THE DETERMINANTS OF CAPITAL STRUCTURE ON THE DEBT- EQUITY RATIO OF SMALL AND MEDUIM SIZED ENTERPRISES

ABSTRACT

The study was to find out the determinants of capital structure on the debt equity ratio of SMEs in Buea. The main objective of the study was to examine the determinants of capital structure of the debt equity ratio of SMEs in Buea. And the specific objectives were: to the examine how cash flow affects the debt equity ratio of SMEs in Buea , to determine how growth prospect affect the debt equity ratio of SMEs in Buea and to determine how cost of capital affect the debt equity ratio of SMEs in Buea . The research was to test whether or not cost of capital affect the debt equity ratio of SMEs in Buea. Quantitative method was use since the data was issues through questionnaires. The study was carryout in buea with a sample size of 50 selected enterprises and the data was collected using primary method through the use of questionnaires and all the questions were closed ended to make our results more accurate. A population of 50 was selected since multiple regression was to use to analysis the relationship between the dependent and independent variable. The descriptive analysis and multivariate analysis was use in in the analysis, the descriptive analysis was conducted using measures of central tendency and also measures of dispersion, and the multivariate analysis was use through multiple regression to analysis the relationship between the dependent and independent variable. The regression analysis was conducted to show the effect of capital structure on the  debt equity ratio of SMEs in Buea, the level of significance was 5% there was enough evidence to reject the null hypothesis and we therefore conduct that capital structure significantly affect the debt equity ratio of SMEs in Buea.

CHAPTER ONE

INTRODUCTION

1.1 Background of the Study

 The means of financing employed for positive net present value projects has important implications for the firm. The cumulative effect of these discrete financing decisions results in the capital structure of the firm, the composition of which has long been a focus of research in the corporate finance discipline. Theoretical discourse on the capital structure of the firm originates from the irrelevance propositions of Modigliani and Miller (1958), stating that the capital structure of the firm was independent of its cost of capital, and therefore of firm value. The propositions of 1958 were based on a number of unrealistic assumptions, and in 1963 Modigliani and Miller introduced taxes into the model. This led to the development of the trade-off theory of capital structure, whereby the tax-related benefits of debt were offset by costs of financial distress.

Alternative approaches, based on asymmetric information between ‘inside’ managers and ‘outside’ investors, include signalling theory (Ross, 1977) and the pecking order theory (Myers, 1984, Myers and Majluf, 1984). The latter postulates that when internal sources of finance are not sufficient for investment needs the firm has a preference to raise external finance in debt markets, with equity issues the least preferable source. (Jensen and Meckling, 1976)A further approach considered a nexus of relationships, characterised as principal-agent relationships, and the potential agency costs on the firm.

(Atseye, 2013) The importance of capital to a business firm cannot be over emphasized. It is the foundation upon which the business operates. Capital absorbs costs and losses; multiplies fixed assets; and in all, enhances growth through mergers, takeovers and acquisitions. In some countries according to Atseye (2013), governments often give financial assistance to business firms to enable them to kick-start and sustain their operations and overcome some teething problems such assistance takes pre-eminence during economic downturn.

Increasingly, business, people are seeking to manage their businesses in a strategic manner. The strategic model of the firm according to Prasad et al (1997) argues that improved firm performance occurs when the firms’ managers select goals and all of the activities of the firm are directed towards meeting those goals. Therefore, the financial strategy of the firm should be consistent with the firm’s strategic objectives. Kochar (1997), asserted that the nature of the firm’s assets predicts efficient ways of organizing transactions. Varying characteristics of assets imply different levels of optimal capital mix of debt and equity.(Hennart, 1994) If transactions with suppliers of finance are not organized as per these predictions, the ability of firms to obtain a competitive advantage over their rivals maybe impaired. The implication is that capacities in managing financial policies are important if a firm is to realize gains for its specialized resources. (Kochar, 1997) Poor capital structure decisions lead to a possible reduction in the value derived from strategic assets. Capital structure may be defined as the combination of debt and equity to finance a firm’s operations. (Chou and Lee, 2010, Hall et al, 2004, Barral and Booth et al, 2001)  Capital structure includes mixture of debt and equity financing. According to Pandey (2000) capital structure refers to the mix of long-term sources of funds, such as debenture long-term debt, preference share capital and equity share capital including reserve and surpluses. In the words of Abor(2008) capital structure is defined as the specific mix of debt and equity a firm uses to finance its operations. (Tekker, et al, 2009) a company’s combination of debt and equity issues to relieve potential pressures on its long-term financing.

Yet, (Pratheepkanth, 2011) the mixture of a variety of long-term sources of funds and equity shares including reserves and surpluses of an enterprise is called capital structure.

From the above, discussion, two financing options are open to financial managers-debt and equity. Thus, the financial manager can increase shareholder claim or increase creditor’s claim on the assets of the firm. Shareholders’ claim increases when shares are issued for public subscription while creditors’ claim increases when the company borrows on a short-term or long-term basis. Therefore, the various means of financing company operations represent what is known as financial structure. The financial structure of a firm is shown on the balance sheet as combination of liabilities and equity.

Similarly, the financial manager can finance the assets of the business by debt or equity. The use of both debt and equity as sources of funds to a business is termed capital structure. It is also known as debt–equity mix. To understand how companies finance their operations, it is necessary to examine the determinants of their financing or capital structure decisions. A company’s financing decisions according to Pratheepkanth (2011) involve a wide range of policy issues. At the private sector, (Green, Murinde and Suppatitjarat, 2002) they have implications for capital market development, interest rates and security price determination, and regulation. Also, such decisions affect capital structure, corporate governance and company development.

