African Journal of Business Management Vol. 5(33), pp. 12762-12767, 21 December, 2011 Available online at http://www.academicjournals.org/AJBM DOI: 10.5897/AJBM11.

666 ISSN 1993-8233 2011 Academic Journals

Full Length Research Paper

Corporate tax rate as a determinant of systematic risk: Evidence from Pakistani cement sector
Fawad Ahmad1*, Mohsin Ali2, M. Usman Arshad1, Syed Zulfiqar Ali Shah3
Graduate School of Management, International Islamic University Islamabad, Pakistan. Environmental Sciences Department, International Islamic University Islamabad, Pakistan. 3 Higher Studies and Research Department, International Islamic University Islamabad, Pakistan.
2 1

Accepted 21 November, 2011

The main purpose of this study is to find the influence of corporate tax rate on systematic risk with three more variables (leverage, return on assets and market value of equity) by using cement sector data of Pakistan. This study used fifteen cement manufacturer data from 2004 to 2009 and fixed effect panel data random regression model. The result showed that corporate tax rate is not a determinant of systematic risk, but showed its effect through leverage, which is having statistically significant relationship with systematic risk. This study showed that leverage had significant influence in determining systematic risk and had positive relationship with systematic risk; whereas return on assets and market value of equity are positively related with systematic risk but had no significant influence on systematic risk. This study investigated the influence of corporate tax rate on systematic risk. This study also presented the managerial and policy related implications and recommendations from the study findings. Key words: Systematic risk, corporate tax rate, leverage, returns on assets, market value of equity, debt to equity ratio. INTRODUCTION Investors are mainly concerned with the risk and return when selecting the assets for investment. In equilibrium, investors look for higher returns by bearing high risk. One of most important model that establishes relationship between risk and return by using systematic risk is capital asset pricing model (CAPM). CAPM uses beta as a measure of systematic risk and establishes linear relationship between risk and return. E( )= + [E ( )] (1) is the equation shows that systematic risk is directly related to required rate of return. Required rate of return is the cost of equity for the firms, so both can be used as having same meanings. This shows that the factors effecting systematic risk may have effect on the firms cost of equity capital and as a result on the firm value. Most countries follows corporate tax structure, firms utilizes different sources of funds, resulting in differences of both tax cash outflows and consequently on firm value. It is because of this reason that corporate tax is considered as one of the determinant of systematic risk, since of having effect on the firms value. Therefore this study investigates the influence of corporate tax rate on systematic risk. Miller and Modigliani (1958, 1963) suggested the relationship between corporate tax, value of the firm and financial leverage by using following equation: = + (1-T) ( ) (2)

Where E ( ) is the expected return on equity, risk-free return, (

is the systematic risk of equity and E

) is the expected return on market. The aforementioned

*Corresponding author. E-mail: fawad.msfin89@iiu.edu.pk. Tel: 092-332-9174212.

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where, is return on equity, is return on assets, D and E are the market value of debt and equity and T is the corporate tax rate. The equation shows that negative relationship between corporate tax rate and return on equity, and consequently on systematic risk. The equation shows that when firm is completely financed through equity than the return on equity is equal to return on assets. The term (1-T) ( ) reflects the financial risk term when financial leverage is used, or in other terms reflects the systematic risk arise by using financial leverage. This study investigated the influence of corporate tax rate on systematic risk by using cement sector data of Pakistan. This study used panel data of fifteen cement manufactures from 2004 to 2009. The result showed that corporate tax rate is not a determinant of systematic risk, but showed its effect through leverage, which is having statistically significant relation with systematic risk. This study also used three more fundamental determinants of systematic risk and showed that leverage had significant influence in determining systematic risk and had positive relationship with systematic risk, where as return on assets and market value of equity are positively related with systematic risk but and had no significant influence on systematic risk. Subsequently, the study provides brief introduction of study; after which we highlight the literature relating the determinants of systematic risk used in previous studies. Thereafter, we discuss data and sample size, methodology, beta estimation and explanatory variables. The empirically analysis is done by using correlation matrix analysis and fixed effect regression analysis model given later on. Finally, we discuss the conclusions, limitations, future research, managerial and policy related implications and recommendations. LITERATURE REVIEW Relationship between financial leverage and systematic risk (beta) had been extensively analyzed by both empirical and theoretical studies (Mnzava, 2009; Ramchand and Sethipakdi, 2000; Hamada, 1972). Hamada (1972) established a relationship between systematic risk of an unlevered firm and that of a levered firm by using Miller and Modiglianis (1963) proposition. The relationship between leverage and corporation tax is not analyzed in the study but it does provide evidence about 24% variations in systematic risk is because of variations in debt. Therefore, the study suggests that the debt-equity ratio might be one of the factors that affect systematic risk. Research by Korajczyk and Sodka (2008) shows that liquidity has significant influence over debt-equity ratio, and considered as a part of systematic risk, as used in CAPM. Corporation tax is a factor that affects the cash outflow of a company will ultimately affect its

