Financial Leverage and Shareholder’s Required Returns: Evidence from South Africa Corporate Sector

Abstract

Recent financial crisis which saw an increase in risk premium and shareholder’s required return around the world has been in part attributed to firms excessive debt leverage. This paper tests the impact of debt leverage on shareholder’s required return in South Africa. The paper specifies dynamic panel models and uses difference generalized method of moment (GMM) estimation technique. The results show that long term debt is positively related to shareholder’s required return. Similarly, total debt is positively related to shareholder’s required return. The results are robust to alternative model specification namely system GMM. Based on the findings, the study suggests that debt leverage is an important risk factor to be priced in equity valuation. The findings also suggest that the dynamic nature of firms’ capital structure decision should not be neglected. The paper contributes to capital structure research by testing Modigliani and Miller proposition two on listed firms in South Africa. Besides, it uses better estimation technique that controls for unobservable firm-specific effects and endogenous problem. In addition, two measures of leverage are used as independent variable compared to a single measure commonly found in the literature.

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