CAPITAL STRUCTURE AND FINANCIAL PERFORMANCE

A CASE OF SELECTED MEDIUM SIZED ENTERPRISES IN KAMPALA

BY

NAIZULI RUTH WAKIDA

2005/HD10/2757/U

SUPERVISORS:

DR. NKOTE NABETA

DR.KAMUKAMA NIXON

A DISSERTATION SUBMITTED TO THE SCHOOL OF GRADUATE STUDIES IN

PARTIAL FULFILLMENT FOR THE AWARD OF THE DEGREE OF MASTER OF
SCIENCE ACCOUNTING AND FINANCE DEGREE OF MAKERERE
UNIVERSITY.

NOVEMBER, 2011

DECLARATION
I Naizuli Ruth Wakida declare that this study is original and has not been published or
submitted for any other degree award to any other university before.

Signed...............................

Date ..

Naizuli Ruth Wakida

2005/HD10/2757/U

APPROVAL
This is to certify that this dissertation has been submitted for examination with our approval
as University Supervisors.

Signed.........................................

Date.............................................

DR. NKOTE NABETA ISAAC

Signed.........................................

Date.............................................

DR. NIXON KAMUKAMA

ii

DEDICATION
I dedicate this dissertation to my husband Emmanuel for his persistence, encouragement,
financial support and for not giving up on this research and also to my parents Mr. & Mrs.
Wakida for your persistence and prayers through this period of my studies.

iii

ACKNOWLEDGEMENTS

Let me take this opportunity to acknowledge my supervisors; Dr Kamukama Nixon for all
the assistance rendered in making this research a reality. Your corrections, insights and
encouragement are indeed invaluable to me. The time that you devoted to this study is indeed
appreciated. Secondly let me recognise the commitment of Dr. Nkote Isaac who has been
very instrumental in shaping this study. You tirelessly made yourself available to supervise,
correct and offer additional reading material; I cannot thank you both enough.
I thank my family for being very supportive to me during the period i was carrying out this
study. Finally i thank my respondents for providing me with the much required information
without which this research would not have been possible.

iv

Table of Contents
Table of Contents......................................................................................................................................................... v
INTRODUCTION ....................................................................................................................................................... 1
1.1.

Background to the Study ............................................................................................................................. 1

1.2.

Statement of the Problem ............................................................................................................................ 2

1.3 Purpose of the Study.......................................................................................................................................... 3

1.4 Research Objectives .......................................................................................................................................... 3
1.5 Research Questions............................................................................................................................................ 3
1.6 Scope of the study .............................................................................................................................................. 4
1.7 Significance ......................................................................................................................................................... 4
1.8 Conceptual Framework. ................................................................................................................................... 5
CHAPTER TWO......................................................................................................................................................... 7
LITERATURE REVIEW........................................................................................................................................... 7
2.0.

Introduction ................................................................................................................................................... 7

2.1. Medium Sized Enterprises in Uganda ........................................................................................................ 7

2.2. Capital Structure Theory ............................................................................................................................ 8
2.4.1 Equity Financing ....................................................................................................................................... 15
2.4.2 Debt Financing .......................................................................................................................................... 15
2.7. Financial Performance .............................................................................................................................. 19
2.9 Relationship between Capital Structure and Financial Performance ...................................................... 21
2.11 Capital Structure and Loan Covenants ..................................................................................................... 23
2.12 Cost of Capital and Financial Performance ............................................................................................. 24
2.13 Loan Covenants and Financial Performance ........................................................................................... 24
CHAPTER THREE .................................................................................................................................................. 26
METHODOLOGY .................................................................................................................................................... 26

3.0.

Introduction ................................................................................................................................................. 26

3.1. Research Design ....................................................................................................................................... 26

3.2. Study Population ....................................................................................................................................... 26
3.3. Sample Size, Selection and Response Rate. ............................................................................................ 26
3.4. Sampling Technique and Procedure......................................................................................................... 27
3.5. Data Sources ............................................................................................................................................. 27
3.6. Data Collection Instruments ..................................................................................................................... 28
3.7. Validity and Reliability ............................................................................................................................ 28
3.8. Measurement of Study Variables ............................................................................................................. 29
Capital Structure ................................................................................................................................................. 29
3.9. Data Processing and Analysis .................................................................................................................. 32
CHAPTER FOUR ..................................................................................................................................................... 33
PRESENTATION, ANALYSIS AND INTERPRETATION OF FINDINGS ................................................... 33
4.1 Introduction ............................................................................................................................................... 33
4.2 Background Characteristics ...................................................................................................................... 33
4.2.1

Gender of Respondents ................................................................................................................... 33

4.2.2

Age of Respondents ........................................................................................................................ 34

4.2.3

Education Background .................................................................................................................... 34

4.3 Firm Characteristics .................................................................................................................................. 35

4.3.1

Period of Existence of the Firm ...................................................................................................... 35

4.3.2

Number of Employees .................................................................................................................... 36

4.3.3

Sector of Operation of the Business ............................................................................................... 36

4.3.4

Capital size of the Business ............................................................................................................ 37

4.3.5

Division of Operation ..................................................................................................................... 37

4.4 Descriptive Summary Statistics................................................................................................................ 38

4.5 Principal Component Analysis ................................................................................................................. 39
4.5.1

Rotated Factor Pattern from Principal Component Analysis of Capital Structure of Medium Sized

Enterprises ..................................................................................................................................................... 39
4.5.2

Rotated Factor Pattern from Principal Component Analysis of Cost of Capital........................... 41

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4.5.3

Rotated Factor Pattern from Principal Component Analysis of Loan Covenants. ........................ 43

4.5.4

Rotated Factor Pattern from Principal Component Analysis of Financial Performance. ............. 45

4.6 Correlation Analysis ................................................................................................................................. 46

4.6.2 To Examine the Relationship between Capital Structure, Cost of Capital and Loan Covenants of Medium
sized Enterprises in Uganda ............................................................................................................................... 48
CHAPTER FIVE ....................................................................................................................................................... 50
DISCUSSION, CONCLUSIONS AND RECOMMENDATIONS ...................................................................... 50
5.1 Introduction ............................................................................................................................................... 50
5.3 Relationship between Capital Structure and Financial Performance ................................................. 51
5.4 Relationship between Capital Structure, Cost of Capital and Loan Covenants ................................. 52
5.8 Effect of Capital Structure, Cost of Capital and Loan Covenants on Financial Performance. .......... 53
5.9 Conclusion ................................................................................................................................................ 54
5.10 Recommendations..................................................................................................................................... 55
5.11 Areas for Further Research ....................................................................................................................... 56

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List of Tables
Table 1: Response Rate.............................................................................................................. 27
Table 2:Stratification Table ....................................................................................................... 27
Table 3: Reliability Test Results of the Study Variables. .......................................................... 29
Table 4: Rank in the Organisation ............................................................................................. 33
Table 5: Age of Respondents ..................................................................................................... 34
Table 6: Education Background ................................................................................................ 34
Table 7: Period of Existence of the Firm ................................................................................... 35
Table 8: Number of Employees ................................................................................................. 36
Table 9: Sector of Operation ...................................................................................................... 36
Table 10: Capital Size of the Business ...................................................................................... 37
Table 11: Division of Operation ................................................................................................ 37
Table 12: Descriptive Summary Statistics ................................................................................. 38
Table 13: Rotated Factor Pattern from Principal Component Analysis of Capital Structure of
Medium Sized Enterprises ......................................................................................................... 39
Table 14:Rotated Factor Pattern from Principal Component Analysis of Cost of Capital of
Medium Sized Enterprises ......................................................................................................... 41
Table 15: Rotated Factor Pattern from Principal Component Analysis of Loan Covenants of
Medium Sized Enterprises ......................................................................................................... 43
Table 16:Rotated Component Matrix for Financial Performance of Medium Sized Enterprises
................................................................................................................................................... 45
Table 17:Zero order Correlation between Capital Structure, Cost of Capital, Loan Covenants
and Financial Performance. ....................................................................................................... 47
Table 18: Multiple Regression Analysis Model ........................................................................ 48

viii

LIST OF ACRONYMS
NAADS

National Agricultural Advisory Services

BUDS

Business Uganda Development Scheme

UNIDO

United Nations Industrial Development Organization

PSFU

Private Sector Foundation Uganda

ix

ABSTRACT

The purpose of this study was to establish the relationship between capital structure and
financial performance of Medium sized enterprises in Uganda. This study was prompted by the
continued poor performance coupled with closure of several small and medium enterprises in
Uganda under the debt burden as was noted in the business power section of the daily monitor
on 25th September 2007. Focus was also placed on the relationship between capital structure,
cost of capital and loan covenants on financial performance of Medium Sized Enterprises. The
objectives of the study were to examine the relationship between capital structure and financial
performance of Medium sized Enterprises in Uganda, to examine the relationship between
capital structure, cost of capital and loan covenants of Medium sized Enterprises in Uganda
and to examine the impact of capital structure, cost of capital and loan covenants on financial
performance of Medium sized Enterprises in Uganda.
The study was cross sectional in nature which aided in the sampling and collection of data.
Empirical data on capital structure and financial performance was analyzed using SPSS and
MS-Excel to establish relationships between the variables selected for the study. Pearsons
correlation coefficient was determined and Regression analysis was also used to determine the
impact of capital structure, cost of capital and loan covenants on financial performance of
Medium Sized Enterprises. Using various measures of financial performance, results indicated
that capital structure influences financial performance, although not exclusively. The results
revealed that capital structure, negatively affected financial performance of Medium Sized
Enterprises. This suggests that agency issues may lead to Medium Sized Enterprises pursuing
high debt policy, thus resulting in lower performance.

Medium Sized Enterprises should therefore consider increasing equity in their capital structure
through capital raising ventures like private placement of shares so as to reduce on the over
reliance on debt. This will help in minimizing the cost of debt thereby enhancing profitability.

xi

CHAPTER ONE

INTRODUCTION
1.1. Background to the Study
The study on capital structure attempts to explain the mix of securities and financing sources
used by companies to finance investments (Myers, 2001). Brigham, (2004) referred to Capital
structure as the way in which a firm finances its operations which can either, be through debt
or equity capital or a combination of both. According to Myers, (2001), there was no universal
theory on the debt to equity choice but noted that there were some theories that attempted to
explain the capital structure mix. (Myers, 2001) cited the trade off theory which states that
firms seek debt levels that balance the tax advantages of additional debt against the costs of
possible financial distress. The pecking order theory states that firms will borrow rather than
issue equity when internal cash flow is not sufficient to fund capital expenditure (Myers,
2001). The theory concluded that the amount of debt will reflect the firms cumulative need for
external funds. The free cash flow theory on the other hand stated that dangerously high debt
levels would increase firm value despite the threat of finance distress when a firms operating
cash flow significantly exceed its profitable investment opportunities.

