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Capital structure and stock market returns

| March 24, 2015

The major aim of this paper is to test the Modigliani and Miller (1958) theorem on capital structure and stock market returns. Existing empirical evidence has proved inconclusive regarding the nature of the relationship between both factors. Several theorists claim that the higher the level of debt, the higher the stock market returns due to tax deductible nature of interest, while others claim that higher equity ratios positively affect stock returns due to the lower risks associated with equity financing. However the theories of capital structure depict that debt equity policies within organizations are based on the trade off theory or pecking order theory, in which the risk associated with debt and the unwillingness to raise equity affect capital structuring decisions.

Empirical evidence was therefore sought to find out which assumption was the most probably explanation for the relationship between capital structure and stock market returns, if there was any. Ten stocks with a market capitalisation exceeding $20billion were utilised during this research. They were separated equally based on their Total Debt/Equity ratio. Five companies had Debt/Equity ratios ranging from 15% – 30%, while the other five companies had high Debt/Equity ratios from 300% – 500%. Two portfolios were created using an online portfolio manager, and the stocks were held for a period of thirty-six days, up until March 30 2010.

The results gathered from the empirical analyses illustrates that the stock market returns across both portfolios are quite similar. The portfolio with the lower leverage had returns of 7.99%, while that with a higher leverage had returns of 10.39%. The portfolio with the higher leverage confirms theories that higher debt could inspire higher returns due to investor sentiment, while those with lower returns could be as a result of information asymmetry associated with higher equity. However, both results are quite similar with no large differences in returns. A difference of 2.4ppt cannot be said to represent considerable differences in returns, therefore confirming Modigliani and Miller’s theorem. Several other views are provided on the determinants of capital structure and stock market returns.

Capital Structure and Stock Market Returns

Financial Managers in medium and large organisations often have the inundating responsibility of adapting the firm’s finances to an optimal capital structure. This structure must appropriately balance the risks associated with debt financing with investor sentiment regarding equity financing (Davidson, 2002). They have to determine the best form of financing for a vast majority of the firm’s operating and investing activities, such that the firm always has available funds to operate efficiently and maximize shareholder value (Damodaran, 2000).

However, the notion that that capital structure and shareholder value – through stock market returns – are somewhat related has been rejected by the seminal work carried out by Modigliani and Miller (1958). They found in 1958 that the capital structure of a firm is unrelated to its stock market returns, due to the tax advantages present with debt financing, and lower risks of equity financing. In 1963, they published another contradicting and controversial finding which depicted that a 100% debt financing would be the most appropriate method for an organisation to fund its operations, based on the notion that interest was tax deductible and could therefore boost a firm’s value. However several other theorists have reached differing conclusions regarding this issue, as some have found a relationship, while others have supported this theorem.

This paper therefore aims to test the Modigliani and Miller theorem by conducting an academic research on the effect that capital structure has on stock market returns. Using an imaginary investment capital of $1 million, two portfolios have been created that adhere to financial ratios of low liquidity and high liquidity respectively (based on their Total Debt/Equity ratio) and have been analysed based on their stock market returns over a thirty six day period. If the results obtained are similar across both portfolios then it would serve to verify this theorem, however if the results are substantially different, then the theorem could be contradicted based on real life empirical findings.

The following chapters entail in-depth literature review on the relationship between capital structure, stock market returns and other firm specific factors. Subsequently followed by a methodology section, which contains the various procedures utilized in conducting the research. The research findings illustrate the results of the analysis, which are then discussed and critically analysed using existing literature, in the discussion chapter. The conclusion is a summary of all the major focus points of this paper.

Ross (1977) depicts that the main objective of corporate finance is to “explain the financial contracts and real investment behaviour that emerge from the interaction of managers and investors”. The following theories are therefore reviewed in accordance with this view and would aim to answer the answer the following research question: Does the capital structure of a firm directly affect it’s stock market returns?

Historically, market perception about the value of stocks have primarily been dependent on their exposure to debt (Yang et al, 2010), as a popular notion was that companies with high level of debt posed a higher risk due to financial uncertainties, interest repayments and bankruptcy costs (Hovakimian et al, 2010). Companies with lower debts were perceived to have higher value, due to their lower risks and equity funding (Jegadeesh, 2000). This perception held valid, albeit with no empirical evidence to support it (Yang et al, 2010), up until the seminal paper published by Modigliani and Miller (1958). The seminal paper explicitly states that “…the market value of any firm is independent of its capital structure and is given by capitalizing its expected return at the rate p, appropriate to its class”, thereby asserting that in an efficient market, wherein the factors of tax and dividend were constant, the debt or equity level of a firm was not important in determining its value.

