*Lecturer, Sarhad University of Science & IT, Peshawar, (PhD scholar IMS, Peshawar). Email: adeel.ba@suit.edu.pk
**PhD scholar IMS, University of Peshawar
***MS scholar, IM Science, Peshawar
****MS scholar, IM Studies, University of Peshawar
Abstract.
This
paper evaluates the effect of leverage on stock returns and systematic risk in
the corporate sector of Pakistan. It determines the relationship between
leverage and systematic risk. Data was collected from eight industries such as;
Cotton, Engineering, Chemicals, Sugar and Allied, Cement, Fuel and Energy, and
transport and Communications. High leverage was experienced which leaded to
high level of systematic risk and volatility in the stock prices.
Key words: Leverage, stock
returns, systematic risk, stock prices, Pakistan Stock exchange (PSX).
Introduction
Risk is the adverse impact on
profitability of several distinct sources of uncertainty: Risk varies in types
and degree and some of factors play a vital role in shaping it such as; size,
complexity in business activities and volume etc. The purpose of leverage in
investment portfolios is to borrow money at lower cost than the return.
Financial leverage is used to get flexible access to capital markets, buy back
equity, and creating shareholder’s value. Strategies varies upon nature of the
company but are closely aligned to management’s overall goals and objectives.
Problem
Statement
The
Corporate Sector of Pakistan is facing multiple issues in Return on
investment specially low Stock returns
because of Leverage and existence of systematic risk in following industries
such as ; Cotton, engineering, chemicals, sugar and allied, cement, fuel and
energy, and transport and communications.
Literature
Review
Financial leverage results from the
difference between the rates of returns the company earn on investment in its
own asset and the rate of return the company must pay its creditors (Garrison
et al., 2004).
Anas (2013) studied relationship between
stock return, systematic risk and financial leverage in context of companies
list on Ammon stock exchange between Jan 2000-Dec 2009 on sample of 48
companies. The results of this study showed were negative relationship between
variable in case of conducting it on more developed stock market while it
showed positive relationship on underdeveloped market.
Majeed (2010) studied corporate sector of
Pakistan. The author on evaluated relationship between leverage and systematic
risk while taking sample of 8 industries of Pakistan, they concluded positive
relationship between leverage, systematic risk and stock prices.
Garrison, et al. (2004) financial leverage
is a end product of difference between rate of return on investment and
dividends to customers. Duffy equity capitals will sometime deliver high rate
of return on equity funds. According to Jones (2003) end product/result of an
investment will always be less than expected outcome and risk will be also high
in this case.
Anderson (2009) risk management is a key
to exploit opportunities and avoid adverse between and has positive
relationship between each if financial leverage is lower. Company stability and
financial leverage ratio are indirectly proportional to company profitability
and vice versa.
Mcewen (2000), through an empirical
research came to the conclusion that large companies takes more long term debt
and risk them small companies. Khedaraloghi (2011), studied relationship
between financial leverage and systematic risk on companies registered on
Tehran stock exchange and found normal effect of both variables on Tehran stock
exchange.
Mavia (2010), investigated relationship
between financial leverage and equity return and their link with firms capital
structure and found the result that determinants of firms capital structure are
sensitive to firm financial leverage and equity return.
Acevdetajdamia (2007) studied effect of
financial leverage at market and firm level and found result that financial
leverage produce less changes in stock return volatility at market level but
significant changes at firm level. They also concluded that financial level
contributes more changes in stock return volatility for a small firm while it
has little/low affect in case of large firms.
Jodsone, et al. (2006) worked on
cross-sectional relationship between leverage and future returns in context of
capital structure and market reactions. Authors concluded that there is a
negative relation between leverage and future returns as expressed by investor
of market.
Paymanalebari and Mohammad (2012) studied 115 companies in Tehran stock market for period of 2008-12 in which systematic risk (beta) relationship with leverages ratios was tested. The data was gathered from financial statements, committee reports and other documents. Results showed no significant relationship between these variables on the basis of regression and Pearson correlation applied to analyze the data.
Darabi, et al. (2009), evaluated
relationship between operating leverage and systematic risk result showed,
significant relationship between operational leverage and systematic risk but
no significant relationship between operational leverage and efficiency.
Jones (2003) analyzed that actual outcome
from an investment will differ from the expected outcome is called risk. Most
investors are concerned that the actual outcome will be less than the expected outcome.
The broader the range of possible outcomes the greater will be the risk.
Anderson (2009) studied risk management
effectiveness combines both the ability to exploit opportunities and avoid
adverse economic impacts, and has a significant positive relationship to
performance. This effect is moderated favorably by investment in innovation and
lower financial leverage. Financial distress has a series of financial events
that reflect diverse phase of corporate adversity. These are decrease in cash
flows from continuing operations, reduction of dividend payments loan default
and technical or troubled debt restructuring (TDR), these are considered as the
financial distress.
