Abstract:
The purpose of this study was to establish the relationship between capital structure and return on equity (ROE) for Industrial and Allied Sector (IAS) in the Nairobi Stock Exchange (NSE). The study explored the relationship between the capital structure proxied by debt equity ratio and performance proxied by ROE during the period 2002 and 2006. The focus was on the firms listed under the Industrial and Allied Sector at the NSE. The objectives of the study were to: i. Establish the debt equity ratio and return on equity; ii. Determine how debt equity ratio affects return on equity of IAS companies listed at the NSE, and iii. Regress the debt equity ratio and ROE to assess the strength and direction of the relationship. The research design was a descriptive research design. The population of the study consisted of the 15 companies quoted on the NSE under the IAS. All the companies under this sector were reviewed except for those that were not continuously listed during the period. Secondary data was utilized for the study. Data was collected by the aid of checklist, by analyzing the balance sheet and profit and loss statement. Subsequently, yearly debt equity ratio, the proxy for capital structure, and ROE were calculated and tabulated. Data analysis was done by forming a trend analysis to enable determination of the impact of debt equity ratio on ROE. Additionally a regression analysis on debt equity ratio and ROE was performed to determine the strength and direction of the relationship. The data was presented in tables and figures. The study found out that the debt equity ratio and ROE varied across the Industrial and Allied companies of the Nairobi Stock Exchange. The average debt equity ratio and ROE was 0.63 and 0.09 respectively, and the standard deviation was 2.21 and 0.39 for debt equity ratio and ROE respectively. The debt equity ratio ranges from a high of 18.38 to a low of 0 whereas the return on equity ranges from a high of 0.47 to a low of negative 3.06. The impact of debt equity ratio on return on equity as determined by the correlation coefficient was 0.9381 (93.81%). Therefore, a variation of 93.81% in the return on equity is attributed to debt equity ratio. Variation of 6.19% in return on equity is attributed to other factors that were not subject of the study. The slope of the regression equation was positive 0.166 while the y intercept was positive 19.4%. The results of the regression show a significant positive linear relationship between debt equity ratio and return on equity. The findings are therefore consistent with the view that as companies apply more and more long term debt, tax shelter benefits accrue. The study concludes that there is a strong positive relationship between debt equity ratio and ROE as signified by correlation coefficient of positive 0.93. Therefore, a variation of 93% in the ROE is attributed to debt equity ratio. A variation of 7% in ROE is attributed to other factors that were not subject of the study. The study recommends that companies should balance the different components of their capital structure, (debt and equity) so as to ensure harmony on their operations. Further, companies should therefore establish a target debt ratio, which is based on various tradeoffs between the costs and benefits of debt versus equity. An efficient mixture of capital reduces the price of capital. Lowering the cost of equity increases net returns and ultimately increases firm value. Therefore, companies should ensure that the debt level maintained balances the financial distress costs of debt and tax shield benefit of debt. The recommendations of the research are that further study be done to cover a representation of all the Kenyan listed companies as per sector. A study be carried out to establish the determinants of capital structure in Kenya, as well as a study to determine the relationship between dividend policy and capital structure in Kenya.