A widespread consequence of these insights have been the invalidation of theories relating to optimal capital structure that could help boost a company’s market value (Ross, 1977). Because if capital structures are indeed not important, then there would be no basis for adopting target debt/equity financing ratios (Graham and Harvey, 2001). Ross (1977), in accordance with this theorem, depicts that the financial risk to equity holders induced by higher leverage would be offset by the higher expected rate of returns demanded, such that the cost of capital remains the same even with more debt. Baker and Wurglar (2002) also express their agreement by proposing that buying a company, then reissuing its financial package on a personal account, could result in an arbitrage profit, which would have been impossible if the value changed with capital structure.

This theory was however contradicted by its authors: Modigliani and Miller (1963) who depicted that the optimal capital structure of an organisation should be 100% debt funding, due to the notion that debt is tax deductible and lower than the expected rate of return by equity investors (Harris and Raviv, 1991), thereby illustrating that a maximum level of debt would result in maximum market value. Though these theories have inspired a wide range of financial research over the past years (Miller, 1988), empirical research illustrates that capital structure varies both across and within industries (Upneja and Dalbor, 2001) and that not all companies adopt 100% debt financing (Myers, 1977). Thereby demonstrating that the capital structure choice of an organization must be dependent on industrial and firm specific factors, regardless of the effect it may have on market value (Wald, 1999).

A firm’s capital structure, according to Van Horne and Wachowicz (1995) refers to the method through which the company is financed: liabilities or owner equity. Decisions regarding a firm’s optimal structure are therefore contingent on management’s willingness to accept either debt or equity as their optimum form of financing (Karandeniz et al, 2009). Damodaran (2000) further states the weighted average cost of capital (WACC), which determines the value of a firm, is determined by the capital structure.

Two major theories exist regarding the major reason determining a firm’s capital structure. These are the trade off theory (Myers, 1977) and pecking order theory (Miller, 1988). The trade off theory depicts that the capital structure a firm adapts depends on the trade off existing between debt and equity financing. Debt financing decisions are influenced by the tax advantage, while adverse effects of debt funding, such as bankruptcy, investment restrictions and agency costs, influence equity funding (Jensen and Meckling, 1976; Myers, 1977). Therefore an organization would choose the best level of financing depending on how the benefits of debt relate to that of equity.

In contrast, the pecking order theory (Miller, 1988) depicts that there is no optimal capital structure within a company. Theoretically, investors would devalue a company during equity raising, due to information asymmetries and agency costs (Welch, 2004). Finance managers would therefore do their best to avoid raising equity so would therefore use up internal funds before resorting to external financing. In the advent that they seek external funds, these companies would prefer to issue the safest financing (debt) first, followed by convertible securities, and finally equity (Bhandari, 1988). Upneja and Dalbor (2001) however argue that only profitable firms can generate the required cash flow for internal financing, thereby restricting an unprofitable company’s ability to utilize this method.

Other theories regarding optimal capital structure have also been proposed by Jensen and Meckling (1976) who demonstrate that the amount of debt an organization incurs is dependent on the agency conflicts between owners and managers. Shareholders may encourage managers to take on more debt because it restricts the actions of managers from engaging in risky activities, thereby acting more in line with shareholder expectations. However, Damodaran (2000) contradicts this argument by arguing that higher leverage does not benefit shareholders due to the restrictions imposed on investment activities. Highly leveraged firms may be unable to invest in positive NPV projects due to these restrictions (Ebaid, 2009) due to its adverse effect on bondholders (Graham and Harvey, 2001).

Yang et al (2010) in contrast found that the main factors determining a firm’s capital structure are the structure of its assets, profitability, product uniqueness, industry, expected growth and stock market returns. The asset structure (proportion of fixed and current asset) determines how much debt is needed to fund operations, while the profitability as described initially by Upneja and Dalbor (2001) could result in free cash flow that reduces the dependence on shirt term debt financing. Unique products could depict a successful company that generates cash quickly on sales, while the industry structure determines the nature of operations within the industry and the average capital structure amongst competitors (Harris and Raviv, 1991). Titman and Wessel (1988) also state that the uniqueness of an organization, with regards to research, sales expense, and motivated employees are really important in determining the capital structure.

