Influence of Financial Leverage on Payoffs to Markets and Shareholder Value - London Stock Exchange - Thesis Proposal Example

Influence of Financial Leverage on the Payoffs to Markets as well as Shareholder Value: Case of London Stock Exchange (LSE) Student’s Name Professor Course Date Abstract This paper will investigate the impact of financial advantage on the shareholder payoff as well as the market value of 35 companies listed in the London Stock Exchange (LSE) - 7 each (4 low and 3 high leverage) from automobile and accessories, telecommunication and technology, banking, insurance and manufacturing and allied. The return to the shareholders will be measured through the earning for every share as well as the return on equity ratio whereas the market value will be calculated through price earning ration and dividend payout. Linear progressions will be employed in quantifying the impact of financial leverage on market value and shareholder return. 1.0 Introduction Financial leverage refers to the use of financing with a fixed charge, for instance interest. It is the payment of a fixed interest rate for the use of fixed-interest bearing securities, for purposes of magnifying the rate of return as equity shares. The leverage is usually successful in case a company earns more on the borrowed funds than it pays to use them. This occurs when the company earns more on the assets bought with the funds than the fixed cost of their use and vice versa. It is usually not successful in case a company earns less on the borrowed funds than it pays to use them. According to Buse et al. (2006), financial leverage is employed in magnifying the shareholders returns and has basis on the assumption that the fixed costs or charges funds can be acquired as a cost, which is lower that the company rate of return on its assets. Sharma (2006) argued that company financial leverage affects its value. Financial leverage is thus linked to a company financing activities and it depicts the association between a company returns before interests and taxes (EBIT) (or operating profits) and earnings which are available for the ordinary shareholders. It exists only when the capital structure comprises of debt and other fixed return capital such as long term financial loans from financial companies or preference shares. It also exists when the company returns on investment (ROI) must be equal to the percentage of interest and other fixed charge. According to Schauten & Spronk (2006), the management endeavours to arrive at a proper mixture of equity and debt in order to maximize the value of the company as well as the return to the shareholders; this is not a simple task for the management. A company can use financial leverage to increase earnings per share as the after tax debt cost is lower than the return on investing the borrowed funds. Alternatively, as the debt ratio or debt/equity rises, the risk of leverage also rises. 2.0 Statement of the Problem There is a negative connection between stock profits and stock instability, which is the leverage effect- the stock prices normally drop as the stock volatility increases. Two major economic justifications exist for this leverage outcome. The first one has basis on the link amid expected returns as well as volatility. The projected profits usually rise when instability increases and this in turn lead to a drop in the stock prices. Consequently, stock returns and volatility correlation is negative. The second justification has basis on financial leverage. The financial leverage usually increases as the stock prices drop causing a rise in volatility of stock profits. There is no agreement on the magnitude of financial leverage on instability of stock. The various experimental researches, which have focussed on this, have produced mixed results, and the studies face various complicatedness. All studies on the impact of this leverage on stock volatility draws on estimations of market debt, which is hard to acquire in reality. The empirical studies also lack a conjectural point of reference for asset instabilities in line with numerous aspects of asset pricing facts in the occurrence of both equity and debt claims. This research will offer such a point of reference. The hypothesis that financial leverage can explain the payoffs to markets and shareholder value has been discussed by various studies, which offer empirical substantiation, derived from a number of well-known companies- for the unconstructive association between volatility and stock profits stimulated by fiscal leverage. For instance, Figlewski and Wang (2000) documented a better financial leverage outcome in down market compared to the up marketplaces. Bekaert and Wu (2000) offer econometric asymmetric instability models. None of the researches applied market debt to ascertain financial advantage. Wu (2001) studied the source of asymmetric volatility of stocks using a partial equilibrium model whereas Tauchen (2005) build a broad stability model, which had an external volatility irregularity. Both Wu and Tauchen models determined the leverage effect by ascertaining the link between expected returns and volatility. This study employs a standard all-purpose stability market with debt to focus on the impacts, which financial leverage has on stock volatility aspects. It explores the effect of financial leverage on stock instability and consequently on the payoffs to shareholder and market value. This study will exemplify the economic ways via which financial leverage impels stock volatility dynamics and compute its leveraging outcome. 