College Papers

1.1 same time it also represents that the

1.1
Background of the study

Over the years,
researchers have struggled to understand the causation of the volatility in
stock returns; it is truly one of the most sought after phenomena in finance. Its
primary importance lies in investment decision making and for academic
purposes. In order to understand the causation of the volatility in stock
returns, we first need to understand what stock return is. In very simple
words, it is the change in price of stocks over a period of time. A great
number of theories and factors have been proposed over the years that play a
role in the change of price of a stock. Researchers have proposed formulas,
equations, models and graphs to calculate and explain the change in afore
mentioned phenomena. Out of the many proposed factors that are responsible for
the volatility of stock returns, this study will focus on the fundamental
factors that are; Firm size, Book/Market ratio, Systematic Risk and leverage of
the firms.

Different methods for
the measurement of firm size are present which studies firm size from their own
different prospective and therefore have different implications. The most
common measures are total assets, total sales and market capitalization. The
method we are using in this study is Firm Agebecause it represents the
ownership of shareholders while total assets represents total resources of the
firm and total sales relates to product market which is not desirable.
Different researchers like (Louis, Hamao & Josef, 1991) and (Keith, 2002)
used Firm Ageas a measure for firm size.

Book/market ratio is
basically the ratio between book and market value of the company, book value of
the company is calculated by taking the historical cost of the assets i.e. cost
at which assets are recorded on the balance sheet, while market value is
calculated by Firm Agei.e. market value of the company’s total shares
outstanding. The higher B/M ratio, usually greater than 1, predicts that
company will perform well in the future but at the same time it also represents
that the stock is overvalued and opposite is the case i.e. when the ratio is
lower than 1.

Systematic risk which
is also known as non-diversifiable risk or market risk is the type of risk that
cannot be eliminated through diversification. It affects all assets in an
economy, some more than the others. The Capital Asset Pricing Model (CAPM) is
one of the most commonly used model to calculate the stock return while taking
the systematic return in consideration. It was proposed by Sharp W. (1964) and
”Beta” is the measure of the systematic risk. And that is the proxy that will
be used in this study to gauge the stock return due to the systematic risk.    

The leverage indicates
how much of debt is used by a company in its financing. It also measures the
long term debt paying ability of a company and shows if the company is replying
on internal financing or external one. The debt/equity ratio is the proxy that
would be used to calculate the leverage.

1.2
Rationale of the study

The importance of this
study lies in the fact that the independent variables named systematic risk,
leverage, firm size and book/market ratio have never been studied together in
their effect on stock returns. Since they are the fundamental factors and have
major impact on stock returns, it is important to observe them all together. In
real world, a small change ripples through the economy and changes the outcome
because everything is connected with one another. Studying the before mentioned
variables should help investors and scholastic individuals understand and
predict the stock returns and hence make better decisions.

1.3
Research Question

Q1- What is the effect
of firm size, book to market ratio, leverage and firm age on stock return?

1.4
Research Objectives

1.      To
study the impact of firm size on stock return

2.      To
study the impact of book to market ratio on stock return

3.      To
study the impact of firm age on stock returns

4.      To
study the impact of leverage on stock returns

 

1.5
Research Hypothesis

 

H1: Firm size has a negative impact on stock
returns.

HN: Firm size has no impact on stock return.

H2: Book to market ratio has positive impact on
stock return.

HN: Book to market ratio has no impact on stock return.

H3: Firm age risk has a positive impact on stock
returns.

HN: Firm age has no impact on stock returns.

H4: Leverage has a negative impact on stock returns.

HN: Leverage has no impact on stock returns.