Effect of operating, financial and total leverage on expected stock return and market value of equity

INSTITUTE OF BUSINESS MANAGEMENT

Effect of Operating, Financial and Total Leverage on Expected Stock Return and

Market Value of Equity Corporate Finance

Term Research Report

Spring 2013

Summary of Team outline

Presented to:

H. Jamal Zubairi (Associate Professor and Head of Finance & Accounting Faculty, IoBM)

Presented By:

Maheen Yousuf 11738

Rabia Saya 11308

Rashida Quettawala 11334

Shoaib Lalani 11541

Individual Work:

Team Member Report Work Data Collection

Maheen Yousuf Literature reviews. 1. Atlas Honda 2. Crescent Textile 3. BYCO

Rabia Saya Abstract. Introduction.

1. Engro Corp 2. Nishat Mills 3. PTCL

Rashida Quettawala Methodology. Source of data. Dependent and Independent Variable.

1. Kohat 2. PSO 3. BYCO

Shoaib Lalani Empirical result & analysis of the findings. Conclusion.

1. Fauji Cement 2. PTCL 3. Linde Pakistan

Table of Contents ABSTRACT .................................................................................................................................................. 1

INTRODUCTION ........................................................................................................................................ 2

COMPANIES INFORMATION............................................................................................................... 3

LITERATURE REVIEW ............................................................................................................................. 5

Analysis of Leverage and how it informs about the profitability and price to book ratios: ...................... 5

Operating leverage, financial leverage and equity risk: ............................................................................ 5

On the Relationship between Systematic Risk and the Degrees of Operating and Financial leverage: ... 5

The stochastic behavior of common stock variances: Value, leverage and interest rate effects: .............. 6

Leverage Effect in Financial Markets: The Retarded Volatility Model: .................................................. 6

METHODOLOGY ....................................................................................................................................... 7

SOURCE OF DATA ..................................................................................................................................... 7

SAMPLE SIZE ............................................................................................................................................. 7

DESCRIPTION OF DEPENDANT AND INDEPENDENT VARIABLES ................................................ 7

INDEPENDENT VARIABLES ............................................................................................................... 8

DEGREE OF OPERATING LEVERAGE (DOL) ............................................................................... 8

DEGREE OF FINANCIAL LEVERAGE (DFL) ................................................................................. 9

DEGREE OF TOTAL LEVERAGE (DTL) ......................................................................................... 9

DEPENDANT VARIABLES ................................................................................................................. 10

EARNINGS TO PRICE RATIO ......................................................................................................... 10

MARKET VALUE OF EQUITY ....................................................................................................... 10

BOOK TO MARKET VALUE RATIO ............................................................................................. 10

HYPOTHESIS ............................................................................................................................................ 11

STATISTICAL TOOLS ............................................................................................................................. 11

EMPERICAL RESULTS & ANALYSIS OF THE FINDINGS: ............................................................... 12

MODEL 1: .............................................................................................................................................. 12

MODEL 2: .............................................................................................................................................. 13

MODEL 3: .............................................................................................................................................. 14

CONCLUSION: .......................................................................................................................................... 15

BIBLIOGRAPHY ....................................................................................................................................... 16

Effect of Operating, Financial and Total Leverage on Expected Stock Return and Market Value of Equity

Corporate Finance Term Report Page 1

ABSTRACT

Regardless of the size and nature, largely all businesses are dependent on leverage. This research

called for analyzing the impact of leverage on equity elements like the earnings to price ratio,

Market value of equity and book to market ratio. Later on we also tested to identify the

relationship between leverage and on expected stock returns. Financial data for different

companies ranging in their own sectors was collected and then financial data from 2002 to 2012

was used to run pooled regression in order to find out any existing relationship

The results were pretty astonishing as it was proved that leverage had no impact on either of the

equity elements. Nevertheless, a relationship could be identified between leverage and expected

stock returns. Hence it will be safe to conclude that Pakistan’s economy is shortsighted and

consumption oriented and that profits and earnings of companies in Pakistan are highly financed

by their respective revenues. But nevertheless judgments about a particular sector couldn’t be

made as this report has various business sectors of Pakistan.

