Impact of Leverage on Stock Returns

By

Abdullah

NI-F09-BBA-0212

A thesis submitted in partial fulfillment of the requirements for the degree of Bachelor in

Business Administration to Newports Institute of Communications and

Economics, Karachi

Karachi, Pakistan. January, 2013

i
 Approval Sheet

This Thesis has been tested and assessed for partial fulfillment of for degree of Bachelors
of Business Administration. This study is approved by the examiner with grade of
________________________

___________________

Examiner

ii
 Certificate

This is to certify that Abdullah has completed the thesis entitled “Impact of Leverage on

Stock Returns” under my supervision. I allow him to submit his thesis for awarding of

BBA degree.

________________
Mr. Saif Ullah
(Thesis Supervisor)

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 ACKNOWLEDGEMENT

First of all I want to thank ALLAH Almighty for his blessings on me right through my
academic life. This comprehensive Research Report is my hard work, which is in front of
you. I worked so hard and spent months to complete this research report. I want to thanks
Sir Saifullah Malik for his guidance by which I could able to complete this research
report.

I want to thanks Miss Isma for her lead and advice that I could easily understand the
importance of this course of my BBA, which will help me to understand the relations of
financial factors and their studies.

I also want to thank you to my friends for their help in my research, without their time
and help I wouldn’t have completed important sections of thesis and make it this far. I
also want to make thanks to my beloved Parents and my brother who supported me in my
education and who have been so encouraging and kind.

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 ABSTRACT

Leverage comes from financial tool. It is necessary for corporation to calculate the

leverage if they need a decent comparison of their debt and equity side. Leverage

suggests many rewards for a firm to move forward and provide snap shots for their

shareholders side and outstanding loans side. Leverage is a key in evaluating a business.

Businesses need to decide however leveraged they need to be, and even in securities

(share) markets, leverage increases the potential loss / gain and risk for businesses. So

businesses have to look up prudently for their leverage side if they want a good bench

market. This Thesis is aimed to determine the impact of leverage on stock return. The

basic objective is to identify whether Debt to Equity Raito and Interest Coverage Ratio

have a significant or insignificant impact on Stock return. This thesis has two hypotheses

which was that (1)-Debt to Equity Ratio and Stock Returns has a positive relationship

between them. (2)-Interest Coverage Ratio and Stock Returns have a positive relationship

among them. Both hypotheses were accepted. Debt to Equity Ratio, Interest Coverage

Ratio which is Independent variable and Stock Returns which is Dependent variable are

studied in this thesis and Research Model of the thesis is based on these. The model used

in this thesis is like this SP= C+DER+ICR+E. SP stands for “Stock Price”, DER stand for

“Debt to Equity Ratio”, ICR stands for “Interest Coverage Ratio” and E stands for Error.

This thesis finds the negative significant impact of Debt to Equity Ratio on Stock return

which elucidate that highly leverage firms have less stock prices as compared to low

leverage firms. Interest Coverage ratio has a positive significant impact on Stock Prices.

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 Table of Contents

Serial No. Description Page No.

1 Acknowledgement IV
2 Abstract V
3 Tables VII
4 Figures VII
5 Chapter. 1 Introduction 1
1.1 Brief Introduction 1
1.2 Problem Statement 3
1.3 Back Ground of Study 4
1.4 Significance of Study 6
1.5 Objectives 7
1.6 Scheme of Study 7
6 Chapter. 2 Literature Review 8
2.1 Short Literature Review 8
2.2 Theoretical Framework 15
2.3 Hypothesis 16
7 Chapter. 3 Methodology 17
3.1 Research Methodology 17
3.2 Variables Under Study 17
3.3 Research Sample Size 19
3.4 Research Model. 19
8 Chapter. 4 Data Analysis 20
4.1 Descriptive Statistic 20
4.2 Graphs of SP, DER And ICR 21
4.3 Unit Root Test (Adf & Pp On Level And 1st Diff.) 23
4.4 Correlation 33
4.5 Estimate Equation 34
9 Chapter. 5 Conclusion & Suggestions 37
10 References 39

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 List of Figures & Tables

Table/Fig Description Page

. No. No.
1.1 Figure of KSE-100 Index Graph 5
4.1.1 Table of Common Sample Size Test Of SP, DER And ICR 20
4.2.1 Graph of Stock Price 21
4.2.2 Graph of Debt To Equity Ratio 22
4.2.3 Graph of Interest Coverage Ratio 23
4.3.A.1 Table of Augmented Dickey-Fuller Test on Level Of SP 24
4.3.A.2 Table of Augmented Dickey-Fuller Test on 1st Difference of SP 25
4.3.A.3 Table of Augmented Dickey-Fuller Test on Level of DER 26
4.3.A.4 Table of Augmented Dickey-Fuller Test on 1st Difference of DER 26
4.3.A.5 Table of Augmented Dickey-Fuller Test on Level of ICR 27
4.3.A.6 Table of Augmented Dickey-Fuller Test on 1st Difference of ICR 27
4.3.B.1 Table of Phillips-Perron Test on Level of SP 28
4.3.B.2 Table of Phillips-Perron Test on 1st Difference of SP 29
4.3.B.3 Table of Phillips-Perron Test on Level of DER 30
4.3.B.4 Table of Phillips-Perron Test on 1st Difference of DER 30
4.3.B.5 Table of Phillips-Perron Test on Level of ICR 31
4.3.B.6 Table of Phillips-Perron Test on 1st Difference of ICR 32
4.4.1 Table of Correlation Test of SP, DER And ICR 33
4.5.1 Table of Regression Analysis of SP, DER And ICR 34

