INTERNAL FINANCING AND SHAREHOLDER WEALTH MAXIMIZATION OF FIRMS LISTED AT THE NAIROBI SECURITIES EXCHANGE

Abstract

Internal funds offer firms a unique financing alternative for investments. When a firm retains earnings, it conserves cash flows that can be deployed into available investment opportunities. Similarly, internally generated finances ought to be less costly than externally sourced funds from issuing ordinary shares. When finances are raised internally, firms avoid floatation cost and hence can reduce the overall cost of capital that is used to discount the expected earnings of such firms and consequently earn higher market value. On the contrast, when a firm employs retained earnings in financing, it may reduce the amount available to pay dividends. A reduction in dividends may communicate information to shareholders that the firm’s future growth prospects are dwindling. This brings forth information asymmetry to investors and increase uncertainty that could lead to decline in firm market valuation. In the same vein, managers may purse their own interests using the excess cash resulting from retained earnings and shrink shareholders value.This study set out to explore the effect of internal financing on shareholder wealth maximization of firms listed at the Nairobi Securities Exchange. The study was grounded on pecking order theory, free cash flow theory and information asymmetry hypothesis. The study population consisted of 65 listed firms that yielded 440 firm-year study observations from 2011 to 2018. Panel data analysis was applied to estimate the random effect and fixed regression ofinternal financing on shareholder wealth maximization. Further, a generalized least square estimator was adopted in attempt to confirm robustness of results. Tests of homoscedasticity and serial correlation as well as the Hausman specification tests were undertaken. The panel data analysis based on random effect model and the generalized least squares estimation findings revealed that internal financing has a negative effect on shareholder wealth. Nevertheless, regardless of the econometric approach employed in the estimation, consistent findings are obtained a sign that the results are robust.The implication of the findings for policy and practice is that internal financing erodes shareholders wealth.