates the
pecking order.

Capital Structure of SMEs in Several Countries
(Ang, 1991) Indicates that theories of capital structure were not developed with thinking
SMEs in first place so they may not be directly appropriate for them. However, the validity
of capital structure theory for SMEs are tested empirically in many countries. In addition to

size, there are two main factors
That differentiate SMEs from large firms (Bhaird and Lucey, 2010). The first one is the SME
owners’ desire for keeping their independence and control. The second one is the fact that
SMEs are having more severe information asymmetry problems in financing decisions. These
following ways are the types of the affect capital structure decisions: In order to keep control,
SME managers tend to not allow to increase debt, even for projects with positive net present
values (Holmes and Kent, 1991). Also, because of information asymmetry problems, lenders
are unwilling to provide finance to SMEs. For example, another literatures show that, small
and young firms have shorter banking relationships, pay higher interest rates and are more
likely to pledge collateral to borrow money.

(Hall, Hutchinson, & Michaelas, 2004) there are several studies of the factors affecting the
CAPM of the structure of SM Enterprises in more countries. Hall, Hutchinson & Michaelas
says that there are differences in the factors that affecting capital structures of small and
medium enterprises, around twenty four years Mr. Van der Wijst & Thurik (1993) works on
financial data average of more than 20 different shops by date analysis on Germany small
enterprises that operating in the retail sectors, they find that there is significant effects of the
tangible assets, sales and ROI however literature are not use sales indeed. Furthermore, they
observe that, non-debt tax shields, measured by depreciation expenses, have no significant
influence on debt ratios. The variables that they use have an influence on maturity structure
of debt rather than total debt. So, the effects on long term debt and short term debt have a
tendency to cancel out. They observe that both industry characteristics and time specific
effects have significant impact on capital structure of firms.

Chittenden et al. (1996) analyze a U.K. database for a sample of both listed and unlisted SMEs
with an emphasis on growth and being quoted in stock market. Using OLS regression, they
find that tangible assets, profitability, size and being listed have significant effects on financial
structure of small firms.

They find that collaterals are used by lenders to solve information asymmetry problem widely,
especially for small unlisted firms. Moreover, the importance of collateral decreases with the
increase in size. Furthermore, long term debts provided to small companies are mostly based
on collaterals. They conclude that financial barriers to enter stock markets for small firms
needs to be reduced and innovative solutions are needed to solve agency problem between
small firms and lenders.

Like Chittenden et al. (1996), Hashemi, R. (2013). also analyze a U.K. database for SMEs.
Using panel data methodology, they find that size, asset structure, profitability, growth, future
growth opportunities, age, stock turnover and net debtors have significant effect on short term
debt and long term debt levels. They find that tax rate has an insignificant effect. Moreover,
their results indicate that average short term debt ratios of SMEs increase during periods of
economic recession and decrease as economic conditions improve. However, long term debt
ratio is positively associated with economic growth.

Cassar, G., & Holmes, S. (2003) also examine Australian SMEs. Using OLS regression, they
find that size, profitability, growth of assets and asset tangibility are important factors in
determining the capital structure of SMEs. Moreover, what is different in their study is that,
they examine if there is a difference between financing and firm characteristics of small firms
and relatively larger firms in the sample. They divide their sample into two using sample
median for total assets. They discover that, the effects of these factors on capital structure are

homogenous across both small and large firm.

Sogorb-Mira, F. (2005). tests how firm characteristics affect small medium enterprises capital
structure in Spain. Their data consists of 6,482 firms over the period between 1994 and 1998.
Using panel data analysis, he finds that non-debt tax shields and profitability are negatively
related with leverage while size, assets structure and growth options have positive effect on
leverage. The results support maturity matching principle. That is, Spanish firms are trying to
finance their long term assets with long term debt and their current assets with short term debt.

Degryse, H., de Goeij, P., & Kappert, P. (2012). Examine the capital structure of Dutch SMEs.
They employ a panel data analysis in their investigation. Their results are in accordance with
pecking order theory. That is, size, asset tangibility, growth of assets and growth opportunities
are positively associated with leverage. Furthermore, they observe that SMEs prefer to use
their profits to decrease their debt levels. They find that the industry that the firm operates in
is also important factor for the capital structure of Dutch SMEs. They also support the maturity
matching principle.

Examine the capital structures of debt maturity choices of 39 developed and developing
countries including United States and Turkey. They measure the total leverage as the ratio of
total debt to market value of the firm. Market value of firms is defined as the market value of
common equity added by book value of preferred stock and total debt. Moreover, they use
long term debt to total debt ratio as indicator of debt maturity. Turkey and USA are found
among five countries which have lowest amount of total debt in their capital structures.
However, when debt maturity is observed, USA is found as the fourth country which has
highest long term debt ratio while Turkey is the thirty seventh. This difference stems from
being a developed economy or not. Hence developed economies have more long term debt in
their capital structure. In order to investigate the difference between countries, they use some
country specific measure like usage of common law, level of corruption, existence of an
explicit bankruptcy code, existence of deposit insurance. They provide such measures from
sources including International Country Risk Guide and Corruption Perception Index. In
general they find that, being a developed economy, common law and low level of corruption
are associated with lower leverage and higher long term debt. Related with USA they report
that, ratio of tangible assets to total assets, profitability and size is positively and market-to-
book ratios of firms are negatively related with both leverage and debt maturity.

