THE RELATIONSHIP BETWEEN LEVERAGE AND MARKET TO BOOK VALUE RATIO: EVIDENCE FROM FIRMS LISTED AT THE NAIROBI SECURITIES EXCHANGE BY: MBUGUA SOSPETER MUIRURI A RESEARCH PROJECT SUBMITTED IN PARTIAL FULLFILMENT O THE REQUIREMENTS FOR THE AWARD OF THE DEGREE OF MASTERS IN BUSINESS ADMINISTRATION SCHOOL OF BUSINESS UNIVERSITY OF NAIROBI 2012 DECLARATION I declare that this is my own original work and to the best of my knowledge it has not been submitted for a degree award in any other University or institution of higher learning. Signature…………..………………………… Date………………………….. SOSPETER MUIRURI MBUGUA D61/62885/2010 This research project has been submitted for examinations with my approval as University Supervisor Signature…………..………………………… Date………………………….. DR. ADUDA Senior Lecturer Department of Finance and Accounting School of Business University of Nairobi ii DEDICATION This research project is dedicated to my parents for constantly reminding me that ambition is priceless. It is also dedicated to my wife who taught me that the greatest task can be accomplished if it‟s done a step at a time. Finally, I dedicate it to my beloved daughter and son who make me look forward to each new day. iii ACKNOWLEDEMENT I would like to extend my appreciation and gratitude to all those that contributed tremendous inputs towards completion of this research project. First and foremost, I am grateful to my University of Nairobi Supervisor Dr. Josiah Aduda for his tireless assistance, invaluable support, high quality and detailed work, experience and initiatives which guided me in enriching and completing my research project. Secondly, I am grateful to the lecturers and non-teaching staff in the University of Nairobi whose assistance to this research project cannot be overlooked, for their inspirations, encouragements, guidance and helpful recommendations. All your time and support will be always remembered. To crown it all, thanks to the almighty God for giving me sufficient grace and favor to carry me through the entire study period. iv TABLE OF CONTENT DECLARATION..................................................................................................................... ii DEDICATION........................................................................................................................ iii ACKNOWLEDEMENT ........................................................................................................ iv LIST OF TABLES ................................................................................................................ vii LIST ABBREVIATIONS .................................................................................................... viii ABSTRACT ............................................................................................................................ ix CHAPTER ONE: .................................................................................................................... 1 INTRODUCTION................................................................................................................... 1 1.1 Background of the Study ................................................................................................. 1 1.1.1 The Nairobi Securities Exchange ............................................................................. 4 1.2 Statement of the Problem ................................................................................................ 5 1.3 Objective of the Study ..................................................................................................... 7 1.4 Value of the Study ........................................................................................................... 7 CHAPTER TWO: ................................................................................................................... 8 LITERATURE REVIEW ...................................................................................................... 8 2.1 Introduction ..................................................................................................................... 8 2.2 Theoretical Review ......................................................................................................... 8 2.2.1 Pecking Order Theory .............................................................................................. 8 2.2.2 The Agency Theory .................................................................................................. 9 2.2.3 The Free Cash Flow Theory ................................................................................... 10 2.2.4 Trade-Off Theory (Optimal Theory) ...................................................................... 11 2.2.5 Static Trade-Off Theory ......................................................................................... 11 2.3 Empirical Review .......................................................................................................... 12 2.3.1 Debt Financing ....................................................................................................... 16 2.3.2 Equity Financing..................................................................................................... 16 2.3.3 Hybrid Securities .................................................................................................... 17 2.4 Key Determinants of Capital Structure ......................................................................... 18 2.4.1 Profitability ............................................................................................................. 18 2.4.2 Growth .................................................................................................................... 18 2.4.3 Tax .......................................................................................................................... 19 2.4.4 Tangibility .............................................................................................................. 19 2.4.5 Risk ......................................................................................................................... 20 v 2.4.6 Size ......................................................................................................................... 20 2.4.7 Non-Debt Tax Shields ............................................................................................ 21 2.4.8 Market to Book Ratio ............................................................................................. 22 2.5 Summary of Literature .................................................................................................. 23 CHAPTER THREE .............................................................................................................. 25 RESEARCH METHODOLOGY ........................................................................................ 25 3.1 Introduction ................................................................................................................... 25 3.2 Research Design ............................................................................................................ 25 3.3 Target Population .......................................................................................................... 25 3.4 Sample Size ................................................................................................................... 25 3.5 Data Collection .............................................................................................................. 26 3.6 Data Analysis ................................................................................................................ 26 CHAPTER FOUR: ............................................................................................................... 28 DATA ANALYSIS AND INTERPRETATION ................................................................. 28 4.1 Introduction ................................................................................................................... 28 4.2 Regression Analysis ...................................................................................................... 28 4.3 Summary and Interpretation of Findings ...................................................................... 36 Table 4.122: Summary of Regression Results .................................................................... 38 CHAPTER FIVE: ................................................................................................................. 42 SUMMARY, CONCLUSIONS AND RECOMMENDATIONS ...................................... 42 5.1 Summary ....................................................................................................................... 42 5.2 Conclusions ................................................................................................................... 43 5.3 Policy Recommendations .............................................................................................. 44 5.4 Limitations of the Study ................................................................................................ 44 5.5 Suggestions for Further Studies .................................................................................... 45 REFERENCES ...................................................................................................................... 46 Appendix I: Population of listed Companies at the NSE as at January 2006 ................. 58 Appendix 2: Sample .............................................................................................................