liquidity and its stocks marketability in financial markets and so it is also related to systematic risk. A more general form of relationship between the beta of equity that is unlevered and the beta of a levered equity was used by Ramchand and Sethipakdi (2000). They further clarify a relationship between debt-equity (D/E) ratio and beta of levered common stock . The relationship they established is given as: = where, +( ) (3) is the beta of

is the beta of levered equity is,

assets, is the beta of debt and D/E is the debt-equity ratio In Equation 3, if it is assumed that = 0 and capital structure decision will not affect (Miller and Modigliani, 1958), then change in beta of equity will be positively related to a change in debt-equity ratio. In more precise words, the change in levered equity beta can be presented as following equation: = (4)

Ramchand and Sethipakdi (2000) by using a sample of 147 equity issues between 1986 and 1993, find that US firms which issued equity (that is, decreased their debtequity ratios) experienced a decline in price volatility and systematic risk. They further showed that a decrease in systematic risk is sensitive to whether the equity issue was global (that is, issued in foreign market) or domestic with a larger decline observed for firms which issued equity globally. As Ramchand and Sethipakdi (2000); Hamada (1972) studies also ignored factors influencing change in D/E ratio and the fact that there are other determinants of beta and debt-equity ratio which might be in operation at the same time. There is a need of controlling for the effects of other determinants in investigating the relationship between beta and D/E ratio. Chung (1989) used firms intrinsic business risk, net income to net equity, degree of financial leverage and degree of operating leverage as a function of systematic risk. The results showed that degree of financial leverage, firms intrinsic business risk and degree of financial leverage are positively related to systematic risk, but only degree of financial leverage and firms intrinsic business risk are statistically significantly related to systematic risk at five percent significant level. The studies that established positive relationship between leverage and systematic risk also showed that change in leverage is also positively related to change in systematic risk. This indicates that increase in leverage results in increase in systematic risk (Mnzava, 2009; Ramchand and Sethipakdi, 2000; Chung, 1989; Hamada,

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1972). Shah (1994) used more focused capital structure approach, suggesting that increase or decrease in leverage convey different qualitative informations. The results of study suggested that leverage decreasing decision by firms might not result in systematic risk decreases. Similarly increase in leverage results in lowering of the investors ability to predict risk. Mnzava (2009) analyzed the impact of corporate tax on systematic risk. The determinants used included effective tax rate, leverage ratio, return on assets, and market value of equity, risk of real estate, financial risk and growth in earnings. The results showed that corporate tax rate is one of the important determinants of systematic risk. Systematic risk was found to be positively related with leverage. In summary most of the previous studies showed the different variables affecting systematic risk. This study uses corporate tax rate, leverage, return on assets and market value of equity as main determinants of systematic risk. The main aim of this paper was to investigate the influence of corporate tax on systematic risk. The hypothesized relation for this study states that corporate tax effects negatively to the systematic risk. The change in corporate tax is same for all but the response to the change in corporate tax is different for every firm depending on the financial condition and tax position.
METHODOLOGY Data and sample size This study used the data from the cement sector of Pakistan. Fifteen cement manufactures data was used in the analysis from 2004 to 2009. The data used for all variables are collected form the Balance Sheet Analysis of Non-financial Firms, 2004 to 2009 and Karachi Stock Exchange website (KSE). The monthly closing stock prices and market returns are collected from the KSE, whereas taxation paid, total operating earning, total liabilities and outstanding shares data is collected from Balance Sheet Analysis of Non-financial Firms, 2004 to 2009. This study included both time series and cross sectional data, such type of data is known as panel data. The same six year data is used for all fifteen cross sectional units, therefore such panel is called balanced panel data. In order to investigate relationship between systematic risk and explanatory variables beta was calculated first and then used as dependent variable in the empirical analysis.

