Abstract
The main aim of this study was to test whether there is a positive relationship between different financial risk measures and the expected return of a share. This study was performed in 1995 by Brümmer and Wolmarans, who obtained results contrary to those of a similar study in the United States of America in 1988. The reasons for the difference were not established. This study follows up the one by Brümmer and Wolmarans to determine whether the passing of 19 years could have brought about any difference in the results. This process was initiated by testing a set of variables from a sample size of 107 JSE-listed companies from 2002 to 2012 for linearity. As there was no such linear relationship between any of the variables, no assumptions can be made about any relationship between share return and the risk measures tested here. If investors were risk averse, one would expect a positive relationship between different financial risk measures and the expected return of a share. This is not the case in the South African market.
Highlights
‘The greater the proportion of debt in the firm's capital structure the more likely it is that shareholders will lose everything or strike it rich’ (Arditti, 1967)
This study aims to investigate the fact that Bhandari (1988) observed a positive relationship between leverage and share returns when the study was conducted in the United States of America, while Brümmer and Wolmarans (1995) found a negative relationship when the study was replicated in South Africa
It was asserted that the debt-equity ratio and other financial risk factors ought to correlate positively with the risk associated with ordinary shares and that the debt-equity ratio can be used in conjunction with beta and other risk measures as proxies for the risk inherent in the ordinary shares of a company
Summary
‘The greater the proportion of debt in the firm's capital structure the more likely it is that shareholders will lose everything or strike it rich’ (Arditti, 1967). An investor according to preferences of risk adversity, accepts only a given level of risk if an accepted level of compensation (return) can be earned This relates to what is known as the indifference point (Lambrechts, 1990), which can be defined as the point at which the use of financial leverage over the use of equity capital does not give rise to any improvement on earnings per share (EPS), creating indifference in investors. Researchers like Bhandari (1988), Fama and French (1992) and Gomes and Schmid (2010) have observed a positive relationship between share returns and leverage. Hwang (2010), Garlappi and Yan (2011) and Obreja (2013), have observed a distinctly negative relationship between share returns and leverage
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