Effect of Leverage on Expected Stock Returns and Size of the Firm

1. IOBM
Effect of Leverage on
Expected Stock Returns
and Size of the Firm
By: Ambreen Qadri, Amina Hassan, Aakash
Kumar and Faizan Ahmed
4/30/2013
Presented to: Sir Jamal Zubairi (HoD Finance)

2. 2
Contents
Abstract.........................................................................................................................................................3
Introduction ..................................................................................................................................................3
Literature Review..........................................................................................................................................4
Variable Description......................................................................................................................................6
Methodology and Data.................................................................................................................................6
Hypothesis.....................................................................................................................................................7
Statistical Tools .............................................................................................................................................7
Results...........................................................................................................................................................8
Conclusion and Recommendations ............................................................................................................11
Bibliography ................................................................................................................................................12

3. 3
Abstract
Leverage is the key determinant of performance of a company. It is financial manager’s prime duty to
determine optimum portion of leverage so that desired results are achieved. This paper investigates
how leverage of a firm classified in KSE100 index affects expected stock returns and the size of the firm.
Value of Market equity was taken as proxy of size of the firm and Expected stock returns were measured
by earning to price ratio. Secondary analysis was also undertaken to see the impact of leverage on Book
to Market Equity. The motive of this research was to test empirically whether there is an effect of
leverage on mentioned variables and whether the finance theory is applicable in Pakistani Industries. In
this article linear regression is used to test the significance of impact on the variables. The conclusions
derived will be used to provide recommendations for further studies.
Introduction
From shareholders point of view, leverage is a major concern for them because it increases the claims
on the operating profit. Hence, profit available for the distribution as dividends reduces. While leverage
increases claims on the profit, it is also one the major determinants of profit. Financial theory states that
as leverage of firm increases, earnings increases hence increase in shareholders wealth. But is it true in
Pakistani Market? This will be evident from the empirical results.
Leverage can be classified in two types. Operational leverage is the portion of fixed cost in total
operating cost. A high operational leverage means high portion of fixed cost. A high degree of operating
leverage means, small change in sales brings about a large change in operating profit. Having significant
advantage associated with high operating leverage, there is risk too. A small in sales may bring a large
decline in net profit too. Other type is financial leverage which is associated with the debt. A high
financial leverage means, firms operations and assets are highly debt financed. High degree of financial
leverage means a small change in operating profit will bring a higher change in Net Profit.
The firsthand findings are based on historical data collected from different companies which are listed in
KSE100 and KSE30. The main objective of this research is to see whether leverage has significant impact
on Size of the firm and average stock returns. And to see whether financial theories are applicable in
Pakistani industries.
Further in the article includes Literature review in which other related articles were studied to support
the research objective of this article. After that Methodology and data, variables, Hypothesis. Statistical
tools used in the article, following with Empirical results and analysis of the findings. In the end article
will be concluded with findings and further recommendations to improve the model.

4. 4
Literature Review
Over the time leverage of a firm has shown varying affects on the performance of the company
therefore the variations in the firm’s profits in lieu of its operating and financial leverage has
received considerable attention in the financial world.It has been affected by various factors
including the economic conditions and the level of business risk faced by the company.Raymar
1991 concluded that the leverage is negatively related to the level of business risk. While Lev
(1974) postulated a positive relationship between the level of business risk and operating
leverage. Other factors the level of investment opportunities, the level of sustainable cash flows
and ability to diversify has been associated with low levels of leverage (Jensen 1986).
Hens and Steude (2006) examined the effect of financial leverage of the firm on the leverage
effect in financial markets through an experimental study It is observed that the firm’s capital
structure does not affect the firms leverage. To determine the effectiveness of this theory the
researchers employed stock markets which had no leverage in the asset under consideration as
the variables. The investors were required to invest a certain sum of imaginary money in the
different stock markets and some specified assets. Researchers illustrated figures in order to
give a general overview of the data of the experiment of the time series of the dividend process
and the traded stock prices. For illustrative purpose the figures also contain the plots of the log
returns and the liquidity for all markets. For all four markets i.e. price series, dividend series,
log return and liquidity, a leverage effect at a significance level of 5% was observed. For the
four markets the correlations of lag one, L(1), are: -0.26 (0.0158), -0.44 (0.0000), -0.52 (0.0000),
and -0.39 (0.0026). All four markets are negative and statistically significant. So although the
capital structure of the underlying firm never changes, a leverage effect in traded asset prices
was observed.
Pachori and Totala (2012) studied the influence of financial leverage on shareholders’ return
and market capitalization of automotive cluster companies of Pithampur, Madhya Pradesh,
India. Researchers used the data from 2006 till 2010 to find out whether there is a significant
influence of financial leverage on shareholders return and market capitalization. The dependent
variables are shareholders’ return and market capitalization while the independent variable is
financial leverage. Linear simple regression was used as a tool to analyze the data by SPSS IBM-
19 version. The p values were (.181) for shareholders’ return and (-.221) for market
capitalization on significance level (.771) and (.721) respectively. So it was concluded that there
is no significant influence of financial leverage on shareholders’ return and market
capitalization. There may be other factors that nullify the impact of financial leverage such as
recession, competition and government policy.