Financial structure’s accounting
measurements, liquidity, performance, firm specific attributes and operating
risk have been shown to capture risk components that potentially impact the
durability of distressed firms. Time varying stock volatility explanation is
that leverage changes as the relative stocks and bonds prices changes, changes
in the volatility of stock returns happened due to change in the leverage firm
causes. Strongly growing corporations represent economic development. The
corporate leverage have negatively relation to corporate growth, it also
include the debt financing to be negatively correlated.
The GDP development Significant negative
effect of economic growth depends on short term debt and total debt but it not
considers the long term debt. The average rate of return on their equity funds
business enterprises leverage their capitals Leverage will do this if the rate
of return on the invested funds is significantly higher than the interest rate
paid on the rented funds. In different situations the equity capital gives a
relatively high rate of return on the equity funds.
Financial structure is optimized over time
by the corporation to reflect asset type, tax rate, profitability bankruptcy
and business risk. Total debt ratio is strongly affected by the tax rates even
if it includes different circumstances like investor’s relevant tax bracket.
Superior corporations usually take on more debt. Companies with a high
proportion of net fixed assets are normally financed with more long-term debt
and less short-term debt.
The marketing and research community has
been measuring the wrong thing that is attitudes versus financial returns and
thinking about investments in the wrong context (communication channels versus
customers). Strategies and investments are not about attitude goals and communication
channels, they are about meeting customer needs better while improving ROI.
Financial leverage results from the difference
between the rate of return the company earn on investment in its own asset and
the rate of return the company must pay its creditors. Risk management
effectiveness combines both the ability to exploit opportunities and avoid
adverse economic impacts, and has a significant positive relationship to
performance. This effect is moderated favorably by investment in innovation and
lower financial leverage.
However, the base of any business is a
healthy appetite for risk, since returns higher than the risk-free interest
rate can only be achieved through risk taking. This is why one of the greatest
and most important challenges for corporate executives is to define the optimal
risk level for their business.
A risk management system is a valuable
instrument for assessing the exposure to risk that participants in the
financial sector in general are subject to. Risk systems also provide a measure
of the amount of capital necessary to provide a cushion against potential
future losses, a vital element for both managers and regulators.
Schnabl, et al. (2013) found that very
little risk is transferred because the risk was highly concentrated towards
banks and that is why the stock returns of banks goes down. Merton (2013) says that
a new kind of systematic risk arises when refinancing opportunities; decreasing
interest rates and increasing home prices collectively create their linkage
with the house owner leverage. This type of risk does not depend upon
dysfunctional behavior. This risk was termed as ratchet effect.
Shibu, et al. (2014) Studying the stocks
of five companies for five years (2006-2010) by using OLS regression methods
said that there is strong negative relationship between the stock returns and
the leverage taken but individually the relation was found not that much
strong. They also showed that there is positive relationship between size and
the stock returns.
Rockinger, et al. (2015) believe that a
firm is considered undercapitalized by any financial institution when the whole
financial system is undercapitalized, this is called systematic risk.
Investigating 196 non-US European financial institutions found that the cost
for some banks were too large to be controlled.
Research Methodology
Research is Quantitative in nature and
data was collected for the period of 2007-15. Secondary data was gathered from annual
reports of the subject eight industries, daily
shares trading documents, State Bank of Pakistan site, Karachi Stock
Exchange (now PSE) site, digital library, finance search engines and sites,
general Index of Share prices site, articles from Pakistan Development Review,
research articles from various journals and online databases of JSTOR, Emerald,
John Wiley and some of data was gathered from face to face interviews with the
top management of selected industries of Pakistan.
Annual reports of selected eight corporations
have been gathered from the industries and retrieved the required information.
The stock prices of last eight years of selected industries have been gathered
from Karachi stock exchange. The total time of data collection was almost four
months including both primary and secondary data.
Review of Pakistani Industries
Cotton textile production is the most
important of Pakistan's industries, accounting for about 19% of large-scale
industrial employment, and 60% of total exports in 2000-01. The textile
industry as a whole employs about 38% of the industrial workforce, accounts for
8.5% of GDP, 31% of total investment, and 27% of industrial value-added.
The Chemical industry is one of the most
basic and important manufacturing business globally. Its total turnover
approaches $1,000 billion, giving it a size comparable to that of other large
international industries such as the automotive, steel, mechanical engineering
and electronic industries. Pakistan's chemical industry produces a number of
basic chemicals used in its other industries, including soda ash, caustic soda
and sulfuric acid. Industrial output from other major industries also includes
refined sugar, vegetable ghee, urea, rubber tubes, electric motors, electrical
consumer products (light bulbs, air conditioners, fans refrigerators, freezers,
TV sets, radios, and sewing machines), and pharmaceuticals.
