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1 Introduction to Capital Structure

A firm funds its operation with capital raised from varied sources. A mix of these various
sources is generally referred to as capital structure. The Capital Structure has been defined as
“that combination of debt and equity that attains the stated managerial goals (i.e.) the
maximization of the firm’s market value”. The optimal Capital Structure is also defined as that
“combination of debt and equity that minimizes the firm’s overall cost of capital”. The firm’s
balance sheet constitutes different proposition of debt instruments, preferred and common stock,
which represents the Capital Structure of the firm. The Capital Structure is an unsolved problem,
which has attracted both academic. Capital Structure and practitioners as the objective of
financial management is to maximize shareholder’s wealth. The key issue here is the relationship
between Capital Structure and firm’s value. The firm’s value is maximized when cost of capital
is minimized. (Khan, and Jain, 2004)
1.1.1 Shareholder Equity Capital
It generally consists of ordinary share capital and preference share capital. A firm has to raise
external equity when its internal equity (retained earnings) is not sufficient for the required
investment opportunity (Graham and Harvey 2001). According to Narayanan (2008) when a firm
raises too much capital through equity issues, it could be interpreted as a signal to the market that
it does not have sufficient reserves or cash flows, and this could result in the undervaluation of
the firm's shares. When investments are financed with external equity, the share prices of firms
sometimes fall. Therefore, it is better to build up reserves so that a higher proportion of capital
needs can be supplied from internal sources. (Brennan, and Schwartz, 2014)
1.1.2 Debt Financing
Debt can either be short-term or long-term. Short-term debt represents funds needed to finance
the daily operations of the firm, such as trade receivables, short-term loans and inventory
financing. These types of funds' repayment schedules take place in less than one year. Long-term
financing is usually acquired when firms purchase assets such as buildings, equipment or
machinery. (De Angelo, and Masulis, 2010)
1.1.3 Combination of Debt and Equity
When considering the characteristics of and the various advantages and disadvantages associated
with debt and equity, it is clear that firms should consider a combination of these different
sources of financing. As already mentioned, using only debt in the capital structure can be very

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risky (especially due to the risk of bankruptcy, because the more debt a firm uses, the higher the
bankruptcy risk). During periods of high interest rates, it can cause the earnings on an investment
to be wiped out by high interest payments. Issuing only shares in an attempt to raise funds can
also be a very risky option.
The main reason is because a firm must use cash to fund new investments, while shares may not
generate cash at the time the firm needs to pay for the new investment.
Theoretical research to date has indicated that firms can influence its value by varying its ratio of
debt and equity. The main argument is that firms need to find an optimal combination of debt
and equity that will ultimately increase the overall value of the firm. Therefore, it appears that
the decisions regarding capital structure could impact on the success and future prosperity of the
firm. (Staking and Babbel, 2005)
1.2 Factors Influencing Capital Structure
Based on the report review, the following variables are selected factors wich likely to influence
the capital structure of Maendeleo Bank
1.2.1 Size
Theoretically, the relationship between size and leverage is unclear. The Trade-off theory states
that large firms tend to be more diversified and less prone to bankruptcy.
They usually have lower transaction costs associated with long-term debt issuance, and are able
to issue debt at a cheaper rate than small firms. (Bhalla, 2007)
1.2.2 Profitability
Pecking order theory indicates a negative relationship between profitability and debt. Profitable
firms prefer internal funds rather than external due to asymmetric information or transaction
costs. A negative relationship if the market for corporate control is ineffective. It has been
identify that the relationship between profitability and leverage tends to be stronger in countries
with weaker shareholder protection. (Bhalla, 2007)
1.2.3 Liquidity
Liquidity risk is the risk that a Bank is unable to meet its payment obligations associated with its
financial liabilities when they fall due and to replace funds when they are withdrawn. The
consequence may be the failure to meet obligations to repay depositors and fulfill commitments
to lend. The Bank’s liquidity management process, as carried out within the Bank and monitored
by the Asset and Liability Committee (ALCO) of the Bank, include:

