African Development Finance Journal http://journals.uonbi.ac.ke/index.

php/adfj
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Does Capital Structure mediate the relationship

between Corporate Governance and Firm Value?
Evidence from Kenyan Listed Firms

George Kungu
Prof. Cyrus Iraya
Prof. Winnie Nyamute
Dr. Caren Angima

Date Received: February, 18, 2024 Date Published: April, 15,2024

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African Development Finance Journal http://journals.uonbi.ac.ke/index.php/adfj
April Vol 7 No.2, 2024 PP 1-15 ISSN 2522-3186

Does Capital Structure mediate the relationship between Corporate Governance and Firm Value?
Evidence from Kenyan Listed Firms
By: George Kungu1 , Cyrus Iraya (PhD) 2 , Winnie Nyamute (PhD) 3 and Caren Angima (PhD)4
Abstract
Whereas capital structure decisions are critical for a firm's financial well-being, enhancing corporate
governance practices could more directly influence the value and performance of the firm. Thus, this study
investigated the impact of capital structure on the relationship between corporate governance and firm
value using longitudinal data from 30 Nairobi Securities Exchange-listed firms. A census survey in Kenya
from 2012-2021, involving 30 firms, found a random effects model most suitable for investigat ing
nonfinancial firms, with panel specification tests confirming this. The hypothesis testing revealed that
capital structure significantly influences FV, but the four-step mediation analysis revealed that capital
structure does not mediate the relationship. The absence of capital structure as a mediator suggests that
governance effects are not influenced by how companies fund investments and operations. Thus, corporate
governance's effect on firm value is neither impacted nor determined by a company's capital structure. It is
apparent that good corporate governance standards and judicious leverage separately play crucial roles
in establishing a firm's value.

Keywords: Corporate governance, capital structure, firm value, panel random effects model

Introduction
Corporate governance not only encourages shareholder trust and alignment but also promotes long-term
growth, both of which significantly influence the firm's overall value. Moreover, ignoring good governance
can trigger decreased trust, increased management risks, and a diminished perception of stakeholder value.
(Mans-Kemp et al., 2018). Effective governance procedures are crucial for companies and organizations to
enhance stakeholder value and performance, ensuring survival and prosperity in the contemporary business
landscape. Kong, Famba, Chituku-Dzimiro, Sun and Kurauone (2020) emphasize the crucial role that
corporate governance (CG) plays in influencing the dynamics among shareholders, who have financ ia l
interests in the firm. Thus, responsibility in management involves managers maximizing shareholder wealth
while considering stakeholder interests. This balanced approach leads to better long-term performance and
value creation for the company. Acting responsibly enhances trust, reputation, and overall firm value by
fostering a balanced decision-making process.

1
PhD Student, Department of Finance and Accounting, University of Nairobi, E-Mail: [email protected]
2
Professor, Department of Finance and Accounting, University of Nairobi
3
Professor, Department of Finance and Accounting, University of Nairobi
4
Senior Lecturer, Department of Finance and Accounting, University of Nairobi

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The relationship between a company's capital structure and its profitability and total value is complex and
debated, with the exact nature of this impact being fiercely disputed. Capital structure (CS), including debt
and equity financing, significantly impacts a company's financial performance and worth. The Modiglia ni-
Miller (1958) theorem initially suggested that financial decisions, including capital structure, do not affect
firm value in perfect capital markets. However, later debates, particularly by Modigliani and Miller (1963),
suggested that adjusting capital structure, particularly by increasing debt, can enhance firm value due to tax
benefits. In real-world imperfect markets with taxes, interest payments on debt are tax-deductible, leading
to lower tax burdens and potentially higher after-tax profits. Empirical studies support Modigliani and
Miller's (1958) theoretical assumptions by examining firm characteristics, temporal elements, and industr y
categories, while Gitman and Zutter (2012) define capital structure as the firm's equity-to-debt ratio,
reflecting cost-effective financing strategies to maximize post-tax profitability, and Yazdanfar (2012)
emphasizes that the concept of capital structure mirrors an attempt for cost-effective financing choices to
maximize post-tax profitability.