(5) In the preceding equation, value, is the intercept and has constant is error term, is

are the slope of coefficient,

the cross sectional unit and t is the time period. The model of this study is given as: (6) where is intercept (has constant value), , , are the

slope of coefficients,

is the error term, is the cross sectional

unit, t is the time period, ETR is the effective tax rate, LVG is the Leverage, ROA is the return on assets and MVE is the market value of equity.

Beta estimation The beta for each individual stock was calculated by regressing the stocks returns against the market returns. This regression results in the characteristics line, given in Equation 7: (7) where, is the return on the equity, is intercept, is the beta

coefficient (slope of the characteristic line), market, and

is the return on the

is the error term. The ordinary least squares (OLS) and , and the error term is

helps in finding the coefficients

minimized. To estimate beta same periods value of individual stock return and market return are used. The problem arises here relating the beta estimation is whether to use monthly or daily return data. Previous studies showed problems exist in using daily returns in estimating betas. Specifically, when the market index against which the individual beta is estimated is traded more actively, then OLS beta estimation is downward biased (Dimson, 1979; Scholes and Williams, 1977). This biasness results in beta estimation insignificant or unreliable. In this study systematic risk (beta) is calculated by using monthly data of each stock return from July 2002 to June 2009. For each stock year beta two years monthly return was used, one previous year return data and second the year for which beta is estimated.

Explanatory variables Theories in corporate finance suggest that number of variables effect systematic risk of firms equity. Among them some are tested empirically and proved significant effect in determining systematic risk. In this study four factors were analyzed and their relation with systematic risk was empirically investigated.

Approach To analyze the variables panel data regression analysis was used. The panel data is more informative, efficient, detect and measure those effects too which are ignored by time series and cross section data. Two types of estimation approaches are used in panel data regression model, that is, fixed effect approach and random approach. This study used fixed effect panel data analysis approach. The fixed effect approach model is given as:

Effective tax rate In this study relationship between tax rate and systematic risk depend on things like, how firms take advantage of tax rate by adjusting their debt-equity ratio to take advantage of tax shield. Firms when adjust their debt to equity ratio for taking advantage of tax shields, positive relation among tax rate and debt to equity ratio

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Table 1. Correlation matrix.

Beta Effective tax rate Leverage Market value of equity Return on assets

Beta 1 -0.19135 0.083162 0.24493 0.011989

Effective tax rate 1 -0.10391 -0.11046 0.4194

Leverage

Market value of equity

Return on assets

1 -0.53067 -0.31884

1 0.233697

is established, resulting in positive relation between tax rate and systematic risk. Similarly when firms do not take advantage of tax shields by adjusting their debt to equity ratio, then negative relation between debt to equity ratio and tax rate exists, resulting in the negative relation among tax rate and systematic risk. Because of the different tax positions the relation between tax and systematic risk is not obvious. Some firms may borrow to take advantage of tax shields (e.g. firms have stable cash flows), whereas some firms do not have incentives to borrow (e.g. firms with variably in or uncertainty relating future cash flows). This factors aims to identify the nature of relation between the systematic risk and tax rate. This study expects the negative relation between tax rate and systematic risk. The effective tax rate is measured as ratio of taxation for the year to total operating earnings.

risk and size of market value of equity. The size of market value of equity is measured through natural logarithm of market value of equity.

EMPIRICAL ANALYSIS Correlation matrix In order to investigate the possible co-linearity variables were correlated, Table 1 shows the correlation coefficient between the systematic risk (beta) and four explanatory variables. The signs in the table indicate the relation, positive sign for positive relation and negative sign for negative relation. The table shows that the tax rate is negatively associated with the systematic risk, whereas leverage, return on assets and market value of equity are negatively related with systematic risk. All these four relations are confirmed by the fixed effect panel regression analysis. Fixed effect panel regression analysis To empirically analyze the relationship between systematic risk and four explanatory variables, panel data fixed effect regression model approach was used. Results of fixed effect model are given in Table 2. The Table 2 shows that R-squared value is 0.594748 indicating that 59.4748% variance in dependent variable (systematic risk) can be explainable through four explanatory variable used. The Table 2 shows that effective tax rate is negatively related to the systematic risk with co-efficient value of 0.030575. Effective tax rate is not significantly related to systematic risk having t-statistics value lower than 2. The result suggests that effective tax rate has no influence on the systematic risk. It also confirms that effective tax rate and debt to equity ratio are negatively related and consequently systematic risk. It suggests that cement manufacturers are not taking advantage of tax shield by utilizing external borrowing option. The negative relation between effective tax rate and systematic risk is in consistent with the findings of Vassalou and Xing (2004). They found that default risk is component of systematic risk, therefore by reducing external borrowing results in decreasing default risk (systematic risk). Whereas, the study conducted by

