Capital Structure: Debt And Equity And Strategic Management

1.1.1 Capital Structure

A firm’s capital structure refers to the mix of its financial liabilities. As financial capital is an uncertain but critical resource for all firms, suppliers of finance are able to exert control over firms (Harris & Raviv, 1991). Debt and equity are the two major classes of liabilities, with debt holders and equity holders representing the two types of investors in the firm. Each of these is associated with different levels of risk, benefits, and control. It is the way the corporation finances its assets through some combination of equity, debt, or hybrid securities. A firm’s capital structure is then a composition or structures of its liabilities, a mix of a company's long-term debt, specific short-term debt, common

It has long been an important issue from the strategic management standpoint since it is linked with a firm’s ability to meet the demands of various stakeholders (Roy and Minfang, 2000). Debt and equity are the two major classes of liabilities, with debt holders and equity holders representing the two types of investors in the firm. Each of these is associated with different levels of risk, benefits, and control. While debt holders exert lower control, they earn a fixed rate of return and are protected by contractual obligations with respect to their investment. Equity holders are the residual claimants, bearing most of the risk and have greater control over decisions. An appropriate capital structure is a critical decision for any business organization. The decision is important not only because of the need to maximize returns to various organizational constituencies, but also because of the impact such a decision have on an organization’s ability to deal with its competitive environment. Following the work of Modigliani and Miller (1958 and 1963), much research has been carried out in corporate finance to determine the influence of a firm’s choice of capital structure on performance. The difficulty facing companies when structuring their finance is to determine its impact on performance, as the performance of the business is crucial to the value of the firm and consequently, its

The cost of funds thus affected firm’s financial performance, increased prices of real estate properties Studies have been done on capital structure and financial performance Rutto (2011) effect of capital structure change on share prices for firm quoted at the NSE, Lokong (2010) the relationship between capital structure & profitability of micro finance institutions in Kenya, Muia (2008) the relationship between capital structure and financial performance of SMEs in Nairobi, kitony (2007) a test of relationship between capital structure and agency costs. Findings appear to suggest that there is a significant impact of capital structure on company performance after controlling for company specific characteristics such as company size, non-duality, leverage and growth. The finding is of significant for investors and policy marker which will serve as a guiding for better investment decision. No sufficient exploitation study has been done on effect of capital structure on financial performance on listed firms in Nairobi security exchange. This study therefore seeks to fill in this gap by investigating capital structure on financial performance with specific reference to listed firms