© 2022 JETIR March 2022, Volume 9, Issue 3 www.jetir.

org (ISSN-2349-5162)

A Study on Impact of Financial Leverage on

Shareholders Return and Market Capitalisation
(with special reference to Indian Pharmaceutical
Companies)
1
Ravleen Kaur
1
Associate Prof, SRGPGPI, Indore, MP, [email protected]

Abstract: The challenge before every financial manager in today’s developing market is to keep its investors contended. Apart
from investing decision the focus today is deciding right mix of financing structure and along with it maximizing the shareholders
wealth. A firm should focus its productive activities and select such a financing source, which will achieve the objective of wealth
maximization. The financial leverage is an essential requirement for achieving optimal capital structure. An optimal capital
structure affects the value of firm through reduced cost of capital. In the present study, an attempt was made to determinate
optimal financial leverage for the pharmaceutical sector and to find out its impact on the firms over all capital structure. Simple
Linear Regression analysis was carried out to judge the impact of financial leverage on shareholders return and market
capitalisation individually. The findings reveal that that financial leverage has no strong influence on the shareholder return of
leveraged sample pharmaceutical firms.

Keywords: Financial leverage, Return on shareholders fund, Market capitalization

INTRODUCTION
The business objective of nearly all companies is to earn profits and maximises its firm value. Once the profits are generated, it
then decides on what to do with those profits. The company may plan to hold back or retain the profits within the company, or
they could pay it out to the owners of the firm in the form of dividends.
The financing decision determines the optimum mix of debt and equity, the relative numbers of shareholders and debt holders, and
the decision for distribution of earnings between interest, dividends and capital gains. Financing and investment decisions are
independent of each other and the latter determine the value of the firm. Therefore, as financing decisions have no effect on firm’s
value, they are irrelevant. However, in practice, firms, managers, and investors, devote much time and resources in analysing
financing decisions about dividends and capital structure. The risk exposure of any firm can be divided into operating and
financial risk. Operating risk arises due to manufacturing and production expense which are usually unavoidable. However,
financial risk is borne by those firms who have debt fund in their capital structure as the company is required to mandatory pay
fixed interest charge on its debt funds. Firms aim at optimal capital structure which leads to ideal level of financial leverage,
wherein a company's return on equity capital increases because the use of leverage increases stock volatility, increasing its level of
risk which in turn increases returns.
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LITERATURE REVIEW

In the sense of finance & economics leverage is perfection to use borrowed money to buy an investment or to buy a company for
business. One can gain a market advantage by leveraging his network of partners. In business, use of borrowed capital for an
investment and expecting the profits made to be greater than the interest payable is leverage. Leverage is an important investment
strategy in case firm plans for using borrowed money. Specifically it is the use of various financial instruments or borrowed
capital to increase the potential return of an investment. A firm can finance its investments by debt, equity or a combination of
both. The use of debt along with equity in the capital structure is described as financial leverage or gearing (Dare and Sola, 2010).
A highly leveraged firm or property means that the firm is employing more debt than equity in its capital. Leverage results from
investing borrowed funds with a view to expand the firm’s asset base and generate returns on risk capital in the long term.

Agency cost theory explains the relationship between principals, for example shareholders and agents, such as a firm's executives.
Agency cost is an economic concept concerning the cost to a principal, when the principal chooses or hires an agent to act on its
behalf. Due to the separation between ownership and control, managers (agents) may not always act in the best interest of the
firm’s owner. This encourages shareholders to incur agency costs to monitor managers’ behaviour. Dividend payments may help
in reducing agency costs between managers and shareholders. As the two parties have different interests and the agent has more
information, the principal cannot directly ensure that its agent is always acting in its best interests. Employing leverage in the
company is one of the effective methods against manager’s behavior.

Trade off Theory

Miller and Modigliani (1961) proposed that in a perfect market the dividend policy shows no impact on firm’s value. In perfect
competitive market, MM Theory is based on the assumptions that investors behave rationally as information is freely shared, there
is no transaction and flotation costs taxes are absent. However, in the real world bankruptcy cost and market imperfections are
present. Kraus &Litzenberger (1973) theory is resulted from the debate on the Modigliani and Miller propositions. As per this
theory, a company uses debt instead of equity to a certain extent to maximize its enterprise value. Highly profitable firms have
high debt ratios thus the chances of bankruptcy are less. Thus, trade-off theory suggests a positive relationship between
profitability and leverage. An optimal Capital Structure can be achieved by establishing equilibrium between the tax saving
benefits of debt and distress costs of bankruptcy due to debt. Bankruptcy costs arise when there is a high probability that a
company will default in paying off its financial obligations. These costs are high in case when a company decides to raise more of
its debt financing rather than use equity. According to the study of Haugen and Senbet (1978), the size of a firm influences how a
firm overcomes its bankruptcy costs. Large capital firms are financial strong to repay its liabilities are less prone to experience
financial distress as compared to smaller ones. Thus, leverage and dividend policy decisions are majorly influenced by size of the
firm. According to Myers (1984), there exists a, “static trade-off framework, in which the firm is viewed as setting a target debt to
value ratio and gradually moving towards it, in much the same way that a firm adjusts dividends to move towards a target payout
ratio”.