Financial performance is a subjective measure of how well a firm can use its assets from its
primary business to generate revenues. Erasmus, (2008) noted that financial performance
measures like profitability and liquidity among others provided a valuable tool to stakeholders
to evaluate the past financial performance and the current position of a firm. Brigham and
Gapenski (1996) argued that in theory, the Modigliani and Miller model was valid however in
practice, bankruptcy costs did exist and that these costs were directly proportional to the debt
levels in a firm. This conclusion implied a direct relationship between capital structure and
financial performance of a firm.
1

Berger & di Patti, (2006) concluded that more efficient firms were more likely to earn a higher
return from a given capital structure, and that higher returns can act as a cushion against
portfolio risk so that more efficient firms are in a better position to substitute equity for debt in
their capital structure. This is an incidental of the trade-off theory of capital structure where
differences in efficiency enable firms to alter their optimal capital structure either upward or
downwards. In addition, Singh & Hamid, (1992) in their research, used data on the largest
companies in selected developing countries and found that firms in developing countries used
more of debt finance in financing their growth than was the case in industrialized countries.
Abor, (2005a) also found a positive relationship between total assets and return on equity and
that profitable firms in Ghana depended more on debt as a main financing option due to a
perceived low financial risk.

Medium Sized Enterprises have seemed to concur with the above findings given that they seem
to have an over reliance on debt and this has led to a number of Medium Sized Enterprises to
be closed down under the debt burden business power section ( 25th September 2007).
Examples of such firms include but arent limited to Avis Company Limited, Green land Bank,
Bugisu Co-operative Union, Sweppes Uganda, Sapoba Printing Press and Lweza Clays
Limited (currently in receivership) being the most recent. The collapse of some companies like
Avis Company Limited is said to have been due to a number of reasons some of which could
be linked to capital mix.

1.2. Statement of the Problem

The continued poor performance coupled with closure of medium sized enterprises has raised
more questions than answers to researchers and practitioners. The performances of such firms
have been deteriorating and even some companies like GTV, Lweza Clays, and Avis among
others have been forced into receivership (Monitor 2008). Apart from companies like GTV
2

facing closure, a survey by Global Entrepreneurship Monitor showed at least other 15 firms
closing business by December 2008. It was also pointed out that the increase from 2.7% to
10.4% in December 2007 in commercial institutions non-performing assets was attributable to
small and medium firms failure to service their loans due to insufficient financial resources
(Background to Budget 2008/9). Arising from the findings of Berger (2006), the capital
structure employed by such firms could be a reason influencing their financial performance
trends an issue that has not been given serious attention. It is on this basis that the researcher
was propelled to investigate the contribution of capital structure on small and medium firms
financial performance.

1.3 Purpose of the Study

The study investigated the relationship between capital structure and financial performance of
Medium Enterprises in Kampala.

1.4 Research Objectives

i)

To examine the relationship between capital structure and financial performance of

Medium sized Enterprises in Kampala.

ii)

To examine the relationship between capital structure, cost of capital and loan covenants
of Medium sized Enterprises in Kampala.

iii)

To examine the effect of capital structure, cost of capital and loan covenants on financial
performance of Medium sized Enterprises in Kampala.

1.5 Research Questions

The researcher conducted the study using the following research questions:i)

Is there a relationship between capital structure and financial performance of Medium

sized Enterprises in Kampala?

ii)

Is there any relationship between capital structure, cost of capital and loan covenants of
Medium sized Enterprises in Kampala?

iii)

Does capital structure, cost of capital and loan covenants have any effect on the financial
performance of Medium sized Enterprises in Kampala?

1.6 Scope of the study

Geographical Scope
The study was conducted in the five divisions of Kampala namely Kawempe, Makindye,
Kampala Central, Rubaga and Nakawa Divisions.
Subject Scope.
The study investigated the effect of capital structure mix in determining financial performance
of Medium sized Enterprises in Kampala.

1.7 Significance
The researcher hopes that the findings from the study shall be useful to the business
community since it will throw more light on the role that capital structure has in determining
financial performance. The study will also enlighten scholars on the importance of the capital
structure to any business and will highlight areas for further research.

1.8 Conceptual Framework.

The conceptual framework below shows the relationship between capital structure and
financial performance.
Figure 1: Conceptual frame work
Cost of Capital
Interest
Dividends
Capital Structure
Debt
Equity

Financial
Performance
Liquidity
Profitability
Loan Covenants
Use of collateral
Repayment terms
Periodic reporting

Source: Adapted from (Edward and Pointon 1984), and (Pandey, 2005)

The independent variable in this study was capital structure and the dependent variable was
financial performance. The relationship between Capital structure and financial performance
was such that they were inversely related as was noted by a number of scholars like Fama and
French 2002, Booth et al (2001) and Wald, (1999) whose studies provided empirical evidence
supporting this negative relationship between debt levels and a firms performance.

The relationship between the independent and mediating variables was such that there was an
inverse relationship between capital structure and cost of capital and a positive relationship
between capital structure and loan covenants. This was noted by Dhankar et al., (1996) who in
their research on cost of capital, optimal capital structure and value of a firm a case of Indian
companies noted that a change in capital structure and cost of capital were negatively or

inversely related because cost of capital decreases with increase in debt levels and that cost of
debt was less than the cost of equity because interest payments were tax exempt.

CHAPTER TWO
LITERATURE REVIEW
2.0. Introduction
This chapter examined the literature relevant to the study. It followed the conceptual
framework, incorporate scholarly works and theories. The rationale of the study was to
ascertain the role capital structure played in determining financial performance. The literature
under review was obtained from journal articles, websites and text books and the procedure
followed in reviewing the literature begun with looking at Ugandas definition of small and
medium sized enterprises, the independent variable, capital structure theories, the moderating
variable, the dependent variable and the relationships.

2.1. Medium Sized Enterprises in Uganda

A Medium Sized Enterprise as defined by the Small and Medium Enterprises Business Guide
(2008) is one employing more than 50 people with an annual revenue of more than Uganda
shillings 360M and assets of more than Uganda shillings 360M. The researcher was guided by
the above definition when designing the questionnaire. Medium sized enterprises in Uganda
have been faced with a number of challenges most of which are capital structure mix related.
A look at the Small and Medium Enterprises Business Guide, (2008) revealed a number of
challenges faced by enterprises in Uganda to include; limited access to finance, a lack of
entrepreneurial skill, lack of general managerial skills, marketing and financial planning, lack
of working business plans, poor record keeping, deficient corporate governance, a short term
business outlook, poor borrowing and banking history among others Small and Medium
Enterprises Business Guide (2008). In addition, Medium sized enterprises are also confronted
with limited access to business development services, limited access to information on market
opportunities and sources of competitive technology, local and international competition.
7

Due to the above, the government of Uganda overtime developed initiatives to enhance the
development of enterprises in Uganda to include the Plan for Modernization of Agriculture.
Plan for Modernization of Agriculture offers opportunities for agricultural business and direct
hands on extension services through NAADS whose main beneficiaries are subsistence
farmers. In addition, BUDS was created which is governed by PSFU a cost sharing grants
project cofounded by the World Bank. This project supports training programs aimed at
increasing capacity and performance of Medium Sized Enterprises. Suffice to say, other
Government initiatives aimed at empowering Medium Sized Enterprises in Uganda include
Microfinance outreach Plan, UNIDO Master Craftsman Program, the Jua Kali initiative and
the Presidential investors round table among others. However, in spite of the investment in
Small and Medium Enterprise projects and programs by government and other stakeholders,
Medium Sized Enterprises have continued to face several challenges in their pursuit for profit
as highlighted above.

2.2. Capital Structure Theory

Capital structure puts into perspective the way in which a firm finances its operations
Brigham,(2004), this can either be through debt or equity capital or a combination of both
David, (1979). Capital structure theory as attributed to Modigliani and Miller concluded that it
doesnt matter how a firm finances its operations and that the value of a firm is independent
of its capital structure making capital structure irrelevant. The study was based on the
assumption that there were no brokerage costs, earnings before interest and tax were not
affected by the use of debt and that investors could borrow at the same rate as corporations
and lastly there was no information asymmetry. Although this statement didnt reject the
possible preference of a firms owner to a certain type of financing over others, it did affect
8

the irrelevance of the value of the firm to the means of financing it given a perfect market
(Fischer, Heinkel, & Zechner, 1989). A number of theories were from then onward advanced
to explain capital structure notable among which are the pecking order theory and trade off
theory which have been often than not a centre of debate.

Trade-off theory of Capital Structure and Taxes

Myers, (2001) in his research on capital structure noted that the trade-off theory justifies
moderate debt ratios. The purpose of the trade-off theory of capital structure is to explain the
strategy a firm uses to finance investments which may be by equity and sometimes by debt.
Tradeoff theory predicts that a weak firm will rely exclusively on a bank for debt capital. That
is, for weak firms, bank debt dominates any mix of market and bank debt regardless of the
priority structure. This result contradicts the notion that small/young firms avoid public debt
because they lack access to such markets or face prohibitive costs in so doing (Hackbarth,
Hennessy, & Leland, 2007). Within the tradeoff theory, there is a debt pecking-order with
bank debt being preferred to market debt due to the lower implied bankruptcy costs. When the
bank holds all ex post bargaining power, the desired level of debt tax shields can be achieved
using only bank debt(Hackbarth et al., 2007).

Myers, (2001) noted that the firm would borrow up to the point where the marginal value of
tax shields on additional debt is offset by the increase in the present value of possible costs of
financial distress. According to Modigliani & Miller, (1958), the attractiveness of debt
decreases with the personal tax on the interest income. A firm experiences financial distress
when the firm is unable to cope with the debt holders' obligations. If the firm continues to fail
in making payments to the debt holders, the firm can even be insolvent. The theory can be
explained by costs of financial distress and agency costs (Pandey, 2005).
9

Pandey, (2005) explained direct costs of financial distress to include costs of insolvency
which may manifest in the form of demoralised employees, customers who eventually stop
purchasing a companys products, investors who may decline to supply capital or avail it at a
high cost and lastly managers who may pass up profitable investment opportunities to in order
to avoid any sort of risk.
Murinde, et al (2002) stated that tax policy has an important effect on capital structure
decisions of a firm. This is in the sense that corporate tax allows firms to deduct interest on
debt when computing taxable profits. This suggests that tax advantages derived from debt
would lead firms to be entirely financed through debt because interest payments associated
with debt are tax deductable whereas payments associated with equity such as dividends
arent tax allowable deductions. This means that the effect of more or less debt in a firm may
either reduce or increase firm value depending on the nature of ones business. It was
concluded that trade-off theory couldnt account for the correlation between high profitability
and low debt ratios. Rajan et al (1995) also confirmed a negative correlation between
profitability and leverage for the United States, Japan and Canada although no significant
correlations were found for France, Germany, Italy and Britain.