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 CHAPTER – 1

INTRODUCTION
1.1 Brief Introduction
This thesis examines the impact of leverage on stock return. Leverage comes from

financial tool. It is necessary for corporation to calculate the leverage if they need a

decent comparison of their debt and equity side. Leverage suggests many rewards for a

firm to move forward and provide snap shots for their shareholders side and outstanding

loans side. Leverage works as a key factor in evaluating a business. Businesses need

to decide how much leveraged they need to be, and even in securities (share) markets,

leverage increases the potential loss / gain and risk for businesses. So businesses have to

look up prudently for their leverage side if they want a good bench market. There is

relationship between changeability of turnover and leverage and further the movements

of profitability. Company’s profits with high rate of leverage level represents the lower

rate of profitability for example if corporation don’t take the decisions and steps to

control the leverage then their profitability will be affecting by leverage however the

company’s profit level with low level of leverage results in higher profitability. In most

cases the results of leverage are used to grow the firm’s financial health and increase

earnings however it shouldn’t be accepted as a principle. It doesn’t mean that the

financial leverage shows only debt and equity side but it also shows the outflow of

interest expense and changeability of turnover. There are two intensive ways to find the

firm leverage, Debt-to-Equity ratio and Interest Coverage ratio. Debt-to-Equity ratio

indicates the shareholders cash (Equity Side) and debt (Borrowing Side) used to finance a

company’s fixed and current assets (Wikipedia). Borrowing cash is usually planning to

1
increase debt side. When a corporation borrows debt continuously, they are making a

picture that might increase the level of risk in the corporation. As a result there may be a

rise in interest rate and a few restrictions would be applied to the borrowing institutions.

Another part that would be suffering from the utilization of leverage is the worth of the

stock it may drop well considerably if the stock holders become involved. It looks that

leverage may be a sensible plan for an organization when interest rate are low however

it’s necessary to use leverage moderately to avoid some of these limitations. The second

intensive method is Interest coverage ratio, the next ratio to measure the leverage ratio of

a company. Basically with the help of this ratio we can find the exact and approximately

figure of interest which corporation is paying of his dazzling debt. If any company

generating the vast amount of cash from debt side to raise the funds for finance the

company’s cash flows, it means that company are paying the large amount of interest,

which is not acceptable for company’s financial health. The other side is equity; Share

holders’ equity is also referred to as owners. If corporations are taking the cash from

equity sides through issuance of shares and bonds then corporations have to pay them

reasonable returns (Dividends). If corporations do not pay the adequate returns than any

investor will never be ready to invest their investments in that firm’s security. The second

part of thesis is stock return. Stock return represents a relationship between dividend and

stock worth (better referred to as capital gain). Stock return is the amount which is return

to its shareholders. Shareholders are the indirect owners of a company. They possess

company’s ownership. If a corporation makes higher profit and positive cash flows then

their shares price will rise in the market and their return will also be higher than other

company’s share return. This topic is important and essential in Pakistan because it is

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major problem with most of the firms of the world. This study will provide the evidence

how leverage impacts the stock return if any company’s stock return is higher in stock

market, every investor will want to invest in that stock of the company to maximize their

returns.

1.2 Problem Statement

This research is based on KSE-100 index listed companies both financial and non-

financial sector and their Stock returns. Leverage is important for corporations because

leverage tells that how much debt and equity is involved in firm’s assets and also tell that

how much risk is involved in that company. If it is risky business any investor will not

invest their investment on that business because there is risk of loss involve and investors

have risk averse mindset, may be that business will default in future and that risk, risk of

loss will affect the profitability of business. Most investors are risks averse they want to

minimize risk on their investments as much as possible while requiring maximum

returns. When investors are not willing to invest in risky businesses, the firm might face

an investment crunch in the future and because of less investment in the firm the

company would not be able to generate good returns for their equity holders. This

research will find the debt to equity ratio and interest coverage ratio relation on stock

returns. If company’s leverage ratios are high, how they impact the shareholders returns

and also profitability.

“To study the impact of leverage on stock returns”

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1.3Background of Study

Karachi stock exchange (KSE) was founded in 1947. It is the major and most liquor

exchange in Islamic republic of Pakistan. It was integrated on Tenth of March 1949. At

the start 5 firms were listed with a paid capital of thirty seven (37) million rupees but on 8

December 2009, 654 companies were listed with a marketplace capitalization of Eight (8)

trillion rupees. After that Karachi Stock Exchange introduced the KSE-100 index on

November 1991. At initial KSE-100 index was launched with a base of 1000 points but it

had matured to 1,770 points on 2001. KSE-100 index was working very precisely and

capture the half market and their points were grown and reached at 12,285 on February,

2007. This was a great deal for KSE however on November 7, 2012 KSE-100 index

created the record of maximum level of 16,218 points and now KSE measured as a

budding market in Asia. The main aim of KSE-100 index is trading the share, it is a share

index and it is working as a standard (benchmark). KSE-100 index evaluate the prices of

shares on the Karachi Stock Exchange over a period. Those companies are listed in KSE-

100 index that have maximum marketplace capitalization and further those companies are

also listed who have maximum marketplace capitalization from each sector. So both

sector and corporation are listed in KSE-100 index. After introducing the KSE-100 index,

KSE intend to introduce the new path for shares and that was KSE-30 index.

KSE-30 index came up with 30 companies and launched on September 1, 2006 with the

base value of 10,000 points. On 13 July, 2007 KSE-30 crossed its peak ever rank of

17,162 points. Public investors share are traded in KSE-30 index. The main features on

which KSE-30 index works and differentiate from other indices are:

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1. The trading of shares in KSE-30 index based on Free-Float concept. Only those shares

will be count which was traded in market through public. 2. Like other indices in KSE,

they represent the total return of marketplace capitalization. They are not reduced the

specific amount (cash or bonus) for dividend. Whereas KSE-30 index is alternative of

this concept, KSE-30 index reduced the specific amount (cash or bonus) for dividend.

KMI-30 index is a joint venture of Karachi Stock Exchange and Meezan Limited.

30 companies were qualified for KMI-30 list. The operation of KMI-30 index was

launched in September 2008 and June 30, 2008 was a base period for this Islamic index.

The main objective of Karachi stock exchange-Meezan Index is to undertaking an

estimate for measure the act of sharia compliment equity investment. In addition trailing

performance of Islamic law tribute equities, its construction can increase capitalist faith

and improve their sharing. Karachi-Meezan Index uses the methodology of Free-Float

capitalization for calculation of stocks.

