International Journal of Humanities and Social Science Vol. 8 • No. 3 • March 2018 doi:10.30845/ijhss.

v9n3p21

Effect of Cost of Capital on Financial Performance:

A Case Study of Listed Commercial Banks at the Nairobi Securities Exchange Market

Charles Odongo Omwanza

P.O. BOX 21882 – 00505
Nairobi - Kenya

Abstract
Commercial banks listed at the Nairobi Securities Exchange (NSE) play crucial role in developing the economy of
Kenya. The firms provide benefits in terms of job creation, driving innovation, economy’s cluster development,
economic multipliers, and knowledge spill-over. Given their importance in the nation’s economy, it is imperative
to explore the effects of cost of capital on their financial performance. This was done using a sample of eleven
commercial banks listed at the NSE during the five-year period, 2012-2016. Data for the selected commercial
banks were generated and analysed using a linear regression technique. The outcome of the study reveals that
commercial banks’ cost of capital has significant effect on their financial performance (i.e. return on assets,
ROA). The study recommends that commercial banks should utilise opportunities created by NSE to access long-
term financing since debt financing carries costs that have effect on their financial performance.
Keywords: NSE, cost of capital, financial performance, commercial banks
1.0 Introduction
Listed companies at the Nairobi Securities Exchange (NSE) play a crucial role in the development of Kenya’s
economy. The reasons for this are the fact that listed companies provide the benefits of job creation, drive
innovation, give cluster development of the nation’s economy, economic multipliers, and knowledge spill-over
(Ajibolade & Sankay, 2013). Provided the importance of commercial banks in an economy, it becomes imperative
to assess the effect of cost of capital on their financial performance, which is a key predictor in their growth and
survival.
Commercial banks occupy a significant portion of Kenya’s economy. A report by Central Bank of Kenya (CBK,
2015) indicates that the performance of commercial banks in Kenya has been improving since 2015, and this is
evidenced by the expanding size in gross loans of Ksh 2.17 trillion, a deposit base of 2.57 trillion, and total assets
of 3.60 trillion. Despite the improvement in the performance of these banks, capital structure has greatly
influenced the financial performance of these banks (Kamau & Were, 2013). Commercial banks listed in NSE are
not making enough return on equity (ROE) or return on investment (ROI), due to insufficient working capital,
financial leverage, cash flow, and control, which shareholders in spite of all the headlines on commercial banking
profitability (Seelanatha, 2010). Financing decision may lead to reduction or loss of value of strategic assets
(Adekunle & Sunday, 2010). Financial reports of NSE listed firms considered for this study, show that their debt
financing mainly comprises of short-term debts (Kajola, 2010). Nonetheless, external financing for NSE listed
firms exceed their investments, thus failing to put into account that excessive external financing results in over
leverage, which implies that the business is exposed to extensive obligations to external investors, who are likely
to disrupt firms’ operations as well as their financial returns.
The Nairobi Securities Exchange (NSE) has created a veritable platform for companies to access capital market to
enhance their growth potential. The NSE seeks to address key challenges of effectively doing business in Kenya’s
economy such as difficulty in accessing long-term capital because of high cost of fund due to perceived high
probable risk (NSE, 2015). Magara (2012) cites finance as one of the major problems. While the listed
companies’ capital structure involves the combination of funds from owners of business (equity owners or
internal financing) that might be because of savings from the owners of the business as well as external financing
(debt), which all have their associate cost. The cost of financing presents an opportunity cost of utilising these
funds in other investment alternatives.

