The Effect of Financial Leverage and Market Size on Stock Retunes

CHAPTER -1
I. Introduction
Investors contribute for foreseen future returns, yet those profits can once in a while be
anticipated definitely as there will dependably be risk connected with investments. The debt
amount which is a part of any companys capital structure is reflected by financial leverage.
Financial leverage the effect on the returns of an adjustment in the degree to which the
companys assets are accounted with acquired cash. Numerous researches in finance history
examined the decisions which are taken for capital structure and leverage.
Financial risk of a company is generally associated with the financing of a company. When a
firm uses higher amount of debt to support its financial operations then in the result the financial
risk become higher. The risk stems from the company is not having the capacity to meet its
financial commitments. This has pushed a rise to an idea in finance of the unambiguous
relationship between capital structure and ROE.
Business leverages their capital in light of the fact that it gives strength for expanding rate of
return for equity reserves. With the help of Leverage the rate of profit for the contributed
resources is altogether greater than the loan cost paid on acquired assets.
Problem statements
Research Question
Research objectives
Limitations of your research
 CHAPTER -2
II. Literature Review
2.1 Introduction
2.1.1 Leverage
The utilization of different monetary instruments and obtained capital for increasing potential
return for the investment. The amount which is used to fund a companys asset called amount of
debt. A firm is said to be highly leveraged because its ratio of debt is more that the ratio of
equity.
2.1.2 Capital Structure
Capital structure is that from which resources a firm can give financially support to its all
operations and growth. There are two main components through which a company finances its
daily operations. A company obtain debt from bond issues (long term) while equity is obtained
from common and preferred stocks or retained earnings.
2.2 Historical Overview
Linter (1956) and Gordon (1959) argued that there exists an ideal leverage proportion that
equates the marginal advantages of debt e.g. tax shields to the marginal costs of debts such as
increase in bankruptcy cost (expected).
Modigliani miller (1958), argued that a firm is estimated to be free from its capital structure. The
implication of same suggestion was the function of leverage increases the return on equity
capital. Hence investors demands maximum return on their stocks because when debt increases,
the risk in stock increases.
Modigliani miller 1958 presented their theory an estimation in which the company is in-
dependent in its capital structure (debt, equity, preferred stock) and they discussed that as debt
increases so, the risk associated with stock and investors will demand more returns.
Modigliani miller 1958 presented the theory that the amount of debt in a firms capital structure
increases when we increase the expected ROE. Theoretical finance views that leverage is one of
the risk source and claims that when firm is more levered, the risk for equity holders will become
high. When risk averse investors are more uncertain about the cash flows, they will demand
maximum rate of return on their investment (Penman 2007).
Modigliani miller (1958) presented the suggestion that when we increase the debt percentage in
companys capital structure the expected ROE will increase. This is the fundamental standards of
corporate finance. On the other hand, empirical confirmation of the relationship of financial
leverage and expected stock returns are rare.
Smith (2002) determined that leverage is the utilization of debt amount to create a speculation
and profit on specific venture. Its very high-risk for an organization to have maximum
proportion of financial leverage. The result occurs for financial leverage, if the purpose of the
financial leverage is greater, the high expected benefits on firms equity. Therefore, financial
leverage is utilized as a part of different circumstances as a means of modifying the cash flow
and financial position of a firm. In perspective of the previously stated, capital structure
decisions are basic as a shift in leverage could expand or diminish the financial barriers on firms.
Investors contribute for foreseen future returns, yet there returns can once be predicted definitely
as there will often risk involved with investments. In the start of the investment period, actual
returns will often differ from expected returns. It is considered that investors always predict
higher expected returns against their investments suitable to take risk (Bodie2008).
Muradoglu, Siva Prasad (2008) recommend that when capital structure is endogenous, it is
feasible that the classic financial arrangement is one that carry low leverage, in order to ease
agency issues while saving financial flexibility. When the market price of an agencys ability for
raising funds if need, the negative relationship of returns and that of leverage occurs Myers
(1977).
Myers presented that high leverage move up the expectations of a firm doing without positive
NPV ventures in future in light of the fact that by one means or another the results from these
investments to investors after satisfaction of debt commitment are lower than the beginning
investment which has been an investors needs to spend. This under investing decreases the
choice of estimating ability of an organization. Subsequently a movement in leverage ratio can
achieve a lower stock value with each other part approach.
2.3 Modern Theories
Pecking order theory
Myers presented the pecking order theory in 1984. According to him when a firm wants to
finance itself it requires internal and external financing. Internal financing is done with the help
of retained earnings. When a firm has no source of internal financing then it prefer outsourcing
which includes mostly debt and equity financing. Equity financing shows that a firm has a
potential capability to lower its share price and its market share will increase respectively. Debt
financing show to investors that management of firm are very much confident that they are able
to compensate the debt in future. When a firm doing debt financing then investors are able to
demand higher return because of the chances a firm will face bankruptcy situation. So the better
option is to adjust the ratio of debt and equity in equal proportion. If a firm has much retained
earnings then it is good for a firm to finance its all financial activities through retained earnings.
Trade off theory
This theory refers that while balancing all costs and benefits a firm estimates that what
proportion of debt and what proportion of equity should be choose to make a capital structure
plan. Capital structures trade off theory actually shows the difference between cost of debt and
benefits obtained from debts. Trade off theory essentially deals with two ideas, agency cost and
financial instability. The purpose of this theory is to clarify that firms are generally financed with
half debt and half equity portion. There are many advantages while financing a firm with debt.
One of them is to obtain some tax benefits but the main drawback of getting higher debt is that a
firm will face bankruptcy cost and chances of getting bankrupt. So, to keep itself save a firm
usually equates the portion of debt and equity same.
Signaling theory
A firm want to do debt financing for future operations. So, for this the stock shares of the
company could be affected by spreading the information publically. Company may faces either
positive or negative performance of the stock. This is obvious that when company obtaining debt
it will pay debt on the principal which shows the good financial performance of the company. In
other case when company reduce the debt amount in future, it is a negative signal to the investors
that now company is not able to pay interest amounts and its financial performance is weak.
Agency cost theory
Agency cost is said to be the conflicts which were raised between manager of the company and
their shareholders. Every shareholder wants to maximize his share value by forcing the
companys manager to take decisions regarding it but instead of raising the value of share,
managers try to expand their business to make increment to salaries. The increase of agency cost
is because of management of the company just try to favor themselves and places their own
personal financial interests, either they use companys resources for their benefits. Shareholders
are the owner of any company so they offer some incentives to the managers to make sure that
they will raise the share value instead of getting their personal interest.