Expected returns on common stock have been found to positively correlate with the level of debt a firm takes on (Bhandari, 1988), while Hovakiian et al (2001) found that the debt ration of an organization changes over time as stock prices and profitability change. Baker and Wurgler (2002) and Welch (2004) also found that the capital structure of firms is strongly related to historical market values of companies. Equity issues in particular have been found to follow high stock market returns, a practice otherwise known as market timing (Bhandari, 1988). Mayer and Sussman (2005) defines market timing as a practice of issuing shares when they are overvalued and repurchasing when they are undervalued. Baker and Wurgler (2002) and Jegadeesh (2002) presented empirical evidence to confirm that firms issue equity based on their market performance, and these are instrumental in determining corporate finance.

Welch (2004) found that the higher the stock market returns of a firm, the lower the debt ratio, thereby confirming the market timing theory, because the higher the stock returns, the higher the shareholder equity, which subsequently decreases the ratio of debt financing. These theories however do not analyse the inverse relationship, which is the effect that capital structure has on performance both within the organization and on the stock market.

Several theories exist on the effects that capital structure have on stock market prices. Rouwenhorst (1999) supports the notion that capital structure affects stock market returns, while the reverse has been found to be true in other situations. Pastor and Stambaugh (2003) found that companies with lower liquidity had higher returns, thereby reflecting a compensation for lower liquidity risk. Rouwenhorst (1999) further explains that small stocks, which are on average less liquid than bigger growth stocks, generally have higher returns also reflecting compensation, this time for their relative illiquidity.

Harris and Raviv (1991) illustrate that the reaction of market participants to leverage increase is usually generally positive as it indicates that the organization is positive about its future, while the reverse is usually true if the company announces intentions to raise capital from the market. Titman and Wessels (1988) also analysed the long-term impact of new equity issues on stock market performance and reported that initial public and seasoned equity offerings are usually followed by a long-term equity underperformance. This underperformance is also related to offerings on convertible debt and public bond (Hovakimian, 2001).

The abnormal effects that these equity or debt offerings have on stock performance has been explained by Mayer and Sussman (2005) to be as a result of the information effect that these information have, than with change to capital structure of the firms. The public would usually associate equity offerings with information asymmetries, which may depict that the finance managers are not confident enough to obtain debt financing due to uncertainties about future performance (Welch, 2004). This would drive the stock prices of the stocks down regardless of the resultant capital structure (Wald, 2004). Giner and Reverte (2001) corroborated this view by conducting a direct test on leverage information and finding that investors usually view deviation from optimal debt level negatively.

Regardless of the stock market returns, the firm capital structure has been found to influence firm performance by limiting conflicts of interest between bondholders and shareholders, modifying incentive packages available to managers (Jensen and Meckling, 1976), restricting the activities of managers (Jensen, 1986), managing information asymmetries information (Ross, 1977), and encouraging investments by the organization in resources such as human capital and business operations (Hovakimian et al, 2001). Yang et al (2010) state that though stock market returns are caused by growth, uniqueness and profitability, these factors are as a result of the combination of the aforementioned factors, and jointly determine the firm performance.

Although these theories depict a relationship between a firm’s capital structure and stock returns, due to information regarding the risk of debt and information asymmetries, empirical evidence regarding these factors has been contradictory and mixed. Ebaid (2009) found no significant relationship between a firm’s capital structure and stock market returns, using three different forms of capital structure calculation. Akintoye (2008) also confirms this assumption by reporting no significant correlation using different research methods. The lack of empirical evidence regarding the relationship between capital structure and stock returns therefore affirms Modigliani and Miller (1958) and Miller (1977) view that the capital structure of a firm has no effect on the firm’s stock market performance.
The following methodology entails the procedure that was utilized in answering the research question.

Ten companies with a market capitalization exceeding $20billion were chosen at random using Google Stock Screener. They were then separated based on their Total Debt/Equity ratio. Companies with market values exceeding $20 billion were chosen while those lower were not included in a bid to eliminate the effects of illiquidity or penny stocks on the stock market returns (Chang et al, 2009). These may have led to abnormal returns either positively or negatively on the value of the stock and would have compromised this research. Ten stocks that pissed these initial selection criteria were chosen at random to test this theorem. 5 of them had a Total Debt/Equity ratio of 15 – 30%, while the other 5 had Total Debt/Equity ratios of 300 – 500%.

Total Debt/Equity ratio was utilized as a measure of the capital structure of the organization since it incorporates the total debt as a percentage of equity, therefore firms with low ratios have lower debt in relation to equity, indicating lower leverage and vice versa. Yang et al (2010) support its use by describing the ratio as a measurement of a firm’s leverage. Wald (1999) also states that using total debts and equity as a capital structure variable provides a very stable platform for measuring the firm’s capital structure. Total debts reflect the firm’s position compared to others and could measure the company’s long-run leverage position.

