AN INVESTIGATION INTO INDUSTRY OPTIMAL GEARING RATIO TARGETING BY FIRMS IN KENYA

BY KIMANI RUHANGA REG NO: D53/RI/11519/2004

A RESEARCH PROPOSAL SUBMITTED TO THE SCHOOL OF BUSINESS, KENYATTA UNIVERSITY IN PARTIAL FULFILMENT OF THE REQUIREMENTS FOR THE AWARD OF A DEGREE OF MASTERS OF BUSINESS ADMINISTRATION

KENYATTA UNIVERSITY JULY 2012

DECLARATION
This research proposal is my original work and has not been carried out in any other institution for examination purposes

Signed: . KIMANI RUHANGA REG NO: D53/RI/11519/2004

Date:

The research proposal has been submitted for defence with my approval as the student supervisor Mr. F. NDEDE

Signed: .

Date:

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ACKNOWLEDGEMENTS
It has been a long journey since I started my course work and it would be impossible not to remember those who in one way or another, directly or indirectly, have played a role in the realization of this research project. Let me, therefore, thank them all equally.

I am indebted to the God for his blessings which have enabled me reach this far. I am deeply obliged to my supervisor for his exemplary guidance and support without whose help; this project would not have been a success. Finally, yet importantly, I take this opportunity to express my deep gratitude to my loving family and friends who are a constant source of motivation and for their never ending support and encouragement all through.

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DEDICATION
I dedicate this study to my family, and especially my wife, for the support, understanding and encouragement provided over the years of my studies and as I prepared and worked on this project.

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ABSTRACT
Despite significant theoretical and empirical developments in the capital structure literature, the question of optimal gearing ratio still remains a big source of debate, and more so the existence and targeting of an optimal gearing ratio by firms. Review of literature on capital structure indicates arguments for the existence of an optimal ratio, implying a target ratio, while empirical findings show that gearing ratios vary significantly by industry and that different industries have different optimal gearing ratios that are a function of their business risk. Other research rationalizes industry norm targeting behaviour, by arguing that firms choose gearing ratios which suit their particular business risk. The objective of this study is to investigate industryoptimal gearing ratio targeting by firms in Kenya. The study will be conducted by researching into the movement of the capital gearing ratios, over the period 2006 to 2011, of firms whose shares are quoted on the Nairobi Securities Exchange, in order to determine whether the firms target an optimal capital gearing ratio over time. The study will purposively sample firms in two sectors; manufacturing and those in communication and technology. The study is expected to contribute new knowledge to this debate and benefit scholars by providing additional knowledge on capital structure and gearing ratios, enlighten investors and managers on short-term and longterm gearing and financing decisions and in addition influence government and policy makers in policy development.

TABLE OF CONTENT
DECLARATION...........................................................................................................ii ACKNOWLEDGEMENTS..........................................................................................iii DEDICATION..............................................................................................................iv ABSTRACT...................................................................................................................v CHAPTER ONE............................................................................................................1 INTRODUCTION.........................................................................................................1 1.1 Background of the study..........................................................................................1 1.2 Statement of the problem ........................................................................................2 1.3 Objective of the study..............................................................................................3 1.4 Hypothesis................................................................................................................3 1.4.1 Research hypotheses testing..................................................................................3 1.5 Significance of the study..........................................................................................3 1.6 Scope of the study....................................................................................................4 1.7 Limitations of the study...........................................................................................4 1.8 Assumptions of the study.........................................................................................5 LITERATURE REVIEW..............................................................................................6 2.1 Theoretical rreview ................................................................................................6 2.2 Empirical review ....................................................................................................7 2.2.1 Effect of an industry-optimal gearing ratio targeting..........................................9 2.3 Knowledge gap.....................................................................................................10 CHAPTER THREE.....................................................................................................12 RESEARCH DESIGN AND METHODOLOGY.......................................................12 3.1 Introduction............................................................................................................12 3.2 Research design.....................................................................................................12 3.3 Population..............................................................................................................13 3.4 Sampling techniques..............................................................................................13 3.5 Sample size............................................................................................................14 3.6 Data collection.......................................................................................................14 3.7 Data analysis..........................................................................................................14 Regression Model with control variables.....................................................................15 REFERENCES............................................................................................................16 APPENDIX I: TIME PLAN........................................................................................21 APPENDIX II: BUDGET............................................................................................22 vi