Pecking Order Theory

The pecking order theory as developed by Myers, (1984) stated that firms prefer internal
sources of finance; they adapt their target dividend payout ratios to their investment
opportunities although dividends and payout ratios are gradually adjusted to shifts in the extent
of valuable investment opportunities. In addition, Myers, (1984) stated that in the event that
external finance is required, firms are most likely to issue the safest security first that is to say
they start with debt then possibly convertible debt then equity comes as last resort. In
summary, Myers argument was such that businesses adhere to a hierarchy of financing
10

sources and prefer internal financing when available. Should external financing be required,
debt would be preferred over equity. Pandey, (2005), also concurred with Myers argument
when he noted that managers always preferred to use internal finance and would only resort to
issuing shares as a last resort. He went on to add that the pecking order theory was able to
explain the negative inverse relationship between profitability and debt ratio within an industry
however; the theory did not fully explain the capital structure differences between industries.

Scherr et al (1993); Holmes et al, (1991) and Quan, (2002) considered the pecking order
theory as an appropriate description of Medium Sized Enterprises financing practises because
debt is by far the largest source of financing and that small and medium enterprise managers
tend to be owners of the business who do not normally want to dilute their ownership. In
addition, they concurred that firms consequently tend to prefer internal financing to external
financing of any sort and if they must obtain external funding, they have a preference of debt
over equity. They also noted that the order of preference reflected the relative costs of various
financing options. Firms therefore would prefer internal sources of finance as compared to
expensive or costly external finance and that firms that are profitable and therefore generate
earnings are expected to use less debt than those that do not generate high earnings.

Cosh & Hughes, (1994) on the other hand argued that within the overall pecking order theory,
Small and Medium Sized Enterprises when compared to large enterprises would depend
more on holding excess liquid assets to meet discontinuities in investment programs, depend
more on short term debt including trade credit and overdrafts, rely to a greater extent on hire
purchase and leasing equipment. Therefore in relation to Small Medium Enterprises
financing, Cosh & Hughes, (1994) proposed a refinement of the theory due to its lack of
information to assess risk both on individual and collective basis.
11

2.3. Determinants of Capital Structure

2.3.1 Introduction
A number of empirical studies have identified firm level characteristics that affect the capital
structure of firms and these include:2.3.2 Asset structure
The asset structure of a firm plays a significant role in determining its capital structure. The
degree to which the firms assets are tangible should result in the firm having greater
liquidation value Titman & Wessels, (1988a); Harris & Raviv, (1991). Bradley et al (1984)
assert that firms that invest heavily in tangible assets also have higher financial leverage since
they borrow at lower interest rates if their debt is secured with such assets. It is believed that
debt may be more readily used if there are durable assets to serve as collateral (Wedig, Sloan,
Hassan, & Morrisey, 1988). This will result in firms with assets that have greater liquidation
value having relatively easier access to finance at lower cost.

Empirical research done by Bradley et al (1984); Wedig et al., (1988); Friend & Lang (1988b);
MackieMason, (1990b); Rajan & Zingales, Shyam-Sunder, (1995);

and Myers, 1999;

Hovakimian et al., (2004b), Kim and Sorensen 1986, suggested a positive relationship between
asset structure and leverage for the firms, and a negative coefficient between depreciation
expense as a percentage of total assets and financial leverage. In other studies done by Van der
Wijst & Thurik, (1993) and Chittenden et al., (1996); Jordan et al., 1998; Michaelas et al.,
(1999); Cassar et al.,( 2003); Hall et al., (2004) suggested a positive relationship between asset
structure and long-term debt, and a negative relationship between asset structure and shortterm debt. However, Esperanca et al, (2003) also found a positive relationship between asset
structure and both long-term and short-term debt. The level of tangible fixed assets therefore
may help firms to obtain more long-term debt.
12

2.3.3 Firm Size

Large firms are seen to be more diversified and therefore have lower variance in earnings
which gives them an upper hand in tolerating high debt ratios (Castanias, 1983). Smaller firms
on the other hand may find it relatively more costly to resolve. Thus lenders to larger firms are
more likely to recover their funds than lenders to smaller firms. This simply means that larger
firms will have higher debt. Empirical evidence on the relationship between size and capital
structure supports a positive relationship. Scholarly works as done by Barclay & Smith,
(1996), Al-Sakran, (2001) and Hovakimian et al., (2004a) suggest that smaller firms are likely
to use equity finance while larger firms are likely to use debt. Cassar et al., ( 2003), Esperanca
et al., (2003) and Hall et al., (2004) found a positive relationship between firm size and long
term debt ratios but a negative relationship between size and short term debt ratios.
2.3.4 Firm Age
As a firm continues in business, it establishes itself as a going concern thereby increasing its
capacity to take on more debt. This therefore makes age positively related to debt. Age of the
firm is a standard measure of reputation in capital structure models because as a firm continues
longer in business, it establishes itself as a going concern and therefore increases its capacity to
take on more debt making age positively related to debt. Hall et al., (2004) concurred to the
above aspect of capital structure noting that age is positively related to long-term debt but
negatively related to short-term debt. Esperanca et al., (2003), however, found that age is
negatively related to both long-term and short-term debt. Green, ( 2002. ) also found that age
has a negative influence on the probability of incurring debt in the initial capital equation, and
no impact in the additional capital equation.

13

2.3.5 Firm Growth

Growth is likely to place a greater demand on internally generated funds and push the firm into
borrowing (Hall et al., 2004). According to Marsh, (1982), firms with high growth will capture
relatively higher debt ratios. In the case of small firms with more concentrated ownership, it is
expected that high growth firms will require more external financing and should display higher
leverage (Heshmati, 2002). Aryeetey, (1994) noted that growing Medium Sized Enterprises
appear more likely to use external finance although it is difficult to determine whether finance
induces growth or the opposite or both. As enterprises grow through different stages, they are
also expected to shift financing sources. They may probably move from internal sources to
external sources Aryeetey, (1994). Myers, (1977) however, holds the view that firms with
growth opportunities will have a smaller proportion of debt in their capital structure.
2.3.6 Firm Risk
Risk levels are one of the primary determinants of a firms capital structure Kale et al.,(1991).
If a firms operating risk is more volatile than the firms earnings stream, the chance of the
firm defaulting and being exposed to bankruptcy and agency costs is high. According to
Johnson (1997), firms with more volatile earnings growth may experience more situations in
which cash flows are too low for debt service.
Inspite of the above studies advanced, a number of studies have indicated an inverse
relationship between risk and debt ratio Bradley et al., (1984); Titman et al.,(1988a); Friend et
al, (1988a); Mackie- Mason, (1990a); Kale et al., (1991). Other studies suggest a positive
relationship Jordan et al., 1998; Michaelas et al.,(1999). Esperanca et al., (2003. ) also found a
positive relationship between firm risk and both long-term and short-term debt.

14

2.4 Components of Capital Structure

2.4.1 Equity Financing
If a firm doesnt use debt financing, its referred to as an un levered firm (Brigham 2004). This
brings about what is referred to as business risk which is defined as riskiness inherent in the
firms operations if it doesnt use debt. If a firm doesnt use debt then its return on invested
capital shall be measured by return on equity which is denoted by net income to common stock
holders divided by common equity.

ROE = Net income to common stock holders

Common equity
This simply means that the business risk of a leverage free firm will be measured by the
standard deviation of its Return on equity Brigham & Houston, (2007). The question is if a
firms Return on capital is measured using Return on equity in the absence of debt will the
efficiency ratios exert a significant effect on leverage?

2.4.2 Debt Financing

When a firm decides to use debt financing for its operations its faced with a financial risk and
its referred to as a levered firm. Brigham & Houston, (2007) defined financial risk as that
additional risk placed on common stock holders as a result of the decision to finance using
debt. Financing risk is the probability that the earnings of the firm will not be as projected
because of the method of financing. He also continues by saying that financing risk arises
because debt has a fixed financing obligation usually in the form of interest which must be met
when the obligation falls due before the shareholders can share in the retained earnings.

15

2.5 Cost of Capital

Companies influence their cost of capital through a number of ways because the choice of
capital structure affects the cost of capital (Sanford, 2001). Sanford (2001) further noted that
investors providing equity capital were in a more risky position as opposed to those providing
debt since owners are the residual claimants of a company's net cash flows. Owners of a
business receive returns through dividend and increase in the value if the firms' as sets often
reflected in stock price appreciation. Debt holders on the other hand obtain interest payment
before dividends are paid out.

Cost of capital therefore in general summarizes the different costs attached to the different
sources of financing obtained by an organization Michael (1992). Michael (1992) noted that
for the case of equity financing, the shareholders will not often make explicit the return they
will require for their capital contribution unlike the capital raised by way of borrowing which
normally has an interest rate attached to it which then forms the basis of an organization's cost
of capital. It is therefore imperative to note that a highly levered business depends more on
debt for its overall financial capitalization which thereby increasing the risk hath to the debt
and shareholders.

Another important aspect Sanford (2001) raised in his work was that in both debt and equity
financing, both instances required higher returns to bear the risk though the weighted average
cost of capital could possibly be reduced up to a point as leverage increased from zero since
the cost of debt was less than the cost of equity. Thus the businesss choice of degree of
financial gearing was likely to have a bearing on its weighted average cost of capital.

16

2.5.1 Interest (Cost of Debt)

Pandey (2006) noted that a company could raise debt in a variety of ways which included
borrowing funds from financial institutions or by way of public debt in the form of bonds
(debentures) for a specified period of time at a certain interest rate. The before tax cost of debt
will therefore become the rate of return required by lenders (Pandey, 2006). Michael (1992) ,in
his scholarly works noted that among the two most popular forms of external financing, debt to
most business operations looks cheaper and thus many businesses are easily tempted to utilize
debt in preference to other forms of financing. Scholars like (Modigliani & Miller,
1958),Michael (1992), and Myers (2002) advanced arguments for utilization of debt in one's
capital structures sighting advantages like the effect of tax shields on corporate financing.
Myers et al (2006) on the other band warned of the dangers of heavily relying on debt to
include financial distress and bankruptcy costs (which can be either direct or indirect) noting
that corporate bankruptcies occurred when shareholders exercised their right to default.