5. 5
Chung 1989 empirically analysed the factors affecting the riskiness of firms by selecting a
sample of manufacturing and utility industries. The results indicated consumer demand and
operating and financial leverage as the key factors affecting a firm’s level of risk.
Lucy Huffman (1983) “Operating leverage, financial leverage and equity risk”, examined the
effect that financial and operating leverage has on a fixed capacity plus any liability on the
return on equity risk. A separate calculation other than the normal formula is used. The results
showed that the capacity decision is firms own decision and this decision reduce the effect on
risk of equity of increasing debt or overall business risk
Gahlon and Gentry (1982)” On the Relationship between Systematic Risk and the Degrees of
Operating and Financial leverage”, in their paper discuss that degrees of operating and financial
Leverage and how they are the determinates of the systematic risk of a security. By employing
variables degree of financial leverage and degree of operating level leverage, through empirical
analysis Gahlon and Gentry conclude that the variability of revenue as well as the sensitivity of
cash flows to the macroeconomic environment also affects the systematic risk of a security. By
estimating the beta through the model it was concluded that degree of operating and financial
leverage represents risk of an asset. Whereas the degree of financial and operating leverage is
the determinant of beta which would influence the systematic risk and value of the firm.
Mandelker and Rhee (1984) empirically analyzed the relationship between DFL, DOL and beta
where the results suggested that the degree of financial and operating leverage lead to
variations in the portfolio beta
Mseddi and Abid (2004) examined the relationship between the value of a firm and the level of
risk faced by a company in USA. For the period 1995 to 1999 using the panel data approach of
403 non financial firms and by estimating DOL and DFL.It was concluded that both financial and
operating risk have a significant positive impact on company value. The return generated by a
firm is positively determined by the level of DOL and DFL.
Larry et al. (1995) studied the relationship between leverage and growth rate in USA for a
period of 20 years by employing the ordinary least square method. The results indicated an
inverse relationship between the company’s growth rate and leverage. Companies facing high
level of debts and lower perceived market value supported the results. However companies
with considerable profits displayed negligible or no adverse effect of leverage on growth of
companies
The degree of financial and operating leverage of a firm may individually or as a total leverage influence
the earning per share of a firm. It causes volatility in the firm’s profits affecting the dividends received by
shareholders. Leverage also affects the indebtedness of a company bringing it under the scrutiny of
creditors thereby affecting the firm’s value.