CHAPTER ONE INTRODUCTION 1.1 Background of the study

Since the arguments put forward in the capital structure irrelevancy proposition by Modigliani and Miller (1958), research and debate on capital structure have been intense but somewhat inconclusive, despite significant theoretical and empirical developments in the capital structure literature. The question of optimal gearing ratio still remains a big source of debate, and more so the existence and targeting of an optimal gearing ratio by firms. Review of literature on capital structure indicates arguments for the existence of an optimal ratio, implying a target ratio, while empirical findings show that gearing ratios vary significantly by industry and that different industries have different optimal gearing ratios that are a function of their business risk. Some researchers rationalize industry norm targeting behaviour, by arguing that firms choose gearing ratios which suit their particular business risk, while other research indicates that accounting for debt tax shields and financial distress costs counters the capital structure irrelevancy proposition and leads to an optimal gearing ratio which maximises firm value Bradley et al. (1984). Other researchers argue that industry classification impacts significantly upon the firm's gearing decision and that each firm targets the average (or norm) gearing ratio of its industry, since the benefits and costs of debt vary significantly across industries. Ang (1976) argues that the existence of an optimal gearing ratio implies the existence of a target ratio. More recently, Antoniou et al. (2002) find that firms adjust their debt ratios towards targets, but at different speeds depending on their industry, suggesting that environmental conditions are important drivers of targeting behaviour. There is no consensus on how capital structure ratios and their components should be defined. Certain ratios stress the importance of market rather than book values, whilst other ratios emphasise the importance of balance sheet values, especially if substantially different from market values. Bowman (1980) and Marsh (1982) find that book measures of gearing are statistically indistinguishable from market value measures. However, book and market gearing ratios are conceptually different. Book measures are by definition backward-looking due to their reliance on accounting 1

data whereas market values are generally held to be forward looking. Thus, there is no reason why these two concepts should match Barclay et al., (2006). Harris and Raviv (1991) and Rajan and Zingales (1995) employ gearing ratios in their empirics using book values for debt and market values for equity, a compromise employed widely in the empirical literature. Another important issue is whether short-term debt should be included in a definition of gearing as its omission may lead to an understatement of financial distress risk. Rajan and Zingales (1995) and Tucker (1995) find that while there is large variation across industries, Most capital structure studies to date are based on data from developed countries. Antoniou et al. (2002) analyse data from the UK, Germany and France, Rajan and Zingales (1995) use data from the G-7 countries, Bevan and Danbolt (2000) from the UK. Only a few studies provide evidence from developing countries. Booth et al, (2001) analyse data from ten developing countries (Brazil, Mexico, India, South Korea, Jordan, Malaysia, Pakistan, Thailand, Turkey and Zimbabwe), Pandey (2001) uses data from Malaysia, Chen (2004) utilise data from China, Omet and Nobanee (2001) use data from Jordan and Al-Sakran (2001) analyses data from Saudi Arabia. This study attempts to reduce the gap by analysing a capital structures from firms in the developing world, and more specifically Kenya. Booth et al, (2001) state that, In general, debt ratios in developing countries seem to be affected in the same way and by the same types of variables that are significant in developed countries. However, there are systematic differences in the way these ratios are affected by country factors, such as GDP growth rates, inflation rates, and development of capital markets. This study is also intended to provide further evidence of the capital structure theories pertaining to a developing country.

1.2 Statement of the problem

The study is an investigation into industry optimal gearing ratio targeting by firms in Kenya. Though scholars have over the years hinted on the existence of an optimal capital gearing ratio and the endeavour by firms to target an optimal gearing ratio, the 2

research so far is inconclusive and therefore the existence of a gap for research. Most studies on capital structure and gearing ratios are based on data from developed countries. This study attempts to reduce the gap by analysing a capital structures from firms in the developing world, and more specifically Kenya.

1.3 Objective of the study

The objective of this study is to investigate industry-optimal gearing ratio targeting by firms in Kenya. The specific objectives are: i. ii. iii. To establish the effect of short-term debt on optimum gearing ratio; To establish the effect of optimum gearing ratio on financial distress risk; and To establish the effect of optimum gearing ratio targeting on capital structures.

