Effect of Debt Financing Options on Financial Performance of Firms Listed at the Nairobi Securities Exchange, Kenya

Abstract

In spite of the dominance of the capital structure debate among both academic researchers and practitioners in the field of corporate finance over the last three decades, finding an optimal capital structure remains an ever-elusive gem. In particular, many contemporary firms are yet to find the optimum debt levels that maximises shareholder value. The purpose of this study was to examine the effects of debt configurations namely short-term, long-term and total debt on firm financial performance measured as return on assets and return on equity of listed firms in Kenya. The study utilizes panel econometric techniques named pooled ordinary least squares (OLS), fixed effects (FE) and random effects (RE) to analyze the effects of debt on financial performance of 40 non-financial firms listed on the Nairobi Securities Exchange between 2009 and 2015. Empirical results show that short-term, long-term and total debt have negative and statistically significant effects on returns on assets across OLS and RE. However, the debt measures have no significant effects on returns on equity across all estimation methods. These mixed empirical results partially follow both the trade-off and Modigliani and Miller’s theoretical predictions and partly contradict the very theories. Consequently, financial managers should adjust debt levels to ensure that they operate at the optimum points. On the other hand, credit institutions should only finance businesses up to the point where profitability is maximized to mitigate against default risks associated with overleveraging.