The Impact of Financial Leverage on Stock Returns on five big companies in NASDAQ Market

(Facebook, Alphabet Inc, Apple, Microsoft, Amazon)

Faculty of Economic, Balkh University

Master of Finance and Accounting (MFA)
January 4, 2019

Instructor: Mr.Mohammad Haroon Asadi, asadi.haroon@gmail.com

Ms.Kubra Alami, Kubra_Alami@gmail.com

Ms.Fatema Khawary, Fatema.kh2016@gmail.com

1. Abstract:

There are two types of leverage, Operating leverage and financial leverage, the main purpose of a
company in using financial leverage is to increase the shareholder’s return. In this paper we collect some
information to find out the relationship of financial leverage and stock returns.

The Leverage of five selected firms were estimated from the annual financial reports covering a
period of four years (i.e.2014-2017). In this study, we find out that in some years the financial leverage is
positive and develop the value of the firm to a better condition, and in some years the financial leverage
has negative impact on the stock return.

Overall high level of leverage creating a high level of risk, leading to fluctuation in the stock prices but
there is no logical and clear relationship between them.

Keywords: leverage, Earning per share, returns, financial risk

2. Introduction:

Leverage activities with financing activities is called financial leverage, it involves the use of funds
obtained at a fixed cost in the hope of increasing the return to the shareholders. It helps to examine the
relationship between EBIT and EPS. If the firm acquire fixed cost funds at a higher cost, then the earning
from those assets, the earning per share and return on equity capital decrease. The greater the amount
of debt a firm uses to finance its operation, the higher the financial risk.

An important job of the board of directors and the CEO is to establish the mix of funds that will be used
to finance a firm’s asset.

Managers should attempt to maximize the value of the firm, managers should choose the capital
structure that they believe will have the highest firm value because this capital structure will be most
beneficial to the firm’s stockholders. (Ross, Westerfield, Jaffe, 2013),

The optimal capital structure for a firm may be defined as the relationship of debt and equity that
matches the firm’s appetite for risk. If a firm borrows and favorable financial leverage increases return

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at an acceptable risk level, the value of its common stock will rise. (Hampton, 2010). Every firm and
project can have a different optimal structure as a result of different risk appetites of investors.

This is the chance that an investment will not generate sufficient cash flows to cover interest and
principal payments on its debt or to provide adequate profits to the owners. If the firm falls short of its
return goal, it may be able to cover its operating expenses but not the financing costs of the original
investment. (Hampton, 2010)

Investors invest for anticipated future returns, but those returns rarely can be predicted precisely. There
will almost always be risk associated with investments. Actual or realized returns will almost always
deviate from the expected return anticipated at the start of the investment period, investors would
prefer investments with the highest expected return. (Bodie, Kane, Marcus, 2014).

Financial risk managers pay considerable attention to ways in which firms accept higher levels of risk in
order to achieve higher likely returns. Leverage is one of those tools. The financial manager can identify
many different types of leverage. In most cases, the effects are reversible, so that the leverage may be
favorable or unfavorable. This is the risk accepted by the firm.

Many financial managers would argue that financial leverage is the most important of the leverage
concepts. It finds particular application in capital-structure management. A firm’s capital structure is the
relationship between the debt and equity securities that the firm uses to finance its assets. A firm with
no debt is said to have an all-equity capital structure. Since most firms have capital structures that
include both debt and equity elements, the financial manager is highly concerned with the effects of
borrowing. If a firm is making money on its borrowing (has favorable financial leverage), the
shareholders are realizing higher earnings per share than they would in the absence of debt. (Hampton,
2010).

Financial leverage can increase return to equity owners by using low-cost debt to finance assets at a
lower interest rate than the return on investment from financed assets.

Here we try to find out: Is there any relationship between financial leverage and stock return?

3. Literature Review:

At the following paragraph we speak about the main concept ideas related to the topic of this research.

3.1 Financial Leverage:

Financial leverage refers to borrowing money to acquire assets in an effort to increase sales and profits.
A company can have either positive or negative financial leverage depending on the difference between
its rate of return on total assets and the rate of return that it must pay its creditors. If the company’s
rate of return on total assets exceeds the rate of return the company pays its creditors, financial
leverage is positive. If the rate of return on total assets is less than the rate of return the company pays
its creditors, financial leverage is negative. (Ray H. Garrison, Eric W. Noreen, Peter C. Brewer, 2018)

Financial leverage is the extent to which a firm relies on debt, and a levered firm is a firm with some
debt in its capital structure. Because a levered firm must make interest payments regardless of the

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firm’s sales, financial leverage refers to the firm’s fixed costs of finance, an increase in financial leverage
(i.e., an increase in debt) increases beta. (Ross, Westerfield, Jaffe, 2013)

3.2 Measures of Leverage:

There is three commonly used measures:
1. Total debt ratio
2. Debt–equity ratio,
3. Equity multiplier