Chai and Zhang (2010), when an organization faces high leverage, an increment in its leverage
proportion ultimately pushed up its expected cost. If we estimate a default risk, the critical
increment in leverage leads towards a greater forecasted return.

Chai and Zhang (2010) noticed that company with high leverage improve their probability of
being default and its expense in shape of cost which is expected. When a company valued a
default risk, there is an increase in leverage which should prompt maximum future return. In
spite of its centrality inside of finance, empirical discoveries on this subject have been blended in
some cases conflicting Penman (2007).

Hamada (1972), Bhandari (1988), Dhaliwal (2006) demonstrate that with increase in leverage
return also increase while other researchers demonstrate also profits become lower with leverage
Kortewag (2009), Dimetrov and Jein (2008), Penman (2007), Muradoglu and Siva Prasad
(2009).

The determination of this issue for the down to earth behavior of operations in the capital market
seems to be essential. This paper investigates the links in the middle of leverage and stock
returns, contributed towards current experimental proof of benefit evaluating implications of
leverage. Besides, the observational information that have been utilized to test this suggestion
have overwhelmingly derived from firms in the United States, there is in this manner the need
to test the strength of this recommendation in an alternate situation and more critical in
developing nations. This has served as an inspiration for the present paper. Enterprises use
financial leverage to make adaptability, keep up access to markets, purchase shares and make
investors esteem. Decisions and plannings vary from an organization to any other organization
but always firmly adjusted to organizations general objectives and targets Garrison (2004).

Financial leverage results from contrast in-between proportion of profit a firm achieve for
investing in particular assets and proportion of return a firm pay to its creditors Garrison (2004).