2.5.2 Dividends (Cost of Equity)

When investors provide equity capital to a firm, they acquire a right to the future dividends of
that firm given that they become partial owners of the company and that these dividends
cannot be determined from the onset (Michael, 1992). Pandey (2006) noted that businesses
have an option of raising capital internally by retaining earnings. The opportunity cost of
retained earnings is the rate of return on dividend forgone by equity holders and the cost of
external equity is the minimum rate of return which the shareholders require on funds supplied
by them by purchasing new shares to prevent a decline in the existing market price of the
equity share.

17

Pandey, (2006) further noted that they even had the option of distributing the entire earnings to
equity shareholders and raise equity capital externally by issuing new shares. It is sometimes
argued that the equity cost of capital is free of cost because it is not legally binding for
businesses to pay dividends to ordinary shareholders and that in addition it is not fixed as is the
case with interest rates and preference dividend rate (Pandey, 2006). Therefore the market
value of the shares determined by the demand and supply forces in a well functioning capital
market reflects the required rate of return to shareholders.

2.6 Loan Covenants

One of the key functions of loan covenants is to restrict leverage and that not only does a
standard loan agreement limit future debt in absolute dollar terms but also act to limit debt in
relationship to cash flows (Fitch, 1999). Loan covenants in general are said to preserve loan
terms through mitigating credit risk and the impact of loan rating of companies that financial
covenants offer material protection for bank loan investors and that standardization of terms
and a shift in the investor mix toward institutional lenders could lead to covenant dilution in
the future (Fitch, 1999). Examples of financial covenants include a maximum total debt to
earnings before interest, and depreciation; maximum total senior debt to earnings before
interest, dividends and tax; a minimum interest coverage, net worth and current ratios. The
negative covenants include limitation on indebtedness, liens, contingent liability obligations,
limitation on sale of company assets, utilization of leases, issuance of dividends and limitation
on capital expenditure among others.

18

2.7.

Financial Performance

2.7.1

Profitability

The concept of profitability is based on the comparison of the cash outflows required for
implementing a strategic alternative with the cash inflows that this alternative is expected to
generate (Michael, 1992). Profitability measured as determined by Pandey, (2006) included
profitability in relation to sales and profitability in relation to investment.
The profitability in relation to sales is measured by;

2.7.2 Net Profit Margin

This can be obtained when operating expenses, interest and taxes are subtracted from the gross
profit. The ratio obtained therefore establishes a relationship between net profits and sales andalso indicates management's efficiency in manufacturing, administration and selling of
company products. The general rule is for the ratio to turn every cash invested in the business
into profits.
2.7.2.1 Return on Investment and Return on Equity
The return on investment and return on equity are measures of profitability in relation to
investment. The return on investment is obtained by dividing the profits after tax by the
investment and the return on equity by dividing the profit after tax by the net worth of the
business. The return on equity indicates how well management is utilizing the resources of the
shareholders and that the ratio of net profits to owners' equity reflects the extent to which
management bas achieved proper utilization of shareholders resources.
2.8 Liquidity
Pandey, 2006 noted that it was important for a business to meet its obligations as and when
they fell due and that liquidity ratios measured the ability of a business to meet current
obligations. Liquidity analysis can be clone by the preparation of cash budgets and cash and
19

funds flow statements (Pandey, 2006). The failure of a business to meet its obligations due to
insufficient liquidity will result in poor credit worthiness, loss of creditor confidence or at the
worst case scenario legal proceedings which if not handled correctly may result into winding
up of the business. Pandey, (2006) noted the most common ratios which indicate the extent of
liquidity or the lack of it to include among others the current ratio and the quick ratio.

2.8.1 Current Ratio

The current ratio is computed by dividing the current assets by the current liabilities. It is
therefore a measure of a firms' short term solvency Pandey, (2005). The current assets include
cash and all those assets that can be converted into cash within a year to include marketable
securities, debtors and inventory. Current liabilities include creditors, payables, accrued
expenses, short term bank loans, income tax liabilities and long term debt maturing within one
year. As a general rule, Pandey, (2005) noted that a current ratio of 2:1 or more is considered
satisfactory and that a ratio greater than 1 meant that the business had more current assets than
current claims against them.

2.8.2 Quick Ratio

The quick ratio on the other band establishes the relationship between quick or liquid assets
and current liabilities Pandey, (2005). It is computed by subtracting inventory from current
assets thereby dividing it by the current liabilities. Inventory or stocks are normally deducted
since they are considered to be less liquid and they require more time before being turned into
cash. A ratio of 1:1 is considered to represent a satisfactory financial performance.

20

2.9

Relationship between Capital Structure and Financial Performance

Hutchinson, (1995) in his scholarly works argued that, financial leverage had a positive effect
on the firms return on equity provided that earnings power of the firms assets exceeds the
average interest cost of debt to the firm. Taub (1975) also found significantly positive
relationship between debt ratio and measures of profitability. Nerlove (1968), Baker (1973),
and Petersen and Rajan (1994) also identified positive association between debt and
profitability but for industries. In their study of leveraged buyouts, Roden and Lewellen (1995)
established a significantly positive relation between profitability and total debt as a percentage
of the total buyout-financing package.

However, some studies have shown that debt has a negative effect on firm profitability. Fama
and French (1998), for instance argue that the use of excessive debt creates agency problems
among shareholders and creditors and that could result in negative relationship between
leverage and profitability. Majumdar and Chhibber (1999) found in their Indian study that
leverage has a negative effect on performance. Gleason et al., (2000) support a negative impact
of leverage on the profitability of the firm. In a polish study, Hammes (1998) also found a
negative relationship between debt and firms profitability. In another study, Hammes (2003)
examined the relation between capital structure and performance by comparing Polish and
Hungarian firms to a large sample of firms in industrialized countries. He used panel data
analysis to investigate the relation between total debt and performance as well as between
different sources of debt namely, bank loans, and trade credits and firms performance
measured by profitability. His results show a significant and negative effect for most countries.
He found that the type of debt, bank loans or trade credit is not of major importance, what
matters is debt in general.

21

Mesquita and Lara (2003), in their study found that the relationship between rates of return and
debt indicates a negative relationship for long-term financing. They however, found a positive
relationship for short-term financing and equity. Abor, (2007) in his scholarly works on debt
policy and performance of Medium Sized Enterprises found the effect of short-term debt to be
significantly and negatively associated with gross profit margin for both Ghana and South
African firms. This indicated that increasing the amount of short-term debt would result in a
decrease in the profitability of the firms.

2.10

Capital Structure and Cost of Capital

Dhankar et al., (1996) in their research noted that sound financing decisions of a firm would
ideally lead to an optimal capital structure because capital structure in general had an effect on
the cost of capital, net profit, earnings per share, dividend payout ratio and the liquidity
position of the firm therefore, when a firm decides to use debt financing for its operations its
faced with a financial risk and its referred to as a levered firm.

Brigham & Houston, (2007) define financial risk as that additional risk placed on common
stock holders as a result of the decision to finance using debt. Financing risk is the probability
that the earnings of the firm will not be as projected because of the method of financing.
Brigham & Houston, (2007) continue by saying that financing risk arises because debt has a
fixed financing obligation usually in the form of interest which must be met when the
obligation falls due before the shareholders can share in the retained earnings. The above gives
rise to a possible relationship between capital structure and cost of capital in the sense that
additional interest payable reduces the earnings available to shareholders thereby increasing
the risk of their investment and consequently increasing the cost of capital as new investors
will require a higher return on equity to compensate for the increased financial risk.
22

Brigham & Houstons, (2007) findings also seem to concur with the findings of Dhankar et al.,
(1996) who in their research on cost of capital, optimal capital structure and value of a firm a
case of Indian companies noted that change in capital structure and cost of capital were
negatively or inversely related because cost of capital decreases with increase in debt levels
and that cost of debt was less than the cost of equity because interest payments were tax
exempt. Furthermore, since the cost of capital is measured using historical data, the weighted
average cost of capital is likely to decrease with the increase in debt. This therefore meant that
a change in capital structure is not denoted by a proportionate change in the cost of capital.

2.11

Capital Structure and Loan Covenants

Dichev and Skinner, (2002a), Beneish et al.,(1993) found that financial covenant violations
lead to significant modifications to loan agreements in terms of higher interest rates and
reduction in credit availability. Chava et al.,(2008) and Nini et al (2008) in their research found
that covenant violations were associated with significant declines in investment spending
which arose as a result of inclusion of new covenants limiting investment spending. In
addition, Cem et al (2008) found that borrowers with tight covenants significantly decreased
their investment spending and net debt issuance after the inception of the loan agreement. Cem
et al (2008) further noted an improvement in covenant variable and decline in investment
spending and net debt issuance for borrowers with tight covenants that were in compliance
with their covenants. They however found no relationship between covenant intensity and the
outcome of covenant violation.

23

2.12

Cost of Capital and Financial Performance

A firms cost of capital is usually determined by calculating its weighted cost of capital
(Erasmus, 2008).The weighted average cost of capital includes the after tax cost of equity as
well as the after tax cost of the different forms of debt. In a research done by Modigliani &
Miller, (1963), it was noted that when a firm utilized debt in its capital structure, the average
cost of capital was reduced and profitability enhanced. Which profitability is considered a
measure of financial performance (Pandey, 2005). This probably became a basis for the
conclusion that cost of capital had an impact on financial performance which can either be
positive or negative.

2.13

Loan Covenants and Financial Performance

Almost every loan agreement made with a bank will carry some type of covenant, either
restrictive or protective in nature. These can be as simple as requiring that the bank be allowed
to view your financial information, or as complex as requiring bank approval for all major
financial decisions that you make. Understanding the terms of your loan agreement and any
covenants that apply is critical for the business owner contemplating financing (Wilmington,
2008).
Justin et al., (2005) noted that banks in addition to setting interest rates and specifying when
and how a loan is to be repaid; they normally impose other restrictions such as loan covenants
on borrowers. They noted that loan covenants require certain activities and limits others
(negative covenants) of the borrower in order to increase the chance that the borrower will be
able to repay the loan. Justin et al.,(2005) noted some examples of loan covenants to include
limitations to the amount the borrower can spend on capital expenditure, debt cannot exceed a
specified amount nor can it be greater than a specified percentage of the firms total assets.
They also cited that a bank may put limits on various financial ratios to make certain that a
24

firm can handle its loan repayments for example to ensure that sufficient liquidity is
maintained, the bank may require that a firms current assets be twice its current liabilities.

Cem and Christopher (2008) in their study on the information content of bank loans found a
positive relationship between loan covenant tightness and performance. This was so because
covenants provided borrowers incentives to improve the covenant variables in order to avoid
technical defaults. Another possible explanation for a positive relationship between loan
covenant tightness and improvement in performance is that borrowers may attempt to
manipulate their compliance reports to avoid violating covenants (Cem and Christopher, 2008).
They however (Cem and Christopher, 2008) add that the ability for a borrower to consistently
trick their bankers using accounting manipulation is likely to be limited.