A firm's primary objective is to maximize its overall value, benefiting all stakeholders (Shuaibu et al., 2019).
This concept is supported by Bistrova and Lace (2012), who argue that firm value is closely linked to its
financial position. Prioritizing this not only enhances shareholder value but also attracts other stakeholders,
highlighting the importance of a strong financial position for long-term sustainability and growth. Firm
value (FV) is a measure of a company's financial health, based on its assets and liabilities, and profits from
its resources (Modigliani, 1980), while Putu et al. (2014) assert that it is the overall value of a firm's
securities, calculated using appropriate methods and pricing models, and Dang, Nguyen and Tran (2020)
argue that FV is the total of a firm's current and expected profits, as determined by appropriate technique s
and pricing models. Firm value evaluation methods include examining financial records and using metrics
like Tobin's Q, the discounted cash flow (DCF) method, and market-to-book value. Tobin's Q (1969), is a
simple and reliable method for assessing undervaluation or overvaluation. Additionally, it is versatile for
industry comparisons and has predictive power for future investments and economic expansion. Thus, the
method was adopted for a comprehensive analysis in the relationship.

Research Problem
Empirical research suggests a complex and uncertain relationship between corporate governance and firm
value, with varying results ranging from positive to negative (Bakay et al., 2021; Latif, Kamardin, Moh'd

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& Adam, 2013; Onguka et al., 2021; Mukyala et al., 2020; Ararat et al., 2017). The results may appear
inconclusive due to the diversity of corporate governance procedures and approaches among firms and
countries, as well as the disparity in measurements used to assess both CG and firm value. Additionally,
the CG framework's complexities can lead to ambiguity in outcomes and distinguish it from other factors
like macroeconomic conditions, industry trends, and firm-specific attributes, causing challenges in
interpreting FV. Thus, this study aimed to address these gaps by investigating the correlation between
corporate governance, capital structure, and firm value in non-financial firms listed on the Nairobi
Securities Exchange.

The NSE's market value disparities among non-financial firms are a cause for investigation into the
relationship between corporate governance practices and market value, particularly if the relationship varies
based on firms' capital structure. The study explores the intricate link between corporate governance and
firm value by suggesting the existence of a mediator, an intermediary factor that influences both, to improve
understanding and move beyond the traditional focus on their direct relationship. The research intends to
elucidate the reasons behind the varying conclusions in current empirical literature regarding the
relationship between corporate governance and firm value through this investigatio n.

Significant differences exist in the outcomes of the relationship between corporate governance (CG) and
firm value (FV) between developed and developing markets (Gerged and Agwili, 2019; Gerged, 2021),
where various factors, including regulatory frameworks, political systems, economic conditions, and
cultural influences, play crucial roles in shaping this relationship across different markets. Additionally,
developing markets often have weaker institutional structures and less stable economic and politica l
environments, leading to mixed findings in prior empirical studies. These differences, combined with less
predictable economic and political conditions, introduce greater variability and complexity into the
relationship between corporate governance and firm value. This variability makes it difficult to draw clear
conclusions from empirical studies, resulting in mixed findings in existing literature. Similarly, the lack of
a universally agreed-upon definition for corporate governance, capital structure, ownership structure, and
firm value has resulted in inconclusive and divergent empirical results due to the absence of standardized
definitions (Onguka et al., 2021). The relationship between CG and FV is complex and uncertain, with
ambiguous empirical evidence failing to conclusively determine whether strong CG practices lead to higher
FV or if higher FV results in better CG practices. This area of study is crucial in corporate finance and

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governance research. The unclear relationship between CG and FV raises questions about the causality. It's
unclear whether good governance practices make firms more valuable or if valuable firms are more likely
to have good governance practices. Understanding this causal direction helps policymakers and
practitioners identify where to focus their efforts to improve firm performance, as changes in one variable
might lead to changes in the other. Thus, this study filled these voids by examining the correlation between
CG, CS, and FV of non-financial firms listed at the Nairobi Securities Exchange.