KSE-100 Points
16000
14000
12000
10000
KSE-100 Points
8000
6000
4000
2000
0
2006 2007 2008 2009 2010 2011

Fig 1.1: Graph of KSE-100

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This is snap shot of KSE-100 index graph. Basically this graph shows the upward and

downward of Karachi Stock Exchange. During these years exclude 2007-2008 there is

minor movement of points in KSE. X-AXIS shows the financial year and Y-AXIS shows

the points of Karachi stock exchange. The graph represents time line of Karachi stock

exchange in annually basis.

1.4 Significance of Study

This research is based on KSE-100 index Firms both financial and Non-financial. This

study provides the facts how leverage ratio of a firm impacts on their stock return. This

study provides the evidence why leverage ratio is important for Pakistani firms, because

leverage plays vital role in firm’s profitability and is a key player in deciding the

company incline or decline. This research will indicate the relationship between

independent variables Debt/Equity ratio, interest Coverage ratio and dependent variable

Stock Return. The study of this thesis will also provide that why calculation of leverage is

essential and important for small and risk adverse investors, if they want good returns of

their investments.

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1.5 Objectives

This research paper is focused to examine the following points which are given below:

1. To establish the impact of leverage on stock returns.

2. To study why leverage ratio is important for Firm.

3. To study how debt effects on capital structure of a company.

4. To determine that how Debt/Equity ratio impacts the stock return.

5. To determine that how Interest coverage ratio impacts the stock return.

1.6 Scheme of Study

The formation of the thesis is as follows: Brief introduction, background study, problem

statement, and objectives of thesis were covered in chapter1. Chapter 2 will reflect the

literature review, theoretical framework and hypothesis of research. After introduction of

the research and related literature review; Methodology, sample size, research model and

definition of variables will studied in chapter 3. Data of Variables (Debt/Equity Ratio,

Interest Coverage Ratio and Stock Return), Results and their regression will explicate in

chapter 4 and last conclusion will be mentioned in chapter 5.

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 CHAPTER – 2

LITERATURE REVIEW

2.1 Short Literature Review

Leverage works as a scale in which there need to be a balance on both debt and equity

side ideally but usually firm’s keep one side either debt or equity heavier than the other to

run their operations efficiently. There is no hard and fast rule for firms to manage this

ideal position, companies adjust and varies their debt and equity side as per their

requirement to maximize their profitability. This profitability is dependent on leverage

that is the debt and equity the firm has obtained for the specific period. Most of the

companies smartly utilize leverage to maximize profitability which will give back high

returns to the shareholders and it will also increase the interest of new investors into the

company. Earlier studies contained several definitions for returns and leverage. The Fama

and French (1992) research was based on Sharpe-Lintner-Black model which represented

that there is a simple positive relations in between market return and average return.

Keeping this model as base Fama and French (1992) conducted their research and came

up with the results which concluded that their test does not support the statement

presented by Sharpe-Lintner-Black model or SLB model and differ from the model of the

research.

Koss (2011) claimed that there is no relation between stock returns and total leverage.

Whereas Poutiainen and Zytomierski (2010) studies have showed there exist a significant

relationship between leverage and stock return. Firms in stability possess higher short-

term debt or lower long-term debts are riskier firms and earn higher expected returns

8
(Kose, 2011). Where if the firm with higher amount of short term debt will more likely to

be riskier but the expected return could not be higher because they have to pay off the

short term debt which will be utilized by available cash and there would be little or no

cash to pay back the investors or stock holders.

Muradoglu and Sivaprasad (2008) claimed that there is an optimistic (positive)

relationship among leverage and stock returns. This statement when compared with other

researches available, the claim of Muradoglu and Sivaprasad (2008) proved the upper

mentioned statement from (Kose, 2011) to be rejected. Muradoglu and Sivaprasad (2008)

conclude that relationship in the entire non-financial sector indicates that leverage have a

unconstructive (negative) relationship with stock prices in the whole sample. Muradoglu

and Sivaprasad (2008) found that Stock Prices cover insignificant relationship with

leverage in the Industrial sectors. The study of Muradoglu and Sivaprasad (2008)

however was theoretically incorrect as the financial sector are highly based on leverage

whereas the non-financial sector will possibly not have negative relation or will have

very less negative relationship with stock return. Muradoglu and Sivaprasad (2008) study

when compared with Dimitrov and Jain (2005) differs entirely in the results as Dimitrov

and Jain (2005) claimed that leverage and stock returns have a negative relationship.

They revise changes in leverage steps and demonstrate that Stock return and leverage are

negatively connected to current and future adjusted returns.

Aivazian, Ge and Qiu (2003) found that profitability and leverage are negatively related

to each other. It also shows that when a firm is highly leveraged they would be left with

little or no investment opportunity in the long run. Aivazian, Ge and Qiu (2003) research

9
is similar to Dimitrov and Jain (2005) research where both the researchers claimed to

have a negative relationship between profitability and leverage.

Korteweg (2004)Concluded that the factor used in the research is leverage and it is of

highly levered companies are too low to find some supporting evidence from their study

where they used simple trading strategy involving firms with extreme levels of financial

leverage. Further stated that low leverage firm has higher returns and highly leverage has

low stock returns. Whereas Bhatti, Majeed, Rehman and Khan (2012) suggested that

even after significant effort on the government organization which have constant or less

movement in the market carries a high level of leverage which raises a high level of

systematic risk. It is important for high instability in the stock prices of those companies

traded on Karachi Stock Exchange to maintain a balanced level of leverage with equity.

They suggested that the debt-to- equity ratio should be brought in line with worldwide

norms, i.e. 40:60. This study also recommends that the private sector should maintain a

debt equity ratio with international norms which is 40:60 if they want good equity side in

their balance sheet.