Pecking Order

Myers and Majluf (1984) and Myers (1984) presented another capital structure theory named Pecking Order Hypothesis. The
pecking order ranks internal equity at the top of the order, followed by debt and then hybrid securities, with external finance in the
form of equity capital at the bottom of the pecking order. This order is followed as it reduces the chances of taking up profitable
opportunities. Initially Donaldson developed the theory, which in 1984, Myers and Majluf modified further. According to this
theory, managers follow a hierarchy of financing. They use internally generated funds as principal source of long-term financing.
If internal financing is not enough, it resorts to debt financing and finally to equity and prefer to raise equity as a last option.
Higher dividend payout means greater need of funds, which suggests positive relationship between dividend payout and leverage.

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Dividends are declared only after meeting all its investment opportunities. Profitability and liquidity of a firm have a significant
role in deciding for leverage and dividend policy.
If a company employs a high level of operating and financial leverage, even a small variation in the sales level will drastically
effect the Earnings per share of the holders. (Mandelkar,et at, 1984). A company having varying sales level will have fluctuating
EPS, but the variation in EPS will be more when the operating and financial leverages are also high. A high degree of FL allows
the shareholders to obtain a high return on equity but on the other hand they are exposed to high level of risks if the return on
investment is low.

Al-Najjar (2009) conducted research in Jordan and used dividend per share, leverage, earning per share, institutional ownership,
return on equity, and business risk as variables. He concluded “the factors which affect the likelihood of dividend payment are
similar to those which affect the dividend policy”. The results showed strong negative relation between institutional ownership and
dividend policy; which were in accordance with signaling theory. Finally, the results showed that the Linter model is valid for
Jordanian data, and that Jordanian firms have target payout ratios and that they adjust to their target relatively faster than firms in
more developed countries.
Short et al. (2002) examine the potential association between ownership structures and dividend policy using three alternative
dividends models for the UK companies. They were the first to present the results for UK, and concluded that ownership structures
are different from those of the US. The results consistently showed positive association between dividend payout policy and
institutional ownership. The results found that a negative association exists between dividend payout policy and managerial
ownership. Gugler & Yurtoglu (2003) investigates the relationship between dividend and ownership and control structure of the
firm for 214 Austrian and German non-financial firms over the period of 1991-1999. The results indicate that state-controlled
firms engage in dividend smoothing, whereas family-controlled firms do not. The findings show that over the years the dividend
payouts have declined and high growth oriented firms have larger payout targets irrespective in whose hands the control of the
firm is vested. Kumar (2003) examines the possible association between ownership structure, corporate governance and firm's
dividend payout policy of all manufacturing firms over the period 1994-2000. He examines the payout behavior of dividends and
the association of ownership structure for Indian corporate firms. Kumar finds positive association between ownership structure
and dividend payout policy and that dividend payout are not influenced by the ownership structure of the firms. The results reveal
that Debt and equity are negatively related whereas past investment opportunities have positive relationship with dividends.

OBJECTIVES OF THE STUDY

1. To study the impact of financial leverage on shareholders return of selected pharmaceutical companies.
2. To study the impact of financial leverage on market capitalization of selected pharmaceutical companies.

METHODOLOGY
The study is empirical in nature to find out the influence of financial leverage on shareholders return and market capitalisation of
selected sample pharmaceutical companies. For this purpose, data was collected in its current state and both quantitative and
qualitative data was used. Data was collected from different websites (like, nseindia.com, moneycontrol.com, and
yahoofinance.com), Print media, newspapers, accounts which are produced by the company to the stock exchange and official
website of the respective company. Sample of top 5 market capitalization companies, which are listed in index of national stock
exchange during the period of 1st April 2012 to 31st March 2021. The data used in this category was collected from official
website of national stock exchange, consider that data sources used as highly reliable due to its function for the financial markets.
Variables: (a) Dependent Variable: The dependent variables are shareholder return and market capitalization.
(b) Independent Variable: Financial leverage is used as an independent variable.
Simple linear regression has been used for data analysis.
Hypothesis Testing
The NIFTY pharmaceutical index comprises of 20 listed firms. The industry is dominated by top 20 companies which comprises
nearly 70% of the total production of the country. Out of which we have drawn a sample of five major companies. Impact of
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financial leverage on shareholders return and market capitalization of all companies of different sector was tested through
regression analysis. For which shareholder return were measured through EPS, DPS, ROE.
Hypothesis for the research was set as follows:
H01: There is no significant influence of financial leverage on the return of shareholders of Cipla.