Research Objective
The objective of this study is to explore the mediating role of capital structure in the relationship between
corporate governance and firm value of non-financial firms listed at the Nairobi Securities Exchange.

Literature Review
Theoretical Literature
The relationship between corporate governance, capital structure, and firm value is explored using various
theoretical perspectives, including agency theory, stewardship theory, and pecking order theory. These
theories aim to explain and clarify the relationship between these factors. Agency theory, a key theory in
understanding the relationship between CG, CS, and firm value FV, is primarily responsible for the debate
on whether capital structure influences the CG-FV relationship, as advocated by Jensen and Meckling
(1976). CG is crucial for firms to sanction operations and enhance value. By implementing strong CG
practices, firms can increase transparency, accountability, and ethical behavior, gaining trust from investors
and stakeholders. Additionally, a well-balanced capital structure reduces costs and increases financ ia l
flexibility. Thus, strong governance structures may influence capital structure decisions, as they may be
viewed more favourable by creditors, potentially leading to better access to debt financing at lower costs.
Increased sanctions often necessitate stricter regulation and ethical standards for firms, leading to improved
governance practices. This commitment to compliance enhances trust and reputation among stakeholders,
boosts investor confidence, and increases firm value. Effective governance helps firms avoid costly
penalties and legal issues, thereby enhancing their overall value.
.

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Empirical Literature Review

The relationship between CG and firm value is not well-defined, with mixed findings from previous studies.
These findings suggest that the relationship is complex and may vary depending on factors like industr y,
country, governance mechanisms, and firm characteristics. Some have exhibited a negative relationship,
suggesting that stronger governance is associated with lower firm value, possibly due to the costs of
implementing and maintaining effective governance structures. Others have established a neutral
relationship, suggesting no significant impact of governance on firm value, possibly due to other factors
like market conditions or external shocks. Lastly, some revealed a positive correlation between robust
governance and increased firm value, suggesting that effective governance practices like board
independence, size, and audit committee independence improve decision-making and performance.

Onguka, Iraya and Nyamute (2020) used Baron and Kenny's four-step approach to investigate the mediating
role of CS in the relationship between CG and FV in NSE-listed firms. They assessed CG, CS, and FV
using a composite score, considering board independence, size, and composition. Further, Tobin's Q was
used to determine CG's FV, and the DER to explore CS based on audited financial accounts from 64 NSE-
listed corporations. The study found that CS did not significantly impact the relationship between CG and
FV, suggesting that CG significantly influences FV. Analogous outcomes are exhibited by Bashir, Bhatti,
and Javed (2020) who analyzed the dynamic components of corporate governance in Pakistan, utilizing a
range of performance measures from non-financial firms listed at the PSX.

In Pakistan, the study by Huynh, Hoque, Susanto, Watto and Ashraf (2022) examined the impact of CG on
FP and the mediating role of CS in non-financial sector companies from 2011 to 2021. The research used
secondary panel data from financial statements and the Securities and Exchange Commission of Pakistan,
with 150 selected for analysis. The study used OLS panel regression with a one-lag right-hand strategy and
qualitative data collection to assess the effect of CG on FP. The findings showed that CG increased financ ia l
distress costs by increasing the debt-to-equity ratio, and CS partially mediated the relationship between CG
and company performance. This implies that the relationship between CG and firm performance is not
solely direct but also mediated through its influence on capital structure decisions. Firms with robust
governance practices maintain an optimal capital structure, contributing to improved performance. Thus,
effective governance enhances firm performance both directly and indirectly through its effects on the
capital structure.