The following stocks were chosen based on their market value exceeding $20 billion and capital

Two portfolios were created containing the different leverage ratios using Yahoo Finance. The stocks were inserted into the portfolio on February 23 2010 and the stock market performance was calculated over a period of thirty-six days, up until the March 30 2010. The results were downloaded into Excel and analysed using Graphs. Stock market returns using portfolio analysis has been described by Yang et al (2010) to constitute a more appropriate form of ascertaining the relationship between capital structure and stock market returns, due to the collective contribution of all participating companies and elimination of firm based factors which may affect research results.

The market returns of both portfolios are depicted in figures 1 – 3. For the sake of analysis and discussion, the portfolio containing the low leverage companies is referred to as Portfolio 15, while the other is named Portfolio 300. Results from figure 1 illustrate that the all the stocks reported positive gains ranging from 1.98% to 13.9%. The lowest earning stock was BlackRock Inc (BLK) a fund management company, while the highest earning was Fedex Corporation (FDX). All companies analysed operate in different industries and have a debt to equity ratio ranging from 15% to 30%. The average stock market returns for the portfolio, as a whole is 7.99%, excluding transaction costs.

ABBcFigure 2 illustrates the stock market returns of the five other companies with total debt equity ratios ranging from 300% to 500%. This illustrates they have leverage ratios ranging from 75% to 85% (Calculated based on debt/equity ratios). The stock market returns of the stocks in this portfolio range from 7.59% for the lowest earning stock (Morgan Stanley – MS) to 14.73% for the highest earning stock (General Electric). All companies operate within different industries, except for Morgan Stanley and American Express, which both operate within financial services, although in different capacities. The average return for this portfolio is 10.39%.


In comparison, Portfolio 300 with the higher Total Debt/Equity Ratio had higher share returns (10.39%), while Portfolio 15, with a lower leverage had a lower stock return, (7.99%) as illustrated in figure 3. Table 2 also illustrates the apparent gain excluding transaction cost that an investor would have had if he invested $1 million in cash into both sets of portfolio. Those with a higher leverage had higher returns.


The main aim of this research was to answer the following research question: “Does the capital structure of a firm affect its stock market returns?” Literature review provided inconsistent information with a number of theories favouring one over the other. The most prominent theory was that of Modigliani and Miller (1958), which also proved to have been contradicted by several theories. This research therefore aims to answer the question using empirical evidence. Ten stocks were selected with a market capitalisation exceeding $20billion, five of which had low leverage, while the rest had a high leverage.

Two portfolios were created in Yahoo Finance to contain stocks with the different capital structures. The stock market movements were recorded over a thirty-six day period, and the results were analysed illustrated using graphs in Excel. The results obtained illustrate the stock returns between both portfolios are similar, though somewhat different. The stocks with a higher leverage recorded slightly higher returns than their counterparts.

Based on the results obtained two distinctions have been drawn regarding the relationship between capital structure and stock market returns. On one hand, the returns for stocks with higher leverage outperform those of lower rations and also beat market averages, while on the other hand; the returns are quite similar (7.99% and 10.39%). These distinctions would be discussed subsequently with the aid of theories already reviewed in the previous chapter.

i. Higher Debt, Higher Returns
The results from the portfolio analysis illustrate that the stocks with higher leverage outperform those who have a lower leverage by a margin of 2.4 percentage points. Though the margin is fairly low compared to extremely high or low betas, it still proposes that the market favours stocks with higher debt better than those with higher equity. Besides, if the market truly favoured equity stocks, then they should have had higher stock returns and even over performed the market averages. These results are in corroboration with Harris and Raviv (1991) who found that market reaction to leverage information is generally positive as it indicates the organizations positive view about its future. Ginner and Reverte (2001) also found that the market views any deviation from optimal debt level negatively, thereby resulting in low stock returns.

This view has also been expanded by Graham and Harvey (2001), who state that the intention to raise debt is viewed positively by investors due to information asymmetries. Harris and Ravid (1991) depicts that an organization taking on extra debt is usually confident its immediate future, and can illustrate that it can generate the required cash flow to meet interest repayments, can handle the risks associated with higher debt, and would be more prudent in non business related costs due to embargoes usually placed by debt holders (Hovakimian et al, 2001). The higher returns on Portfolio 300 could also be explained by the tax saving benefits of adopting debt financing (Leland and Toft, 1996). These, according to Jegadeesh (2000), are reasons why the market values higher debt companies higher, and could be contributing reason to why Portfolio 300 has higher returns.

