# Literature Review On Minimizing Equity Risk Finance Essay

CHAPTER 2:

LITERATURE REVIEW

It was common question which arose in finance that how firms raise their equity, how to minimize equity risk and is there any factor or factors which influence the equity? In the last forty years a large number of ideas and related theories have been proposed to answer these questions. The empirical study of the determinants of risk can be classified in to two broad categories according to their macro and micro orientation. The number of studies has analyzed the relationship between risk premium on stock market as a whole, the level of standard and poor’s stock index, and required rate of return on equity, on the one hand macro means aggregate such as, the money supply, the federal deficit, the long- term short-term interest rate spread and expected inflation, on the other hand. (Robichek and Cohn, 1975) tested the influence of real economic growth and inflation on systematic risk (beta) of individual firms’. They found that macro variables did not light on determinant of the systematic risk, and only small firms’ influenced by real growth and inflation. In the micro category, Fisher and Hall (1969) have focused on risk-rate of return relationship through analysis of mean and higher moment of the rate of return distribution. Beaver, Kettler, and Scholes (1970) examined the relationship between financial ratios (payout, liquidity, and earning variability etc) to systematic risk or beta, and found a significant relationship among them. Breen and Lerner (1973) used same type of explanatory variables and found same results and provided additional evidences. Hamada (1972) found that, conditional on the validity of Modigliani and Miller’s model, leverage accounts contributed a portion (21% to 24%) of systematic risk or beta. Rosenberg and McKibbon (1973) tested the joint power of accounting data and its historical stock return on systematic and specific risk of its common stocks. Melicher and Rush (1974) found same results as previous studies presented and selected explanatory variables on the basis of factor analyzed and not on intuition basis. They presented a study which was different from previous study. (1) They focused on relatively small number of economic variables but previous study emphasized on large number of accounting and financial variables. (2) Previous study used one measure of risk (beta) whose results were somewhat challenged. But they used three alternative risk measures, and found a consistency and interrelationship. (3) With the exception of Hamada (1972) all previous used accounting measure of leverage based on book value, whereas the appropriate measure would be market value and equity risk was depend upon the ratio of firm’s debt to market value of its total capital. Fisher (1959) demonstrated that firm’s size and financial leverage were important determinants of equity risk in corporate bonds. It is analyzed that total risk of firm’s equity was divided into two subcomponents: systematic risk and unsystematic risk. Research has proved that unsystematic risk can be eliminated through portfolio formation; financial research has more focused on systematic risk. Hamada (1962, 1972) analyzed and empirically tested the relationship between operating characteristic of the firm and their systematic risk. Hamada (1969) also analytical showed that if a firm increases its leverage that directly affect the betas. Rubenstein (1973) gave a model which included two component of operating risk of firm: the amount of fixed and variable cost employed in the production technology and second, covariabilty of firm’s output with market return. Lev (1974) empirically tested that a negative relationship between level of unit variable cost and systematic risk. Hill and Stone (1980) empirically confirmed that a positive relationship between covariabilty of firm profitability with market return. Gahlon and Gentry (1982) gave a model which included financial and operating leverage and systematic risk tried to find a relationship between them. Ang, Peterson and Peterson (1985) included a degree of operating leverage is an independent variable in the regression model to explain a systematic risk but they failed to produce conclusive results. In the contemporary study, Mandelker and Rhee (1984) found a positive relationship between both degrees of operating leverage and degree of financial leverage and systematic risk. Later, Huffman (1989) he replicate the work of Mandelker and Rhee and found a positive relationship between systematic risk and degree of financial leverage in the analysis. His conclusive result of degree of operating leverage was not so clear with systematic risk. The theoretical worked by Huffman (1983) and Prezas (1987) demonstrated that there might be an important relation between degree of financial leverage and degree of operating leverage. Prezas showed that the amount of debt employed in a firm which could be impact the degree of operating leverage. Huffman found same results as Prezas demonstrated. Harold Biermand, jr (1968) found that addition of debt to capital structure in a corporation directly affects the risk of common shareholders and he also found that addition of debt to capital structure affected on earnings per dollar of common stock investment. Harold Bierman, jr changed the rule of game and varied the size of firm. He noted that add a debt to common stock investment and increased the size of firm. If addition debt earned interest rate at equal to interest rate currently being earned by firm on common stock investment, the addition of debt was not affected the expected return of the common stock. However, addition of debt affected the earnings per dollar of common stock investment. Rosenberg and McKibbon (1973) traditionally, accounting variables such as leverage and payout were used to assess the risk