3.3 Debt–equity ratio:

The debt-to-equity ratio measures the amount of debt capital relative to equity capital. Interpretation is
similar to the preceding two ratios (i.e., a higher ratio indicates weaker solvency). A ratio of 1.0 would
indicate equal amounts of debt and equity, which is equivalent to a debt-to-capital ratio of 50 percent.
Alternative definitions of this ratio use the market value of stockholders’ equity rather than its book
value (or use the market values of both stockholders’ equity and debt). (Thomas R. Robinson, Elaine
Henry, Wendy L.Pirie, Michael A.Broihahn, Jack .T, Timothy S.Doupnik, 2015)

The debt-equity ratio can be defined as follow:

𝑇𝑜𝑡𝑎𝑙 𝐷𝑒𝑏𝑡
𝐷𝑒𝑏𝑡 − 𝐸𝑞𝑢𝑖𝑡𝑦 𝑅𝑎𝑡𝑖𝑜 =
𝑇𝑜𝑡𝑎𝑙 𝐸𝑞𝑢𝑖𝑡𝑦

3.4 Return

The objective of investors is to maximize expected returns subject to constraints, primarily risk. Return is
the motivating force in the investment process. It is the reward for undertaking the investment.

Returns from investing are crucial to investors, they are what the game of investment is all about. The
measurement of realized (historical) returns is necessary for investors to assess how well they have
done or how well investment managers have done on their behalf. Furthermore, the historical return
plays a large part in estimating future, unknown returns. (P.Jones, 2012)

3.5 Expected Return

This is the return that an individual expects a stock to earn over the next period. Of course, because this
is only an expectation, the actual return may be either higher or lower. An individual’s expectation may
simply be the average return per period a security has earned in the past. Alternatively, the expectation
may be based on a detailed analysis of a firm’s prospects, on some computer-based model, or on special
(or inside) information. (Ross, Westerfield, Jaffe, 2013)

The “expected” return is not the return investors believe they necessarily will earn, or even their most
likely return. It is instead the result of averaging across all possible outcomes, recognizing that some
outcomes are more likely than others. It is the average rate of return across possible economic
scenarios. (Bodie, Kane, Marcus, 2014)

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3.6 Market Return

The market return is the expected return on the market portfolio. It is the average return, if you will, on
all the assets traded in the market. (Hampton, 2010)

3.7 Earning per share

Net income divided by the number of shares outstanding. It expresses net income on a per share basis.
(Ross, Westerfield, Jaffe, 2013)
𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒
𝐸𝑃𝑆 =
𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑆ℎ𝑎𝑟𝑒 𝑜𝑢𝑡𝑠𝑡𝑎𝑛𝑖𝑛𝑔

3.8 EBIT

Earnings before interest expense and taxes. EBIT is usually called “income from operations” on the
income statement and is income before unusual items, discontinued operations or extraordinary items.
To calculate EBIT operating expenses are subtracted from total operations revenues. Analysts like EBIT
because it abstracts from differences in earnings from a firm’s capital structure (interest expense) and
taxes. (Ross, Westerfield, Jaffe, 2013)

3.9 Risk

Risk is the chance that the actual outcome from an investment will differ from the expected outcome
specifically most investors are concern that the actual outcome will be less than the expected outcome,
the more variable the possible outcome that can occur , the greater the risk (P.Jones, 2012).

3.10 Financial Risk

Financial risk is associated with the use of debt financing by companies. The larger the proportion of
asset financed by debt (as opposed to equity), the larger the variability in the returns, other things being
equal. Financial risk involves the concept of financial leverage, explained in managerial finance courses.
(P.Jones, 2012)

3.11 Risk-free return

The return on a riskless asset, often peroxide by the rate of return on Treasury securities. RF is the
return on a risk-free asset such as Treasury bills. This position has zero risk (on a practical basis, in the
sense of default) and an expected return equal to the current rate of return available on risk-free assets
such as Treasury bills. This risk-free rate of return is available to all investors. (Hampton, 2010)

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3.12 Risk and Return Relationship

Return and risk are opposite sides of the same coin. (P.Jones, 2012)
Investors invest for anticipated future returns, but those returns rarely can be predicted precisely. There
will almost always be risk associated with investments. Actual or realized returns will almost always
deviate from the expected return anticipated at the start of the investment period. Investors would
prefer investments with the highest expected return, if you want higher expected returns, you will have
to pay a price in terms of accepting higher investment risk. If higher expected return can be achieved
without bearing extra risk, there will be a rush to buy the high-return assets, with the result that their
prices will be driven up. If returns were independent of risk, there would be a rush to sell high-risk
assets. Their prices would fall (and their expected future rates of return rise) until they eventually were
attractive enough to be included again in investor portfolios. We conclude that there should be a risk–
return trade-off in the securities markets, with higher-risk assets priced to offer higher expected returns
than lower-risk assets. (Bodie, Kane, Marcus, 2014)

4. Research Question:

Is there any relationship between financial leverage and stock return?

5. Methodology:

5.1 The stock price for the five selected companies have been download from Yahoo Finance historical
data section, and the leverage percentage of the selected firms obtained from www.csimarket.com,
Income statement, Balance sheet downloaded from www.Nasdaq.com. Increase/decrease of the stock
return, Earning per share, Debt-Equity ratio compared over the four year with the increase/decrease of
Debt-Equity ratio.