2.4 Relation in Leverage and Stock Returns

M.M (1963) defined that because of different advantages of tax relaxation on debt, it is benefit
for investors that there is a debt present in their capital structure. The conventional perspective is
there are many advantages for tax relaxation to get debt but the fact is it increases the bankruptcy
cost which a company faces financial distress.

Hull (1999) had found that the value of stock is affected by this that how a company can changes
leverage in relation to its industry leverage. Campello (2003) gives proves that an organization
which depends on debt will probably reduce their investments.

Hou and Robinson (2006), they find that organizations in highly focused commercial enterprises
get lower profits. This research manages an analysis of relation among enterprise concentration
and stock returns. Also finds that an impact of leverage on the return stays negative for low with
maximum concentration firms.

Dhaliwal (2006) analyzes the relationship among leverage, taxes of corporations and companys
cost of capital. They found that in spite of the fact that cost of equity capital increments with
leverage when taxes on corporations are presented, it diminishes risk premium.

Many researchers found an impact of capital structure on stock returns Dimitrov and Jain in
(2007), George and Hwang (2009). That research analyzes and shows the relation between stock
returns and capital structure. The decisions on capital structure are apparently a standout amongst
the most critical decisions managers face. An adjustment in leverage proportion will influence a
companys cost of capital, financial limit, investors wealth and risk.

Dhaliwal (2006) analyzes the relationship among leverage, taxes of corporations and companys
cost of capital. They found that in spite of the fact that cost of equity capital increments with
leverage when taxes on corporations are presented, it diminishes risk premium.

2.5 Empirical Studies

2.5.1 The Concept of Stock
In basic terms we say a stock relates with the share in ownership and responsibility for company.
Stock shows a perfect claim on the firms assets and earnings. Rate stake a shareholder holds is
reflected in the quantity of stocks the shareholder obtain from companys stock. In this way,
more shares which one obtains, ultimately his or her proprietorship rights in an organization.
At the point, one holds stocks of an organization, it suggested that individual is one of many
proprietors or stockholders of the company and has everything the firm possesses. Share
certificate is a certificate which shows the ownership of the investors share. It is a proof of ones
ownership. Brigham and Ehrhardt (2009) according to them a normal stock just shows the
ownership interest for an enterprise. In this current time of business however, such endorsements
are once in a while given the shareholder because the financier firms keep these records
electronically also called holding shares. This is done trying to make the stock effectively
tradable. Not at all like in the past where one needs to physically take a share certificate to
brokerage in order to sell, with only a click on mouse or a telephone call, stock can effectively
sold out.

2.5.2 Return
Return alludes to the money related rewards gained as a consequence of making an investment.
Return which is obtained at the last of the operations, its nature depends on the criteria of an
investment. For instance, firm that puts resources into settled resources and business operations
expects returns as benefit, which is measured before interest amount, before taxes and in the
form of cash flows. A shareholder who purchases normal shares expects returns as profit
installment and capital gain. And shareholder who purchases corporate securities expects
consistent returns as interest installments Frimpong (2010)

2.5.3 Measures of Leverage

Rajan and Zingales (1995), according to them the target of a study has a crucial impact on the
measure of leverage. Along with this, one ought to be consider what the target of this study is.
Aggregate liabilities to aggregate assets is the wider definition of leverage, however Rajan and
Zingales (1995) contend, is not a decent intermediary for financial risk. Since numerous balance
sheet items incorporated into aggregate liabilities are utilized for exchange purposes as opposed
to financing.

Total Liabilities
Leverage=
Total assets

2.5.4 Debt to Equity Ratio

Ross, Wseterfield and Randolph (2002) according to them Debt to equity ratio is a substitute for
evaluating the level of leverage of a firm. A company with high Debt to equity ratio gives higher
returns to its investors. In accordance with risk that confronted by an organization contrasted
with different organizations with lower debt to equity ratio.

Total Debt
DER=
Totalequity

Werner and Jones (2004), according to them Debt to equity ratio demonstrates a corresponding
relationship between debt and equity. A lower DER implies that the ratio or total debt is
moderately lower that total equity. DER of an organization are assessed from a couple of
viewpoints.

1) DER of similar firms.

2) At which business arrange the organization is in (new organization have a tendency to
have more obligation).
3) Firms strategies that considers the ideal level of debt financing.