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Most commercial banks may be constrained by the fear of the cost involved in long-term financing through
various ways including capital market where opportunities are available for firms to access funds for capital.
Various studies have been conducted on cost of capital and financial performance of companies, but studies on
listed commercial banks’ cost of capital with regard to the Nairobi Securities Exchange is still inadequate. The
current study is expected to add to the existing literature on the correlation between commercial banks’ cost of
capital and their financial performance. Therefore, the present study aims at assessing the effect of cost of capital
on financial performance of listed commercial banks. The study is structured into five different parts. Following
the introductory part is the literature review section explores the Nairobi Securities Exchange (NSE) and provides
empirical review. Section 3 discusses the methodology applied in this study. This is followed by section 4 that
discusses data presentation and analysis. Section 5 provides the conclusion.
2. Literature Review
2.1. Nairobi Securities Exchange (NSE)
The Nairobi Securities Exchange (NSE) was established in 1954 as a voluntary organization of stockbrokers,
which is currently regarded as one of the most active capital markets in Africa. NSE as a capital market institution
plays a significant role in the economic development of the country (NSE, 2015). It mobilizes domestic savings
thus bringing about the reallocation of financial resources from dormant to active agents. Long-term investments
are made liquid, as the transfer of securities between shareholders is facilitated. The Nairobi Securities Exchange
(NSE) has made it possible for companies to engage local participation in their equity, thus providing Kenyans
with an opportunity to own shares. It also enables firms to raise extra finance for expansion and development. A
new issuer publishes a prospectus that provides all pertinent particulars concerning the operations and future
prospects and states the price of the issue to raise funds. NSE facilitates the inflow of international capital, and it
provides useful tools for privatization programmes.
2.2. Cost of Capital and Financial Performance
According to Mogaji (2011), cost of capital can be defined as the price incurred to obtain fund or capital. The rate
is paid to use capital. Moreover, the cost of a firm’s fund is the minimum rate of return that a company must earn
on its investment. Capital structure that is also termed as financial leverage or gearing refers to the proportion of a
company’s long-term debt and or preference shares to ordinary share capital (Matemilola & Bany-Ariffin, 2011).
Going by this definition, it is the percentage of debt to business owners’ equity or fund with regard to listed
commercial banks, as these constitute major sources of finance for companies. The description is in conformity
with the record of Ajibolade and Sankay (2013) that the two main sources of finance for listed firms are debts
(borrowing) and equity (owners’ equity).
Several studies have been conducted on the effects of sources of finance, their cost effect as well as the variations
exhibited in their combination on a company’s value or its resulting future earnings. A study by Modigliani and
Miller (1958) was the first to explore the association between financial leverage (capital structure) and the cost of
capital as well as firm value. The study aimed to ascertain that market value of the company is independent of its
capital structure, irrespective of the fluctuations in financial leverage. Modigliani and Miller’s (1958) study
focused on American firms and established evidence that ruled out the positive effect of capital structure on cost
of capital and that it never affects the value of a firm and investment decisions. Nonetheless, capital structure was
found to influence financing decision that affects a firm’s value.
Correia and Cramer (2008) conducted an analysis of cost of capital, capital structure and capital budgeting
practices: a survey of South African listed companies. Their study employed a sample survey to determine and
analyse the corporate finance practices of South African listed companies in relation to cost of capital, capital
structure and capital budgeting decisions. The results of the survey were mostly in line with financial theory and
were generally consistent with a number of other studies. Their study found that companies always or almost
always employ DCF methods such as NPV and IRR to evaluate projects. Companies usually use CAPM to
determine the cost of equity and most companies employ either a strict or flexible target debt‐equity ratio.
Furthermore, the researchers found that most practices of the South African corporate sector are in line with
practices employed by US companies.
Magara (2012) studied capital structure and its determinants at the Nairobi Securities Exchange. The study sought
to find out the major determinants of capital structure.