25

CHAPTER THREE
METHODOLOGY
3.0.

Introduction

This section presents the methods that were used in executing the study. It includes the
research design, population and sample selection, data collection sources and research
instruments, measurement of variables, and data processing and analysis.

3.1.

Research Design

The research design was cross sectional in nature with the aim of capturing the views of firm
owners and or managers. Cross sectional research design was selected because it gave a snap
shot of the population thereby enabling the researcher draw conclusions across a wide
population about capital structure and financial performance within the given point in time.
In addition, both quantitative and qualitative data was collected for analysis.

3.2.

Study Population

The Study Population consisted of Medium sized Enterprises operating in Kampala. According
to Uganda Bureau of Statistics Business Register (2007), a total of approximately 25,000
businesses operated in Uganda of which 45% (11,250) operate in Kampala.

3.3.

Sample Size, Selection and Response Rate.

The sample size was determined using Krejcie et al., (1970) who developed a formula for
estimating the sample size and a table for determining the sample size based on confidence
level needed from a given population. Based on a population of 25,000 businesses in Uganda,
of which 11,250 operate in Kampala, the recommended sample size was 375 although the total
number of questionnaires distributed totalled 380.
26

Table 1: Response Rate

Questionnaires Distributed

Responses

Response Rate - %

260

68.42%

380
Source: Primary data

From the Table 1 above, a total of 380 questionnaires were distributed during the research and
out of the 380, only 260 were collected representing a response rate of 68.42%.
3.4.

Sampling Technique and Procedure

Stratified sampling was used by the researcher as a procedure for selecting the sample. The
stratification variable was divisions in Kampala namely Kawempe, Makindye, Kampala
Central, Rubaga and Nakawa division of which purposive sampling was used in selecting
businesses operating in each stratum as shown in Table 2 below. For each division, an equal
number of firms were chosen which was disproportionate to make 380 business operations.
Table 2: Stratification Table

Stratum

Sample Size

Response Rate per stratum

Nakawa

76

74

Kawempe

76

17

Makindye

76

58

Rubaga

76

53

Kampala Central

76

58

380

260

Total
Source: Primary data

3.5.

Data Sources

o Primary Data
Primary data on capital structure and financial performance of medium sized enterprises was
obtained from the questionnaires administered to respondents. Primary data was categorized
into 3 sections each of which covered questions on all the variables.
27

o Secondary Data
Secondary data on capital structure and financial performance on medium sized enterprises
was collected from scholarly works on capital structure and financial performance, documents
and journals obtained from internet libraries and published literature.

3.6.

Data Collection Instruments

A structured questionnaire was used for purposes of data collection. The questionnaire
consisted of mainly close ended questions using the five step Likert scale. A few open ended
questions were included in the questionnaire to ensure clarity in responses. The questionnaire
was prepared in English and there was no need for translation as all respondents were
conversant with the English language. Some of the secondary data was taken out from
published company annual reports.

3.7.

Validity and Reliability

The researcher conducted a pilot study with 10 respondents to determine the validity of the
questionnaire. The researcher also in addition directly interviewed some of the medium sized
business owners in order to aid validity of content which also assisted the researcher in
understanding the responses better. A validity and reliability test was determined using the
cronbach alpha co-efficient as indicated in the Table 3 below;

28

Table 3: Reliability Test Results of the Study Variables.

Variables
Capital Structure

Cronbach Alpha
Debt

0.8485

Equity

0.6162

Security Provision

0.8919

Dividend Restriction

0.7517

Interest

0.7802

Dividends

0.7517

Loan Covenants

Cost of Capital

Financial Performance

0.7954

Source: Primary Data

From Table 3 above, it was noted that the Cronbach alpha co-efficient were above 0.6 which
meant that the scales used to measure the study variables were consistent thereby making them
reliable.
3.8.

Measurement of Study Variables

Capital Structure
Capital structure was measured by the debt to equity ratio, which was determined by dividing
the total liabilities of the business by the total shareholders funds (Pandey, 2005) as indicated
below. The businesss total liabilities were limited to third party liabilities regardless of the
term of the loan.
Debt to Equity Ratio = Total Liabilities
Total shareholders funds

Guided by the above formulae, the debt to equity ratios were grouped in ranges of 20% thereby
enabling respondents select the ratio representative of their business operations.
Cost of Capital
The firms cost of capital was the overall or average required rate of return on the aggregate
investment which is also referred to as the weighted average cost of capital (WACC) (Pandey,
29

2005). The WACC was measured on an after tax basis (Pandey, 2005). The formula applied
was;

ko=kd (1-T) wd+kewe

ko=kd (1-T) D

+ ke

D+E

E
D+E

Where ko is the WACC,kd (1-T) and ke are respectively, the after tax cost of debt and equity, D
is the amount of debt and E is the amount of equity.
Loan Covenants
Loan covenant restrictions were calculated using the loan covenant correlation which was
computed using the Pearson correlation coefficient denoted by;

Where x and y are the sample means of X and Y, sx and sy are the sample standard deviations of
X and Y and the sum is from i = 1 to n.

The Pearson correlation coefficient was used to analyse the relation between security
provision, repayment terms, periodic reporting and financial performance as measured by
profitability and liquidity ratios as proposed by (Bradley & Roberts, 2004).

Financial Performance
Financial performance was measured in two different aspects namely in terms of liquidity and
profitability ratios (Pandey, 2005). Liquidity ratios measured the ability of the firm to meet
current obligations (liabilities) and profitability measured the operating efficiency of the
30

company. Pandey, (2005) highlights the most common measures of liquidity as the Current
Ratio measured by;

Current Ratio= Current Assets

Current Liabilities
And the Quick Ratio measured by;
Quick Ratio= Current Assets-Inventories
Current Liabilities

Profitability was measured as a margin in relation to sales and investment (Pandey, 2005). In
relation to sales, the net profit margin was obtained by dividing profit after tax by sale denoted
by;

Net Profit Margin = Profit after tax

Sales

And profitability on investments was measured by Return on investment and Return on Equity
(Pandey, 2005). Both measures will be denoted by the formulae below;

ROI =

EBIT (1-T)
Total Assets

ROE =

Profit after tax

Equity (Net Worth)

31

3.9. Data Processing and Analysis

Data collected from the primary survey was compiled, sorted, edited, classified, coded and
analysed using a computerised data analysis package known as SPSS 10.0. Tables, pie charts
and bar graphs were used for purposes of analysing and presenting the descriptive findings of
the study. Pearson correlation was used to measure the strength of relationships between the
study variables.

32

CHAPTER FOUR
PRESENTATION, ANALYSIS AND INTERPRETATION OF FINDINGS
4.1

Introduction

This chapter outlines findings of the study derived from both primary and secondary data. The
findings are summarised from both the primary and secondary data presented in tables and
graphs. The relationship between the variables was ascertained by correlation and multiple
regression analysis. The findings were interpreted in relation to the research objectives and in
consistence with the literature reviewed in chapter two. The first section presented the
descriptive summary statistics, background information characterised by individual and firm
characteristics and the second section presented the findings of the study.

4.2

Background Characteristics

The background information constituted information relating to individual characteristics that

included gender, age, rank in the organisation and education background. The firm
characteristics included period of existence of the business, number of employees, capital size
of the business and the division of operation.
4.2.1

Rank/Position held in the Organisation

Table 4 below represents the rank of the respondents in the organisation that participated in the
study conducted on capital structure and financial performance.
Table 4: Rank in the Organisation

Gender of Respondents
Management
Business Owners
Invalid
Total

Frequency
108
140
12
260

Percent
54%
42%
4%
100.0

Source: Primary Data

From Table 4 above, 54% of the respondents constituted business owners and managers which
formed the target group of managers and business owners. In addition, for ease of data
33

collection, accountants and Finance personnel were considered as part of management. It was
also noted that 11 respondents did not rank their positions which represented 4% of the total
responses thereby being termed invalid.
4.2.2 Age of Respondents
Table 5 below illustrates the age of the total respondents that participated in the research study.
Table 5: Age of Respondents

Age
Less than 30 years
30-39 years
40-49 years
50 years and above
Total

Frequency
108
112
38
2
260

Percentage
41.5%
43.1%
14.6%
0.8%
100%

Source: Primary Data

The results in Table 5 above revealed that the highest number of respondents were between the
ages of 30-39 years representing a mode of 2 and a percentage of 43. It was also noted that
only 1% of the total respondents was 50 or above 50 years of age. These findings seemed to
reveal that most business operations in Kampala according to the survey were being operated
by young people.
4.2.3

Education Background

Table 6 below illustrate the education background of the total respondents that participated in
the research study.
Table 6: Education Background

Frequency
62
120
23
3
27
1
236
24
260

Diploma
Degree
Masters
PhD
Professional
None
Total
Invalid
Total

34

Percentage
23.8%
46.2%
8.8%
1.2%
10.4%
0.4%
90.8%
9.2%
100.0%

Source: Primary Data

Findings in Table 6 above revealed that Degree holders ranked highest with 46.2% representing a
mode of 2. 23.8% were Diploma holders and the lowest percentage of 1.2% was recorded among PHD
holders. The other forms of respondents were Masters degree and Professional course holders
representing 8.8% and 10.4% respectively. It should be noted that, 9.6% of the 24 respondents did not
indicate their level of education at the time of filling out the questionnaire. The above results gave a
general understanding of the level of education of the respondents to mean that they had the ability to
understand and interpret the questionnaire correctly.

4.3

Firm Characteristics

A number of firm characteristics were included in the formulation of the research questionnaire
whose responses are discussed below:
4.3.1

Period of Existence of the Firm

Table 7 below illustrates the period of existence of the firms that participated in the research
study on capital structure and financial performance.
Table 7: Period of Existence of the Firm

Years of Existence
Less than 5 years
5-10 years
10-15 years
15 years and above
Total

Frequency
93
122
31
14
260

Percentage
35.8%
46.9%
11.9%
5.4%
100%

Source: Primary Data

Results as presented in Table 7 above revealed that 47% of the businesses surveyed had been
in operation for a period between 5 to 10 years where as those that were above 15years of
operation were 5.4% representing 14 business operations. These results seemed to imply that at
least 122 business operations had exceeded infancy stage.

