THE EFFECT OF CAPITAL STRUCTURE ON THE FINANCIAL PERFORMANCE OF MICROFINANCIAL INSTITUTIONS IN BUEA

ABSTRACT

The impact of capital structure on the value of the firm has been a puzzling issue in corporate finance since the capital structure “irrelevance” proposition introduced in 1958 by Modigliani and Miller. To date, determining the mix in the firm’s capital that will improve a firm’s value is a contentious topic in financial literature. This study evaluated the effect of capital structure on financial performance of Micro financial Institutions in Buea.  by determining the effect of short-term debt asset ratio, long term debt asset ratio, interbank borrowings and equity on financial performance. In evaluating the relationship between the variables, a descriptive research design was applied. The target population was all Micro financial Institutions in Buea. A panel data model was used to analyze all data from 34 commercial banks that had been in operation over a study period of 10 years (2005 –2014) … The results of the study will be useful to all those interested in bank policy making. The study established that interbank borrowing and equity have significant positive effect on profitability. However short-term debt and long-term debt asset ratio do not have a significant effect on profitability. The following recommendations are made. First, since long term or short-term debt to asset ratios do not significantly affect profitability of micro financial Institutions, the study recommends to finance managers to focus on finding a satisfactory debt level that satisfies regulations and focus on other variables that, may be critical in influencing profitability. Secondly, the study recommends Micro financial Institution managers to focus on improving the capital strengths of their micro financial institutions by either rights issue, bonus issue of shares or through high retention of profits. Lastly, Microfinance managers should devise effective relationships with other banks so as to be able to access lending from them when needs arise.

Key words: Capital structure and Financial Performance.

CHAPTER ONE

INTRODUCTION

1.1 Introduction

The study is organized in to five main chapters. The first chapter which is chapter one deal with introductory part which covers the background of the study, statement of problem, objectives of the study, hypotheses of the study, scope of the study, significant of the study and lastly operational definition of terms. Chapter is literature review which is further subdivided in to conceptual literature, theoretical literature and empirical literature. Chapter three is the methodology which captures the research design, area of the study, data collection, population, sampling, sample size, instruments, data analysis and ethical considerations. Chapter four discuss the findings and analysis of data. The last chapter presents summary, conclusion and recommendation drawn from the findings.

1.2 Background of the Study

Performance of MFIs is determined by the way they are run given the environment in which they operate, risk management capabilities, their competitive strategies, quality of their management and levels of capitalization.

Low profitability weakens the performance of MFIs to absorb negative shocks, which subsequently affect Microfinance institutions solvency. (Berger K. U., 2006) holds that MFIs are more likely to have been licensed to mobilize deposits and therefore may have a higher deposit to assets, deposit to loans, and loans-assets ratio. It is also evident that MFIs have higher debt-equity composition perhaps because as firms mature, they become known to the market, which enables them to expand their access to capital. (Berger B. ,2000) holds that, financing choice involves a tradeoff between risk and return to maximize shareholder wealth. The objective of an optimal financing choice for any firm is therefore to have a mix of debt, preferred stock, and common equity that will maximize shareholders wealth, since changes in financial leverage affect firm value.

Capital structure is the combination of equity and debt in achieving the defined management goal of maximizing shareholder wealth (Musah, 2017). Also capital structure refers to several alternatives that could be adopted by a firm to get the necessary funds for its investing activities in a way that is consistent with its priorities. A key factor manager’s face today is the proportion of equity and debt which attains optimum capital structure which enables the firm to minimize its cost of capital and maximizing shareholders wealth.

Most of the effort of the financial decision-making process is centered on the determination of the optimal capital structure; where the cost of capital is minimized and firms’ value is maximized. Capital structure theory suggests that firms determine what is often referred to as a target debt ratio; which is based on various trade-off between the costs and benefits of debt versus equity. The theory of capital structure was first established by Modigliani and Miller in 1958. Following Modigliani and Miller (1958), a vast theoretical literature developed, which led to the formulation of alternative theories, such as the static trade off theory, pecking order theory and agency cost theory.

On the other hand, microfinance is a tool to fight poverty by Gondon\P Lissa. microfinance mainly refers to micro credit which is a small loan which is granted to people with low income. Microfinance institutions offer tailored financial and nonfinancial services and products for startup clientele. Microfinance alleviates poverty and offers the poorest in the society with the possibility of economic independence by promoting entrepreneurship. this was propounded and popularized by Muhammed Yunus, winner of the Nobel Peace Prize in 2006. Initially, microfinance used “social capital” to overcome the lack of collateral   

and limited information on credit worthiness that had long hindered the extension of financial services to poor populations.