1.4 Hypothesis
By testing the movement in capital gearing ratios over time we are implicitly testing the hypothesis of the targeting of an industry optimal capital gearing ratio.

1.4.1 Research hypotheses testing

The study will test the following hypotheses: Hypotheses I: H0: Short-term debts have an insignificant effect on the optimum gearing ratio H1: Short-term debts have a significant effect on the optimum gearing ratio Hypotheses II: H0: The optimum gearing ratio has an insignificant effect on financial distress risk H1: The optimum gearing ratio has a significant effect on financial distress risk Hypotheses III: H0: Optimum gearing ratio targeting has an insignificant effect on capital structure H1: Optimum gearing ratio targeting has a significant effect on capital structure.

1.5 Significance of the study

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This study is expected to contribute to the theory and practice of capital structure management in a number of ways: i. It will inform investors and managers of firms on short term and long

term gearing and the correlation between short term and long term financing objectives; ii. Policy makers will obtain knowledge on capital structures as regards optimum gearing ratios as well as corporate governance. They can therefore obtain guidance from this study in designing appropriate policies that may regulate various sectors; and iii. The study will provide information to current and potential scholars on gearing ratios and capital structure. This will expand their knowledge on their corporate governance mechanisms and also identify areas of further study.

1.6 Scope of the study

The study will be conducted by studying the five year the movement capital gearing ratios of firms in Kenya whose shares are listed on the Nairobi Securities Exchange. The study will sample, purposively, firms in two sectors; manufacturing and those in communication and technology.

1.7 Limitations of the study

The first limitation is the sample size as this is dictated by the number of firms listed on the Nairobi Securities Exchange. Statistical tests normally require a larger sample size to ensure a representative distribution of the population to whom the results can be generalised. However, the researcher believes that the study of data over the five year period mitigates the limitation occasioned by the sample size. The second limitation is that the study will be conducted using secondary data whose reliability cannot be verified by the researcher. However the data will be obtained from independently audited annual financial statements and therefore is reliable and adequate for the study.

1.8 Assumptions of the study

The study hypothesis assumes that short-term debts have an insignificant effect on the optimum gearing ratio, the optimum gearing ratio has a significant effect on financial distress risk, while optimum gearing ratio targeting has a significant effect on capital structure. This study also assumes that the firms listed on the Nairobi Stock Exchange are representative of firms in Kenya and the findings of this study can be generalised to firms in Kenya.

CHAPTER TWO LITERATURE REVIEW 2.1 Introduction

This section provides a review of the relevant theoretical and empirical literature. Theoretical arguments suggest the existence of optimal gearing ratios and the implicit endeavour by firms by attain the optimal gearing ratio.

2.1 Theoretical rreview

Review of literature on capital structures indicates that past research findings broadly support the existence of optimal gearing ratios implying the incidence of target gearing behaviour within firms. Central to this understanding of financing behaviour is the trade-off theory which asserts that an optimal gearing ratio is reached by the firm at the point where the marginal benefits of employing debt, such as interest tax shields, equals its marginal costs such as financial distress and bankruptcy costs Kim (1978). Further, an optimal gearing ratio may also be reached by trading off the agency costs and benefits of debt Jensen and Meckling (1976). Francis and Leachman (1994), Leary and Roberts (2005) and Flannery and Rangan (2006) for US firms, and Ozkan (2001), Antoniou et al. (2002), Bunn and Young (2004) and Beattie et al. (2006), amongst others, provide evidence in support of targeting behaviour. Bradley et al. (1984) and Flannery and Rangan (2006) argue that the optimal gearing ratio varies for firms in different industries because it is the typical asset structures and the stability of earnings which determine inherent risks vary across industries. Firms in cyclical sectors such as leisure firms will suffer greater variability in profitability, while other firms, such as information technology firms, are subject to technological risks and typically employ firm-specific non-accounting assets which have value only when employed by a going concern entity. Further, they suggest intuitively that firms characterised by high operating risk are more susceptible to financial distress. Additionally, Brealey and Myers (2001) argue that high growth sectors such as biotechnology may experience high agency costs through restrictions imposed by lenders to reduce the greater opportunities for asset substitution. The degree of competition can impact upon the capital structure decisions of the firm. 6

