AN EMPIRICAL ANAYSIS OF THE RELATIONSHIP BETWEEN CAPITAL STRUCTURE AND STOCK RETURNS FOR QUOTED COMPANIES: EVIDENCE FROM THE NAIROBI STOCK EXCHANGE

This project sought to conduct an empirical study that tests the relationship
between capital structure and stock returns for companies listed at the Nairobi Stock
Exchange for the period 2001 to 2008. I investigated this relationship by first undertaking
a linearity test, of mean excess returns and the capital structure of a firm using the
Sivaprasad and Muradoglu (2007) methodology with slight modifications. I employed the
Actual Debt Ratio (ADR) of Ivo Welch (2004) as the measure of capital structure instead
of the leverage ratio of Sivaprasad and Muradoglu (2007). Secondly, I undertook a
portfolio level analysis of the mean excess returns and the firm’s ADR using the Fama-
French (1992, 1993) models. The findings of this paper could not confirm whether stock
returns react to ADR hence cannot be said to be consistent with the findings of Miller-
Modigliani and other published papers done in developed economies such as the United
States of America and United Kingdom, in which stock returns were found to increase
with leverage. The linearity tests failed to establish a linear relationship between excess
returns and the actual debt ratios. The Fama-French (1992, 1993) models, on the other
hand did show a moderate linear relationship with the market risk premium being the
dominant influencing factor.
Key words: Capital Structure, Stock Returns, Actual Debt Ratio.

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