Shah (2010) evidently claimed that judicial effectiveness increases leverage ratios of

huge corporations and reduces leverage ratios of tiny corporations which is suggestion so

as to creditors, transform credit away from tiny corporations to huge corporations in the

attendance of incompetent judicial system. This in accordance with Korteweg (2004)

research and is accurately stated with the evidence that small firms have likely low

leverage when compared to large firms. The cash flows to the corporations from money

owing financing are most excellent represent by the volume leverage. Corporations with

lesser leverage will be apparent as fewer risky due to lesser sorrow risk and have the

10
benefit of higher returns. Similarly Adami, Gough, Muradoglu and Sivaprasad (2010)

claimed in their study regarding low leveraged firms to be perceived as less risky this is a

valid statement in accordance with Shah (2010) study. Adami, Gough, Muradoglu and

Sivaprasad (2010) concluded the results which designate that returns contain a negative,

although little, relative among leverage in different models which they used for

estimation. The results point out that returns reduce in leverage. Which indicates that if

the company is highly leveraged their returns will decrease similarly if the company is

low leveraged their returns will increase.

Dhaliwal et al. (2006) disputed that company level taxes decline the result of leverage on

the price of equity. The statement is accepted because taxes reduce the crash of leverage

on price of equity. Dhaliwal et al. (2006) Found that the result of the private tax price on

the relationship between leverage and the cost of equity is usually positive and

considerable. Further argued that capital arrangement decisions are linked to the

corporation specific size of the business tax profit of debt and the personal tax price

connected with debt.

Aydemir, Gallmeyer and Hollifield (2006) in their research stated that inside in financial

system with additional sensible difference in interest rates and the price of risk, there is

important difference in stock return instability at the market and corporation level. In

such financial system, monetary leverage has slight cause on the dynamics of stock return

instability at the market level. Though monetary leverage depends on the mass of

corporation in respect with the change in market dynamics. They also argued that when

stock prices go down monetary leverage increases, leading to boost in stock return

11
instability. The dynamics of stock instability are generally ambitious by the shifting

market situation at the market point.

The research of Figlewski and Wang (2000) and Aydemir, Gallmeyer and Hollifield

(2006) are related as both the studies have mutual claim of stock instability where

Figlewski and Wang (2000) stated in their research the volatility of stock prices and with

comparison of leverage and influenced that if the leverage of a firm increases then the

stock prices would also increase this is because of the risk factor involved between these

two variables. They also concluded in their research that a decline in the market value of

company’s equity would be caused by leverage it will create a negative impact on the

firm’s equity. Figlewski and Wang (2000) also stated that significant leverage impact

could be seen only when some other variable is kept constant. Their research also showed

that leveraged also impacts permanent change in volatility. The pure impact of leverage is

visible on individual stock return where other company’s stock returns are constant.

Identical results were found in the research of Poutiainen and Zytomierski (2010) where

they pointed out that theoretical finances is claimed as sources of stock return risk and on

highly levered firm risk is involved and therefore indicates that the higher the risk is the

higher the return. Poutiainen and Zytomierski (2010) claimed a positive relationship

between leverage and stock return and also claimed that when one variable will move in

upward direction the other variable will also move positively towards upward direction

but when they applied test to their research they found that their regression results are

opposite to their hypothesis and thus leads to rejection of their claim.

Obreja (2006) argued that Leveraged corporations are riskier for the reason that they are

wedged with too much capital, throughout times of small output. Obreja (2006) presented

12
that leveraged corporations are likely to keep up superior stocks of capital throughout

times of small output, for the reason that they can’t size downward output without raising

the possibility of failure to pay.

Soomro, Bhutto and Abbas (2012) and Chugtai, Zamir, Riaz and Khan (2012) researches

resulted in similar manner where negative impact was noticed on stock prices. Soomro,

Bhutto and Abbas (2012) were based on 71 companies from the non-financial sector of

KSE-100 index. Their research resulted that debt to equity has a negative impact on stock

prices and they further suggested that every firm should maintain an optimal level of debt

to increase share price which will lead to the goal of wealth maximization of

shareholders. Whereas Chugtai, Zamir, Riaz and Khan (2012) presented that there is no

exist no significant impact on stock return of a company. This also indicates that capital

structure has no significant impact on determining stock return of a firm. Although Cai

and Zhang (2010) documented that financial leverage ratio and stock price have a

negative and significant relationship between them. They found a strong negative impact

for those firms that have high leverage ratio, more chance for default. Cai and Zhang

(2010) argued that extremely leverage firms have less future investments as compared to

minor leveraged firms.

Pachori and Totala (2012) said higher financial leverage allows the shareholders to get

higher returns on equity, but they are risk taker and they are taking a risk of default. They

found a negative relationship between leverage and stock returns and additional

concluded that there are many other non-quantitative factors which may cause to nullify

the impact of leverage on stock return. Their research’s claim was similar to Poutiainen

and Zytomierski (2010) and Figlewski and Wang (2000) where both considered high risk

13
and high return concept but Pachori and Totala (2012) result was different from these

studies and was similar to Soomro, Bhutto and Abbas (2012) and Chugtai, Zamir, Riaz

and Khan (2012) research where a negative impact of leverage to stock prices were

found.

Yang and Tsatsaronis (2012) according to banking sector, found the positive relation of

leverage with stock returns. It means if leverage ratio of bank will increase their impact

on stock returns will be positive (stock prices will increase) and further they argued that

the up and down in stock returns of banks based on their business cycle. In addition they

said those banks that have higher leverage ratio need a higher cost of equity to reduce the

impact of debt (equal the debt/Equity side) (Yang &Tsatsaronis, 2012).

The research paper of Huang (2009) investigated the volatility of stock market on Asian

stocks. The markets which were under investigations were NASDAQ, stock market of

South Korea and Taiwan. The result drawn from conducting the research revealed

significant positive impact for stock returns. While there was a negative correlation found

among all three stock exchanges between returns and volatility. The impact of leverage

was only significant in Taiwanese stock market.

Sahalia, Fan and Li (2012) argued that leverage effects and possess a negative bond with

stock return and stock prices instability. Additional claim that the variance or the

instability on stock prices is because of high volatility in stock prices. The mystery lies in

reality that there is no relationship between the shares and leverage.