Therefore, the impact of determinants on capital structures may vary significantly across industries. Optimal gearing ratios will vary across industries not just in terms of magnitude but also in terms of ratio definition. For example, the optimal total debt to total assets employed ratio for the textile industry may be, say 40 percent while for the oil industry it may be 50 percent. However, the optimal ratio to target for information technology firms may be, say 10 percent as measured by the total debt to market value equity ratio. The proposition of the existence of a target ratio of course raises the issue of optimal adjustment policy. Fischer et al. (1989), Mauer and Triantis (1994), Dissanaike et al. (2001) and Flannery and Rangan (2006) argue that some researchers fail to acknowledge the multiple time periods required by firms to achieve their target capital structure ratios. This particular dynamic problem lies at the heart of the capital structure debate: do firms fully adjust their debt ratios to new information within one accounting period (typically one year) or does adjustment take longer? To address this issue, a functional form that permits partial adjustment of the firm's initial gearing ratio to its target must be specified. Estimating target gearing in a simple crosssectional regression implicitly assumes that firms always attain their target gearing ratios within one time period. However, if adjustment costs are non-trivial, unrealistically restricting the adjustment speed to equal unity will bias coefficient estimates. While Flannery and Rangan (2006) found that US firms have target gearing ratios, they also found that the sample average debt ratio over the period 1966-2001 is very volatile. Fischer et al. (1989) developed a model of dynamic optimal gearing choice and demonstrated that debt ratios are characterized by wide swings. These findings suggest that firms do not identify a strict, single optimal capital structure ratio as such, but rather a range over which their capital structures are allowed to vary.

2.2 Empirical review

Review of studies on targeting behaviour suggests that instead of a unique gearing ratio to which firms immediately adjust, firms may engage in a multi-period adjustment if actual gearing ratios are outside the optimal range. This implies that 7

gearing studies should employ methods capable of modelling the dynamic adjustment of capital structures undertaken by firms in the real world. It may be understood that that gearing decisions would improve if econometric methodologies enabled some synthesis of competing capital structure theories. The approach taken in this study facilitates the testing of such a synthesis model. Not only do we seek to determine empirically the nature of the targeting behaviour of firms but also which industries are expected to be more prone to targeting behaviour. A further question then, concerns which ratios we might expect to observe as being targeted. We might expect firms in cash rich, mature industries with abundant cash flows to take on more debt and target industry ratios as a form of management discipline Jensen (1986). Additionally, firms with unique and/or specialised products, tangible and liquid assets, and high asset turnover would be expected to target their gearing ratios Titman and Wessels (1988). Firms in these industries should, in theory, target book value gearing ratios and/or total debt to total assets employed ratios. Wellestablished may attempt to target, or should monitor, market-value gearing ratios as they recognize that establishment brings with it know-how and extra earning power which is difficult to capture in a gearing measure otherwise; hence the market value of the firm would be significantly different from its book value. Industries dominated by small firms, such as the leisure industry, and cyclical industries or industries with longer operating cycles, such as the building industry, are more likely to target total debt gearing ratios Titman and Wessels (1988). On the other hand, industries which are characterized by large firms which employ significant amounts of fixed (tangible) assets rather than current assets, such as the utilities and real estate industries will typically monitor and target ratios with longterm debt and total assets employed as components. This is due to the easier access of member firms to bond markets at non-prohibitive costs, that is, they enjoy significant debt issue cost economies Bevan and Danbolt, (2000). Industries which as considered as young such as information technology, with significant non-accounting assets, are expected to target ratios with total debt as a component according to the well-accepted maturity matching principle that tangibles are best financed with long-term debt and growth opportunities with short-term debt 8

Myers, (1977); Barclay et al. (1995). In industries where non-accounting assets are the most important asset class, we would expect firms to target market value gearing ratios as opposed to book value ratios. However, because the common practice in these industries is to retain rather than to distribute earnings, we would expect to find some evidence of firms targeting ratios which include retained earnings (i.e. ratios which include total equity rather than base equity capital alone). However, the more heterogeneous an industry is, the less likely it is that the results will conform to expectations.