Keywords: Leverage, Equity, Degree of Operating Leverage (DOL), Degree of Financial

Leverage (DFL), Degree of Total Leverage (DTL), Market Value of Equity, Book to Market

Value Ratio,



INTRODUCTION

This research paper comprises of the financial data of ten non-financial companies from various

sectors of Pakistan. For simplification, the past ten years (2002-2012) have being considered.

The task assigned accounted for identifying any relevant relationship between the various

components within this data. After evaluating the data, three models were developed and

subsequently three relationships between E/P and DOL, Market value and DOL and book to

market equity to DOL were examined. Under any sector, generally sales are the most obvious

component of a firms operating performance. There are various tools that provide investment

analysts with the required information, while evaluating a company’s performance .EBIT helps

weigh a company’s performance but ignores any impact of taxes and interest. While EAT

considers the impact of both these components and is generally the final profit generated for that

particular year. Leverage can be identified as use of various financial instruments or borrowed

capital, such as margin, to increase the potential return of an investment. Degree of Operating

Leverage (DOL) refers to how much capital is tied up in fixed costs. Naturally a larger company

is more likely to have a higher DOL since its large profits encompasses greater proportion of

fixed costs. In a nutshell, DOL basically identifies the two extreme situations that are good or

worse. Degree of Financial Leverage (DFL) is very similar in this regard except that it

encompasses effects of the fixed financial costs (Loans, Bonds Obligations). Companies that use

debt a lot in order to pay off its assets may subsequently have a higher DFL. In an extreme

scenario, a small company worth all equity financing may end up with a zero DFL altogether.



COMPANIES INFORMATION

In order to have a comprehensive analysis, financial data of ten companies from diversified industries

were collected. Following is the background to respective companies:

1. Byco: Pakistan’s emerging energy companies engaged in the businesses of oil refining,

petroleum marketing, chemicals manufacturing and petroleum logistics. They have their head

quarters in Karachi but the mission continues to fulfill the energy demand globally as well.

2. Atlas Honda Limited (ATLH): is a joint venture between the Atlas Group and Honda

Motor Co. Ltd., Japan. AHL manufactures and markets Honda motorcycles in collaboration

with Honda Motor Company. Honda motorcycles are by far the largest selling motorcycles in

the country with an unmatched reputation for high quality, reliability and after-sales-service.

3. Engro Corporation (ENGRO): Engro Corp is one of Pakistan’s largest conglomerates

with businesses ranging from fertilizers to power generation. Currently, Engro Corp’s

portfolio consists of seven businesses, which include chemical fertilizers, PVC resin, a bulk

liquid chemical terminal, industrial automation, foods, power generation and commodity

trade. From its existence, Engro has come a long way in its vision of becoming a premier

Pakistani company with a global reach.

4. Pakistan Telecommunication Company Ltd (PTCLA): PTCLA has redefined

the boundaries of the telecommunication market and is shifting the productivity frontier to

new heights globally. Today, for millions of people, PTCLA has been the prime source for

instant access to new products and ideas. More importantly it allowed better living standards

for people with increased values in this ever-shrinking globe. They are setting free the spirit

of innovation.PTCLA is going to be your first choice in the future as well, just as it has been

over the past six decades.

5. Pakistan State Oil (PSO): is the nation’s largest energy company, and is currently

engaged in the marketing and distribution of various POL products.



6. Kohat Cement (KOHC): Kohat Cement Company Limited was incorporated in 1980

and is one of the leading cement manufacturers of Pakistan. It is an ISO 9001-2008 certified

company. KOHC is listed on the Karachi Stock Exchange and its plant is located in Kohat.