6. 6
Variable Description
In this article we used six variables to find out the empirical results. Six variables are degree of operating
leverage, degree of financial leverage, degree of total leverage, Market Equity, Earnings to Price ratio
and Book equity to market equity ratio. These variables are used in our regression model to identify the
relationship between the variables and how significant the impacts are.
Degree of Operating Leverage is type of a ratio which summarizes the effect upon operating profit due
to change in sales. As fixed cost rises DOL rises. Degree of Financial Leverage is same type of ratio,
which summarizes the effect upon net profit due to change in operating profit. A high degree means
magnified effect on operating profit, hence higher change in net profit. A small increase in sales may
bring about higher change in profit and ultimately earnings left for shareholders. DOL is calculated by
percentage change in EBIT, divided by, percentage in Sales. DFL is calculated by change in EAIT; divided
by, change in EBIT. Degree of Total Leverage is the combined effect of both the leverages on earning per
share due to change in sales. These three variables are independent variables of our regression model.
Market Equity is measured by market price/share into number of outstanding shares in the market.
Market equity differs from book equity because books doesn't take account the future value of growth
opportunities.
Earning to Price Ratio is also the inverse of P/E ratio; it helps us to decide in process of stock valuation.
It can also help us to determine the expected growth of the firm.
Book to Market Equity Ratio is used to measure the value of the stock. If value is more than 1, than
stock is said to be undervalued and if less than 1 then it is overvalued.
Methodology and Data
In order to find empirical results, we will make regression model to test different hypotheses. By
merging all the data collected we will run regression command by putting one dependent variable
against 3 independent variables. From the output we will interpret beta coefficient to see the
relationship between the variables. R-square will be analyzed to see whether our model was successful
enough to explain the variable in the data. P-value will determine the significance of the independent
variable.
Data from the model was extracted from Annual reports of the company and missing data was
recovered from archives of SBP. SBP publishes a document called ‘Balance Sheet Analysis of Non-
Financial listed Companies ‘. From KSE100 12 companies were chosen to run the model. We tried to
collect 12 recent observations, 2000-2012, but some company’s data was missing. So we increased the
number of companies so that sufficient data is available to run the model. The companies we chose are
Lucky Cement, Pakistan State Oil, Pakistan Tobacco Ltd, Unilever Pakistan, Nestle Pakistan, Fauji
Fertilizer, Fauji Cement, Attok Petroleum, Engro Corporation, DG Khan Cement and Dewan Textiles.
Data collected from these companies is attached in the annexure.

7. 7
Hypothesis
Our research main objective is to see whether Leverage, measured by DOL, DFL and DTL, has a
significant impact on Market Capitalization, Average stock returns and BE/ME ratio in the Pakistani
Industry. In order to achieve the motive we tested three hypotheses:
(1) H0: Leverage of the firm does not affect Market Capitalization of the companies listed in Karachi
Stock Exchange.
(2) H0: Leverage of the firm does not affect Average stock returns of the companies listed in Karachi
Stock Exchange.
(3) H0: Leverage of the firm does not affect Book to Market Equity Ratio of the companies listed in
Karachi Stock Exchange.
We ran regression model on the compiled data of different companies listed in KSE100 index. The data
was collected from 2000 to 2012, depending on availability and information disclosure. Three
regressions created are:
  DTLDFLDOLME 3210
  DTLDFLDOLPE 3210
/
  DTLDFLDOLMEBE 3210
/
Where
DTL = Degree of Total Leverage
DOL = Degree of Operating Leverage
DFL = Degree of Financial Leverage
ME = Market Capitalization measured by Market Price into Outstanding Shares
PE / = Average Stock Returns measured by Earnings/share divided by Price
MEBE / = Book to Market Equity Ratio
 = the error term with zero mean and constant variance
Statistical Tools
SPSS 17.0 was used to analyze the data and create regression model. This software is extensive platform
to analyze data. This software can import data from any form of file and make it useful to analyze. It
helps to generate reports in tabular form, statistical analysis and descriptive statistics. The command
used to run the regression was:
Analyze Regression Linear.

8. 8
Results
H0: Leverage of the firm does not affect Market Capitalization of the companies listed in Karachi Stock
Exchange.
Model Summary
Model R R Square
Adjusted R
Square
Std. Error of the
Estimate
1 .035
a
.001 -.027 1.668653693433
E10
a. Predictors: (Constant), DTL , DOL, DFL
Coefficients
Model
Unstandardized Coefficients
Standardized
Coefficients
t Sig.B Std. Error Beta
1 (Constant) 4.711E9 1.597E9 2.950 .004
DOL 130874.698 476453.239 .026 .275 .784
DFL -2303372.624 5.871E7 -.010 -.039 .969
DTL -26095.247 204004.530 -.032 -.128 .898
a. Dependent Variable: ME
The analysis based on 112 observations shows a positive relationship between degree of operating
leverage and Market Capitalization. P-value associated with t-statistics is very large, signifying that DOL
has no significant impact on Market Capitalization. Degree of financial leverage is negatively related to
Market Capitalization and does not hold a significant impact on Market Capitalization. As DFL effects
negatively, degree of total leverage also has a negative relationship with Marker Capitalization and has
insignificant effect. The model has very low R-square value which means model was not able to explain
the variance in dependent variable. There might be other suitable variables which can further improve
the model.