14
2.2Theoratical Framework

The theoretical framework for this thesis represents the independent variables and

dependent variables and further shows the relation between the independent variables

towards the dependent variable. Theoretical framework will help to understand the

variables of thesis.

INDEPENDENT VARIABLES DEPENDENT VARIABLE

DEBT/EQUITY RATIO

STOCK RETURN

INT.COVERAGE RATIO

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2.3 Hypothesis

To analyze the impact of leverage on stock return, this research paper has two different

hypotheses in indication with the defined variables.

H1: Debt to equity ratio and Stock Return have a positive relationship between them.

H2: Interest coverage ratio and Stock Return have a positive relationship among them.

16
 CHAPTER – 3

METHODOLOGY

3.1 Research Methodology

The data sample of this thesis base on 100 Financial and non-financial firms which are

listed and authorized by KSE-100 index. This study required Debt/Equity ratio and

interest coverage ratio and stock Prices. The data gather from annual reports of KSE-100

listed companies’ official website and SBP website. Annually Data is utilized to calculate

the stock returns, Debt-to-Equity Ratio and Int. Coverage Ratio in this research. The data

examine and use for this research is secondary data. The duration of sample period range

is 3 years which starts from January, 2009 till December, 2011. EVIEWS software will

exercise to analyze the data of research. Correlation and regression test will be conduct

on research variables.

3.2Variables Under Study

Three Variables are taken in this research to find out the impact of leverage on stock

return which is given below;

3.2.1 Dependent Variable:

A: Stock Price:

Stock Price represents the amount which an individual invest in a company to gain its

ownership. There are many ways to calculate the stock Price of a firm but in this

research Stock Price has been calculated on daily basis of share price of firms. To

17
 calculate the daily share price of firm take an average of that share prices, which

would be the stock price of specific year and then take a LG (log) and after that for

taking LN (anti log) on that stock prices we would divide the log by 10 and then we

will able to convert the log into LN (Antilog).

Average (SP) = Log (Avg. SP)

Log (Avg. SP) / 10 = Ln (Avg. SP)

3.2.2 Independent Variables:

A: Debt/Equity Ratio:

The equity side in balance sheet shows the investment of shareholders into the

company while the debt side shows the loans undertaken by the company. To

calculate debt to equity ratio balance sheet is necessary through which we will get

short and long term loans which represents the actual debt of the company and from

equity common and preferred stocks plus reserves. The mathematical equation

through which D/E ratio calculates is shown below;

Debt to Equity Ratio = Total Debt / Total Equity

The breakup of the above formula is mentioned below;

Total Debt = Short Term Loans + Long Term Loans + current portion of long term loan

Total Equity = common + Preferred shareholders equity.

B: Interest coverage ratio:

A financial ratio used to resolve how easily and efficiently a debtor (company) pay

interest on dazzling debt. Income Statement is mandatory for Interest Coverage ratio

18
 calculation. Operating income comes after subtracting all the expenses from Gross

profit. In some firm’s income statement, operating income is written as earnings

before interest tax (EBIT). Interest expense is written as Finance cost. Interest

expense comes after EBIT. The formula used in this research is given below;

Interest Coverage Ratio = Operating Income / Interest Expense

3.3Sample Size

The sample size of the research is 300 which base on KSE-100 index listed firms (both

financial and Non-Financial) and their 3 years data “January, 2009 till December, 2011”.

But after some deduction the sample size of thesis data is 165. 55 firm both Financial and

Non-Financial of data is tested in this sample. The reason of deduction is unavailability

of data. Remaining 45 firm data is not available in their annual reports and SBP (data of

independent variables and dependent variable).

3.4 Research Model

To find the relation between independent variable and dependent variable this study will

examine the formula which mentioned below:

Y = C + X 1 + X2 + E

SP = C + DER + ICR + E

Where Y represents stock return “dependent variable” of research, C represents constant,

X1representsdebt to equity ratio and X2 represents interest coverage ratio which are the

“independent variables” of research and last E represents E

19
 CHAPTER – 4

DATA ANALYSIS

The thesis explores and analyzes descriptive Statistic, unit root test, correlation test and

estimate equation test to find out the impact of leverage on stock returns and further the

results of variables will classify the hypothesis whether it is accepted or rejected. These

tests are the basis of acceptance or rejection of hypothesis which was previously set in

this research the correlation test further explains the relationship among the variables and

shows their direction and movement with one another which either could be upward or

downward movement.

4.1Descriptive Statistics

The table 4.1 which is given below shows the results of different Statistical methods for

Independent and Dependent Variables.

SP DER ICR
 Mean -1.800911  0.823636  7.372667
 Median -1.723261  0.460000  2.150000
 Maximum -0.989901  4.060000  271.0000
 Minimum -3.687201  0.000000  0.020000
 Std. Dev.  0.439110  0.886653  24.21258
 Skewness -1.361766  1.576098  8.727936
 Kurtosis  5.894489  4.891001  89.87366
 Jarque-Bera  108.5954  92.89652  53980.71
 Probability  0.000000  0.000000  0.000000
 Sum -297.1503  135.9000  1216.490
 Sum Sq. Dev.  31.62209  128.9292  96144.82
 Observations  165  165  165
Table 4.1.1: Common Sample Size

20
The above table 4.1 common sample size shows the Mean, Median, Maximum and

Minimum value of Research Variables. The Probabilities of SP, DER and ICR can be

seen at 0.0000 respectively.

4.2 Graphs

4.2.1Dependent Variable:

Stock Prices:

-0.5

-1.0

-1.5

-2.0

-2.5

-3.0

-3.5

-4.0
25 50 75 100 125 150

SP

Fig 4.2.1: Graph of Stock Price

Above Figure shows the observations and values of KSE-100 index listed companies

both (Financial and Non-Financial) Stock Prices. These Stock Prices are based on

Average Annual Returns which show dynamics of 3 years. As we can see that the highest

stock return is -1.0 in 165 observations.

