Impact of Capital Structure on Stock Returns: 'A Case of Pakistani Textile Industry'

Abstract

Capital structure and stock returns are of central importance to judge the financial performance of the firms, and more importantly to know whether stock returns are sensitive to changes in capital structure. To investigate the relationship empirically, data for 69 textile firms for the period 2003-2009 were collected. To quantify the impact, stock return was taken as a dependent variable and debt to equity ratio, return on equity ratio, gearing ratio, dividend ratio to equity, cash flow ratio, net profit margin ratio, earning per share, current ratio and time interest earned ratio were used as independent variables. Using various specifications of fixed effect model, results were drawn. In the first fixed effect model specification, any internal heterogeneity was ruled out in the firms holding time factor as constant. It was concluded that net profit margin ratio negatively affects the stock returns while debt to equity ratio, return on equity ratio, cash flow ratio, earning per share and time interest earned ratio were positively affect stock returns. Gearing ratio and current ratio negatively affected stock returns but the relationship found insignificant. The impact of dividend ratio to equity on stock returns was positive but insignificant. In the second fixed effect model specification, internal heterogeneity of the firms was taken into account while keeping time impact as constant. This yielded the results that debt to equity ratio , return on equity ratio, earning per share and current ratio affects stock returns positively and significantly, while In the third fixed effect model specification, firms were considered homogeneous but the impact of time on stock returns were captured through time dummies. The result of the model revealed that debt to equity ratio, return on equity ratio and earnings per share were still positively significant. The fourth fixed effect model specification considered both heterogeneity between firms and the impact of time in stock returns. It was concluded that debt to equity ratio and earnings per share were positively associated with stock returns. Thus, based on the empirical finding of our four fixed effect model specifications, it was concluded that variation in capital structure does affect the stock returns.