7. The Crescent Textile Mills Ltd (CRTM): The Crescent is a public limited

company incorporated in Pakistan under the Companies Ordinance 1984. Its shares are

quoted on all the Stock Exchanges in Pakistan. CRTM is engaged in business of textile

manufacturing comprising of Made ups, processed fabric, greige fabric and Yarn made from

raw cotton and synthetic fiber(s). CRTM also operates a cold storage and a power generation

house.

8. Nishat Mills Limited (NML): is the flagship company of Nishat Group. It was

established in 1951. It is one of the most modern, largest vertically integrated textile

companies in Pakistan. The Company's production facilities comprise of spinning, weaving,

processing, stitching and power generation.

9. Fauji Cement (FCCL): Fauji is a longtime leader in the cement manufacturing industry,

it is headquartered in Rawalpindi. The Company has a strong and longstanding tradition of

service, reliability, and quality that reaches back more than 15 years. Sponsored by Fauji

Foundation the Company was incorporated in Rawalpindi in 1992.In addition to the Pakistan

market, Fauji Cement is expanding its promising coverage in the neighboring regions

/countries like Sri Lanka, India, Afghanistan, South Africa, Middle East & Africa.Fauji

Cement is ISO certified for its Quality & Environment Management Systems and has won

number of awards in its category.

10. Linde Pakistan Limited: is a member of The Linde Group in Pakistan. They

manufacture and distribute industrial, medical and chemical gases as well as welding

products and a wide range of related services that includes the installation of on-site plants,

pipelines, gas equipment and associated engineering services. Its sales centers are almost

all over Pakistan with nationwide network of production as well as distribution facilities and

vast portfolio of products and solutions are capabilities unmatched in the local industry.



LITERATURE REVIEW

Analysis of Leverage and how it informs about the profitability and price to

book ratios:

Nissim and Penman (2003) in their research paper have discussed two types of leverage. One,

which comes about when borrowing, is done to finance operations and the other when borrowing

is done during the course of the operations. When the two gentlemen did analysis of the

empirical data they came to the conclusion that the two types of leverages affect the book value

of return on equity in different ways. The analysis of the financial statements of the company

shows differences in the price to books ratios, which is based upon the expected return on equity

as well as future and current rates of return. Thus the paper reaches to the conclusion that items

in the balance sheet, which are in line with operating leverage, are priced differently compared to

the ones, which are in line with the financial leverage. This sort of an analysis, give us

information on appropriate price to book ratios and future profitability.

Operating leverage, financial leverage and equity risk:

Lucy Huffman (1983) through her research paper has tried to find out that 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 capacity decision is firms

own decision and this decision reduce he effect on risk of equity of increasing debt or overall

business risk.

On the Relationship between Systematic Risk and the Degrees of Operating

and Financial leverage:

Gahlon and Gentry (1982) in their paper discuss that degrees of operating and financial Leverage

and how they are the determinates of the systematic risk of a security. Along with these factors,

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.



Thus they came up with a model for estimating beta which was affected by the above variables

and reached the conclusion the degree of operating and financial leverage represent risk of an

asset.

The stochastic behavior of common stock variances: Value, leverage and

interest rate effects:

Andrew A. Christie (1982) In this paper the authors have studied the relationship between the

variance on the return of equity and other relevant variables. Through this paper Christie proves

that variances of equity have a strong relationship with financial leverage. A large degree we see

that the negative elasticity of variance in relation to the value of equity is a result of financial

leverage

Leverage Effect in Financial Markets: The Retarded Volatility Model:

Bouchaud, Matacz, Potters (2001) the writers of this paper used empirical data to find out about

the leverage effect. A negative correlation exists between past returns and future volatility. For

individual securities this relationship is not very strong, it may last for 50 days. How however for

stock indices it is strong but lasts for days lesser in number compared to individual securities.

Mseddi and Abid (2004) in their paper have concluded that there is a positive impact of

operating and financial leverage on the firms’ profitability and hence the value of the firm. They

analyzed data of 403 companies over a period of 4 years, 1995 through 1990, drew this

conclusion. Baxter (1967) through empirical data analysis found a negative relationship between

the variance of leverage and operating earnings. He said that a business with stable cash flows is

more likely to be leveraged compared to those which have an uncertain income stream.