These findings therefore invalidate that of Pastor and Stanbaugh (2003) who found that companies with lower liquidity had higher returns because of liquidity risk compensation. Further contradictions to Paster and Stanbaugh have been found by Harris and Raviv (1991) who illustrated that the market views stocks negatively when they make announcements to raise capital. Mayer and Sussman (2005) also found the long-term impact of equity issuing to be generally negative, when analysing initial and secondary public offering against market performance. A vast majority of the stocks in Portfolio 15 have very low leverage ratios and could be suffering from these effects. However, Mayer and Sussman (2005) reject that assumption by arguing that the abnormal effects that information announcements have on equity are mostly as a result of the information effect and not necessarily as a result of structural change.

The fact that several other theorists (Miller, 1988; Ebiad, 2009) also reported inconclusive information regarding these effects, leads me to draw the assumption that though higher debt may inspire investor confidence in the long run due to information asymmetries, it does little to influence the long-term effect on stock market returns. The second discussion in the following subchapter, however paints a better picture regarding the relationship between stock returns and capital structure, as opposed to the assumption that higher debt such as in Portfolio 300 could influence higher stock returns.

ii. It Doesn’t Matter
The results derived from the portfolio analysis illustrate that the stocks of both portfolios would have had similar averages, if the following underperforming stocks were excluded from the portfolios (BlackRock Inc and EMC Corporation). The implication of such findings would corroborate Modigliani and Miller’s (1958) statement illustrating that the capital structure has no effect on the stock market returns of a firm, thereby resulting in investors omitting that financial ratio when seeking companies to invest in. It also conforms to Baker et al’s (2004) view that a consequence of this theorem has been the invalidation of a wide range of management and investing practices that aimed to determine an optimum capital structure that could enhance a firm’s value.

It seems that the lower risk and shareholder ownership associated with adopting majority equity financing is offset by the tax and agency benefits of debt financing, thereby invalidating the premise that majority based equity financing would positively influence investor’s decision regarding a stock (Titman and Wessels, 1988). While a majority based debt financing increases the risk of liquidation and bankruptcy costs associated with high debt. It also imposes financial, investment and operational constraints on the activities of a firm, thereby illustrating why Portfolio 300 did not have that high a stock return as initially postulated by Ginner and Reverte (2001).

However, the reasons behind the stock market returns of both portfolios are inconclusive based on the notion of capital structure. The liquidity ratio does not explain why the stock market prices are generally positive across all stocks with a similar range in value, though they may be from different industries. Looking at the fundamentals of the underperforming stocks, it was found that a price warning had been issued on EMC Corporation in the beginning of March regarding their earnings forecast (Google Finance). In the case of BlackRock, its recent decision to acquire Helix Financial Group impacted negatively on its stock returns due to investor sentiment during mergers and acquisitions (Upneja and Dalbor, 2001).

The other participating firms in both portfolios reported positive stock returns as a result of a general upbeat in the stock market (Wald, 1999), their market status as blue chip companies operating without any adverse effects on their profitability also influenced their earnings. This explanation confirms assumptions by Ross (1977), Zingales (2000) and Yang et al (2010) who depicted that the stock market returns are more dependent on firm specific factors like profitability and market growth options, as opposed to capital structure.

The nature of companies operating within each portfolio is also different and could better explain capital structure and stock return decisions. For instance Portfolio 15 constitutes FedEx Corporation (courier company), BlackRock Inc (fund management), EMC Corporation (Data storage manufacturer), Cisco (Software and Hardware manufacturing company) and ABB (Energy company). All these companies operate within industries that do not require extensive debt financing. BlackRock for instance operates using investor funds, while FedEx, Cisco and ABB operate in service industries that generate cash flow and require low short term funding.

In contrast, Portfolio 300 companies include two major financial institutions: Morgan Stanley and American Express, and GE – an organisation operating across multiple markets. Morgan Stanley accept funds from customers in the form of liabilities and invests these in Money Markets. American Express provides credit cards to customers, their funding is obtained from other institutions and their profit is based on the difference in interest between cash borrowed and loan provided. However, this has no substantial adverse impact on their profitability, due to the prevailing nature of the industry. According to Welch (2004), the tax savings benefits associated with using debt is offset by the lower risks and higher dividends associated with equity finance. Therefore in accordance with Modigliani and Miller (1958), the capital structure of an organisation has no effect on its stock market returns.
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