H02: There is no significant influence of financial leverage on market capitalization of Cipla.

H03: There is no significant influence of financial leverage on the return of shareholders of Zydus.

H04: There is no significant influence of financial leverage on market capitalization of Zydus.

H05: There is no significant influence of financial leverage on the return of shareholders of Lupin.

H06: There is no significant influence of financial leverage on market capitalization of Lupin.

H07: There is no significant influence of financial leverage on the return of shareholders of Sunpharma.

H08: There is no significant influence of financial leverage on market capitalization of Sunpharma.

H09: There is no significant influence of financial leverage on the return of shareholders of Dr. Reddy.

H010: There is no significant influence of financial leverage on market capitalization of Dr. Reddy.

Data Analysis

The companies taken for the study are Cipla, Zydus, Lupin, Sun Pharma and Dr Reddys. The data was analysed company wise. On
significant level of 5%, nine hypothesis were accepted, whereas H010 was rejected. The R values are (.245) for shareholders
return and (.030) for market capitalization on sig level .146 and .634 respectively. Therefore, there is no significant influence of
financial leverage on shareholders return and market capitalization of Cipla Pharmaceuticals.

The R values are (.013) for shareholders return and (.255) for market capitalization on sig level .749 and .137 respectively.
Therefore, there is no significant influence of financial leverage on shareholders return and market capitalization of Zydus
Pharmaceuticals.

The R values are (.153) for shareholders return and (.222) for market capitalization on sig level .263 and .170 respectively.
Therefore, there is no significant influence of financial leverage on shareholders return and market capitalization of Lupin
Pharmaceuticals.

The R values are (.072) for shareholders return and (.030) for market capitalization on sig level .454 and .410 respectively.
Therefore, there is no significant influence of financial leverage on shareholders return and market capitalization of Sun
Pharmaceuticals.

The R values are (.315) for shareholders return and (.659) for market capitalization on sig level .091 and .004 respectively.
Therefore, there is no significant influence of financial leverage on shareholder’s return.

The results show that high leveraged companies increase shareholders return only when the return on equity capital is higher than
the cost of debt. The capital structure of the selected sample companies consist of very less percentage of debt and the cost of debt
may be higher or equal to the cost of equity capital.

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Table 1: Simple Linear Regression Output

Hypotheses Company Variables R Square F value Beta Sig. value

H01 Shareholder’s .245 2.596 -96.920 .146

return
Cipla
H02 Market .030 .244 71402.261 .634
Capitalization

H03 Shareholder’s .013 .109 -23.702 .749

return
Zydus
H04 Market .255 2.732 -72507.891 .137
Capitalization

H05 Shareholder’s .153 1.446 -36952.464 .263

return
Lupin
H06 Market .222 2.280 -37.106 .170
Capitalization

H07 Shareholder’s .072 .620 -5348.820 .454

return
Sun
H08 Market .086 .756 .942 .410
Capitalization

H09 Shareholder’s .315 3.678 -368122.205 .091

return
Dr. Reddy
H010 Market .659 15.454 -1579.294 .004
Capitalization

Company Regression Equations Result

Cipla Shareholder’s Return = 120.323 +(-96.920)FL Insignificant

Market Capitalization = -30223.859 +(71402.261)FL Insignificant

Zydus Shareholder’s Return = 50.065 +(-23.702)FL Insignificant

Market Capitalization = 113849.495 +(-72507.891)FL Insignificant

Lupin Shareholder’s Return = 87072.373 +(-36952.464)FL Insignificant

Market Capitalization = 80.801 +(-37.106)FL Insignificant

Sun Shareholder’s Return = 131311.481 + (-5348.820)FL Insignificant

Market Capitalization = 3.575 +(.942)FL Insignificant

Dr. Reddy Shareholder’s Return = 431156.511 + (-368122.205)FL Insignificant

Market Capitalization = 1731.710 +(-1579.294)FL Significant

CONCLUSIONS AND SUGGESTIONS

Financial leverage show significant influence on shareholders return and market capitalization when the cost of debt fund is lower
than the cost of equity. In Pharmaceutical sector the sample companies taken for the study comprises nearly 40% of the total
pharma sector with a market capitalization of nearly 2.2 lacs crores. Increasing expenditure in R & D and acquisition are driving

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this sector’s growth and needs more capital. It is suggested to the research scholars to include wide spread areas for further studies
so that the results may be generalized for the entire business sectors of the country. In addition, the researchers are suggested to
collect data for more years for further studies. The study reveals that some companies provide lack of financial information, which
was a limitation for the present study. Therefore, to overcome the problem the companies are suggested provide adequate
information required to enhance the leverage and return of shareholders fund. Last but not the least, all business sectors are
advised to reduce their business risks regarding the factors that influence the revenue growth of the companies.

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