Abstract

This study aimed to explore the determinants of capital structure and their impact on the debt equity ratio of  Small and Medium Enterprises (SMEs) in Buea. The primary objective was to examine the determinants influencing the capital structure in relation to the debt equity ratio of SMEs. The specific objectives were to investigate the influence of cash flow, growth prospects, and cost of capital on the debt equity ratio of SMEs in Buea.

The research adopted a quantitative methodology, utilizing questionnaires to gather data from a sample of 50 selected enterprises in Buea. The primary data collection method exclusively employed closed-ended questions in the questionnaires to ensure greater accuracy in the results. A sample size of 50 was chosen to facilitate multiple regression analysis for assessing the relationship between the dependent and independent variables.

The analysis included both descriptive and multivariate analyses. Descriptive analysis involved measures of central tendency and dispersion, providing a detailed overview of the collected data. The multivariate analysis utilized multiple regression to examine the relationship between the debt equity ratio and the determinants of capital structure, specifically cash flow, growth prospects, and cost of capital.

The regression analysis aimed to demonstrate the impact of capital structure on the debt equity ratio of SMEs in Buea. With a level of significance set at 5%, the results provided sufficient evidence to reject the null hypothesis, indicating a significant influence of capital structure on the debt equity ratio of SMEs in Buea.

This study concludes that capital structure significantly affects the debt equity ratio of SMEs in Buea.

CHAPTER ONE: INTRODUCTION

1.1 Background of the Study

The approach to funding positive net present value projects bears critical implications for a company. The cumulative impact of these specific financial decisions leads to the capital makeup of the firm, which has long been a central topic in corporate finance studies. The theoretical discussion on the company’s capital structure originated from Modigliani and Miller’s propositions in 1958. They suggested that a company’s capital structure was unconnected to its cost of capital and, therefore, its overall value. These propositions were based on various unrealistic assumptions and were later adjusted by Modigliani and Miller in 1963, taking taxes into account. This adjustment led to the formulation of the trade-off theory of capital structure, which weighed the tax-related benefits of debt against the costs of financial distress.

Alternate viewpoints, rooted in the information gap between ‘inside’ managers and ‘outside’ investors, include signaling theory (Ross, 1977) and the pecking order theory (Myers, 1984, Myers and Majluf, 1984). The latter theory posits that when internal finance isn’t adequate for investment needs, companies tend to prefer external financing from debt markets, with equity being the least preferable option (Jensen and Meckling, 1976). Another approach examined a network of relationships, characterized as principal-agent relationships, and potential agency costs for the company (Atseye, 2013).

Capital is of utmost importance to a business entity, as it forms the foundation on which the business operates. Capital absorbs costs, multiplies fixed assets, and ultimately fosters growth through mergers, takeovers, and acquisitions. Governments in some countries often extend financial support to business entities to help them initiate and sustain their operations and overcome initial challenges, especially during economic downturns.

Businesses are increasingly seeking strategic management practices, aligning the financial strategy with the company’s strategic objectives. The nature of a firm’s assets determines the most efficient ways to organize transactions. Diverse asset characteristics imply varying optimal capital structures of debt and equity (Kochar, 1997). Managing financial policies is critical for a firm to maximize gains from its specialized resources. Poor decisions on the capital structure can potentially diminish the value derived from strategic assets. Capital structure is defined as the combination of debt and equity used to finance a firm’s operations. It encompasses a blend of debt and equity financing options (Chou and Lee, 2010, Hall et al, 2004, Barral and Booth et al, 2001).

Financial managers face choices between debt and equity, influencing the claims of shareholders or creditors on the firm’s assets. This array of financing options represents the financial structure, which is evident on a firm’s balance sheet as a mix of liabilities and equity.

1.2 Statement of the Problem

A review of relevant literature on capital structure reveals that most studies focus on listed SMEs, largely overlooking the capital structure of small businesses. Empirical research predominantly collects data from large companies, showing significant differences in financing behavior between SMEs and larger firms. SMEs encounter distinct complexities, including issues like estate tax, shorter life expectancy, intergenerational transfer problems, and reliance on implicit contracts.

The scarcity of management skills and limited separation of business decisions from personal purposes are challenges specific to SMEs. Research focusing on the determinants of capital structure and their influence on borrowing decisions in SMEs is limited. The capital structure decisions of SMEs significantly impact a country’s economic and political conditions.

This gap in the literature underscores the need to explore how the determinants of capital structure influence the performance of SMEs in Buea, especially in the case of electronic dealers.

1.3 Research Questions

1.3.1 Main Research Question:

• What factors determine the capital structure of small and medium-sized enterprises in Buea?

1.3.2 Specific Research Questions:

• To what extent does growth prospect influence the debt-equity ratio of SMEs in Buea?
• Does the cost of capital impact the balance between debt and equity in SMEs in Buea?
• How does cash flow affect the debt-to-equity ratio of SMEs in Buea?

1.4 Research Objectives

1.4.1 Main Research Objective:

• To investigate the determinants of capital structure in small and medium-sized enterprises in Buea.

1.4.2 Specific Objectives:

• Assess how growth prospects influence the debt-equity ratio in SMEs in Buea.
• Evaluate the impact of the cost of capital on the balance between debt and equity in SMEs in Buea.
• Analyze how cash flow influences the debt-to-equity ratio of SMEs in Buea.

1.5 Research Hypothesis

• Null Hypothesis (H0): The cost of capital does not significantly impact the debt-equity ratio of SMEs in Buea.
• Alternative Hypothesis (H1): The cost of capital has a significant influence on the debt-equity ratio of SMEs in Buea.

1.6 Significance of the Study

• For Academics: This research contributes to the existing body of literature, providing additional materials for students and researchers to use as references in their studies.
• For SMEs in Buea: It offers insights into the factors influencing SME performance and suggests strategies to improve their capital structure and overall business performance.
• For the Researcher: The study fulfills part of the requirements for a bachelor’s degree in accounting.