2.2.1 Effect of an industry-optimal gearing ratio targeting

The objective of this study is to investigate whether industry-optimal targeting arises in the long run while a hierarchy of financing arises in the short run. The relationship between measures of corporate capital structure is investigated using the Johansen cointegration test. The application of this technique represents an improvement upon the cross sectional tests often employed in the capital structure literature as it tries to capture the financing behaviour of firms in a dynamic rather than static framework. Further, it allows for variability in gearing ratios and adjustment to a target in a multiperiod framework, a common finding in the literature. Examining the target gearing behaviour of firms at the industry level necessarily involves a trade-off between information loss and results generalisation. It is easier to generalise results if we aggregate the data at the market level, though we may lose useful information regarding firm-level gearing correction because at this level any changes will be very small. While there are limits to the change in capital sources from year to year (for instance, bank borrowing may well remain stable), the variation of gearing ratio components for individual firms will be much greater than the variation of the aggregated gearing ratio components. Conversely, while firm-level analysis retains all information available, it is not clear how generalisable the results may be. Further, given that business risk and other gearing determinants are often assumed to be similar for firms in a given industry, by aggregating at the industry level, we retain the most essential information while also retaining results generalisation. There is no consensus on how capital structure ratios and their components should be defined. Certain ratios stress the importance of market rather than book values, whilst 9

other ratios emphasise the importance of balance sheet values, especially if substantially different from market values. Bowman (1980) and Marsh (1982) find that book measures of gearing are statistically indistinguishable from market value measures. However, book and market gearing ratios are conceptually different. Book measures are by definition backward-looking due to their reliance on accounting data whereas market values are generally held to be forward looking. Thus, there is no reason why these two concepts should match Barclay et al., (2006). Harris and Raviv (1991) and Rajan and Zingales (1995) employ gearing ratios in their empirics using book values for debt and market values for equity, a compromise employed widely in the empirical literature. Another important issue is whether short-term debt should be included in a definition of gearing as its omission may lead to an understatement of financial distress risk. Rajan and Zingales (1995) and Tucker (1995) find that while there is large variation across industries,

2.3 Knowledge gap

Most capital structure studies to date are based on data from developed countries. Antoniou et al. (2002) analyse data from the UK, Germany and France, Rajan and Zingales (1995) use data from the G-7 countries, Bevan and Danbolt (2000) from the UK. Only a few studies provide evidence from developing countries. Booth et al, (2001) analyse data from ten developing countries (Brazil, Mexico, India, South Korea, Jordan, Malaysia, Pakistan, Thailand, Turkey and Zimbabwe), Pandey (2001) uses data from Malaysia, Chen (2004) utilise data from China, Omet and Nobanee (2001) use data from Jordan and Al-Sakran (2001) analyses data from Saudi Arabia. This study attempts to reduce the gap by analysing a capital structures from firms in the developing world, and more specifically Kenya. Booth et al, (2001) state that, In general, debt ratios in developing countries seem to be affected in the same way and by the same types of variables that are significant in developed countries. However, there are systematic differences in the way these ratios are affected by country factors, such as GDP growth rates, inflation rates, and development of capital markets. This

10

study is also intended to provide further evidence of the capital structure theories pertaining to a developing country.

2.4

Conceptual framework

The researcher has developed the framework outlined below to explain the relationships of the variables under investigation and the overall study objective. Independent Variable Short-term debt to equity Distress risk Figure 1 Long-run total debt to total assets Long-run total debt to market value of equity Long-run total debt to total equity Finance costs Co-lateral Government policy Shareholder preferences Optimum gearing ratio Moderating Variables Dependent Variable

Figure 1

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CHAPTER THREE RESEARCH DESIGN AND METHODOLOGY 3.1 Introduction

This chapter discusses the research methodology that will be adopted in order to meet the objectives of the study. Included in this chapter are the research design, study population, sampling method, data collection tools, and data analysis tools to be used to be used in the study.

3.2 Research design

The study will use a cross-sectional survey design as this allows the observation of the full population, or a sample thereof, at a specific point in time. This method has been selected because the researcher seeks to collect data from a cross-section of firms at one point in time. It is important to note that cross-sectional studies involve data collected at a defined time and they often rely on data originally collected for other purposes. In this case the researcher will study financial data presented on annual audited financial statements of the firms selected. The study involves the analysis of the movement of each firms gearing ratio over time and to capture the financing behaviour of firms in a dynamic rather than static framework. The researcher will improve on the cross sectional tests by applying co integration analysis, to allow for the variability of gearing ratios and the adjustment to a target in a multi-period framework, results commonly found in the literature Dissanaike et al., (2001); Flannery and Rangan, (2006). Implicitly, this technique tests a synthesis model of capital structure determination where the long-run gearing ratio is determined by the trade-off theory while the short-run variations may be driven by the pecking order theory.