In the same vein, Adeshola (2009) explained that the determining factors affecting the choice of the capital structure of firms can be broken down into four categories, according to their purpose towards;

1. Improving the conflicts between the various stakeholders with claim upon the firm resources, machines, managers (the agency approach).

2. Conveying private information to the capital markets or mitigating effects of adverse selection (the asymmetric information approach).

3. Influencing the nature of products or competition in the product/input

Markets and

1. Influencing the results of disputes over corporate control (Harris and Ravir, 1991).

However, the capital structure of a firm is determined by internal and external factors. The external factors are the macroeconomic variables which include tax policy of government, inflation rate and capital market conditions. The characteristics of an individual firm, growth rate, profitability, debt servicing capacity and operating leverage according to Baral (2004), are determinants of capital structure. Teker, et al, (2009) identified the determinants of capital structure of firms to include tangibility, size, growth opportunities, profitability and non-debt tax shields. The determination of capital structure in practice according to Pandey (2000) involves additional considerations in addition to the concerns about EPS-earnings per share; value and cash flow attitude of managers with regards to financing decisions are quite often influenced by their desire, not to lose control, to maintain operating flexibility and to have convenient and cheap means of raising funds. He argued that the most important considerations are: concern for dilation of control, desire to maintain operating flexibility, ease of marketing capital inexpensively, capacity for economies of scale, and agency costs. Owolabi and Inyang (2012) identified the determinants of capital structure of Nigerian firms as corruption, political instability and nature of financial market.

The research of small and medium sized enterprises(SMEs) financing in Cameroon highlights results that are close to those observe in the other economies of Africa .Cameroonian SMEs rely mainly on the equity to finance their various needs ,when they go for debt, they generally access to short term debts (Yumgue ,2007) we note the preponderance tontine and social network capital injection in the Cameroonian SMEs .The characteristics of the firms sector and type of assets to be financed also influences the financial structure of SMEs in Cameroon .Other studies allows us to recognize the importance of financial information on the lending decision of SMEs in Cameroon. The transition economy of Cameroon, SMEs are still subject to financial difficulties that limit their growth and development compared to large enterprises.

1.2 Statement of the Problem

Review on the relevant literatures regarding the capital structure issues, shows that the focus of the most capital structure studies is on the listed SMEs, and the small business’s capital structure is highly overlooked. Various empirical researches on capital structure gathered data from the firms, which are classified as large businesses (Van der Wijst and Thurik, 1991; Chittenden et al., 1996a; Jordan et al., 1988). Researches on the SMEs capital structure clearly show that there is a massive difference between SMEs financing behavior and their large counterparts. According to Agn (1992), small businesses are not engaged in the problems, as well as opportunities, of large firms. However, small firms face different complexities, such as the presence of estate tax, shorter expected life than large firms, intergenerational transfer problems, and prevalence of implicit contracts. Moreover, Pettit and Singer (1985) argued that standard problems like asymmetric information and agency cost is more severe in small firms than large firms. According to Cassar and Holmes (2003), lack of management skills, and the limited separation of business decisions from personal purpose is another problem in SMEs only limited amount or researches have focused on SMEs and the factors that have an impact on the borrowing decisions of them. SMEs are notable because the financial policy and capital structure of these firms play a key role in a country economic and political condition. (Keasey and Watson, 1987; Storey et al., 1988; Lowe et al., 1991) Studies on the failure of the SMEs reveal that financial leverage is a main cause of decline. SMEs borrowing decisions are different form large companies, due to the borrowing constraints they face. Therefore, the problem is to find out how capital structure determinants affect the borrowing behavior of the SMEs. It is useful to know whether all the determinants have a same level of significant on the firm’s leverage or not.Numerous literatures have investigated about the determinants of capital structure, and their impact on the listed companies. Nevertheless, number of research with the focus on the SMEs capital structure and SMEs borrowing behavior are limited in general. Specifically, I believe that there is a gap in the literature regarding the influence of capital structure determinants on Iranian SMEs borrowing behavior. The purpose of this thesis is to test empirically the impact of capital structure determinants on Cameroon SMEs borrowing behavior. In fact, this thesis aims to test the static trade off theory and the pecking order theory on Iranian SMEs, and examine if the selected factors have an impact on the firm’s capital structure. There are relatively few empirical studies exploring the perception of owner-managers in finance even though they actually play a vital role in SMEs’ financing decisions. Alternatively, most of the prior studies in capital structure determinants obtained information from secondary sources of panel data such as Affärsdata, DataStream, Osiris database, Global Vantage database, Compustat, Center for Research in Security Prices (CRSP) database, public databases, World scope financial data, Social and Behavioral Instruments (SABI) database, annual reports, and others. Therefore, this study seeks to assess how the determinants of capital structure influence the performance of small and medium size enterprise in Buea-Cameroon, case of electronic dealers.

 1.3 Research Questions

1.3.1The main research question is

• What are the determinants of capital in small and medium size enterprises in Buea?

1.3.2Specific Research Question

• To what extent does growth prospect influences the debt equity ratio of SMEs in Buea?

• Does cost of capital influence the ratio between debt and equity in SMEs in Buea?

• How does cash flow influence the debt and equity ratio of SMEs in Buea?

1.4 Research Objective

1.4.1 The main research objective

• To examine the determinants of capital in small and medium size enterprise in Buea

1.4.2 Specific Objective

 To determine how growth prospect influences the debt equity SMEs in Buea.

• To determine how growth prospect influences the debt equity SMEs in Buea.
• To evaluate how cost of capital influence the ratio between debt and equity in SMEs in Buea.
• To determine how cash flow influence the debt and equity ratio of SMEs in Buea.

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