The Impact Of Capital Structure On Profitability Of Banks In Malawi

The relationship between capital structure and firm profitability is under researched in Malawi and most African countries. The theoretical explanation of the subject dates back to the Modigliani and Miller capital structure irrelevance theory of 1958 which states that the capital structure decision of a firm has no impact on profitability and firm value. Most recent theories suggest an existence of an optimal combination of debt and equity that maximises profits. Literature from different countries has produced mixed results on the subject. Using data of six banks from 2005 to 2016, this study examines the impact of capital structure on bank profitability in Malawi. Specifically, it examines the impact of debt equity ratio on profitability of banks in Malawi. We use the Arellano and Bover General Method of Moments estimator to estimate a dynamic panel model of the relationship between capital structure and bank profitability. Evidence shows that debt equity ratio has no impact on profitability measured by return on assets but has positive impacts on return on equity. The square of debt equity ratio is positive and significant on return on assets but insignificant on return on equity. The findings reject the existence of an optimal debt equity ratio in the Malawi banking sector. This study concludes that debt in Malawi has a positive impact on bank profitability. As debt increases, bank profitability measured by return on equity also increases. Banks should therefore focus on financing assets through debt than equity as it positively affects return on equity.