of return on common stock. Recently, historical security prices were used to predict the future risk of common equity in the firm. Beaver, Kettler, and Scholes (1970) used accounting variables as instrument variables which predicted the future market betas on the basis of past estimated betas and gave better results than the direct use of past betas. Beaver, Kettler, and Scholes (BKS) found that beta was empirically associated with several factors, including leverage, earning variability, payout, and growth as well as accounting earning beta. Modigliani and Miller (1958) made a proposition that corporate leverage occupied a central role in the eyes of finance students. He made another proposition that personal leverage was perfect substitute for corporate leverage. If this proposition made true then corporate borrowing could substitute for personal borrowing in capital asset pricing model as well. Both in pricing model and MM found that borrowing whatever sources firms applied, while maintaining a fixed amount of equity and increased the risk to investors. Robichek, Higgins, and Kinsman (1972) was theoretically and empirically analysis the effect of leverage on cost of equity capital for electric utility firms. He gave an importance to the topic due to two reasons. First, the influence of leverage on cost of equity capital and second, from a regulatory point of view, how cost of capital change due to degree of variation in the leverage. Modigliani Miller (1963) tested the effect of leverage on value and required rate of return on equity share. He gave a proposition II which in the tax correlated version states k=k* + (I - T) (k* -i) D/S, where k denoted the cost of equity capital, k* showed the absence of leverage, T denoted the corporate tax, i showed the borrowing rate, and D/S denoted the debt/ equity ratio measured with market term. They assumed that all variables kept constant for cross section of the firms. Then, equation was k = a, + a, D/S. finally they worked on K which denoted the earning/price ratio and D/S denoted the market value of debt equity. Barges (1963) criticized the work of MM due to presence of market value. He argued that the presence of share price in the denominators of both dependent and independent variables introduced the spurious correlation between variables which created the bias a, upwards. Instead, he used book value to measure leverage, but most theories used market weights. MM gave four assumptions; (1) rate of interest on debt is constant over the degree of leverage, (2) expected earning stream was constant and did not change due to leverage, (3) k (cost of equity capital) is given by the earning/price ratio; and in the tax case, (4) the effect of taxes on the value of the firm is equal to tD. Assumption (2) was the heart of MM model. Nerlove (1968) investigated the factors affecting the rate of return on investment in the common stock used multiple regression technique and concluded that firm’s sales growth was a only important explanatory variable. Financial decision did not affect the sales growth but financial policy affected the sales growth. Brigham and Myron (1968) argued that firm could generate funds through two different sources for corporate investment; retained earning and long term debt. These financial decisions affected the corporation. Beaver (1968) argued the failure firm, was costly to supplier of capital because reorganization or liquidation cost consumed a major portion of firm’s value. He tested that financial ratios were a good predictor tool to analyze a firm’s probability of failure and he also gave another tool to predict the failure of firm was change in market price of stock. Ronald W. Melicher (1974) decomposed a risk into systematic or market risk and specific or diversified risk. Hamada (1969) theoretically based analyzed that difference in degree of market risk was depend upon the financial management activities and practices. Melicher has proved that firm could not directly observe the true beta of capital assets. Instead, we must rely on estimated beta which was computed through the historical return data. The relationship between market risk and financial factor was expressed in term of estimated beta. Melicher included a study and focused on developing a multivariate link between estimated beta and financial data. Logue and Merville (1972) employed a multiple regression technique attempted to relate a financial variables and estimated beta. Assets size, return on assets, and financial leverage found a significant. Hamada (1972) and Galai and Masulis (1976) linked, the firm’s equity beta with other factors like, level of financial leverage, debt maturity, variation in income, cyclicality, operating leverage, dividends, or non optional growth. Berg, Green, and Naik (1999) and Carlson, M., A. Fisher and R. Gaimmarino (2003) found that firm size and book to market ratio on dynamic relation between return and risk due to continuous changes in firm’s current business and its future growth. Breen and M. Lerner (1973) tested the beta variance through independent variables such as the ratio of debt to equity, growth of earning, stability of earning growth, size of company, dividend payout ratio, number of shares traded. These were the variables which affected the corporate activities and decisions. Sharp (1964), Lintner (1965), and Mossin (1966) gave a capital assets pricing model (CAPM) which measured the performance of assets in term of return. They proposed that an assets risk could be measured by the covariance of assets return with the market portfolio return. Pradosh Simlia (2009) reinvestigated the performance of common stock return with respect to two characteristics: firm size and book to market ratio. His empirical results showed that firm size and book to market ratio play significant role.

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