9. 9
H0: Leverage of the firm does not affect Average stock returns of the companies listed in Karachi Stock
Exchange.
Model Summary
Model R R Square
Adjusted R
Square
Std. Error of the
Estimate
1 .039
a
.002 -.026 1.016699725144
E0
a. Predictors: (Constant), DTL , DOL, DFL
Coefficients
Model
Unstandardized Coefficients
Standardized
Coefficients
t Sig.B Std. Error Beta
1 (Constant) -.015 .097 -.154 .878
DOL -1.146E-5 .000 -.038 -.395 .694
DFL -9.058E-5 .004 -.006 -.025 .980
DTL 1.363E-7 .000 .003 .011 .991
a. Dependent Variable: E to P
The above results show a negative relationship between degree of operating leverage and Average stock
returns. P-value associated with t-statistics is very large, signifying that DOL has no significant impact on
E to P ratio. Degree of financial leverage is positively related to P to E ratio and does not hold a
significant impact on P to E ratio. As DFL and DOL both affect negatively, degree of total leverage has a
positive relationship with Average stock returns and has insignificant effect. The model has very low R-
square value which means model was not able to explain the variance in dependent variable. There
might be other suitable variables which can further improve the model.

10. 10
H0: Leverage of the firm does not affect Book to Market Equity Ratio of the companies listed in Karachi
Stock Exchange.
Model Summary
Model R R Square
Adjusted R
Square
Std. Error of the
Estimate
1 .102
a
.010 -.017 .917541922580
a. Predictors: (Constant), DTL , DOL, DFL
Coefficients
Model
Unstandardized Coefficients
Standardized
Coefficients
t Sig.B Std. Error Beta
1 (Constant) .767 .088 8.731 .000
DOL -2.185E-5 .000 -.080 -.834 .406
DFL .000 .003 -.048 -.193 .847
DTL -4.669E-6 .000 -.104 -.416 .678
a. Dependent Variable: BE/ME
The above results show a negative relationship between degree of operating leverage and Book to
Market Equity ratio. P-value associated with t-statistics is very large, signifying that DOL has no
significant impact on BE to ME ratio. Degree of financial leverage is positively related to P to E ratio and
does not hold a significant impact on P to E ratio. As DOL both affects negatively, degree of total
leverage has a negative relationship with Average stock returns and has insignificant effect. The model
has very low R-square value which means model was not able to explain the variance in dependent
variable. There might be other suitable variables which can further improve the model.

11. 11
Conclusion and Recommendations
Our model used 12 companies’ data to create a regression model to see impact of total leverage on Size
of the firm measured by Market Capitalization and Expected Stock Returns measured by Earnings to
price ratio. The data gathered was from 2000 to 2012. We have concluded that Pakistani Market does
not follow financial theories. Leverage has insignificant impact on all three subject variables which are
Size of Firm, expected returns on stock and Book to Equity Ratio. In our research we can conclude that
financial leverage reduces size of the firm, if the proxy is Market value of the equity. High financial
leverage may send negative signal to investors which may cause market price to fall, hence causing
market value to equity to fall. However, theory says to some extent if benefited from tax shield,
optimum portion of debt and equity may cause size of the firm to rise.
Expected Stock return is affected positively by firms’ total leverage. This is because leverage helps firms
to magnify their earnings and as evident from the above results it also reduces market price/share.
Lastly Total leverage has a negative impact on book equity to market equity ratio, which can be
explained also. As firms’ financial leverage increases, it causes book value to fall, hence ratio falls too.
Overall model was not strong. It is evident from very low R-square; our model was not successful to
explain the variance in the data. This can be because of lower observations or data is not stationery.
Another reason can be relationships of variables are weak in Pakistani Market. Pakistani Investors are
more speculative and Trading oriented. They might overlook or ignore the effect of internal operations
of the firm and may gamble due to price fluctuations. In Pakistan it is not the endogenous factors that
affect market and the firms but it’s the exogenous factor which cannot be controlled like law and order
situation. Sometimes model created based on Pakistani data may not be aligned with the prevailing
theories.
This model can be improved by some corrective measures. First of all this model can be more
explainable if only one company’s or industry’s data is used to generate results. This will make R-square
more acceptable. We can change the proxies of variables. In our case Size of the firm can be
transformed into Log (Size of the firm) so that large amounts can be denominated into smaller amounts.
Expected stock returns can also be measured by earning (available to shareholders) divided by number
of outstanding shares. Lastly Operational leverage and financial leverage can be measured by
operational fixed cost and interest fixed charge. Some of these steps may help us to increase the R-
square and create significant impact between the variables.

12. 12
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