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5.2.1 Stock Return (Dependent Variable)

5.2.2 Leverage (Independent Variable)

𝑇𝑜𝑡𝑎𝑙 𝐷𝑒𝑏𝑡
𝐷𝑒𝑏𝑡 − 𝐸𝑞𝑢𝑖𝑡𝑦 𝑅𝑎𝑡𝑖𝑜 =
𝑇𝑜𝑡𝑎𝑙 𝐸𝑞𝑢𝑖𝑡𝑦

6. Presentation of Results, Analysis and Discussion

Table 6.1: (Facebook Company)

Year 2014 2015 2016 2017

EPS 1.1 1.29 3.49 5.39
Debt to Equity 0.01 0 0 0
Stock Return Average 0.022 0.031 0.004 0.029

Interpretations:

As you can see in the table 6.1, Facebook has debt only on 2014 but the average stock return is lower
than other years which proves that leverage has negative effect on the stock return and it may because
of interest expense. Also earning per share on 2014 is in the lowest level than other years.

Facebook
100%
100%
99%
99%
98%
98%
97%
97%
96%
96%
2014 2015 2016 2017

EPS Debt to Equity Stock Return Average

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Table 6.2: (Alphabet Inc.)

Year 2014 2015 2016 2017

EPS 20.57 22.84 27.85 18
Debt to Equity 0.05 0.04 0.03 0.03
Stock Return Average -0.009 0.037 0.007 0.024

Interpretations:

In the table 6.2, Alphabet Inc. on 2015 the D/E ratio and average stock return is higher than 2016, on
2014 the D/E is higher than 2016 but the average stock return is lower than 2016, also D/E on 2017 is as
same as 2016 but the average stock return is higher than 2016, all these finding lead us for unclear
relationship between Debt-Equity ratio and stock return.

Alphabet
100%

100%

100%

99%
2014 2015 2016 2017

EPS Debt to Equity Stock Return Average

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Table 6.3: (Apple)
Year 2014 2015 2016 2017
EPS 6.45 9.22 8.31 9.21
Debt to Equity 0.32 0.54 0.68 0.86
Stock Return Average 0.039 0.012 0.000 0.036

Interpretations:

In the table 6.3, Apple. on 2017 the D/E ratio is higher than 2016, and average stock return raised from
zero to 0.036, on 2014 the D/E is lower than 2017 but the average stock return is higher than 2017, on
2015 and 2016 the D/E is higher than 2014 but the average stock return is lower than 2014, all these
finding lead us for unclear relationship between Debt-Equity ratio and stock return.

APPLE
100%

98%

96%

94%

92%

90%

88%

86%
2014 2015 2016 2017

EPS Debt to Equity Stock Return Average

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Table 6.4: (Microsoft)

Year 2014 2015 2016 2017

EPS 2.63 1.48 2.56 3.25
Debt to Equity 0.25 0.44 0.75 1.19
Stock Return Average 0.025 0.005 0.027 0.022

Interpretations:

In the table 6.4, Microsoft. on 2017 the D/E ratio is very higher than the previous years but the average
stock return except year 2015, are in the same range, on 2015 the D/E is higher than 2014 and 2016 but
the average stock return is very lower than them, in this company also we can’t find a clear relationship
between Debt-Equity ratio and stock return.

Microsoft
100%
90%
80%
70%
60%
50%
40%
30%
20%
10%
0%
2014 2015 2016 2017

EPS Debt to Equity Stock Return Average

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Table 6.5: (Amazon)
Year 2014 2015 2016 2017
EPS -0.52 1.25 4.9 6.15
Debt to Equity 1.5 1.31 1.06 1.59
Stock Return Average -0.011 0.064 0.027 0.034

Interpretations:

In the table 6.4, Amazon. on 2017 the D/E ratio is 1.59 and on 2014 is 1.50 but the average stock return
of 2014 in minus it means lose but on 2017 is 0.034, with leverage in same range we see a big difference
in average stock returns, on 2015 the D/E and average stock return is higher than 2016, overall in this
company also we can’t find a clear relationship between Debt-Equity ratio and stock return.

Amazon
100%

80%

60%

40%

20%

0%
2014 2015 2016 2017
-20%

-40%

EPS Debt to Equity Stock Return Average

7. Conclusion

In this paper we studied the relationship between stock return and Debt-Equity (A mesure of
financial leverage) of selected firms (Facebook, Alphabet Inc, Apple, Microsoft, Amazon), We found out
that In some years the financial leverage is positive and develop the value of the firm to a better
condition, and in some years the financial leverage has negative impact on the stock return.

Overall high level of leverage creating a high level of risk, leading to fluctuation in the stock prices but
there is no logical and clear relationship between them.

Leverage is a powerful tool that cannot be ignored by modern corporations. Enterprise risk management
tells us that the firm needs to establish its appetite for risk. Then, it can use leverage in its profit
planning to reach the desired profit goals at a risk level that is acceptable to it.

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