35

4.3.2

Number of Employees

Table 8 below illustrates the survey findings on the number of employees employed by
Medium Sized Enterprises.
Table 8: Number of Employees

Number of Employees
Less than 20
20-40
40-60
60-80
More than 80
Total
Invalid
Total

Frequency
122
51
43
23
20
259
1
260

Percentage
46.9
19.6
16.5
8.8
7.7
99.6
0.4
100

Source: Primary Data

Table 8 above indicates that 122 business operations had less than 30 employees with the
remaining 138 business establishments having above 30 employees. Of the 138 business
operations, 20 businesses operations employed more than 80 employees. These were in line
with the definition of Medium Sized Enterprises under the Uganda Investments Authority
Small and Medium Enterprise guide which defines Medium Enterprises as those employing
more than 50 employees and a Small Enterprise as one employing less than 50 employees.

4.3.3

Sector of Operation of the Business

Table 9 below gives a breakdown of the different sectors within which the businesses that were
surveyed are operational.
Table 9: Sector of Operation

Sector of Operation
Manufacturing
Service
Trading
Agriculture
Total
Invalid
Total

Frequency
30
164
46
19
259
1
260

Source: Primary Data

36

Percentage
11.5
63.1
17.7
7.3
99.6
0.4
100

Table 9 above revealed that the businesses that constituted the sample study were mainly from
Service which represented 63%, trading with 18%, Manufacturing 12% and Agriculture that
had 7% business operations as indicated. These results seemed to indicate that most Medium
Sized Enterprises are operating in the service sector.

4.3.4

Capital size of the Business

Table 10 below summarises the capital size of the businesses that were surveyed.
Table 10: Capital Size of the Business

Capital Size of the Business

Less than 500M
500M-1Billion
1-1.5Billion
2Billion and above
Invalid
Total

Frequency
149
50
31
27
3
260

Percentage
57.3%
19.2%
11.9%
10.4%
1.2%
100%

Source: Primary Data

From Table 10 above, it was also noted that 149 business operations recorded a capital size of
less than 500M which represented 57.3% and 27 businesses were above 2Billion shillings in
terms of capital size.
4.3.5

Division of Operation

Table 11 below summaries the results obtained during the survey as follows;
Table 11: Division of Operation

Division of Operation
Nakawa
Kawempe
Makindye
Rubaga
Kampala Central
Total

Frequency
74
17
58
53
58
260

Percentage
28.5
6.5
22.3
20.4
22.3
100

Source: Primary Data

Of the 380 business operations surveyed, an equal distribution of 76 questionnaires was done
for each of the five divisions. However, Nakawa division recorded the highest response rate
with 74 questionnaires being collected representing 28% whereas Kawempe division recorded
a 7% rate representing 17 questionnaires that were collected. The other divisions recorded an
37

average response rate of 21.3%. It was also noted that businesses operating in divisions like
Kawempe were not at liberty to disclose information that they felt was confidential thus the
low response rate as illustrated above.
4.4

Descriptive Summary Statistics

Table 12 below provides the descriptive summary statistics for the variables tested. The means
of the capital structure, cost of capital, loan covenants and financial performance were 3.09,
3.12, 3.19 and 2.40 respectively.
Table 12: Descriptive Summary Statistics

Variable

Mean

SD

Min

Max

Capital Structure

260

3.09

1.40

Cost of capital

260

3.12

1.34

Loan Covenants

260

3.19

1.32

Financial Performance

260

2.40

1.21

Source: Primary data

From Table 12 above, descriptive statistics were run on the variables that were used in the
study for purposes of computing the mean average. The results obtained were interpreted based
on the likert scale.

A mean average of 3.09 and a standard deviation of 1.4 (M=3.09,

SD=1.40) were obtained as an overall mean and standard deviation from the mean for all the
responses obtained with regard to capital structure. This response pattern seemed to reveal that
Medium Sized Enterprises were balancing between debt and equity financing given that the
mean was above 2.5. With regard to financial performance, a mean average of 2.40 and
standard deviation of 1.21 (M=2.40, SD=1.21) seemed to agree with the research problem
which noted that there was a continued poor performance of Medium Sized Enterprises which
could have led to some of the Medium Sized Enterprises closing down.

38

4.5

Principal Component Analysis

Principal component analysis is a multivariate technique that analyzes a data table in which
observations are described by several inter-correlated quantitative dependent variables (Smith,
2002). Principal component analysis was carried out in order to transform a number of possibly
correlated variables into a smaller number of uncorrelated variables called principal
components. The analysis assisted in accounting for as much of the variability in the data as
possible, and each succeeding component accounted for as much of the remaining variability
as possible.
4.5.1

Rotated Factor Pattern from Principal Component Analysis of Capital Structure

of Medium Sized Enterprises

Table 13 below shows the results of principal component analysis for capital structure of
Medium Sized Enterprises.
Table 13: Rotated Factor Pattern from Principal Component Analysis of Capital Structure of Medium
Sized Enterprises

Component

Capital Structure

Debt Financing Equity Financing

We work very hard just to repay the loan so as to avoid

defaulting
You finance this business using loans

0.799

The loans this business takes depends on the security the

business has

0.786

You purchase raw materials and stocks using loans

Taking loans ties this business in fixed repayment plans
You purchase assets like cars, land and machines using long
term loans

0.797

0.749
0.701
0.699
0.698

Our loans have been increasing overtime

This business's loans are more than the income it is currently
making

39

0.655

We take long before paying dividends

0.618

Almost all the interest paid leaves us with nothing to pay

dividends
The way you finance the business affects how it performs

0.570
0.560

Retained profits provide financing for the business's long term

growth
At times we issue additional shares to raise more financing for
the business

Eigen Values
Variance %
Cumulative %

0.540
0.509

5.274
26.371
26.371

3.041
15.206
41.578

Source: Primary Data

Responses to capital structure questions were subjected to a principal component analysis

using ones as prior communality estimates. Prior to performing principal component analysis,
the suitability of data for factor analysis was assessed. Inspection of the correlation matrix
revealed the presence of many coefficients of .3 and above. The Kaiser-Meyer-Olkin value was
.772, exceeding the recommended value of .6 (Kaiser 1970, 1974) and Bartletts Test of
Sphericity (Bartlett 1954) reached statistical significance (Sig=0.000), supporting the
factorability of the correlation matrix.

The principal component method was used to extract components and this was followed by a
varimax rotation. Only two components displayed Eigen values greater than 1 and the results
of the scree test also suggested that only the first two components were meaningful. Therefore
only the first two components were retained for rotation. A combination of the two
components 1 and 2 accounted for 42% total variance. Questionnaire items and corresponding
factor loadings are presented in Table 13 above. In interpreting the rotated factor pattern, an
item was said to load on a given component if the factor loading was 0.39 or greater for that
component and was less than 0.39 for the other. Using this criteria, two items were found to
load on the first component which was labelled debt financing and two other items also loaded
on the second component labelled equity financing.
40

4.5.2

Rotated Factor Pattern from Principal Component Analysis of Cost of Capital.

Table 14 below shows the results of principal component analysis for cost of capital of
Medium Sized Enterprises.
Table 14:Rotated Factor Pattern from Principal Component Analysis of Cost of Capital of Medium Sized
Enterprises

Component
Cost of Capital

Interest

We are given insufficient periods to pay back the loan

The business pays a lot in terms of interest

Dividends
0.839
0.823

The business is finding it hard to pay back the loan and

interest
The interest rates have not been consistent
The interest charged on this business has been increasing
overtime
This business has ever failed to repay a loan and interest
The income generated is enough to cover interest payments
on loans
Buying back of shares from shareholders reduces dividends
to be issued in future
Inflation can hinder the business from issuing dividends

0.725
0.703
0.653
0.533
0.400
0.833
0.821

Banks limit the business from issuing dividends when

repaying loans
Dividends act as evidence that a business is able to generate
cash
The business does not have sufficient cash to pay dividends

0.744
0.691
0.626

Our distribution profits are not enough to clear dividends

0.625

The business sometimes issues bonus shares to shareholders

0.547

Shareholders take long before being paid dividends

0.485

The business has sufficient cash to pay dividends

0.407

Eigen Values
Variance %
Cumulative %

4.220
22.210
22.210

Source: Primary Data- Extraction Method: Principal Component Analysis.

41

4.017
21.142
43.352

Responses to cost of capital questions were also subjected to a principal component analysis
using ones as prior communality estimates. However, prior to performing principal component
analysis, the suitability of data for factor analysis was assessed. The Inspection of the
correlation matrix revealed the presence of many coefficients of .3 and above. The KaiserMeyer-Olkin value was .801, exceeding the recommended value of .6 (Kaiser 1970, 1974) and
Bartletts Test of Sphericity (Bartlett 1954) reached statistical significance (Sig=0.000),
supporting the factorability of the correlation matrix.

The principal component method was used to extract components and this was followed by a
varimax rotation. Only two components displayed Eigen values greater than 1 and the results
of the scree test also suggested that only the first two components were meaningful. Therefore
only the first two components were retained for rotation. A combination of the two
components 1 and 2 accounted for 43% total variance. Questionnaire items and corresponding
factor loadings are presented in Table 14 above. In interpreting the rotated factor pattern, an
item was said to load on a given component if the factor loading was 0.39 or greater for that
component and was less than 0.39 for the other. Using these criteria, two items were found to
load on the first component which was labelled Interest and the two other items also loaded on
the second component labelled dividends as illustrated in the table above.

42

4.5.3

Rotated Factor Pattern from Principal Component Analysis of Loan Covenants.

Table 15 below presents the results of principal component analysis for loan covenants of
Medium Sized Enterprises in Uganda.
Table 15: Rotated Factor Pattern from Principal Component Analysis of Loan Covenants of Medium Sized
Enterprises

Component
Periodic
Reporting

Loan Covenants
Banks keep on monitoring our business

Repayment
Terms

Use of
Collateral

0.842

Banks restrict us on how to use assets that

have been secured

0.781

We secure bank loans using assets

0.754

Banks ask us to give them title deeds till we

repay loans

0.751

We are forced to make regular reports to the

banks

0.682

When repaying a loan, the business is not

allowed to get another

0.844

When we fail to pay, banks tend to modify

the loan agreements

0.759

They limit us from changing management

when servicing loans

0.674

Bank restrictions tend to decrease the way

this business invests

0.829

Banks restrictions affect the way this

business performs

0.827

Eigen Values
Variance %
Cumulative %

3.269
32.693
32.693

2.190
21.904
54.597

1.888
18.882
73.479

Source: Primary Data- Extraction Method: Principal Component Analysis.

Responses to loan covenant questions were subjected to a principal component analysis using
ones as prior communality estimates. The analysis was done using SPSS version 10. Prior to
performing principal component analysis, the suitability of data for factor analysis was
43

assessed. Inspection of the correlation matrix revealed the presence of many coefficients of .3
and above. The Kaiser-Meyer-Olkin value was .890, exceeding the recommended value of .6
(Kaiser 1970, 1974) and Bartletts Test of Sphericity (Bartlett 1954) reached statistical
significance (Sig=0.000), supporting the factorability of the correlation matrix.

