Cost of Capital and Financial Performance of Non-Financial Firms Listed at the Nairobi Securities Exchange

Abstract

Financial performance is a critical indicator of a firm's efficiency in utilizing resources, generating profits and delivering value to shareholders. For firms listed on the Nairobi Securities Exchange (NSE), cost of capital plays a pivotal role in shaping profitability, yet many continue to face performance challenges. This study investigated the relationship between the components of cost of capital specifically, the cost of debt and cost of equity and the financial performance of non-financial firms listed on the NSE in Kenya. It further examined the moderating effect of firm size on this relationship. The study was based on pecking order theory, Modigliani and miller theory, trade-off theory and agency cost theory. The study adopted a descriptive research design, analyzing panel data from 38 non-financial firms over the 2019–2023 period. Secondary data was extracted from audited financial reports. Financial performance was measured using Return on Assets (ROA) and Net Profit Margin (NPM), while cost of capital was operationalized through effective interest rates, dividend policy metrics, and Beta. The study found that cost of debt had a statistically significant negative effect on ROA (β = –0.284, p = 0.015) and NPM (β = –0.239, p = 0.016). Similarly, cost of equity was negatively associated with both ROA (β = –0.337, p = 0.001) and NPM (β = –0.295, p = 0.004), highlighting the performance-reducing effect of higher investor return expectations and risk premiums. Beta also showed a negative influence on ROA (β = –0.164, p = 0.035), consistent with the Capital Asset Pricing Model (CAPM) in the context of Kenya’s volatile market conditions. Firm size, measured as log-transformed revenue, had a positive and significant effect on financial performance (ROA: β = 0.145, p = 0.046; NPM: β = 0.178, p = 0.012). However, interaction effects indicated that larger firms experienced more pronounced negative effects from rising debt and equity costs suggesting that firm complexity and market visibility may increase vulnerability to financial risks. The study concludes that high financing costs significantly erode profitability and that firm size both strengthens performance and magnifies sensitivity to capital cost shocks. The study recommends that corporate finance managers in Kenya adopt balanced financing strategies that minimize reliance on high-cost debt and carefully manage equity costs. Firms should prioritize internal financing and retain earnings as far as possible, in line with pecking order preferences, while ensuring that debt and equity financing are optimized to avoid excessive cost burdens. Larger firms should implement robust risk management frameworks to mitigate exposure to financing shocks. For investors, the findings underscore the importance of evaluating firm-specific financing structures when assessing profitability prospects, as reliance on costly capital erodes shareholder value. Policymakers and regulators are urged to foster capital market efficiency by promoting lower cost financing options, improving transparency, and stabilizing the macroeconomic environment.

Keywords: Cost of capital, cost of debt, cost of equity, firm size, financial performance, Nairobi Securities Exchange