It is estimated that production of
engineering goods in terms of value amounted to more than Rs.200 billion, with
average annual growth rate around 10 %. Total fixed assets in the engineering
sector are estimated to be around Rs. 125 billion. The Eighth Five Year Plan
envisaged an investment of Rs.80.43 billion in the promotion and development of
engineering goods industry out of which 40 percent or Rs.32.64 billion was
proposed to be absorbed in the modernization and creation of new capacity in
transport equipment while 39.32 % or Rs.31.63 billion would be channelized.
Pakistan's sugar industry is passing
through an unprecedented tempo of growth. As of 1991-92 there were 53 sugar
mills operating in the country with a total installed TCD of about 172,200
which produced 2.33 million tons of sugar. With the advent of 1992-93 seasons
so far five new sugar mills have come into operation. Pakistan at present has
53 sugar mills with a cane crushing capacity of 180,000 tons per day (including
beet adjusted to cane). These are capable of producing about 1,800,000 tons of
sugar in a normal crushing season of 150 days and at average recovery-
Energy is one of the world's most
important resources. Over the last century, petroleum products have become the
major supplier of the world's energy demand. In Pakistan petroleum products
supply 42 percent of the energy needs. The industry which comprises exploration
and production (upstream), refining and marketing (downstream), is the single
largest contributor to the national exchequer. Demand for oil products has
grown at nearly 8% per annum in Pakistan since 1948 and is expected to continue
at similar levels in the years to come. This translates into the demand of oil increasing
from the current 14 million tones to almost 25 million tones within 10 years.
With the government's emphasis on rapid economic growth, road construction and
a shift towards greater urbanization, the country's vehicle population is
expected to reach 3.9 million by 1999 from the present 2.6 million. Tractors
are also expected to add to the demand for diesel fuel.
Transport and Communication network is
among the most important of basic infrastructures. The development of country's
economy is largely dependent on its efficiency. At the time of independence, Pakistan
had inherited a limited network. There was only 50,367 km of roads, 8.553 km of
rail track, and seven shipping vessels having 59,414 dead-weight ton
capacities, only 21,209 registered vehicles on the roads, 3,036 posts offices,
and seven telegraphs offices (all located in the urban areas). There were only
12,436 telephones and 45,426 radio sets and no air transport facilities were available
for common use. The network has since been vastly expanded and improved but
still remains deficient in fully meeting the present requirements.
Cement Production in 1995-96 is estimated
at 9.403 million tones as compared to 8.420 million tons in the preceding year.
The present installed capacity of 22 cement plants (17 private & 5 public sectors)
is 10.492 million tones. Total estimation of production of these plants was
8.544 million tons in 1994-95. As many as eleven new cement plants are being planned
or implemented all in the private sector. The capacity of these projects is
estimated at 12.988 million tones. The existing plants have also planned to
expand their capacities. This worked out to 5.070 million tones. Thus the total
capacity of cement projects, existing and upcoming is increasing day by day.
Production of paper and board increased
from 80,920 tons in 1984 to 169,228 tons in 1990 showing more than 100 % rise
in six years. In the last three years the paper industry has shown improvement.
This is evident from the capacity utilization which was 63 % in 1988-89
increased to 70 % in 1990-91. At present Karachi Stock Exchange have 13
companies in the paper and board section with total paid-up capital of Rs.
743.60 million. According to Pakistan Pulp Paper & Board Makers Association,
there were 23 paper units that were its members. Production of these units increased
from 80,920 tons in 1984 to 169,228 tons in 1990 showing more than 100% rise in
six years. The production in different categories was: writing and printing
paper 33% packing and other 20% paper board and 26 chip board 21 %. In the last
three years capacity utilization in the paper industry has shown improvement.
This is evident from the capacity utilization which was 63 % in 1988-89
increased to 70 % in 1990-91.
Analysis and Interpretation
After data collection researchers have
analyzed data by using formulas of return on equity, return on investment, CAPM
formula, standard deviation, and leverage and applied all these formulas in Microsoft
Excel, Beta through risk free rate, rate of return (stock & market) etc.
Research Hypothesis
A hypothesis is a statement that shows the
inferred relationship among the different variables. The conjectured
relationships among the variables are established on the basis of previous
literature available. These relationships can be verified using certain
statistical tests/techniques. These hypotheses may be substantiated or not,
depending upon the results derived from statistical analysis.
The following hypotheses have been
proposed in the light of literature:
H0:
High leverage increases the risk.
H1:
High leverage decreases the risk.
H0:
High leverage increases the stock return.
H2:
High leverage decreases the stock return.