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It was established that from the period 2007 to 2011, there was a positive significant relationship between the cost
of capital, firm size, tangibility and growth rate and the degree of leverage of the firm. The study did not take into
consideration macro- economic factors like inflation and interest rates.
Mwangi (2010) examined capital structure on firms listed at the Nairobi Stock Exchange (NSE) also tried to look
on the relationship between capital structure and financial performance. Data was collected using structured
questionnaires. The study identified that a strong positive relationship between leverage and cash flow, return on
equity, liquidity, and return on investment existed.
Edelen and Kadlec (2013) studied the association between a company’s investor base, profitability, capital
budgeting decisions, and discount rate. The researchers argued that a downward change in discount rates (costs of
capital) linked to an expanded investor base could result in poor stock returns as well as operating performance
following some security offers. The study outcome confirms that an expansion in the company’s investor base is
both a necessary as well as sufficient condition to support anomalous poor performance. The study finding
contradicts M&M study since a shift in the capital structure can influence performance of a company.
Hamidreza, Fatemeh and Hamid (2014) studied the effect of cash flow on capital structure of firm and finance
through debit and capital in future. To meet this goal, the study used a multi variable regression statistical method
and their research was carried out from 2006 until 2010 at Tehran stock exchange. In the way of carrying out their
study, the information related to dependent variable, independent variable and control variable through
Tadbirpardaz database and Rahavard Novin database and through website and library affiliated to stock exchange
organization and the sample was collected among 415 firms. Outcome of the finding established that as it was
expected there is significant relationship between operational cash flow with external financing, finance through
stock, finance through debit for the firm listed at Tehran stock exchange.
Khaled and Samer (2013) investigated the influence of cost of capital, growth rate of dividend, as well as financial
leverage on rate of return on investment. The researchers applied a multiple regression analysis and included in
the model various independent variables of growth rate of dividends, financial leverage, and cost of capital. The
findings of the study ascertained that the existence of a positive relationship and statistically significant growth
rate of dividends on rate of return on investment. The study also established no effect with statistical significance
for cost of capital as well as financial leverage on return on investment. The finding confirms the M&M study that
there is insignificant relationship between cost of capital, rate of return on an investment, and financial leverage.
2.3. Theoretical Framework
The relevant theoretical literature focus on the link between capital structure and cost of capital and how they
influence the performance of a firm. In relation to the impact of capital structure on the value of a company, two
views exist, which are the traditional view as well as the net operating income approach. Traditional view posits
that optimal capital structure is achievable, and this can be attained through the decision management makes
concerning the proportion of equity and debt to utilise (Matemilola & Bany-Ariffin, 2011). The optimal capital
structure is one that maximises the firm’s cost of capital and maximises the total value of the company. The
theory indicates that high cost of capital can influence a firm’s value, and hence a cost-cutting strategy should be
devised to reduce the cost of capital.
The net operating income (NOI) approach is of the assumption that weighted average cost of capital (WACC) and
the total value of the firm remains the same irrespective of the gearing level. The viewpoint indicates that capital
structure and cost of capital do not influence the value of a company. Modigliani and Miller (1958) confirm the
net operating income approach (NOI) on the lack of any association between total value of a company or its
gearing level or cost of capital. Modigliani and Miller believe that the total value of a firm depends on the future
earnings stream of the firm as well as the risk of the earning but not the way the firm is being financed. The
theory was eventually reviewed in 1963 with the implementation of the tax benefit of debt. It is referenced to the
fact that a perfect market never exists in the real world. Interest pegged on debt is tax-deductible, a factor that
results in creating tax savings to the debtor (borrower), and it renders it possible for a company to minimise its
cost of capital as well as maximises the wealth of shareholders by utilising debt. It is referred to as the leverage
effect of borrowing (debt).
According to Matemilola and Bany-Ariffin (2011), the most relevant theories to explore the capital structure of
listed commercial banks comprise M&M theory, trade-off theory, and pecking order theory.

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While the optimisation of capital structure comprises the trade-off between the present values of the tax rebate
linked with the marginal increment in leverage as well as the present value of the bankruptcy cost. Agency
problem of asymmetric information can influence the availability of credit and thus capital structure of
commercial banks. On the other hand, pecking order theory posits that a well-defined optimal capital structure is
lacking and instead the debt-ratio comes due to the effect of hierarchical financing over a period of time. The
foundation of pecking order theory is that companies lack well-defined debt-to-value ratio. Management prefers
to select internal financing before external financing. When a company is compelled to utilise external sources of
financing, issuance of debt becomes preferred over new equity.
3. Methodology
The study used descriptive survey design. A descriptive survey design used to collect the required information
from the population targeted after which the data collected will be analyzed through quantitative methods to show
the causation factor of determinants of capital structure on financial performance of NSE listed commercial banks.
The target population comprised 43 commercial banks, but a simple random technique was used to sample 11
NSE listed commercial banks with complete and audited annual report for five years from 2012 to 2016.
Data were collected by review of documents, the Nairobi Securities Exchange handbooks, annual reports of the
companies, and published books of accounts. To measure the cost of capital, cost of debt, and cost of equity
constitute the whole cost of capital of a company (WACC). The study used the cost of debt only to compute the
cost of capital. In analysing the correlation between cost of capital and financial performance of listed commercial
banks, the study utilised a simple linear regression technique to test the hypothesis that cost of capital does not
affect financial performance.
Yit = α + βXit + ε
Where: Yit = financial performance of the NSE listed commercial banks, as measured by ROA
α: = a Constant that defines the financial performance without inclusion of independent variables i.e. the value of
Y when the value of X is zero
Xit = cost of capital (measured by WACC)
β= Coefficients of variable i which measures the extent to which the variation in Y is explained by the variations
in X
ε = is the error term of the test equation
4. Results and Discussions
Table 1: Descriptive Statistics
Mean Std. Deviation
Statistic Std. Error Statistic
Cost of Capital 1.352 .028 .019
ROA 2.306 .031 .021
Source: Researcher’s Computation using SPSS 20.0
Table 1 presents the mean value of the variables as 1.352 for cost of capital and 2.306 for financial performance.
The table also presents a standard deviation of 0.019 for cost of capital and 0.021 for financial performance
(ROA), implying some level of variations among listed commercial banks concerning the study variables.
Table 2: Model Summary
Model R R Squared Adjusted R Std. Error of the
Squared Estimate