Leverage ratio The increase in the debt financing increases the interest payments resulting in the fixed payments made after a fix period of time. This results in the variability of earnings left for the equity holders. The uncertainty of the equity holders results in the agency conflicts between the creditors and equity holders. The management starts to satisfy the equity holders by increasing return through investment in high risk projects hence systematic risk associated with equity increases. This study expects a positive relation between leverage and systematic risk. The leverage is measured as ratio of total debt to the market value of equity.

Return on assets The relation between systematic risk and return on assets was derived from the Badhani (1997) model. Previous empirical results have proved a positive relationship between leverage and return of assets. As discussed earlier, leverage are positively related to the systematic risk, hence systematic risk is also positively related to return on assets. In this study positive relation is expected. The return on assets is measured by total operating earnings to total assets.

Market value of equity This study adopts the relationship between systematic risk and market value of equity as given by Brenner and Smidt (1997) nonstationary model. According to their model, beta given at time t is inversely related to the market value given at t-1. This inverse relation assumes that small firms have volatile returns as compared to the market return because of their financial weakness to absorb economic shocks. Similarly opposite is applicable to the large firms, because they have stable earnings and ability of handling economic shocks. This study expects negative relation between systematic

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Table 2. Fixed affect model results.

Parameter Intercept Effective tax rate Leverage Market value of equity Return on assets R-squared Adjusted R-squared

Co-efficient -3.29723 -0.30575 824517 0.160657 1.230343 0.594748 0.453523

Standard error 3.497704 0.427572 403982.3 0.142959 0.899513

t-statistic -0.94268 -0.71508 2.040973 1.123796 1.367788

P-value 0.3493 0.4771 0.0453 0.2652 0.176

Mnzava (2009) showed positive and significant relationship between effective tax rate and systematic risk for UK firms data. The reduction of external borrowing results in effective tax rate increase. The estimated co-efficient has a positive value for leverage indicating a positive relation between systematic risk and leverage. The t-statistics value for the relation is 2.040973 with p-value of 0.0453, indicating statistically significant relationship. This shows that leverage has significant influence as a determinant of systematic risk. The possible explanation for the positive significant relation of leverage and insignificant negative relation of effective tax rate with systematic risk is that in literature the effect of leverage on systematic risk arises because of tax and both are mostly opposite related as shown in Table 1, the correlation co-efficient value is 0.0391 between leverage and tax rate, showing negative relationship. This validates the opposite relation of both effective tax and leverage with systematic risk. Mnzava (2009) also found positive but insignificant relationship between leverage and systematic risk. This also supports the current study findings that any one of the corporate tax rate or leverage has the significant effect on the systematic risk, whereas the second shows its effect through the significant variable. The estimated co-efficient for market value of equity is positive and statistically insignificantly correlated with systematic risk having p-value of 0.2652. This shows that market value of equity has no significant influence on systematic risk. The positive sign suggests that as the market value of equity raises the systematic risk increases, which is opposite to the findings of Brenner and Smidt (1997). Mnzava (2009) showed opposite results and found negative relationship between market value of equity and systematic risk. The positive relation suggests that increasing market value of equity may result due to the overvaluation, which may result in lower of prices back to equilibrium value in future, resulting in increase in systematic risk. The results shows that estimated co-efficient for return on assets have a value of 1.230343 with t-statistics value of 1.367788. This shows that return on assets are statistically insignificantly positively related to the systematic risk, indicating that the systematic risk increases with borrowing. The firms should borrow till point where