21
4.2.2Independent Variable:

Debt to Equity Ratio:

0
25 50 75 100 125 150

DER

Fig 4.2.2: Graph of Debt to Equity Ratio

The above figure is mentioning the debt to Equity Ratio of KSE-100 index listed

companies. X-axis shows the observations and Y-axis shows the value of D/E Ratio. The

highest value is 4.3 in 165 observations. These observations are based on 55 firms both

Financial and Non-Financial firm.

22
Interest Coverage Ratio:
280

240

200

160

120

80

40

0
25 50 75 100 125 150

ICR

Fig 4.2.3: Graph of Interest Coverage Ratio

The above Graph shows the Interest Coverage Ratio of KSE-100 index listed companies.

The highest values of interest coverage ratio meets at 277.55 firm interest coverage ratio

were included in this graph.

4.3Unit Root Test

Unit root test is the statistics test which shows the expansion of variables whether the

time series variable is non-stationary using auto regressive model and unit root, test the

Null hypothesis. If Null hypothesis rejected then Alternate hypothesis will accepted and

if Null is accepted then Alternate will rejected.

23
4.3. A) Augmented Dickey-Fuller:

ADF (Augmented Dickey-fuller) is subtest of Unit root. It is a time series sample test. It

is a version of Dickey-Fuller test and commonly this test is used for larger and more

complexities set of time series models and further Augmented Dickey-Fuller test

analyzes the Null hypothesis.

4.3. A.1Dependent Variable:

Stock Price:

The tables which are given below 1.1 and 1.2 are the ADF test on Level and 1st

Difference of Stock Price “SP”. These tables represent the probabilities of Stock Price on

Level test and 1st Difference test and further analyze the Null hypothesis whether it is

accepted or rejected.

Level:

Null Hypothesis: SP has a unit root

Exogenous: Constant
Lag Length: 3 (Automatic based on SIC, MAXLAG=13)

t-Statistic   Prob.*

Augmented Dickey-Fuller test statistic -3.941789  0.0022

*MacKinnon (1996) one-sided p-values.
Table 4.3.A.1: Augmented Dickey-fuller test on Level of SP

24
Interpretation:

The ADF on Level result shows that Stock Price does not has Unit root because the

Probability of Stock Price is 0.0022 comparing it with significance level it results less

than 0.05, hence Null hypothesis is rejected and Alternate Hypothesis is accepted.

1st Difference:

Null Hypothesis: D(SP) has a unit root

Exogenous: Constant
Lag Length: 2 (Automatic based on SIC, MAXLAG=13)

t-Statistic   Prob.*

Augmented Dickey-Fuller test statistic -11.90355  0.0000

*MacKinnon (1996) one-sided p-values.
Table 4.3.A.2: Augmented Dickey-Fuller on 1st Difference of SP

Interpretation:

The ADF on 1stDifferenceresult shows that Stock Price does not has Unit root because the

Probability of Stock Price is 0.0000 comparing it with significance level it results less

than 0.05, hence Null hypothesis is rejected and Alternate Hypothesis is accepted.

4.3. A.2Independent Variable:

Debt to Equity Ratio:

The tables which are given below 1.3 and 1.4 are the ADF test on Level and 1st

Difference of Debt to Equity Ratio “DER”. These tables represent the probabilities of

Debt to Equity Ratio on Level test and 1st Difference test and further analyze the Null

hypothesis whether it is accepted or rejected.

25
Level:

Null Hypothesis: DER has a unit root

Exogenous: Constant
Lag Length: 0 (Automatic based on SIC, MAXLAG=13)

t-Statistic   Prob.*

Augmented Dickey-Fuller test statistic -5.869217  0.0000

*MacKinnon (1996) one-sided p-values.
Table 4.3.A.3: Augmented Dickey-Fuller test on Level of DER

Interpretation:

The ADF on Level result shows that Debt to Equity Ratio does not has Unit root because

the Probability of Debt to Equity ratio is 0.0000 comparing it with significance level it

results less than 0.05, hence Null hypothesis is rejected and Alternate Hypothesis is

accepted.

1st Difference:

Null Hypothesis: D(DER) has a unit root

Exogenous: Constant
Lag Length: 2 (Automatic based on SIC, MAXLAG=13)

t-Statistic   Prob.*

Augmented Dickey-Fuller test statistic -11.29313  0.0000

*MacKinnon (1996) one-sided p-values.
Table 4.3.A.4: Augmented Dickey-Fuller test on 1st Difference of DER

Interpretation:

The ADF on 1st Difference result shows that Debt to Equity Ratio does not has Unit root

the because Probability of Debt to Equity Ratio is 0.0000 comparing it with significance

level it results less than 0.05, hence Null hypothesis is rejected and Alternate Hypothesis

is accepted.
26
Interest Coverage Ratio:

The tables which are given below 1.5 and 1.6 are the ADF test on Level and 1st

Difference of Interest Coverage Ratio “ICR”. These tables represent the probabilities of

Interest Coverage Ratio on Level test and 1 st Difference test and further analyze the Null

hypothesis whether it is accepted or rejected.

Level:

Null Hypothesis: ICR has a unit root

Exogenous: Constant
Lag Length: 2 (Automatic based on SIC, MAXLAG=13)

t-Statistic   Prob.*

Augmented Dickey-Fuller test statistic -4.272528  0.0007

*MacKinnon (1996) one-sided p-values.
Table 4.3.A.5: Augmented Dickey-Fuller test on Level of ICR

Interpretation:

The ADF on Level result shows that Interest Coverage Ratio does not has Unit root

because the Probability of Interest Coverage Ratio is 0.0007 comparing it with

significance level it results less than 0.05, hence Null hypothesis is rejected and Alternate

Hypothesis is accepted.

1st Difference:
Null Hypothesis: D(ICR) has a unit root
Exogenous: Constant
Lag Length: 1 (Automatic based on SIC, MAXLAG=13)

t-Statistic   Prob.*

Augmented Dickey-Fuller test statistic -17.98228  0.0000

*MacKinnon (1996) one-sided p-values.
Table 4.3.A.6: Augmented Dickey-Fuller test on 1st Difference of ICR

27
Interpretation:

The ADF on 1stDifferenceresult shows that Interest Coverage Ratio does not has Unit

root because the Probability of Interest Coverage Ratio is 0.0000 comparing it with

significance level it results less than 0.05, hence Null hypothesis is rejected and Alternate

Hypothesis is accepted.