3.0 Background of the Study Financial leverage of a critical aspect in financial management. Financial leverage can maximize the shareholder and market value earning per share in case the management attempts to arrive at a proper mix of equity and debt. The earning for every share of a company can also be increase with financial leverage as the after tax debt cost is lower than the return on investing in the borrowed funds. On the other hand, the risk of financial leverage is also enhanced by a rise in debt /equity ratio and the debt ratio. The variation of companies’ situation may also affect the financial leverage negatively and thus each company has to cover the interest cost of debt in case of a decrease in return on equity. This implies that there would be a clear decrease in returns for every share than in there is less leverage. Using financial leverage results in a fixed financing charge, which can materially affect the earning available to common shareholders. This study will focus on two important things while looking at financial leverage as part of the financial analysis; the degree of financial leverage as this is a type of opportunity or risk measurement from the stockholder perspective. The higher the degree of financial leverage, the greater the multiplication factor and this leads to the second issue, which is the major focus of this study: determining whether financial leverage work against or for the owners. 4.0 Significance of the Study The aim of this research is to quantify the effect of financial leverage on market value and stockholder returns. Because financial leverage is one of the method by which the shareholder return and market value can be stimulated, this study will evaluate the impact of financial leverage on the chosen 35 companies to evaluate whether financial leverage has the same impact. Some studies have suggested that financial leverage is advantageous at the start up and growth stage of companies (Schauten & Spronk 2006; Tauchen, 2005). This study will help to establish this statement. The study will show the implications of using financial leverage to increase the shareholder return. The importance of financial leverage is understood to increase the returns of shareholders and this has basis on the assumption that the fixed charges can be effortlessly recovered at reduced costs than the company rate of return on net assets. As a result, the distinction between returns accruing from assets funded by the fixed charge and the cost of these funds is distributed to the stockholders, consequently, there in an increase in equity. This study will also assess this statement. The study will show the impact of financial leverage on companies in different sectors to establish whether some sectors benefit from financial leverage than other so that shareholders can become knowledgeable on the firms, which can generate maximum returns. The primary aim of using the 35 companies’ financial leverage is to boost the shareholders returns and company market value. 5.0 Research Questions and Hypothesis It is a widely known fact that high degree of financial leverage leads to high financial risk (the risk of the company failing to cover its fixed financial costs). Nevertheless, financial leverage is not always bas as it can increase the shareholder return on investment and often brings about tax advantages, which are associated with borrowing. Financial leverage is this important in stimulating the shareholders return on investment as well as the market value. The main research questions of this study are: How does financial leverage affect the shareholder and market value? How does financial leverage affect earnings per share How does financial leverage affect return on equity How does financial leverage affect price-earnings ratio and dividend payout Based on the objectives, the following hypotheses will be tested H1: “Financial leverage has no effect on shareholder and market value” H2: “ Financial leverage has no affect earnings per share” H3: “Financial leverage has no impact on return on equity” H4: “Financial leverage has no impact on price-earnings ratio and dividend payout.” 6.0 Literature Review One of the main bases of risk, which pervades financial decision-making, is the choice between debt and equity financing. The company may acquire assets using its own assets or by borrowing them. Financial leverage takes place when companies borrow funds and in return agrees to pay fixed payments like interests and repay the principal after duration of time. In case the company earns higher return than it agreed to pay, the difference accrues to it, and magnifies return on the investment. On the other hand, if it earns a lower return, it can make up the difference, which magnifies its loss. The company cannot have it both ways and thus in increasing the potential return, it can increase the potential loss. The tradeoffs between magnifying returns in opposition to magnifying possible losses usually take place in