Result and Findings
The researcher found high level of
leverage calculated through Debt to equity which was 1.68 (2015) creating a
high level of systematic risk, leading to high volatility in the stock prices
of these industries traded on PSE.
Table 1 Leverage of Eight Industries for
the Period (2007-15)
|
Industries Cotton |
2007 0.3092 |
2008 1.546 |
2009 0.249966 |
2010 1.2495 |
2011 0.43464 |
2012 0.240663 |
2013 2.546 |
2014 1.4094 |
|
Chemicals |
0.0909 |
0.455 |
0.018537 |
0.0925 |
0.1154 |
0.01787 |
0.578 |
1.8400 |
|
Engineering |
0.3963 |
1.982 |
0.325681 |
1.628 |
0.56 |
0.25815 |
2.8 |
2.2978 |
|
Sugar & Allied |
0.3371 |
1.686 |
0.313745 |
1.569 |
0.411 |
0.29583 |
2.381 |
1.3192 |
|
Paper &Board |
0.3864 |
1.932 |
0.294686 |
1.473 |
0.5395 |
0.22605 |
2.697 |
1.5165 |
|
Cement |
0.4653 |
2.327 |
0.43631 |
2.182 |
0.7008 |
0.47649 |
3.503 |
1.8938 |
|
Fuel &Energy |
0.1993 |
0.997 |
0.049779 |
0.249 |
0.2532 |
0.01628 |
1.266 |
0.6829 |
|
Transport & Communication |
0.1161 |
0.581 |
0.351013 |
1.755 |
0.2481 |
0.41163 |
1.240 |
|
*The market risk that beta was 2.178548
during the studied period of eight years.
Table 2 Industry
Leverage for Fiscal Year (2015)
|
Industry Leverage Ratio |
|
Cotton
Textiles 1.4094 |
|
Chemical
1.840 |
|
Engineering
2.297 |
|
Sugar
& Allied
1.3192 |
|
Paper
& Board 1.5165 |
|
Cement 1.893 |
|
Fuel
& Energy 0.6829 |
|
Transport
and Comm 2.1785 |
|
Average 1.6803 |
Average leverage is 1.6803. Engineering,
cement, and transport and communication, indicated the value above than average
leverage ratio. However, the pattern of leverage across industries does not change
much over time. The extent of leverage is lower compared to previous years as
determined by the other researchers. This is because of reforms introduced from
1988 onwards in corporate sector by the Government of Pakistan, primarily,
through the Securities and Exchange Commission of Pakistan. The strategy of
corporate financing has also been changed gradually to reduce debt to equity
ratio from 80:20 and 60:40 to 50:50 over time.
The
notable change is observed in Engineering, cement, and transport &
communication where the leverage magnitude is higher. Other industries do have
variations in their leverage magnitudes. But the pattern has been almost the
same in the January 2001 to December 2010.Transport &communication;
Engineering has the highest level of leverage whereas fuel and energy, sugar
and allied have the lowest level of leverage.
Conclusion
The researcher found high level of
leverage calculated through Debt to equity which was 1.68 (2015) creating a
high level of systematic risk, leading to high volatility in the stock prices
of these industries traded on PSE. The market risk that is beta was calculated
to be 2.17. The strategy of corporate financing needs to be changed to reduce
debt to equity ratio from 80:20 and 60:40 to 50:50 depending upon size and financial position of
the industry over the time .
Despite the reforms introduced so far by
the Government, corporate sector still carries a high level of leverage
creating a high level of systematic risk, leading to high volatility in the
stock prices of these industries traded on KSE. It is recommended that the debt
equity ratio should be brought in line with international norms, i.e. 40:60.
The commercial banks can be advised by the
State Bank of Pakistan to keep this ratio in view while extending fresh loans
to the corporate sector. The underwriters in Pakistan significantly
under-priced the new issues (IPO’s) to minimize their own risks of the new
issues. This under-pricing causes direct loss to the issuing firm and their collection
of funds is lower than the intrinsic value of the issued stock. It may
temporarily increase the stock price of the firm but in the long run it works
negatively and increases the systematic risk of the firm leading to lowest
stock prices. It is, therefore, recommended that the SECP and KSE Now Pakistan
Stock exchange (PSX) should ensure that underwriters price the new issues
relevant to the intrinsic value of the stock. As in the U.S. and other
development countries, there could be an under-pricing of up-to 10% to make the
stock attractive for the investors. This research could be beneficial for Corporate
Sectors specialists like: financial analyst, investors, Brokers, and PSX
traders who can use this research for investment decisions in buying or selling
stocks enlisted on PSX.
In future of this research can be extended
to all 34 sectors listed on Pakistan Stock exchange and not only limited to
these eight sectors discusses. Financial analyst and PSX traders can use this
research for investment decision making in future as well.
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