In recent years, with the maturing of the microfinance industry, large numbers of microfinance institutions (MFIs) have greatly increased their outreach and sustainability. Furthermore, the formal market of microfinance is influenced by the process in which informal MFIs convert into formalized or regulated financial institutions which was refer red to as “up scaling” before. This usually requires fresh capital from outside investors, regulatory approval by local banking authorities and improved governance plus internal controls. The transformation process then typically allows MFIs to mobilize client deposit as an additional source of refinance and offer additional non-credit products. Furthermore, with the transformation and growth of their assets, MFIs get improved access to new sources of funding in the international capital markets and also product diversification which allows them then to broaden their outreach and serve more clients. Overall, the microfinance market currently faces a trend towards “commercialization” which is a broad term used to refer to the application of market-based business principles to microfinance.

Regulated MFIs’ capital structure has also been maturing and is progressively approaching the structure that predominates in banks. While many MFIs initially depended on domestic and international borrowing, their main source of funds is now by far deposits. At the same time, borrowing has generally decreased in importance in the MFI capital structure. The issuance of bonds, while promising, continues to be little used.

Instead, the capital base of the MFIs has been increased mostly by reinvesting a large share of the sizable profits that the MFIs have generated. Many MFIs also look to deposit financing and commercial debt as essential elements of funding future growth in the microfinance sector (De Sousa-Shields, 2004). Commercial debt financing is an important tool in MFI funding and management; both short-term as well as longer-term debt financing.

1.3 Statement of the Problem.

There exist significant capital structure constraints concerning microfinance institutions. The growth of microfinance programs remains a challenge to the microfinance sector. Besides, it is clear that microfinance institutions have varying degrees of financial performance.

Some organizations and governments stress financial performance as a means to exploit outreach width urging the MFIs’ capital structure is critical for high performance and sustainability. Studies on the impact of capital structure for Cameroon on firms’ performance have been insufficient and scarce; such studies have in most cases been done on developed economies. Understanding the impact of MFIs’ capital structure and its composition on financial performance, constitutes a knowledge gap in Cameroon hence studying the arena is of absolute importance.  Even though there has been an ongoing academic contest on capital structure and profitability of banks, there is quite slight proof on how firms actually arrange between financing sources to attain a defined profit level. This places a strong emphasis on the call to study the sources by which public commercial banks can raise funds and the efficient mix of these funds and its relationship with profitability of commercial banks in Cameroon in order to avoid future crisis.

The determinants of capital structure and firm value have been contested for many years and still represent one of the most unresolved issues in corporate finance literature. Only a few of the developed theories have been tested by empirical studies and the theories themselves lead to different, not mutually exclusive and sometimes opposed result and conclusion (Rajan & Zingales,1995). Morri & Beretta (2008) explained that numerous theoretical studies and much empirical research have addressed those issues, but there is no a fully supported and generally accepted theory; and the debate on the significance of determinant factors of capital structure and profitability/ firm value is still open.

Moreover, although earlier studies have great contributions to the theory of capital structure and profitability, they were limited to developed financial system and restricted to non-banks. Less developed countries like, Cameroon received little attention in the literature. According to Octavia & Brown (2008), the capital structure of MFIs are still a relatively under-explored area in the banking literature and the special nature of the deposit contract, the degree of leverage in banking and the regulatory constraints imposed on banks have meant that MFIs (and financial institutions in general) have been excluded in previous empirical studies on standard capital structure choice. However, understanding the determinants of capital structure and profitability as well as the impact of financing decision or capital structure on profitability is as important for banks as for non-banks firms. According to Amidu (2007) currently, there is no clear understanding on how banks choose their capital structure and what factors influence their corporate financing behavior. Likewise, the relationship between capital structure and profitability is one that received considerable attention in the finance literature. However, in the context of banking industry, the subject has received a limited research attention (Taani, 2013).

1.4 Research Questions

1.4.1 Main Research Question

What is the effect of capital structure on the financial performance of MFIs in Buea?

1.4.2. Specific Research Questions

1. To what extent does short term debt ratio affect the financial performance of MFIs?
2. How does long term debt ratio affect the financial performance of MFIs in Buea?
3. What is the effect of interbank borrowing on the financial performance of MFIs in Buea?
4. What is the effect of log of equity on the financial performance of MFIs