various instances. Financial leverage thus refers to the magnitude to which interest on debts magnifies operating income changes into even larger proportionate changes in returns after taxes. It magnifies the increase in earnings for every share during periods of increasing operating income, however is adds considerable risks for creditors and stockholders which arise from obligation of added risks. It results from using debts to fund assets; the larger the ratio of finance contributed by compared relative to funds contributed by shareholders, the larger the company financial leverage. It magnifies variations in net income relative to variations in operating income. For instance, financial leverage may cause a company reported net income to rise by 25% whereas its operating income increases by 15%. The 20% rise in operating income can generate an equal percentage rise in net income without financial leverage. The magnifying effect works both downward and upward and this means that the shareholders benefit from financial leverage during good times and the firm operation income in rising. Nonetheless, their investments in the company can be at a considerable risk during bad times when the operating income is falling. Various researchers have tested the relationship between financial leverage and returns. Hovakimian et al. (2001) put forward that a company capital structure is a critical component in explaining returns. They investigated the link between the ration of equity to assets and returns, which was inversely related to leverage. There are researchers who have established that increase in returns occurs with increase in leverage (Dimitrov & Jain 2005; Korteweg 2004). They showed that financial leverage is a sign of the debt amount used in a company capital structure and that it is an impact on returns of change in the extent to which the company assets are financed with finance, which are borrowed. Pandey (2007) argued that the financial leverage that a firm employs is meant to earn more on the fixed charge as opposed to their relative costs. It is thus the final element of return on equity. It is a measure on the way companies use debt and equity to finance assets. A rise in debts causes a rise in financial leverage. The management is prone to prefer equity financing over debt because it has limited risks. 7.0 Definition of terms Financial Leverage Financial leverage is a requirement for attaining maximum capital structure. According to Pandey (2007), to acquire the financial leverage ratio, assets are divided by shareholder equity. An optimum capital structure can affect the value of an organization and shareholder wealth through reduced cost of capital. As a result, optimal debt level determination and its influence on the company all capital structure is taken as a fundamental part of the financial decision of a company (Ward & Price 2006). A profitable company experiences a higher return on equity (ROE) which results from an increase in the borrowings (Ward & Price 2006). All companies should make sure that their capital structures are largely slanted to a higher debt level, nevertheless, the amount of debt that a company should take on is limited (De Wet 2004). Earnings’ per Share The amount of income earned on a share of common stock in an accounting duration applies to common stocks and company income statements. Private companies are not required to report earnings per share because of cost-benefit considerations. Earnings per share are calculated by “dividing (net income-preferred dividends) by the weighted average number of ordinary shares outstanding.” The earning for every share in increased by financial leverage as the after-tax debt cost of less that the return on investing the money, which is borrowed. According to Firer et al. (2004), earnings per share is calculated by expression net profit on a per share basis and indicates the amount a market is ready to pay for a share depending on what they perceive as the quality of a company future earnings. Return on Equity The return on equity calculates the profit that investors get from investing in a certain company. The return on equity results from the effectiveness of all operational, commercial, as well as financial activities of a company. The utter size of the total return of shareholder varies with the stock market; however, the relative position depicts the market perception of general performance. The shareholder return is calculated by deducting the price of the share at the commencement of trade time from the value at the end of the period and then multiplying by the number of shares. The total shareholder return combine price appreciation and dividends paid to show the total returns to the shareholders. According to Firer et al. (2004), it measures after tax net profit over the total equity. It is this imperative parameter for assessing a company’s performance from the shareholders perspective. Generally, most shareholders invest with a company for a long period because they are getting good profits. Market Capitalization Market capitalization refers to the sum resulting from the current stock price per share multiplied by the outstanding number of shares. It indicates the value of a company although it is a temporary metric, which has basis on the current stock market. A company true value such as balance sheet, product positioning, and profits are not adequately by market capitalization. Nonetheless, the market capitalization shows the aggregate value of a company stock. 