Bhandari (1988) according to him, a characteristic intermediary for risk of basic value of a
company is that organizations (debt to equity ratio).

When a company increases its debt to equity ratio ultimately risk of its common equity become
increase. Measuring risk in any sensible way financial leverage obtain by distinction between the
proportion of profit an organization win for investing in its own particular resources and the rate
of return an organization givesto its creditors from where they had taken the debt Garrison
(2004).

Hamada (1972) and Rubinstein (1973) shows that a companys beta ought to be increased if the
company do more debt financing. These speculations are the expansion of pre-CAPM working
which is done by Modigliani and Miller (1969), who demonstrate that utilization of debt expands
equity returns variability. Many investors were worried about genuine outcome are not exactly
what we expect.

The Fama French 3 component model and thenFama French addition to Carhart 4 element
model. Stock returns for every organization are ascertained month to month, utilizing the rate
change as a part of back to back closing prices balanced for dividends, splits and right
issues.
Second study gauges unusual returns in overabundance of the riskfree rate utilizing Sharpe
(1964) Capital Asset Pricing Model, Fama French (1993) model and Carhart (1997) model.

It is simple to calculate debt ratio which is useful to shareholders searching for a firms leverage.
Debt ratio gives clients to measure amount of debt that a firm has on its monetary records
contrasted with its advantages.

The connection between future returns and current leverage incorporates connection between
those profits and both target excess leverage. The last relation urgently relies on upon whether
the business sector comprehends and seizes in price the data content of excess leverage as for
changes in the companys basics whether it simply does all things considered with a deferral as
those progressions develop like surely understood securities exchange inconsistencies. E.g.
Bernard and Thomas (1990), Jegadesh and Titman (1993), Sloan (1996) and Hirshleifer (2001).

To present the leverage of an organization in sample. It presents total debt aggregate financing of
the organization and is characterized as:

( long term debts+ short term debts )currentportionoflongtermdebts

Leverage =
( total capital + short term debts )currentportionoflongtermdebts

Financial leverage is taken from the difference between that rate of return which is earned by a
company for its investment which is invested in asset and also that rate of return which a firm
will pay to its creditors Garrison (2004). The utilization of obtained assets with purchased assets
for investing called leverage. The ration of obtained funds to possess funds called leverage
ratio.

total debts+totalliabilities
leverageratio=
total income

Hamada (1972) and Rubinstein (1973) exhibit that an organizations beta ought to be increased if
the company do more debt financing. These speculations are the expansion of pre-CAPM work
which is done byM.M (1969), they demonstrate the utilization of debt expands equity returns
variability. Their inspection of business sector risk, then Hamada decides that 21-24 % of a
companys uncontrollable risk could be clarified the way of investment. Hill and Stone in (1980)
and Chance (1982) expand Hamadas risk decomposition approach. Bowman (1989) Leverage
and the checking beta are specifically identified to uncontrollable risk. Firms which have high
levered shows a perfect negative relation as per stock returns.There is a reverse relation between
period (t) firm stock returns and changes in firm stock return instability from period (t) to (1+t).
This reverse connection is more grounded for firms with vast debt to equity ratio Cheung (1979).
As indicated by stock unpredictability as far as returns are greater in value that results in the rise
of the debt to equity proportion. Future instability increases as indicated by the raising riskiness
of the companies Yaushaun (1976).

Leverage is ordinarily portrayed as the utilization of carried off cash to do financing and getting
a return on investment. It is very unsafe to an organization to get high proportion of monetary
leverage. It has additionally seen that the result of financial leverage, if the purpose of financial
leverage is greater, more is expected benefit on organizations equity. Accordingly, financial
leverage is used as a part of different circumstances as a method for adjusting the cash flows and
budgetary position of an organization. There are about 4 positions which demonstrate an
association with financial leverage level. To begin with its connection with equity and debt, e.g.
rate of capital. At that point the organizations business and branch entire financial leverage
level. Furthermore the relationship between financial leverage proportion of an organization and
the centered leverage level. Ultimately conformity of organizations goal and theory with
circumstances associated with relationship of financial leverage. The result of financial leverage
can likewise use to help to increase income and growth. It is very normal for enterprise
commercial enterprises in the period of youth. Financial leverage is with respect to variability of
benefits and in spite of stability.