1 .512a .832 .781 .039

Predictors: (Constant), cost of capital α= 0.05
Source: Researcher’s Computation using SPSS 20.0

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Correlation co-efficient (R) reveals the relationship among the study variables, revealing a strong positive
relationship of 0.512 among the study variables. The R-squared, also referred to as the co-efficient of
determination, explains the variation in the dependent variables that the independent variables cause. R-squared
is used to measure the performance of model regression against known observations, and thereby providing a high
correlation of 83.2% between the cost of capital and financial performance (ROA).
Table 3: ANOVA
ANOVA
Model Sum of Squares Df Mean Square F Sig.
b
Regression .012 3 .002 .037 .001
Residual .138 38 .007
Total .151 41
a. Dependent Variable: ROA
b. Predictors: (Constant), cost of capital
Source: Researcher’s Computation using SPSS 20.0
The study used the probability value (p-value) of a statistical hypothesis test to analyse the test statistic value. The
low F-value of 0.037 shows a low variability between the variables used in this study. It is also low enough to
reject the null hypothesis that there is no correlation between cost of capital and financial performance using a
significance level of 0.05. The findings of this study presented by the ANOVA table 3 also that there is a positive
relationship between capital structure and financial performance of commercial banks listed at the NSE because
the significance (p- value) of 0.01 that is less than 0.05. Hence, alternative hypothesis that cost of capital
influences financial performance is accepted because the p-value is less than 0.05.
Table 4: Regression Coefficients
a
Coefficients
Model Unstandardized Standardized T Sig.(p-value) Interpretation
Coefficients Coefficients
B Std. Error Beta
(Constant) 0.003 .017 .0162 .038
Cost of capital 1.524 .026 .048 .0197 .029 Significant
a. Dependent Variable: ROA
Level of Significance (α) = 0.05
Source: Researcher’s Computation using SPSS 20.0
The study finding, with a constant of 0.003, showed that if the a unit measure of cost of capital, then financial
performance of commercial banks listed at NSE can be presented as 0.003. X= 1.524 shows a unit change in cost
of capital leading to 1.524 units increase in financial performance. T-values presented in table 4 for cost of capital
(0.0197). The T-values are closer to zero (0), and thus providing strong evidence against the null hypothesis that
there is no significant difference among the study variables. The t-values are low enough, in fact lower than the
significance value (p-value) of 0.05 to support the rejection of the null hypothesis that cost of capital does not
influence financial performance. The study finding confirms the study by Edelen and Kadlec (2013) that there is
association between a company’s investor base, profitability, capital budgeting decisions, and discount rate.
Nonetheless, it contradicts M&M study and studies by Khaled and Samer (2013) and Hamidreza, Fatemeh and
Hamid (2014) since a shift in the capital structure can influence performance of a company.
5. Conclusion
The study examined the effect of Nairobi Securities Exchange (NSE) listed commercial banks’ cost of capital on
their financial performance using cost of debt and return on assets (ROA) as the proxies for this research. The
result established a significant relationship between the variables at 95% confidence level. Based on this outcome,
the study rejects the null hypothesis that the NSE listed commercial banks’ cost of capital has no significant effect
on their return on assets (ROA) that has been used as their measure for financial performance. Hence, the study
recommends caution while exploring the use of debt (borrowing) financing since it poses threat to financial
performance and instead more equity financing available at the NSE should be adopted.

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