The principal component method was used to extract components and this was followed by a
varimax rotation. Only three components displayed Eigen values greater than 1 and the results
of the scree test also suggested that only the first three components were meaningful. Therefore
only the first three components were retained for rotation. A combination of the three
components 1, 2 and 3 accounted for 73% total variance.

Questionnaire items and

corresponding factor loadings are presented in table 15 above. In interpreting the rotated factor
pattern, an item was said to load on a given component if the factor loading was 0.39 or greater
for that component and was less than 0.39 for the other. Using these criteria, three items were
found to load on the first component which was labelled periodic reporting and two other items
also loaded on the second component labelled repayment terms as illustrated in the table
above.

44

4.5.4

Rotated Factor Pattern from Principal Component Analysis of Financial

Performance.

Table 16 below presents the results of principal component analysis of financial performance
of Medium Sized Enterprises in Uganda.
Table 16: Rotated Component Matrix for Financial Performance of Medium Sized Enterprises

Component
Financial Performance

Profitability Ratios

Return on investment

Liquidity Ratios

0.879

Net profit margin

0.836

Return on capital employed

0.815

Quick ratio

0.816

Return on equity

0.521

Current ratio

0.580

Eigen Values
Variance %
Cumulative %

2.635
37.641
37.641

2.181
31.153
68.794

Source: Primary Data- Extraction Method: Principal Component Analysis.

Responses to capital structure questions were subjected to a principal component analysis

using ones as prior communality estimates. Prior to performing principal component analysis,
the suitability of data for factor analysis was assessed. Inspection of the correlation matrix
revealed the presence of many coefficients of .3 and above. The Kaiser-Meyer-Olkin value was
0.846, exceeding the recommended value of .6 (Kaiser 1970, 1974) and Bartletts Test of
Sphericity (Bartlett 1954) reached statistical significance (Sig= 0.000), supporting the
factorability of the correlation matrix.

45

The principal component method was used to extract components and this was followed by a
varimax rotation. Only two components displayed Eigen values greater than 1 and the results
of the scree test also suggested that only the first two components were meaningful. Therefore
only the first two components were retained for rotation. A combination of the two
components 1 and 2 accounted for 69% total variance. Questionnaire items and corresponding
factor loadings are presented in Table 16 above. In interpreting the rotated factor pattern, an
item was said to load on a given component if the factor loading was 0.39 or greater for that
component and was less than 0.39 for the other. Using these criteria, two items were found to
load on the first component which was labelled profitability ratios and two other items also
loaded on the second component labelled liquidity rations as illustrated in the table above.

4.6

Correlation Analysis

Correlation is a statistical measurement of the relationship between two variables. Pearsons

correlation was used to determine the relationship between the study variables and also predict
the contribution of the study variables to financial performance. The analysis was done based
on the research questions tested for the purpose of conducting the study while relating the
findings to the research objectives as discussed below;

46

4.6.1 To Examine the Relationship between Capital Structure and Financial

Performance.
Table 17 below presents the correlation between capital structure, cost of capital, loan
covenants and Financial Performance of medium sized enterprises in Uganda.
Table 17: Zero order Correlation between Capital Structure, Cost of Capital, Loan Covenants and
Financial Performance.

Capital
Structure
Capital Structure

Cost of
Capital

Loan Covenants Financial

Performance

1.000

Cost of Capital

0.585**

1.000

Loan Covenants

0.528**

0.642**

1.000

-0.285**

-0.307**

-0.266**

Financial Performance

1.000

** Correlation is significant at the 0.01 level (2-tailed).

Source: Primary Data

From the findings indicated in Table 17 above, there was a negative (inverse) relationship
between Capital Structure and financial performance (r=0.285, P-value <0.01). The negative
correlation implied that an upward change in capital structure would result in a decrease in
financial performance. Results of the study as indicated above indicate that capital structure
negatively affected financial performance. The negative relationship implied that Medium
Sized Enterprises in Uganda are averse to using more equity because of the fear of losing
control and therefore employ more debt in their capital structure than would be appropriate.
Employing debt excessively is likely to result in high bankruptcy cost which could negatively
affect performance.

47

4.6.2 To Examine the Relationship between Capital Structure, Cost of Capital and
Loan Covenants of Medium sized Enterprises in Uganda
A Pearson product-moment correlation coefficient was computed to examine the relationship
between capital structure, cost of capital and loan covenants of medium sized enterprises as
indicated in Table 17 above. The findings revealed that there was a positive correlation
between capital structure and cost of capital (r = 0.585, P-value<0.01). On the overall, there
was a strong, positive correlation between capital structure and cost of capital. The findings
above revealed that the capital structure employed by Medium Sized Enterprises in Uganda
had a significant effect on the cost of capital. That is to say a change in capital structure would
lead to an increase in the cost of capital. With regard to the relationship between capital
structure and Loan covenants, a positive correlation was established (r=0.528, P-value< 0.01).
These findings seemed to reveal that the capital structure mix employed by Medium Sized
Enterprises in Uganda had a significant effect on the loan covenants.
4.7 Zero order Regression.
Multiple regression is a statistical technique that allows one to predict a score on one variable on the
basis of scores on several other variables. Multiple regression analysis was performed to predict

financial performance levels as shown in the Table 18 below.

Table 18: Multiple Regression Analysis Model

Unstandardized
Coefficients

Standardized T
Coefficients

B
(Constant)

Std. Error
3.806

0.234

Capital Structure

-0.166

0.098

Cost of Capital

-0.188
-7.48E-02

Loan Covenants
R-Square=0.115

Adj R-Square = 0.103

Sig.

Beta
16.232

0.000

-0.137

-1.690

0.092

0.096

-0.172

-1.963

0.057

0.071

-0.087

-1.047

0.296

F = 9.683

48

Sig = 0.000

Dependent Variable: Financial Performance

Source: Primary Data

From the multiple regression analysis model presented in Table 18 above, capital structure,
cost of capital and loan covenants are negatively and linearly related to financial performance
(F=9.683, Sig=0.000). The prediction of capital structure cost of capital and loan covenants on
financial performance were also tested and the interpretation of the findings is as below;

4.8.1 To Examine the Effect of Capital Structure, Cost of capital and Loan covenants
on Financial Performance.
From the regression model presented in Table 18 above, capital structure, cost of capital and
loan covenants predicted 11.5% of financial performance of Medium Sized Enterprises. This
implied that 11.5% of the variation in the financial performance was as a result of the capital
structure employed by Medium sized enterprises in Uganda. The model shows that a change in
capital structure affects financial performance by a factor of -0.166 and that a change in cost of
capital also affected financial performance by a factor of- 0.188. Loan covenants were found to
have an inverse though insignificant effect on financial performance of -7.48E-02.

It however, was important to note that the cost of capital contributed more (Beta=0.172) to
financial performance than capital structure which contributed (Beta=-0.137). This implied that
cost of capital contributed more to financial performance of medium sized enterprises in
Uganda. The above analysis revealed that the financial performance of medium sized
enterprises slightly depended on the capital structure employed. Therefore, adopting a high
debt policy would not significantly lead to lower profitability.

49

CHAPTER FIVE
DISCUSSION, CONCLUSIONS AND RECOMMENDATIONS
5.1

Introduction

This chapter highlights the discussion, conclusions and recommendations of the findings from
the study as presented below. This section is arranged as per the research objectives. In order to
achieve the research objectives, a survey was carried out on a sample of 380 respondents of
Medium Sized Enterprises in the 5 divisions of Kampala namely Nakawa, Kampala central,
Kawempe, Rubaga and Makindye respectively. A response rate of 68.42% was obtained from
the survey. Secondary data was also obtained from journal articles, Uganda Investment
Authority website, Uganda Bureau of Statistics among others. The data was processed and
analyzed using Statistical Package for Social Scientists (SPSS) computer software.

5.2 Demographic and Firm Characteristics of respondents.

Findings indicated that males dominated the operations of Medium Sized Enterprises in
Uganda (61%) of the study findings as opposed to women (39%). This may be as a result of
having a larger number of males opting to start up businesses before or immediately after
school. According to the results in Table 6, majority of the respondents were degree holders
(46.2%) and the lowest percentage of 1.2% was recorded among PHD holders. Further, 23.8%
of the respondents completed diplomas, 8.8% held Masters Degrees whereas 10.4%
represented respondents with professional qualifications. These findings showed that the
majority of people employed by Medium Sized Enterprises in Uganda were educated.

Majority (46.9%) of the Medium Sized Enterprises in Uganda as illustrated in Table 7have
been in existence for periods between 5-10 years, 17.3% are between 10-15 years and above of
existence where as 35.8% have been in operation for less than 5 years. These results imply that
50

most of the Medium Sized Enterprises in Uganda have exceeded infancy stage. The service
sector in Uganda employs majority of workers (63%) in Medium Sized Enterprises, whereas
Trading, Manufacturing and Agriculture employ 18%, 12% and 7% respectively Table 8.

5.3

Relationship between Capital Structure and Financial Performance

The first research objective of the study sought to find out whether there was a relationship
between capital structure and financial performance. Findings from the study revealed that
there was a significant inverse relationship between capital structure and financial performance
as illustrated in Table 17 above. The negative correlation implied that a change in the capital
structure of medium sized enterprises in Uganda would result in a decrease in financial
performance. The negative relationship further implied that Medium Sized Enterprises in
Uganda are averse to using more equity because of the fear of losing control and therefore
employ more debt in their capital structure than would be appropriate.

These findings were in line with the findings of Rajan & Zingales, (1995) and Wald, (1999)
who found a significantly negative relationship between profitability and debt/ asset ratios for
the USA, UK and Japan. In addition, these findings were similar to the findings of Fama and
French, (2002), Booth et al., (2001) and Wald, (1999) whose studies provided empirical
evidence supporting this negative relationship between debt levels and a firms performance or
profitability. In addition, Fama and French (1998), for instance argued that the use of excessive
debt resulted into agency problems among shareholders and creditors which could result in a
negative relationship between leverage and profitability.

Furthermore, Majumdar and Chhibber , (1999) in their Indian study found that leverage had a
negative effect on performance, while Krishnan and Moyer (1997) connect capital and
51

performance to the country of origin. Gleason et al., (2000) also found a negative impact of
leverage on the profitability of the firm. Abor, (2007) in his scholarly works on debt policy and
performance of Medium Sized Enterprises found the effect of short-term debt to be
significantly and negatively associated with gross profit margin for both Ghana and South
African firms. This indicated that increasing the amount of short-term debt would result in a
decrease in the profitability of the firms.