Smith (2002), Organizations benefits with high rate leverage contrast with the organizations
benefits with lesser leverage level. The relationship between rates of return on equity on account
of leverage is only an extra ordinary instance of relation of risk and return. The business sector
sets up a relation between risk of an action and its forecasted rate of return.
2.6 Conceptual Model and Theoretical Framework

DEPENDENT VARIABLE

STOCK RRETURNS

INDEPENDENT VARIABLES INDEPENDENT VARIABLES

Leverage Market Size

2.7 Hypothesis
Hypothesis is such statements which demonstrate deduced relation between distinctive variables.
The guessed relations between the variables are set up on premise of past literature. Those
relations can be checked utilizing certain factual tests. Those hypotheses may be justify or not,
depends on the findings from statistical analysis.

The following hypothesis presented according to literature review.

H1: There is a positive relationship between stock return and leverage.

H2: There is a positive relationship between market size and stock returns.
 CHAPTER -3
III. Methodology
Leverage
The utilization of different monetary instruments or obtained capital e.g. margin to expand the
potential return of investment and the amount of debt used to fund an associations benefits. A
firm which has more debt against equity is considered to be highly levered.

Stock return
When we obtain a gain and loss on a security in a specific period then return contains income
and capital gains relative to an investment. It is generally quoted as a rate.

Market size
The number of buyers and sellers in a particular market and this is especially important for
companies that wish to launch a new product or service, since small markets are less likely to be
able to support a high volume of goods. Large markets could bring in more competition

3.1 Sources and type of Data

3.1.1 Empirical Model Specification
R= + 1 Leverage + 2 Market size +

Where,

1 and 2 are the co-efficient of the estimates and is the error term

is the constant of the regression equation representing other factors that could have had an
effect on the stock return.

R is the return for stock

3.1.2 Stock Return (Dependent Variable)

Rt = Pt-Pt-1/Pt-1 100%

Where,

R is stock return for period t,

Pt is the market price of stock i in period t,

Pt-1 is the market price of stock i in period t-1

The stock price data for the analyses were gathered from the KSE data base. Daily closing stock
prices of the selected stocks were averaged to get the monthly stock prices used for the analyses.
Stock market data covering the period of (2012-2014) were used for the analyses.

3.1.3 Leverage (Independent Variable)

The leverage of the various selected stocks was estimated using the equation (3) below:

( long term debts+ short term debts )currentportionoflongtermdebts

Leverage =
( total capital + short term debts )currentportionoflongtermdebts

The data for the leverage estimations were extracted from the yearly published financial
statements of the selected stocks. Financial statements also covering the period from 2006-2010
were used.

3.1.4 Size (Independent Variable)

The Size of each selected stock as used in this research refers to the market capitalization of the
stock. This is estimated by multiplying the number of common stocks issued by the firm by the
closing stock market price of the stock.
 CHAPTER -4
IV. Analysis and Results
Table #1 Summary Statistics, using the observations for the variable 'market size'
Mean Media Minimu Maximu Std.de C.V Skewnes Ex. Withi Betwee
n m m v s Kurtosi n S.D n S.D
s
1.250 77258 75600 2.2213 71100 0.568 0.70680 -1.5000 7524 16825
0 81 5

Interpretation
Table -1 shows the summary of the statistically using the observation for the variable. The
variable (market size) which deals with the size of the market. Mean shows the average number
of samples in the market and the value of mean is (1.2500) in the above model.

The standard deviation of high result (75245) shows that the date is less reliable and the data
with low standard deviation (16825) shows that the data is more reliable. If the value is smaller
than the difference between the mean value than the hypothesis is more supported and if the
standard deviation is greater than the difference between the mean value so it not support the
hypothesis. Coefficient of variation (CV) 0.56881 is defined as the ratio of standard deviation to
the mean.