8.0 Research Methodology 8.1 Introduction This study will be empirical in nature and the study population will include 35 companies listed in the London Stock Exchange (LSE) - 7 each (4 low and 3 high leverage) from automobile and accessories, telecommunication and technology, banking, insurance and manufacturing and allied. These companies will be selected using purposive sampling method. The study will be completed in duration of 6 months and the data will be collected from the company website. 8.2 Variables The dependent variables in this case will be the 35 companies’ debt equity-to-equity ratio, which will be the measure of financial leverage. Various ratios such earnings per share, return on equity, dividend payout ratio, price earnings ratio will be calculated to determine the effect of financial leverage on the payoffs to shareholders and market value. All these ratios will be dependent variable whereas financial leverage will be the independent variable. The return of equity variable will be used to calculate the payoffs to the stockholders. Price Earnings ratio will be used to calculate the market value. 8.3 Ratios The ration will be calculated as follows: “Earnings per share = (Net profit after Tax –Preference Dividend) / Amount of Equity Shares” “Return on Equity = (Net Profit After Tax – (Preference Dividend/Paid up Equity share capital)” “Price Earnings Ratio = (Market Price for every Equity share / Earnings for every share)” “Dividend Payout Ratio = (Dividend for Equity Share/ Earnings for every share)” In quantifying the impact of financial leverage on market value and shareholder return, linear regression will be used. The research will take on a cause and effect relationship between financial leverage and shareholder returns and market value. Secondary data relating to the sampled firms financial performance will be sourced from the company annual financial statements availed in their online databases. This data will thus be sourced to undertake the analysis. 8.4 Population and Unit of Analysis This study will be confined to companies, which are listed in the London Stock Exchange (LSE). The study will focus on 35 companies and assess the impact of financial leverage on shareholder return and market return. The unit of analysis will be a firm listed in the LSE. 8.5 Sample Selection A sample refers to a subset from a large population. Sampling refers to the process of using a sample of a population to derive conclusions about a particular population (Zikmund 2003). The information collected from the sample can be generalized to the large population. This study will use stratifies sampling by industry sector to understand the characteristics of the companies in the subset. The data obtained from the companies will be categorized by industry sector. 8.6 Possible Research Limitation This research might face these limitations The research will be restricted to the financial data of the companies listed on the London Stock Exchange (LSE) and thus fails to represent firms which are listed in other stock exchanges’ or those which are not listed. Reference List Bekaert, G & Wu, G 2000, Asymmetric volatility and risk in equity markets, The Review of Financial Studies, vol. 13, pp. 1–42. Buse, L., Siminica, M & Ionascu, C 2006, The impact of the financial leverage on the return of the romanian industrial companies, Available at: www.revistadestatistica.ro/rezumate/11_20buse.doc. [Accessed 3 May 2012] Dimitrov, V & Jain, P 2005, The value relevance of changes in financial leverage, SSRN Working Paper Series. De Wet, J 2006, Determining the optimal capital structure: a practical contemporary approach, Meditari Accountancy Research, vol. 14, no. 2, pp. 1-16 Figlewski, S & Wang, X 2000, Is the “leverage effect” a leverage effect? Working Paper New York University. Firer, C., Ross, S., Westerfield, R & Jordan, B 2004, Fundamentals of Corporate Finance. 3ed., Berhshire, McGraw Hill. Hovakimian, A., Opler, T & Titman, S 2001, The Debt-Equity Choice. Journal of Financial and Quantitative Analysis. Vol. 36, no. 1, pp. 1-24. Korteweg, A 2004, Financial leverage and expected stock returns: evidence from pure exchange offers, Available at SSRN: http://ssrn.com/abstract=597922 or http://dx.doi.org/10.2139/ssrn.597922 [Accessed 3 May 2012] Pandey, I 2007, Financial management, Vikas Publishing, New Delhi Sharma, A 2006, Financial leverage and firm’s value: a study of capital structure of selected manufacturing firms in India, The Business Review, vol. 6, no. 2, pp. 70-76. Schauten, M & Spronk, J 2006, Optimal capital structure: reflections on economic and other values, ERIM Report Series Reference No. ERS-2006-074-F&A. Tauchen, G 2005, Stochastic volatility in general equilibrium, Working Paper Duke University. Ward, M & Price, A 2006, Turning vision into value, Van Schaik Publishers, Pretoria Wu, G 2001, The determinants of asymmetric volatility, The Review of Financial Studies, vol. 14, pp. 837–859. Zikmund, W 2003, Business research methods, 7ed. Thomson Learning, Mason, OH. . Read More