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  Day-to-day funding, managed by monitoring future cash flows to ensure that
requirements can be met. These include replenishment of funds as they mature or are
borrowed by customers. The Bank maintain an active presence in money markets to
enable this to happen;
 Maintaining a portfolio of highly marketable assets that can easily be liquidated as
protection against any unforeseen interruption to cash flow;
 Monitoring balance sheet liquidity ratios against internal and regulatory requirements;
and
 Managing the concentration and profile of debt maturities.
1.2.4 Tax shield
According to MM theory, interest tax shield generate incentives for firms to raise leverage.
Interest on debt is a tax-deductible expense which creates a tax shield. A positive relationship
between tax shield effects and leverage is expected.
1.3 Capital Structure of Maendeleo Bank
The Bank has a capital of TZS 7,350,962,481 comprising of shares of various shareholders
including; Church institutions, individuals, ELCT-Eastern and Coastal Diocese and United
Evangelical Mission. (Directors’ Report, 2017)
1.3.1 Capital Expansion through Rights Issue
As a means of raising capital that was needed to enable the bank to open branches and strengthen
its operations, the shareholders during their first Annual General Meeting on 16 May 2015
approved issuance of rights issue and subsequent approval by necessary authorities were
obtained. Rights issue of 6,000,000 new ordinary shares of TZS 500 par value was issued at an
offer price of TZS 510 per share, at the rate of two new ordinary shares for every three shares
held at 30 October 2015. The exercise was successfully done and completed on 29 January 2016
where TZS 2,839,000,000 was realized against a target of TZS 3,060,000,000 which is 93%
achievement. When we add this to the existing capital of TZS 4,514,528,000 we have a total
capital of TZS 7,350,962,481, which is enough to support branch expansion. (Directors’ Report,
2017)

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Capital Structure
The Bank`s capital structure for the year under review is as follows:
Details 2016(TZS “000”) 2015 (TZS “000”)
Authorized share capital 30,000,000 30,000,000
60,000,000 shares of TZS 500 each
Issued and fully paid-up share Capital
9,029,056 shares of TZS 500 each 4,514,528 4,514,528
5,561,635 rights issue of TZS 500 each 2,780,818 -
Premium (5,561,635 rights issue of TZS 10 each) 55,616 -
Total Capital 7,350,962 4,514,528
Source: (Audited Financial Report of Maendeleo Bank, 2017)
During the period, the Bank has complied with the requirements of Bank of Tanzania. The
details on capital management are provided on Note 4.5.
1.4 Conclusion
Therefore Capital Structure is an area that is unresolved with scope to be looked into, though
there are many theoretical and empirical works. All these works analyzed in detail the role
played by debt capital in determining the optimal Capital Structure to enable the firm to increase
their Profit and thereby improve the value of the firm however, still determinants of optimal
Capital Structure remains an unresolved puzzle.

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References
Brennan, M., and E. Schwartz. (2014) Optimal financial policy and firm valuation. Journal of
Finance 39: 593-607.
Bhalla, V. K. (2007) Financial Management and Policy. Anmol Publications Pvt. Ltd., New
Delhi: 832.
De Angelo, H. and R. Masulis. (2010) Optimal capital structure under corporate and personal
taxation. Journal of Financial Economics 8: 3-29.
Directors’ Report (2017) Audited Financial Report of Maendeleo Bank, Innovex-Dar-es-Salam,
Tanzania
Khan, M. Y., and P. K. Jain. (2004) Financial management. Tata McGraw-Hill Publishing
Company Ltd., New Delhi: 14.3.
Staking, K. B., and D. F. Babbel. (2005) The relation between capital structure, interest rate
sensitivity, and market value in the property-liability insurance industry. The Journal of
Risk and Insurance

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