Table -2 Summary Statistics, using the observations for the variable 'Leverage'
Mean Media Minimu Maximu Std.de C.V Skewnes Ex. Withi Betwee
n m m v s Kurtosi n S.D n S.D
s
4.071 4.135 1.2950 8.5145 2.238 0.549 0.34819 - 2.282 87491
5 2 4 79 0.9700 1
0

Interpretation
Table -2 shows the summary of the statistically using the observation for the variable
(leverage).Mean (4.0715) shows the average number of samples. The standard deviation of high
result (87491) shows that the date is less reliable and the data with low standard deviation
(2.2821) shows that the data is more reliable. If the value is smaller than the difference between
the mean value the hypothesis is more supported and if the standard deviation is greater than the
difference between the mean value so it not support the hypothesis. Coefficient of variation (CV)
0.54979 is define as the ratio of standard deviation to the mean.

Table -3 Summary Statistics, using the observations for the variable 'STOCKRETURNS'
Mean Media Minimu Maximu Std.de C.V Skewnes Ex. Withi Betwee
n m m v s Kurtosi n S.D n S.D
s
8.910 8.900 0.74500 26.475 6.656 0.747 1.2055 1.4349 6.919 2.1388
0 0 5 08 6

Interpretation
Table -3 shows the summary of the statistically using the observation for the variable (Stock
returns).Mean shows the average number of samples in the market the value of mean is (8.9100)
in the above model. The standard deviation of high result (6.9196) shows that the date is less
reliable and the data with low standard deviation (2.1388) shows that the data is more reliable. If
the value is smaller than the difference between the mean values the hypothesis is more
supported and if the standard deviation is greater than the difference between the mean value so
it not supported the hypothesis. Coefficient of variation (CV) 0.74708 is defined as the ratio of
standard deviation to the mean.

Fixed-effects model
Table -4
Coefficient Std. Error T-statistics P-value
Leverage -4.38625 7.08352 -0.6192 0.54962
Market size -6.2704 2.14832 -2.9187 0.01533

Interpretation
Table -4 shows the coefficient between the dependent variable and independent variable.
Coefficient shows the relationship between the two variables in which the stock returns is the
dependent variable and the leverage and the market size are the independent variables.

There is the negative relationship between leverage and stock returns with t value - 0.6192 with p
value 0.54962 which show that this relationship is insignificant and stock returns and the market
size has also negative relationship with stock returns with p value 0.01533, which shows that this
negative relationship is significant.

The value of R2 is 0.501805 that almost 50% of variation in dependent variable is due to the
mentioned independent variables. F-statistic shows the value 0.104609 with p value 0.901649

F statistics shows the significance of the whole model. The result suggests that the overall model
is not significant.

Pooled OLS model

ORDINARY LEAST SQUARE
Table -5
Coefficient Std error T-statistic p-value

Constant 19.0212 3.79230 5.016 0.00030

leverage -5.04810 6.12936 -0.824 0.42624

Market size -6.44483 1.92971 -3.340 0.00589

Interpretation
The ordinary least square regression estimates the coefficient of the regression model.

The coefficient regression model used to explain the relationship between the leverage and
market size which is independent variables and the stock returns is the dependent variable among
the three variables. The coefficient of determination R2 for the model is (0.501805) for the time
series and R2 of 0.5 and above is said to be good and is acceptable.

The value of R2 (0.501805) shows that the independent variable leverage and market size explain
the 51% of total variation in stock returns and the remaining of 49% of variation is explained by
other factors not included in the model given above.

Results
Modigliani miller (1958) stated that when leverage increases the return on stock increases. When
the market price of an agencys ability for raising funds if need, the negative relationship of
returns and that of leverage occurs Myers (1977). Chai and Zhang (2010) stated that when
leverage increases then the expected future return of the firm will also increases. Hamada (1972),
Bhandari (1988), Dhaliwal (2006) demonstrate that with increase in leverage return also
increases.

The current work suggest a negative relationship between leverage and stock return so the
current work will reject the hypothesis of positive relationship between leverage and stock
returns.

A shareholder who purchases normal shares expects returns as profit installment and capital gain.
And shareholder who purchases corporate securities expects consistent returns as interest
installments Frimpong (2010).

The current work shows the positive relationship between market size and stock returns. So the
current work will accept the hypothesis of positive relationship between size and stock returns.
 CHAPTER -5
V. Conclusion