This study of the research design and an answer of the questionnaire which was feedback of
the target population. It main feature the description of the select population, research sampling
means that date sampling form population and date collection process and the method that I
will use so as to get the findings and then to analysis my data that I was collected.
Research Design
In order to find the best equity and debt choice for fund In Kenyan firm last ten year period.
We will use in this thesis study analytical designs and correlation about these two factors debt
and equity. This paper will use to add all over view of the date and to check if any relationship
between debt ratio and equity ratio of the firm that mean we have two variables or more now
we mention only debt and equity ratios, as we see our research was very attractive because the
feedback of our questionnaire tells us the information is relevant on the issue of interest and
conclusions to enable one to mention the strong financing choice of the companies in Kenya
(Cooper &Schindler, 2003).

Population of the Study
According to Mugenda and Mugenda (2003), a population is well-defined as all set of people,
service, elements and events, group of things or households that are being investigated under
the study. Target population in statistics is the specific population about which information is
desired. The target population of interest in this study consisted of 300 listed firms in the
Nairobi Securities Exchange as at December 2015.
Table 1.1 Target Population
Banking 15 8 3.2%
Insurance 20 18 7.2%
Construction &
Allied 70 64 25.6%
Manufacturing &
Allied 10 4 1.6%
Investment 75 70 28%
Agricultural 10 8 3.2%
Energy and
Petroleum 4 3 1.2%
&Technology 3 3 1.2%
Automobiles and
Accessories 8 3 1.2%
Commercial and
Services 85 69 27.6%
TOTAL 300 250 100%
Source: Research data 2015

All items in any field of inquiry constitute a universe or a population. Complete enumeration
of all items in the population is known as a” census inquiry”. The researchers undertook a
sample study of 250 firms out of 300 targeted public firms as at 31st December 2015.It was
presumed that in the sample inquiry, all items were covered, thus no element of chance was
left and the highest accuracy was obtained. The researchers targeted financial
managers/controllers depending on the organizational structure of the firm.
Sampling Design
Due to variability of characteristics among items in the population, we applied probability
sample design in the sample selection process to reduce the distortion view risk of the
population and made inferences about the population based on the information from the
sample survey data. According to Mugenda and Mugenda (2003), a sample ratio of 0.3 was
used to obtain sample representation of all respondents. In this case, twenty (20) public listed
firms were subjected to the study. Only the sampled population was subjected to the data
gathering exercise to provide the necessary information to the study.
Data Collection
The two sources of data collection used were primary and secondary data. Primary data used
was obtained by administering questionnaires to the sampled firms through drop and pick later

and in some instances the researcher discussed the contents of the questionnaire with the
respondents and left them to be filled at their own time. Secondary sources were used to provide
information and data from published annual reports and financing sources of firms spanning
five years. In this study questionnaire and abstraction methods was used in data collection.
Primary data was used to collect data directly from respondents. It consisted of questions on
expertise and the attitude of top management. Abstraction method was used to collect
secondary data from published reports and statements provided by sampled firms. In order to
increase reliability of the findings, a combination of data from secondary and primary sources
was used.
Data Analysis
Regression was performed to establish the significant differences and relationship between the
independent variables (firm size, profitability, tax implications and asset structure) and the
dependent variables of debt and equity, observation of the data was also applied. SPSS
(statistical package for social scientist) software was used in the analysis of quantitative data.
The results from the annual financial reports and other documentations were presented in form
of tables, charts, graphs, and narrative statements.

The Regression Equation
= + 1 + 2 + 3 + 4 + ?
= + 1 + 2 + 3 + 4 + ?

= Equity of a firm
= debt of a firm
= A constant
= Profitability of a firm
= Tax effect of a firm
= Asset structure
=Firm size
?= Standard error
, , & =Are the beta coefficients

Reliability and Validity of Tests

Content validity and reliability was assured that each question in the questionnaire is valid and
correctly structured for ease of understanding. Moreover, the secondary data to be reviewed
had to be recent and up to date as well as containing relevant contents. To ensure reliability,
the researchers had to pre-test the questionnaires using three firms. The purpose of the pilot
study was to enable the researchers to improve on the reliability of the data collecting
instruments and to familiarize with their organization structure /administration. Pre-testing was
to provide a check on the feasibility of the proposed procedures for coding data and showing

up flows and ambiguities in the instruments of data collection. It yielded suggestions for
improving data collecting tools as per, Masibo (2005).

On the other hand the content validity of the two instruments of data collection was assured by
ensuring that each of the items in the questionnaire addressed specific content and objectives
of the study. Moreover, the instruments were given to three public firm experts who assessed
the concepts which the instruments were trying to measure. The end result was that the
instruments were appropriate in terms of content validity. The validity and reliability of the
tools for data collection were eventually ascertained and used to collect data from the sampled
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