4.3. B) Phillips Perron:

Phillips-Perron test is a sub-test of unit root. Phillips-Perron test used in time series data

analysis like Augmented Dickey-Fuller test used. Phillips-Perron test analyze the Null

hypothesis. Phillips-Perron test performs the inferior in infinite data samples.

4.3. B.1Dependent Variable:

Stock Price:

The tables which are given below 2.1 and 2.2 are the PP test on Level and 1 st Difference

of Stock Price “SP”. These tables represent the probabilities of Stock Price on Level test

and 1st Difference test and further analyze the Null hypothesis whether it is accepted or

rejected.

Level:
Null Hypothesis: SP has a unit root
Exogenous: Constant
Bandwidth: 9 (Newey-West using Bartlett kernel)

Adj. t-Stat   Prob.*

Phillips-Perron test statistic -5.551622  0.0000

*MacKinnon (1996) one-sided p-values.
Table 4.3.B.1: Phillips-Perron test on Level of SP

28
Interpretation:

The PP on Level result shows that Stock Price does not has Unit root because the

Probability of Stock Price is 0.0000 comparing it with significance level it results less

than 0.05, hence Null hypothesis is rejected and Alternate Hypothesis is accepted.

1st Difference:

Null Hypothesis: D(SP) has a unit root

Exogenous: Constant
Bandwidth: 62 (Newey-West using Bartlett kernel)

Adj. t-Stat   Prob.*

Phillips-Perron test statistic -29.57710  0.0001

*MacKinnon (1996) one-sided p-values.
Table 4.3.B.2: Phillips-Perron test on 1st Difference of SP

Interpretation:

The PP on 1stDifferenceresult shows that Stock Price does not has Unit root because the

Probability of Stock Price is 0.0001 comparing it with significance level it results less

than 0.05, hence Null hypothesis is rejected and Alternate Hypothesis is accepted.

4.3. B.2Dependent Variable:

Debt to Equity Ratio:

The tables which are given below 2.3 and 2.4 are the PP test on Level and 1 st Difference

of Debt to Equity Ratio “DER”. These tables represent the probabilities of Debt to Equity

Ratio on Level test and 1st Difference test and further analyze the Null hypothesis

whether it is accepted or rejected.

29
Level:

Null Hypothesis: DER has a unit root

Exogenous: Constant
Bandwidth: 6 (Newey-West using Bartlett kernel)

Adj. t-Stat   Prob.*

Phillips-Perron test statistic -5.746960  0.0000

*MacKinnon (1996) one-sided p-values.
Table 4.3.B.3: Phillips-Perron test on Level of DER

Interpretation:

The PP on Level result shows that Debt to Equity Ratio does not has Unit root because

the Probability of Debt to Equity Ratio is 0.0000 comparing it with significance level it

results less than 0.05, hence Null hypothesis is rejected and Alternate Hypothesis is

accepted.

1st Difference:

Null Hypothesis: D(DER) has a unit root

Exogenous: Constant
Bandwidth: 92 (Newey-West using Bartlett kernel)

Adj. t-Stat   Prob.*

Phillips-Perron test statistic -34.91238  0.0001

*MacKinnon (1996) one-sided p-values.
Table 4.3.B.4: Phillips-Perron test on 1st Difference of DER

Interpretation:

The PP on 1st Difference result shows that Debt to Equity Ratio does not has Unit root

because the Probability of Debt to Equity Ratio is 0.0001 comparing it with significance

level it results less than 0.05, hence Null hypothesis is rejected and Alternate Hypothesis

is accepted.

30
Interest Coverage Ratio:

The tables which are given below 2.5 and 2.6 are the PP test on Level and 1 st Difference

of Interest Coverage Ratio “ICR”. These tables represent the probabilities of interest

coverage ratio on Level test and 1 st Difference test and further analyze the Null

hypothesis whether it is accepted or rejected.

Level:
Null Hypothesis: ICR has a unit root
Exogenous: Constant
Bandwidth: 7 (Newey-West using Bartlett kernel)

Adj. t-Stat   Prob.*

Phillips-Perron test statistic -9.819909  0.0000

*MacKinnon (1996) one-sided p-values.
Table 4.3.B.5: Phillips-Perron test on Level of ICR

Interpretation:

The PP on Level result shows that Interest Coverage Ratio does not has Unit root because

the Probability of Interest Coverage Ratio is 0.0000, comparing it with significance level

it results less than 0.05, hence Null hypothesis is rejected and Alternate Hypothesis is

accepted.

1st Difference:
Null Hypothesis: D(ICR) has a unit root
Exogenous: Constant
Bandwidth: 7 (Newey-West using Bartlett kernel)

Adj. t-Stat   Prob.*

Phillips-Perron test statistic -27.68762  0.0000

*MacKinnon (1996) one-sided p-values.
Table 4.3.B.6: Phillips-Perron test on 1st Difference of ICR

31
Interpretation:

The PP on 1st Difference result shows that Interest Coverage Ratio does not has Unit root

because the Probability of Interest Coverage Ratio is 0.0000 comparing it with

significance level it results less than 0.05, hence Null hypothesis is rejected and Alternate

Hypothesis is accepted.

32
4.4 Correlation

To find and explore the relationship between Dependent Variable and Independent

Variables this thesis utilizes the Correlation test. Correlation test is the test which shows

the relationship between dependent and independent variable and correlation test is

applied on two variables (Dependent and Independent). Positive sign shows the strong

and direct relationship. If Dependent Variable will increase then Independent Variable

will also be increasing, while negative sign shows the weak and inverse relationship. If

Dependent Variable will increase then Independent will be decreasing.