Modigliani and Miler (1958) studied the effect of the capital structure on earnings and market

value of the firm. Through their analysis they concluded that firm with and without leveraged

have the same market value.



METHODOLOGY

For our report we collected data of ten companies from different industries namely

automobile, petroleum, cement and consumer goods. Financial data of the

companies were obtained from their annual reports on their respective websites.

Financial data of these firms were taken from the year 2002 to 2012. The company

wise data sheet has been provided in the last section. We produced a regression

model using SPSS software to test our hypothesis.

SOURCE OF DATA

The source of the data used for the purpose of our research is primarily secondary data which

was available through the financial statements in the annual reports of the companies. The

financial statements include balance sheets and cash flow statements and balance sheets. The

stock prices for these firms were taken from the Karachi Stock Exchange (KSE) Website.

SAMPLE SIZE

In order to have a comprehensive analysis, we took 10 listed and non-financial companies from

various sectors from petroleum to cement, textiles and automobiles and used their financial data

from 2002 to 2012.

DESCRIPTION OF DEPENDANT AND INDEPENDENT

VARIABLES

This section explains the dependent and independent variables we used for the purpose of the

research report.



The Independent variables

1. Degree of Operating leverage

2. Degree of Financial leverage

3. Degree of Total leverage

The Dependent variables

1. Earnings to price ratio

2. Market value of equity

3. Book to market ratio

We used Degree of operating leverage, Degree of financial leverage and Degree of total leverage

as our independent variables. The purpose of our research was to find out the relationship

(positive or negative) between our independent variables and our dependent variables; the equity

elements like earnings to price ratio, book to market ratio and total market value of equity.

INDEPENDENT VARIABLES

DEGREE OF OPERATING LEVERAGE (DOL)

Operating leverage measures the extent to which a company’s operating costs are fixed. The

quantitative measure of operating leverage is the degree of operating leverage. DOL is defined as

a fractional change in EBIT due to a fractional change in sales. It can be calculated with the

formula:

DOL = % change in EBIT

% change in Sales

The higher the proportion of operating costs is fixed, the higher is the operating leverage and

vice versa. And the higher the operating leverage, the larger its impact on operating profits. So a

higher operating leverage magnifies the operating profit to a greater extent. However there are

two sides to a coin. Just how a high operating leverage magnifies the operating profits for a

company, if the operating leverage falls, it has a magnified downward impact on the profits.



Thus just how high operating leverage can be very beneficial for a firm, a small decline in

operating leverage can cost a lot to the company. It results in greater variability of returns and so

a higher risk for the firm.

DEGREE OF FINANCIAL LEVERAGE (DFL)

Financial leverage measures the extent to which a company is utilizing borrowed money. When a

part of a company’s assets is financed through debt, we say financial leverage exists. The

quantitative measure of financial leverage is the degree of financial leverage. DFL is defined as a

fractional change in net income due to a fractional change in EBIT. It can be calculated with the

formula:

DFL= % change in EPS

% change in EBIT

The higher the proportion of a company’s assets is financed through debt, the higher the financial

leverage. Companies that are highly leveraged are likely to be at higher risk of bankruptcy as

debt carries a fixed cost and if the company is unable to pay its existing creditors, they will be

unable to find new lenders. However financial leverage is not always bad news. Financial

leverage gives a company tax benefits from borrowing and can increase the shareholders return

on investment. Financial leverage involves fixed costs to finance the firm which will incur higher

expenses before tax. This will make EPS more volatile.

