Value Relevance of Degree of Leverages and its Impact on Systematic Risk An empirical study on Indian manufacturing firms

Abstract

The inquiry, do investors value the accounting numbers in the marketplace, is always of considerable interest for the scholars and the practitioners in the context of developed and emerging markets. However, many research studies on this topic have not been examined in the Indian context; therefore the present study claims the inquisitiveness of this inquiry to be explored in the context of India. India is one of the biggest ten emerging markets (Garten, 1997) and the structures of business organizations in the emerging or developing markets are different from those in developed markets (Sarkar et al. 2008). A relationship between earnings, an accounting number, and the value of common stock was extensively hypothesized by valuation theory (Beaver, 1968). The valuation theory and the theory of decomposition of systematic risk explicitly into the degrees of operating and financial leverage are the bases of this study. This valuation theory takes the point of view of equity investors to empirically examine the value relevance of accounting information (Beisland, 2009). Mandelker and Rhee (1984) presented an alternative theory of decomposition of systematic risk by explicitly introducing the degrees of operating and financial leverage to the theory of systematic risk decomposition of Hamada and Rubinstein. The present study also takes theory of the capital asset pricing model (CAPM) developed by Sharpe (1964), Lintner (1965), and Black (1972); theory of decomposition of systematic risk developed by Hamada (1972) and Rubinstein (1973); and the capital structure theory developed by Modigliani and Miller (1958). Although, there is an extensive research available on the value relevance of accounting information; however limited work is done on the value relevance of the degrees of leverage, particularly in the Indian context. The degrees of leverage in financial literature are of two types, the degree of operating leverage (hereafter DOL) and the degree of financial leverage (hereafter DFL).