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Okiro et al. (2015) presented conflicting findings concerning the influence of corporate governance and
capital structure on the performance of firms traded on the East African Community securities exchange.
They used agency theory to develop a comprehensive framework to explore whether effective corporate
governance enhances firm performance by integrating capital structure considerations. The study analyzed
56 firms, representing 57% of the total, from 2009 to 2013. Results showed a significant positive correlatio n
between corporate governance and firm performance, with a positive and significant mediating effect of
capital structure on the relationship. The study underscores the importance of capital structure within a
corporate governance framework and the role of corporate governance in enhancing firm performance. The
study findings align with Itan and Chelencia's (2022) research on the relationship between Indonesia n
family firm performance and corporate governance, examining 117 firms on the Indonesian Stock Exchange
between 2016 and 2020, focusing on capital structure as a mediator.

Additionally, Bashir, Bhatti, and Javed (2020) conducted a comprehensive analysis of corporate governance
in Pakistan, focusing on non-financial companies listed at the PSX. They explored how capital structure
interacts with corporate governance practices and financial performance metrics. Using Baron and Kenny's
(1986) four-step process, the study examined various corporate governance aspects, including insider and
institutional shareholdings, top twenty shareholder composition, board size, independence, audit committee
effectiveness, and duality. The analysis incorporated financial leverage and control factors such as liquidity,
size, age, market-to-book ratio, cash ratio, and tangibility ratio. Their sample included 113 non-financ ia l
firms randomly selected based on data availability, spanning various industries. Panel estimating
methodologies, including fixed or random effects, were employed, along with time-fixed effects to address
time-variant effects. The study found that capital structure does not significantly impact the relations hip
between dynamic corporate governance components and financial performance metrics. Additionally, it
identified relationships between financial leverage and top twenty shareholdings, as well as between
financial performance and financial leverage.

Conceptual Framework
The relationship between CG, CS, and FV is based on agency theory. Governance mechanisms, such as
board structures and diversity, aim to align the interests of managers and shareholders, reducing agency
costs and improving firm performance. This leads to increased firm value. The interplay between
governance and CS is complex, with strong governance resulting in better capital allocation decisions,

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resulting in an optimal capital structure and increased firm value. Conversely, poor governance may lead
to suboptimal choices and lower firm value. The conceptual model is presented in Figure 1.1

Corporate Firm Value

governance Capital structure
•Board independence
•Board size Debt to equity ratio
•Board diversity Tobin’s Q
•Audit committee
independence

Figure 1.1 Conceptual Model

Research Hypothesis
H01 : There is no significant mediating effect of capital structure on the relationship between corporate
governance and firm value of listed non-financial firms at the NSE.

Methodology
The study uses a longitudinal approach to analyze the relationships between three secondary sources, CG,
CS, and FV, over time. The study used descriptive analysis to analyze data distribution, identify outliers,
and establish links between variables, while Pearson correlation analysis was employed to determine
correlation direction and strength. Diagnostic tests were conducted to assess normality, multicollinearity,
stationarity, homoskedasticity, autocorrelation, and model specification. Additionally, panel regression
analysis was then used to test the hypothesized relationship, and Barron and Kenny's four-step mediatio n
model was applied to assess the mediating influence of capital structure on the corporate governance and
firm value relationship. The notion of mediation, in which one variable influence another, is important to
the research. The mediation process involves a mediator influencing the dependent variable (path a), an
independent variable affecting the mediator (path b), and a dependent variable influencing the independent
variable (path c), ensuring effectiveness and efficiency. After controlling for pathways, a and b, path c
becomes statistically insignificant.

