Influence of leverage on the return on equity

HUANG Song, SUN Huixia, ZHAO Huimin, ZHANG Yuening

Systems Engineering - Theory & Practice ›› 2020, Vol. 40 ›› Issue (2) : 355-365.

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Systems Engineering - Theory & Practice ›› 2020, Vol. 40 ›› Issue (2) : 355-365. DOI: 10.12011/1000-6788-2019-1820-11

Influence of leverage on the return on equity

  • HUANG Song1, SUN Huixia2, ZHAO Huimin3, ZHANG Yuening1
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Abstract

The core goal of the listed company's operation is to maximize the wealth of shareholders, expected return on equity is an important indicator to value the change of shareholders' wealth. This paper studies the impact of leverage on the expected return on equity of listed companies. And based on this, this paper discusses whether there is an optimal capital structure can maximize the expected return on equity. Due to the existence of financial distress costs and agency costs, it's difficult to discuss the optimal capital structure from the perspective of maximizing firm value, thus, it's more realistic to discuss this problem from the perspective of maximizing shareholder's wealth, implied cost of capital can represent the expected return on equity and reflect the change of shareholder's wealth. This paper uses Gebhardt-Lee-Swaminathan (GLS) model to measure implied cost of capital, and uses it to measure the expected return on equity. This paper empirically finds that the leverage ratio has a positive correlation with the return on equity of the listed company. The relationship between leverage ratio and expected return on equity appears to an inverse "U", when the leverage ratio is higher than the optimal level, deleveraging is beneficial to increase the expected return on equity, when the leverage ratio falls below the optimal level, increasing leverage can increase the expected return on equity.

Key words

leverage ratio / expected return on equity / implied cost of capital

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HUANG Song , SUN Huixia , ZHAO Huimin , ZHANG Yuening. Influence of leverage on the return on equity. Systems Engineering - Theory & Practice, 2020, 40(2): 355-365 https://doi.org/10.12011/1000-6788-2019-1820-11

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Funding

National Social Science Foundation of China (17CJY061)
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