Abstract

Empirical evidence suggests that capital structure varies across firms facing different levels of information asymmetry, however, this evidence contradict the prediction of pecking order hypothesis. Although debt capacity constraints offer some explanation for this discrepancy, it fails to explain the behavior of small high growth firms who do not issue debt even with no debt capacity constraints. Against this backdrop, this study investigated the effects of financial constraints on firm capital structure in Kenya. This was implemented by interacting a financial constraints dummy with the right-hand side variables of pecking order test equation to allow for any variation of capital structure across financial constraints regimes. The results show that constrained firms use less internal funds and have less cash than unconstrained firms. Pecking order theory was not supported. However, allowing financial constraints regimes in pecking order equation improved the fit of the model and produced results that are consistent with pecking order prediction. Financing behavior varies with financial constraints status. The wider the wedge between the cost of debt and the opportunity cost of internal funds, the higher the value transferred to debt-holders and the lower the debt utilization. To improve firm access to capital, policies should be geared towards reducing the wedge between the cost of external and internal funds.

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