SP DER ICR
SP 1.000000
DER -0.173098 1.000000
ICR 0.216471 -0.102388 1.000000

Table 4.4.1: Correlation Matrix

As the results of dependent and independent variables show that debt to equity ratio and

stock price are weakly correlated with each other which is -0.173 (-17.3%). It describes

that if stock price (sp) will increase then debt to equity ratio (der) will decrease by 17%.

The second independent variable result shows there is positive relationship with

dependent variable which is 0.216 (21.6%). If stock price (sp) will increase then interest

coverage ratio (icr) will also be increasing by 21%.

4.5 Estimate Equation

33
Estimate Equation for research Variables: SP C DER ICR

Variable Coefficient Std. Error t-Statistic Prob.

C -1.765548 0.04726 -37.3516 0.0000
DER -0.075541 0.03772 -2.00246 0.0469
ICR 0.003643 0.00138 2.63681 0.0092
R-squared 0.069882
Adjusted R-squared 0.058399
Durbin-Watson stat 0.755358
F-statistic 6.085747
Prob(F-statistic) 0.002829
Dependent Variable: SP

Table 4.5.1: Regression Analysis

The thesis applies the estimate equation test which is the final test of the thesis, to find

the exact impact of Debt to equity ratio (DER) and Interest Coverage Ratio (ICR) on

Stock Prices (SP). The first Independent variable has a negative significant impact on

Stock Prices because the Probability of DER with SP is 0.0469 (4.69%). Thus first

hypothesis of research is accepted H1: There is a significant relation between debt to

equity ratio and stock return. T-Statistic shows the direction between D/E and SR which

is -2.002.It indicates negative relation; if debt to equity ratio will increase then stock

returns will decrease. The second independent variable has a positive significant impact

on Stock Prices because the probability of Interest Coverage ratio with Stock Price is

0.0092 (0.92%). Thus second hypothesis of research is accepted H2: there is a significant

relation between interest coverage ratio and stock return and t-statistic is 2.636 which

specify the positive direction. If interest coverage ratio will increase then stock returns

will be increasing. R-squared explains the variability (sum of squares)of data set that used

in this research and Adjusted R-Squared is a modifier of R-squared that adjusts the

number of R-squared. R-squared is 0.0698 (6.98%) which is near to 1. It indicates that

34
the regression table almost fits perfectly. Adj. R-squared is 0.0583 (5.83%) which is

closer from R-squared. The R-squared and Adj. R-squared are close to each other which

mean that the model is correct in respect with this research and it does not require much

of adjustments which show that the model is strong. Durbin-Watson stat shows

autocorrelation between the variables of this research the ideal value is 2 and below 2

shows evidence of positive serial correlation where the value of DW is 0.755 which

shows that the variables are auto correlated slightly there is not a very strong bond

between them. F-statistic shows the explanation of research model which is 6.08 it

describes that model is not explained efficiently. Prob(F-Statistic) is the subsidiary

significance level of F-Statistic. P-value is less than the significance level which is 0.002.

That is why Null hypothesis of research is rejected.

According to the results of regression analysis of this research there are many literatures

available in accordance with this research’s results. Let us consider the research of

Dimitrov and Jain (2005) where they claimed negative relation between leverage and

stock returns. They revise changes in leverage levels and demonstrate that they are

negatively connected to current and future adjusted returns. Similarly Aivazian, Ge and

Qiu (2003) found that profitability and leverage are negatively related to each other. It

also shows that when a firm is highly leveraged they would be left with little or no

investment opportunity in the long run. The researches of Adami, Gough, Muradoglu and

Sivaprasad (2010) and Aydemir, Gallmeyer and Hollifield (2006) also showed negative

yet little relationship between stock returns and leverage. Whereas Soomro, Bhutto and

Abbas (2012) showed that there is a negative relationship between debt to equity ratio

and stock prices and suggested maintaining a level of debt in the company will result into

35
balance in stock prices and leverage. Cai and Zhang (2010) found that there is significant

and negative relation between financial leverage ratio and stock price. They found a

strong negative impact for those firms that have high leverage ratio, more chance for

default. Certainly Sahalia, Fan and Li (2012) and Pachori and Totala (2012) also found

negative relationship between the two variables.

CHAPTER – 5

36
 CONCLUSION

The thesis is basically conducted on KSE-100 index listed companies both Financial and

Non-Financial sector. The time series of data sample of this thesis was 3 years which

started from January, 2009 till December, 2011. The basic aim of this thesis was to find

the impact of leverage on stock return. To achieve this objective the research underwent

multiple tests on these variables such as unit root test and regression result. The

correlation test applied in the dependent and independent variables showed negative

relationship between debt to equity ratio and stock prices with the value of -17.3% where

stock prices and interest coverage ratio are 21.6% positively correlated with each other.

And debt to equity ratio and interest coverage ratio also possess a negative correlation

between them of -10%.The results found from unit root test from both Augmented

Dickey Fuller and Phillip Perron test on all three variables namely interest coverage, debt

to equity and, stock prices showed significant results on all level this result indicates that

both of the independent variables possess significant impact of stock prices which means

that the hypothesis defined in this research will be accepted showing a positive

relationship of interest coverage and debt to equity ratio with stock prices.

After conducting the research and concluding the results i can suggest some points from

which both companies and investors from Pakistan and internationally can get benefited,

37
as we know that leverage plays an important role in the evaluating any business therefore

it is also very important for investors to understand the depth of this ratio. Companies in

Pakistan do not have a pattern in stock return the dynamics of the industry varies too

much and this increases the risk in the volatility of the stock prices. Companies should

take measures to control debt in their organization this will save the cost of debt that is

being paid, this saving could further be utilized in operations which will increase

profitability of the company and attract investors. I would like to suggest that companies

should maintain 40:60 debt to equity ratio which is also an international norm to increase

profitability and also mitigate risk. If we take investors point of view we will find that

there are two types of investors first risk takers and secondly risk averse investors, in

Pakistan most of the investors are risk averse as the market is also not stable. Therefore it

is also very important for the investor to thoroughly study debt to equity ratio and

understand it before investing in any corporation’s equity to get better returns from their

investment.

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41