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CG FV

CG FV

CS

Figure 1: Simple Mediation Model

The study utilized a simple regression model (3.2a) to determine the significant effect of CG on FV. This
is the total effect given by:
(c = ab + c’)
FVit = β0 + cCGit + εit …………………………………………………............... (a)
Where FV = firm value, CG = corporate governance, β0 = constant, c = path coefficient and ε = error term.
In the second step, the influence of CG on CS was established using a simple regression model (3.2b),
which should also be significant.
CSit = β0 + aCGit + εit …………………………………………… (b)
where β0 = constant, a = path coefficient, CG = corporate governance, CS =capital structure, and ε = error
term.
Instep 3, a simple regression analysis was conducted, with CS acting as a predictor of firm value. CS should
significantly impact FV while controlling for CG.
FVit = β0 + bCSit + εit …………………………………………… (c)
where FV = firm value, CG = corporate governance, CS = capital structure, β0 = constant, b = path
coefficients, and ε = error term
The model aims to determine if capital structure reliably predicts firm value while accounting for corporate
governance. It involves a multiple regression analysis that considers both corporate governance and capital
structure to predict firm value. If the impact of capital structure is positive, partial mediation is retained for
step four. If the impact of capital structure remains significant after controlling for corporate governance,
full mediation is supported. If both corporate governance and capital structure predict firm value, partial
mediation is justified. A variable has an intervening effect when β 2 is significant and β1 has a lesser impact
on overall value contrasted to step one results.
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FVit = β0 + aCGit + bCSit+ εi…………………………………………………………. (d)

Where FV = firm value, CG = corporate governance, CS = capital structure, β0 = constant, a and b are the
path coefficients, and ε is the error term.

Findings and Discussions

Descriptive Statistics, Diagnostic Test and Correlation Analysis
Table 1: Statistics
Variable N Mean SD Min Max
Board independence 300 0.67 0.208 0.2 1
Boad size 300 0.818 2.831 3 17
Audit committee
independence 300 0.853 0.266 0 1
Board diversity 300 0.17 0.168 0 0.667
Capital structure 300 0.371 0.422 0 1.93
Firm value 300 3.072 0.853 0.9 5.7

The findings established that board independence among non-financial organizations was consistent, with
a mean of 0.670, a standard deviation of 0.208, and a variance of 0.043, suggesting minimal variation. The
data distribution was platykurtic, with a strong leftward skew. Additionally, the descriptive statistics for
board size showed a mean of 0.818, a standard deviation of 0.2.831, a variance of 0.801, a minimum of 3,
and a maximum of 17. The data indicated nominal variation in board sizes among listed non-financial firms,
with a nearly symmetrical distribution and a moderate peak, suggesting a significant difference in board
sizes. Further, the audit committee independence varied marginally among listed non-financial firms, with
a mean of 0.853, a standard deviation of 0.266, a variance of 0.071, a minimum of 0, and a maximum of 1.
The coefficient of variation was 0.312, indicating minimal variation. Despite this, the data distribution was
negatively skewed and platykurtic, suggesting a flatter shape than a normal distribution with a stronger
inclination to the left. Moreover, the analysis revealed that board diversity among listed non-financial firms
exhibited a higher coefficient of variation, indicating a broader range. The mean value was 0.170, with a
standard deviation of 0.168 and a variance of 0.028. The diversity ranged from a minimum of 0 to a
maximum of 0.667. Thus, the data distribution displayed symmetry and a positive kurtosis.

Diagnostic Tests
Diagnostic tests play a crucial role in validating results by evaluating the assumptions of the statistica l
model, including normality, homoscedasticity, and linearity in linear regression. These tests also identify

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outliers and influential points, providing further insight into the data. Additionally, they assess the model's
overall goodness-of-fit and detect multicollinearity which is a regression analysis issue where multip le
independent variables are highly correlated, can lead to unreliable coefficients and mislead ing
interpretations. Detecting this issue involves calculating the variance inflation factor for each variable. The
results are presented in Table 2.

Table 2: Multicollinearity Tests Results

Variable Tolerance VIF
CG Index 0.893 1.120
CS 0.98 1.021

The study exhibited no multicollinearity issues between capital structure and corporate governance
variables, allowing them to be included in the regression model without risking inflating standard errors or
misleading interpretations. The low variance inflation factor (VIF) values and high tolerance values suggest
that both variables are effective predictors of the dependent variable in the model.