DEGREE OF TOTAL LEVERAGE (DTL)

Operating leverage and financial leverage combine to obtain total leverage. A firm having a large

financial and operating leverage will see that a small change in sales will lead to large variability

in EPS. DTL is calculated by the formula:

DTL= DOL x DFL



DEPENDANT VARIABLES

EARNINGS TO PRICE RATIO

This ratio is the inverse of the more common price to earnings ratio. Earnings to price ratio

shows the rate at which the equity holders will get the most out of firms expected earnings. It

also measures the expected growth of the stock. It is calculated by the following formula:

E/P = Earnings per share

Price per share

MARKET VALUE OF EQUITY

Market value of Equity is the total market value of all outstanding shares of a company. It is

calculated:

MV = (Current price of the stock) x (no. of outstanding shares)

A company’s market value of equity is different from book value of equity because book value

does not take into the company’s growth potential. The market value of equity is constantly

changing as the input variables change. The price changes on a daily basis.

BOOK TO MARKET VALUE RATIO

This ratio is used to compare a company’s book value of equity to its market value of equity.

Book value comes from the stocks historical cost or accounting value while market value is

calculated by multiplying price of stock to the no. of shares outstanding. It is calculated by the

formula:

Book to market ratio = Book value of firm

Market value of firm

This ratio identifies under-valued and over-valued stock. If this ratio is above 1 then the security

is undervalued and vice versa; if the security is below 1, it’s overvalued.



HYPOTHESIS

The objective of the report is to find out the impact (positive or negative) of leverage (both

operating and financial) on equity elements like E/P ratio, Market value of equity and Book-to-

market ratio.

In order to identify the relationship between our dependent and independent variables we

formulated these hypotheses:

a. Hypothesis (Ho): There is a significant relationship between E/P ratio, DFL, DOL

and DTL.

b. Hypothesis (Ho): There is a significant relationship between Market value of

equity, DFL, DOL and DTL.

c. Hypothesis (Ho): There is a significant relationship between Book to market

value ratio, DFL, DOL and DTL.

STATISTICAL TOOLS

After analyzing the data we required, we used the 85 samples of the ten companies ranging

from five to ten years to run regression through the SPSS 17.0.



EMPERICAL RESULTS & ANALYSIS OF THE

FINDINGS:

Our Findings are based on three models depends on the each hypothesis. We test our models on

the basis of t-test regression model and stability of the data is checked by R-square and

correlation is check on the basis of Durbin Watson test. Below is the analysis of each model in

detail.

MODEL 1:

Ho: There is a significant relationship between E/P ratio, DFL, DOL and DTL.

Model Summaryb

Model R R Square Adjusted R Square Std. Error of the Estimate Durbin-Watson 1 .903a .816 .809 .1921807 1.564

There is an insignificant relationship between dependent variable (Earning to Price Ratio) and

Independent variable (DFL and DOL), however there is a significant relationship between

dependent variable (E/P) and Independent variable (DTL). There would be a 0.001change in E/P

due to a unit increase or decrease in DTL. Furthermore, 81% of variation in Earning to price

ratio is explained by DTL; remaining 19% of variation is due to growth, and other macro

economic factors. Durbin Watson shows that there is a high correlation between the variables.

E/P = 0.064 + 0.001 DTL + E

Where:

E/P = Earning Price Ratio

DFL = Degree of Financial Leverage

DTL = Degree of Total Leverage

E = Error

Coefficientsa

Model

Unstandardized Coefficients

t Sig. B Std. Error

1 (Constant) .064 .018 3.457 .001

Degree of Operating Leverage of Company -3.691E-5 .001 -.033 .974

Degree of Financial Leverage of Company .005 .003 1.754 .083

Degree of Total Leverage of Company .001 .000 5.645 .000

a. Dependent Variable: Earning Price Ratio of Company



MODEL 2:

Ho: There is a significant relationship between Market value of equity, DFL, DOL and DTL.

Model Summary

b

Model R R Square Adjusted R Square Std. Error of the Estimate Durbin-Watson

2 .156a .024 -.012 4.179E9 .954

We failed to find any significant relationship between dependent variable (Market value of

equity) and independent variable (DFL, DOL and DTL). Only 2.4% of variation in Market value

of equity is explained by DFL, DOL and DTL. Therefore, we conclude that DOL, DFL and DTL

are not a good predictor for Market value of equity. Durbin Watson shows that there is a weak

correlation between the variables.