5.4

Relationship between Capital Structure, Cost of Capital and Loan Covenants

The second research objective was to examine the relationship between capital structure, cost
of capital and loan covenants of Medium Sized Enterprises in Uganda. Findings from the study
as illustrated in Table 17 revealed that there was a positive correlation between capital
structure, cost of capital and Loan covenants.These findings implied that a change in capital
structure would result in an increase in the cost of capital and loan covenants. In other words
the higher the debt to equity ratio, the higher the interest rates and the more the security that
will be required as a pledge for the loans the business will have acquired. This therefore meant
that Medium Sized Enterprises that took on more debt were most likely to suffer the burden of
loan repayment given that a lot of their cash flows would be tied up in loan repayments. This
was also evidenced by the type of interest rates that were being paid by the various businesses.
It was also noted that the interest rates charged to the businesses by the various financial
institutions were quite high which probably can help explain why some businesses were being
shut down due to failure to service loans as indicated by the statement of the problem.

It was also important to note that the above findings were contradictory to the findings of
Dhankar et al., (1996) who in their research on cost of capital, optimal capital structure and
value of a firm a case of Indian companies noted that a change in capital structure and cost of
52

capital were negatively or inversely related because cost of capital decreases with increase in
debt levels and that cost of debt was less than the cost of equity because interest payments
were tax exempt. In other words, since the cost of capital is measured using historical data, the
weighted average cost of capital was likely to decrease with the increase in debt. This therefore
meant that a change in capital structure was not denoted by a proportionate change in the cost
of capital. The contradiction could possibly be explained by difference in the environment,
within which the research was conducted, the measures that were used in measuring the
variables and possibly the kind of respondents that took part in the survey.

The positive findings on capital structure and loan covenants were in line with the findings of
Dichev and Skinner, (2002b), Beneish et al.,(1993) who found that financial covenant
violations lead to significant modifications to loan agreements in terms of higher interest rates
and reduction in credit availability. Chava et al., (2008) and Nini et al (2008) in their research
found that covenant violations were associated with significant declines in investment
spending which arose as a result of inclusion of new covenants limiting investment spending.

5.8

Effect of Capital Structure, Cost of Capital and Loan Covenants on Financial

Performance.

The third objective sought to examine the effect of capital structure, cost of capital and loan
covenants on financial performance of Medium Sized Enterprises in Uganda. Findings from
the Regression analysis performed in order to predict the effect of capital structure, cost of
capital and loan covenants on financial performance as illustrated in Table 18 revealed that
capital structure, cost of capital and loan covenants predicted 11.5% of financial performance.
The difference of 88.5% is explained by other factors that were not covered by this study.
Financial performance therefore slightly depended on capital structure. Therefore, adopting a
53

high debt policy may not significantly lead to lower profitability. Increasing the proportion of
debt in the firms capital structure may not significantly impact the overall financial
performance of Medium Sized Enterprises as illustrated by the results.

5.9

Conclusion

The study showed that medium sized enterprises used both debt and equity in their capital
structure although debt was predominant. This was largely due to the fact that medium sized
enterprises perceived debt as a cheaper source of funding and that it lowered the taxes paid
since it acted as a tax shield. The debt preference over equity implied that interest was the
dominant form of cost of capital among these entities.

Many of the medium sized enterprises that employed debt in their capital structure alluded to
paying a lot in terms of interest rates, hence a reduction in profitability of the overall business.
It was also established that medium sized enterprises that employed debt in their capital were
subjected to loan covenants which forced them to comply in order to avoid defaulting.
Findings showed that many of the businesses that used debt in their capital structure were
constrained in terms of loan repayments due to the fact that interest rates levied to their
businesses were high. This in turn affected their financial performance. It can be concluded
that the capital structure measures used in the study had a slight effect on the financial
performance of medium sized enterprises as most of these medium sized enterprises
performance to some extent depended on the capital structure mix they employed.

Although findings of the study revealed that medium sized enterprises preferred debt financing
due to its advantages, this still had a bearing on their overall financial performance as many of
such firms alluded to having challenges in financing loan obligations largely due to high
54

interest rates (cost of capital). Unless additional equity is injected into such operations in order
to reduce the effect of capital erosion, many of such operations will be forced to shut down as a
result of their inability to meet financial obligations.

5.10

Recommendations

o Medium Sized Enterprises in Uganda should avoid an over reliance on debt financing
alternatively, Medium Sized Enterprises that pursue a high debt policy compared to the
industry average should seriously consider increasing the equity component in their capital
structure in order to avoid the negative effects of excessive debt on performance. This can
be by way of private placements which are a form of raising capital without necessarily
over borrowing from financial institutions.
o Bank or financial institutions need to regularly visit and try to understand the operations of
Medium Sized Enterprises better thereby nurturing long lasting relations which would
eventually result into customer loyalty.
o On the aspect of interest rates, it is recommended that Financial Institutions should
consider a further lowering of their base lending rates and overall interest charged to
Medium Sized Enterprises in order to reduce on non performing loans and improve on the
financial performance of Medium Sized Enterprises.
o Financial Institutions should also consider extending repayment periods especially for
clients whom they consider to be low risk. If considered, it may probably help financial
institutions increase their chances of recovery of probable bad loans.

55

5.11

Areas for Further Research

o Capital structure does not account for much of the financial performance of Medium Sized
Enterprises as indicated by the results. Further research needs to look at the other factors
other than capital structure that affect financial performance of medium Sized Enterprises.
o The study concentrated on Capital Structure and Financial Performance of Medium Sized
Enterprises in Uganda although the Geographical scope was the five divisions in Kampala.
Researchers should consider widening the scope of this research by conducting a similar
research at district level in Uganda.
o Debt Policy and Financial Performance of Medium and Large Sized Enterprises in Uganda
is another potential area for further research.

56

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Appendix 1- Questionnaire

TO BE FILLED BY MANAGERS AND BUSINESS OWNERS

Dear Respondent:
I am a Masters student from Makerere University Business School conducting a study on the
relationship between Capital Structure and Financial Performance of Medium sized Enterprises
in Uganda. It is purely academic and the information obtained shall not be used for any other
purpose other than for its intended use and will be treated with utmost confidentiality. Your
assistance in this research shall be highly appreciated.
Thanking you for your co-operation and invaluable contribution(s)
Section A: Back ground information
Please tick answers as applicable to you
1. Gender: Male

Female

2. Age of respondents:
Less than 30 years

30-39years

40-49 years

50 and above

3. What is your rank in the organization

Top Management

Business Owner

4. Education Background
Diploma

Degree

Masters

PhD

Professional

Firm Characteristics
5. How long has this firm been in business
Less than 5 years
5-10 years

10-15 years

6. How many employees does this business have

Less than 20
20-40
40-60
7. In what sector does the business operate
Manufacturing
Service

Trading

8. The firms capital size in shillings is

Less than 500M
500-1 billion
9. In what division does the business operate
Nakawa

Kawempe

60-80

1-1.5 billion

Makindye

62

Rubaga

15 and above

80 and above

Agriculture

2billion above
Kampala Central

GUIDELINES TO THIS SECTION:

Please tick the appropriate answer using the following scale;
1= Strongly Disagree 2= Disagree 3= Not sure 4= Agree 5= Strongly Agree:
Section A: Debt
You finance this business using loans
Our loans have been increasing overtime
Loans are the cheapest source of business capital
Loans help to reduce the taxes this business pays
You purchase assets like cars, land, machines using long term loans
You purchase raw materials and stocks using loans
Taking loans ties this business in fixed repayment plans
We work very hard just to repay the loan so as to avoid defaulting
This businesss loans are more than the income it is currently making
The loans this business takes depends on the security the business has
Debt to Equity Less than 20%
Ratio

20-40%

40-60%

1 2 3 4 5

60-80%

Section A : Equity
We hardly use equity to finance this business
We do not normally refinance the business using ploughed back profits
You prefer to use profits to refinance the business instead of loans
Our equity levels have been reducing overtime
At times we issue bonus shares to raise more financing for the business
We take long before paying dividends
Almost all the interest paid leaves us with nothing to pay dividends
The way you finance the business affects how it performs
We hardly pay dividends
Retained profits provide financing for the businesss long term growth

Section B: Interest

Over 80%

1 2 3 4 5

The interest charged on this business has been increasing overtime

The income generated is enough to cover interest payments on loans
Interest charged affects your profits
Our continuity in business is questionable because of high costs
The business is finding it hard to pay back the loan and interest
This business has ever failed to repay a loan and interest
The business pays a lot in terms of interest
We are normally given insufficient periods to pay back the loan
The interest rates have not been consistent

63

Interest Rates

Less than 15%

18-20%

21-23%

24-26%

Over 27%

Suggest ways in which banks can help your business in loan repayment/ servicing

Section B:Dividends

We pay dividends
Our distributable profits are not enough to clear dividends
Shareholders take long before being paid dividends
The business has sufficient cash to pay dividends
Dividends act as evidence that a business is able to generate cash
The business sometimes issues bonus shares to shareholders
The business accepts the buying back of shares from shareholders
Inflations can hinder the business from issuing dividends
Banks limit the business from issuing dividends when repaying loans

Section C: Security Provision

We secure bank loans using assets
Banks restrict us on how to use the assets that have been secured
Banks ask us to give them title deeds till we repay loans
Banks keep on monitoring our business
We are forced to make regular reports to the banks
They limit us from changing management when servicing loans
When repaying a loan, the business is not allowed to get another
When we fail to pay, banks tend to modify the loan agreements
Banks restrictions affect the way this business performs
Bank restrictions tend to decrease the way this business invests

Formulae for computing ratios are; Debt to Equity Ratio= total loans/equity; Current Ratio=
current assets/current liabilities; Quick Ratio=current assets-stocks/current liabilities; Interest
Coverage Ratio= EBIT/interest; Net Profit Margin= profit after tax/sales revenue; Return on
Investment = EBIT (1-T)/total assets; Return on Equity=Profit after tax/equity

1.

Quick Ratio

Less than 0.2

0.2-0.4

0.4-0.6

0.6-0.8

Over 1time

2.

Interest
Coverage Ratio

Less than 2

2- 4

4- 6

6- 8

Over10times

64

3.

Current Ratio

4.

Return
On
Less than 20%
Equity
Return
On
Less than 10%
Investment
Net
Profit
Less than 5 %
Margin

5.
6.

Less than 1.5

1.6-2

2.5-3

3.5-4

Over 5times

20-30%

30-40%

40-50%

Over 60%

10-20%

20-30%

30-40%

Over 50%

5-10%

10-15%

15-20%

Over 25%

THANK YOU ONCE AGAIN

65