Correlation Analysis
Table 3 outlines the relationships between different variables. Capital structure displayed a positive but
weak and statistically insignificant association with corporate governance (r = 0.019, p > 0.05), while firm
value demonstrated a weak yet significant positive correlation with corporate governance (r = 0.120, p <
0.05). The correlation between capital structure and firm value was positive but weak and statistica lly
insignificant (r = 0.084, p > 0.05), suggesting that capital structure may not significantly influence firm
value in this context.

Table 3: Correlation Analysis Results

CG CS FV
CG 1.00
CS 0.019 1.00
FV 0.1204* 0.084 1.00
* This implies that a p-value less than 0.05, indicating statistical significance in a two-tailed test.

The study aimed to assess the mediation effect of capital structure on the relationship between CG and FV
in non-financial companies listed on the NSE. The variables included CG, CS, and FV. The CG composite
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score was calculated using board independence, board size, audit committee independence, and board
diversity. The CS was defined by the proportion of debt to equity, while FV was represented by Tobin Q.
The study used Baron and Kenny's causal steps approach, consisting of four phases and four regressions.
The null hypothesis was tested using the following method.

H01 : Capital structure does not significantly mediate the relationship between corporate governance and
the value of non-financial firms listed at the Nairobi Securities Exchange.

The study used Baron and Kenny's causal steps approach to examine the mediation effect of capital structure
on the relationship between CG and FV in non-financial companies listed on the NSE. The researchers
found a positive and significant relationship between CG and FV, and a significant indirect effect through
capital structure. This suggests that while CG directly influences FV, part of this effect is also mediated by
the company's capital structure. This approach offers valuable insights into the complex interplay between
corporate governance, capital structure, and firm value in the NSE context (see Table 4)

Table 4: Estimation Results of Corporate Governance and Capital Structure

Overall Model Fit Statistics
Model: Random Effect (GLS) Regression Number of observations 300
Panel Variable: ID (strongly balanced) Number of groups 30
Time Variable: TIME, 2012 to 2021 Obs. per group minimum 10
R 2 within 0.002 average 10
between 0 maximum 10
overall 0.001 Wald chi2 (1) 0.65
Corr (u-i, x) 0 Prob chi2 0.421
Parameter Estimates Statistics
CS Coefficient Std Error z-stat Prob

Constant 0.837 0.032 26.15 0

CG 0.009 0.011 0.8 0.421

The study found that CG did not predict CS at 95% confidence interval, with approximately 0.1% of
variance in FV predicted by CG. The parameter estimates revealed that CS was insignificantly influenced
by CG, failing to meet the conditions of the 2 nd step of the mediation process using the causal step approach.
As a result, the other steps (3rd and 4th ) were not tested. The results confirmed that the CG-FV linkage was
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not mediated by CS, leading to the failure to reject hypothesis that postulated an insignificant mediating
influence of CS on the CG-FV relationship.

Conclusions and Recommendations

The findings indicate that corporate governance directly impacts firm value, without capital structure being
a significant intervening factor. Consequently, the relationship between strong corporate governance
practices and higher firm valuations is not substantially affected by whether a company has a capital
structure tilted more towards debt or equity financing, since the positive impact of good corporate
governance on firm value seems to hold regardless of the firm's capital structure decisions. Therefore, these
findings diminish the importance of capital structure choices in realizing the benefits of corporate
governance implementations on enhancing firm value, as the capital structure composition appears to
neither facilitate nor hinder the value-enhancing effects of robust corporate governance mechanisms within
this research context. In essence, while capital structure is undoubtedly a vital financial decision for
companies, these results suggest that it does not play a critical role in mediating or transmitting the positive
relationship between corporate governance quality and firm valuations or performance, implying that the
impact of corporate governance on firm value is more direct and independent of capital structure
considerations. The study acknowledges limitations in data quality and the limited number of corporate
governance proxies used. Despite these constraints, the study ensures the robustness of its results. It
employs a correlation and descriptive methodology, providing valuable insights into variable relationship s
but unable to establish causation or fully explore complex interactions.

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April Vol 7 No.2, 2024 PP 1-15 ISSN 2522-3186

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