Pooled Regression Test

Coefficientsa

Model


t Sig. B Std. Error

2

(Constant) 2.340E9 4.641E8 5.043 .000

Degree of Financial Leverage of Company 3.468E7 3.265E7 1.062 .291

Degree of Total Leverage of Company 2416944.222 1772452.697 1.364 .176

Degree of Operating Leverage of Company 1.176E7 2.888E7 .407 .685

a. Dependent Variable: Market value of company equity



MODEL 3:

Ho: There is a significant relationship between Book to Market equity ratio, DFL, DOL and

DTL.

Model Summary

b

Model R R Square Adjusted R Square Std. Error of the Estimate Durbin-Watson

3 .072a .005 -.032 .5679796 .440

We failed to find any significant relationship in our last model between our dependent variable

(Book to Market Value of Equity) and independent variable (DOL, DFL and DTL). Only 0.5%

of the variation in dependent variable is explained by independent variable. We conclude that our

third model is highly unreliable. Durbin-Watson reveals that there is weak correlation between

the variables.

Pooled Regression Test

Coefficientsa

Model


t Sig. B Std. Error

3

(Constant) .220 .063 3.492 .001

Degree of Financial Leverage of Company -.003 .004 -.595 .554

Degree of Total Leverage of Company -6.805E-5 .000 -.282 .778

Degree of Operating Leverage of Company .000 .004 -.175 .861

a. Dependent Variable: Book to Market equity ratio



CONCLUSION:

There are 85 samples collected of each variable from ten different companies over the period of

five to ten years. All the companies are public listed companies over Karachi stock exchange

(KSE). We used SPSS 17.0 Pooled regression test to test our model and found firm evidence that

1) There is strong positive effect of total leverage on the average return of the stock. 2) There is

no relationship between Degree of all leverages and market value of equity. 3) There is no

relationship between any degree of all leverages and Book to Market value of equity.

It is surprising, that Degree of Leverages doesn’t have any significant impact on the value and

earning of the stock. Pakistani economy is more towards consumption. Profits and earning of

companies, mostly depends on the revenues. Increase in revenue usually leads to increase in the

earnings of the companies. Moreover Financial Market in Pakistan is not fully developed and has

leak holes. Therefore, KSE doesn’t show the true financial picture of the companies. KSE over

the past few years has been over priced due to non-availability of other financial instruments.

Stocks have also been over priced due investor pessimism and due to excessive demand of stock

by few huge market players. Other factors like growth of the project and other macroeconomic

variables affect the price and earning of the companies in KSE.



BIBLIOGRAPHY

http://www.sciencedirect.com/science/article/pii/0304405X77900204

http://onlinelibrary.wiley.com/doi/10.1111/j.1540-6261.1967.tb02975.x/abstract

http://papers.ssrn.com/sol3/papers.cfm?abstract_id=255868

http://www.sciencedirect.com/science/article/pii/0378426683900328

http://link.springer.com/article/10.1023/A%3A1027324317663#page-1

http://www.jstor.org/discover/10.2307/3665021?uid=3738832&uid=2&uid=4&sid=21102104121771

www.kse.com.pk

http://www.sciencedirect.com/science/article/pii/0304405X77900204

http://onlinelibrary.wiley.com/doi/10.1111/j.1540-6261.1967.tb02975.x/abstract

http://papers.ssrn.com/sol3/papers.cfm?abstract_id=255868

http://www.sciencedirect.com/science/article/pii/0378426683900328

http://link.springer.com/article/10.1023/A%3A1027324317663#page-1

http://www.jstor.org/discover/10.2307/3665021?uid=3738832&uid=2&uid=4&sid=21102104121771

http://www.kse.com.pk/

Effect of operating, financial and total leverage on expected stock return and market value of equity

Economy & Finance

leverage effect

analysis of leverage

impact of leverage

degree of total leverage

market value ratio

equity risk

equity elements

financial markets