3.2.1 Definition and measurement of variables

The study involves the analysis of the movement of the capital gearing ratios of firms over time to determine the existence of optimum capital gearing ratio targeting. The various components of gearing ratios are shown in the table below.

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Table 1: Gearing ratio constituents

Variable Book value of equity Market value of equity Total assets employed Book value of equity plus reserves Long-term debt Short-term debt Total debt Book value of total capital employed Book value of total capital employed and reserves Market value of total capital employed TDTE TDME D SD TD TDBE 321 318 Label BE ME A TE Datastream Definition code 305 HMV 391 307 (Ln of) Book value of equity at balance sheet date (Ln of) Market value of equity at balance sheet date (Ln of) The sum of all assets less current liabilities (Ln of) Book value of equity and reserves at balance sheet date (Ln of) All loans repayable in more than one year (Ln of) All loans payable in one year or less (Ln of) The sum of longterm and short-term debt (Ln of) The sum of total debt and book value of equity (Ln of) The sum of total debt and total equity (Ln of) The sum of total debt and market value of equity

3.3 Population
The study will be conducted by researching into the movement of the capital gearing ratios of firms whose shares are listed on the Nairobi Securities Exchange.

3.4 Sampling techniques

In order to sample different determinants of gearing ratios, whether based on asset book values or market values the study will purposively sample listed firms in two sectors; manufacturing and technology. 13

3.5 Sample size

Out of the 56 firms listed on the Nairobi Securities Exchange the researcher will purposively sample those in two sectors; manufacturing and technology, which are 7 in number. In the opinion of the researcher manufacturing firms are characterised by significant amounts of tangibles assets, and those likely to base their optimal gearing ratios on total assets to debt, while those in technology are likely to hold insignificant amounts in tangible assets and may prefer to base their optimum gearing ratio on the market value of the firm.

3.6 Data collection

The study will use secondary data, and involves the collection of quantitative data from published audited annual financial statements of the firms sampled and data obtained from the Nairobi Securities Exchange database.

The data required is: i. ii. The balance sheet amounts of the companies equity, liabilities and assets; and Daily stock prices to compute the market value of the firms equity.

The data will be collected by the use of tables and spreadsheets.

3.7 Data analysis

The data will be analyzed using regression analysis. This will be aided by the use of Statistical Package for the Social Sciences (SPSS), a computer statistical analysis program. The data will be analysed using descriptive statistics. The results will be tested using student T- test to test the significance of the data. Regression analysis will be carried out to establish the relationship and correlation of the variables. The model to be used is the one that was successfully used by Mamoghli and Dhouibi (2009) to study optimum gearing ratio and insolvency risk in emerging markets.

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The researcher will use the following regression model to analyze the data collected:

Regression Model with control variables

The Regression Model will test for the number of the characteristic roots that are significantly different from unity can be constructed using the following two test statistics:
n

trace(r ) = T ln(1 i )
i = r +1

(1)

max(r , r + 1) = T ln(1 r + 1)
x1t = a1( x1, t 1 x 2, t 1) + e1t
x 2t = a 2 (x1, t 1 x 2, t 1) + e 2t

(2) (3) (4)

The general form of the panel model can be specified more exactly as: to check the consistency of the ECM results, in addition to TD/(BE+RE) ratio, we also examine the adjustment speed coefficients of D/(BE+RE), TD/BE and D/BE ratios

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APPENDIX I: TIME PLAN

Activity Proposal development Approval Data collection Data analysis/ Project write up Project submission

JUN

JUL

AUG

SEPT

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APPENDIX II: BUDGET

Proposal development Stationery Typing and printing proposal Photocopy (proposal questions ) Transport Miscellaneous expenses (15%) Total

3,000.00 5,000.00 5,000.00 2,000.00 15,000.00 4,500.00 34,500.00

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