borrowing costs are lower than the return on assets. This result is in consistent with the positive and significant relation proved by Mnzava (2009) between return on assets and systematic risk. In summary aforementioned results shows that leverage has significant effect on systematic risk and is important determinant of systematic risk, where as effective tax rate, return on assets and market value of equity are positively related to systematic risk. Conclusion The objective of this study was to test the significance of corporation tax as a determinant of systematic risk by using cement sector data of Pakistan. The study utilized fixed effect panel data regression analysis to provide empirical evidence that the corporation tax is negatively influencing systematic risk and has insignificant relation with systematic risk, whereas leverage play influencing role and has significant relationship with systematic risk. This study indicated that corporate tax rate influenced the systematic risk through leverage as both (corporate tax rate and leverage) are negatively correlated (Table 1). As a result increasing leverage level results in lowering tax payments, consequently higher systematic risk. In utilizing the tax shields benefits firms increases its leverage level results in increase in systematic risk associated with the firm equity. The negative relationship between corporate tax rate and systematic risk are in lined with findings of Vassalou and Xing (2004). Mnzava (2009) found positive relationship between corporate tax rate, leverage and systematic risk, whereas corporate tax was positively related to systematic risk. The study also proved a positive relationship between return on assets and systematic risk, indicating that decrease in total assets level results in bad signal to the investors and decrease in the confidence of investors resulting in increase in systematic risk. The result shows that market value of equity is negatively related to effective tax rate, indicating that increasing market value of equity shows the lack in confidence of investors and overvaluation of equity, consequently resulting in increase in systematic risk

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Limitation and future research The analysis was done by using the cement sector data of Pakistan, so the findings of this research may not be generalized on other sectors of economy. Thus future research can use the data form all the sector of economy to made findings generalizable to whole economy. The estimation of beta assumed that capital markets are competitive and efficient so the findings of research may not be the same if analysis is done in imperfect market. The study was conducted during a periods of no change in corporate tax rate, so future research can be done by using data of corporate tax rate change period. Future studies can also use other determinants such as liquidity, ratio of net income to net equity, growth in earnings, financial risk, risk of real estate, and change in corporate tax rate with the corporate tax rate. MANAGERIAL RECOMMENDATIONS IMPLICATIONS AND

for the fair valuation of their investments and stabilizing the market price of equity, resulting in the stabilizing the systematic risk. Based on the findings of this study, few policy related implications and recommendations are given as: 1. Rules have to be made for the publication of systematic risk information in the financial reports, for the fair valuation of equity by the investors. 2. It should be made obligatory for the firms to publish trends of market value of their issued equity. The market value information can be given in reports on monthly or weekly basis for the reported year. This will give better information and understanding to the investors relating the volatility in the market value, consequently of the systematic risk of firm. 3. Some sort of analysis relating the systematic risk, such as given in this study has to be given in financial reports.
REFERENCES Badhani KN (1997). Effects of financial leverage on systematic risk, cost and value of equity under capital assets pricing model. Financ. India, 11: 343-352. Brenner M, Smidt S (1977). A simple model of non-stationarity of systematic risk. J. Financ., 32: 1081-1092. Chung KH (1989). The impact of the demand volatility and leverage on systematic risk of common stocks. J. Bus. Financ. Account., 16: 343360. Dimson E (1979). Risk Measurement When Shares Are Subject to Infrequent Trading. J. Financ. Econ., 7: 197-226. Hamada RS (1972). The effect of firms capital structure on the systematic risk of common stocks. J. Financ., 27: 435-452. Korajczyk RA, Sadka R (2008). Pricing Commonality across different measures of liquidity. J. Financ. Econ., 87: 45 -72. Mnzava ID (2009). The significance of corporate tax as a determinant of systematic risk: evidence using United Kingdom (UK) data. KCA. J. Bus. Manage., 2(1): 44-61. Miller M H, Modigliani FF (1958). The cost of capital, Corporation Finance, and the Theory of Investment. Am. Econ. Rev., 48: 261-297. Miller MH, Modigliani FF (1963). Corporation Income Tax and the Cost of Capital: A correction. Am. Econ. Rev., 53: 433-443. Ramchand L, Sethipakdi P (2000). Changes in systematic risk following global equity issuance. J. Bank. Financ., 24: 1491-1514. Scholes M, Joseph W (1977). Estimating Betas from Nonsynchronous Data. J. Financ. Econ., 5: 309-327. Shah K (1994). The nature of Information Conveyed by Pure Capital Structure Changes. J. Finan. Econ., 36: 89-126. Vassalou M, Xing Y (2004). Default Risk in Equity Returns. J. Financ., 592: 831-868.

The results of this study shows that cement manufacturer mangers has to consider the following things: 1. Corporate tax rate does not play important role in determining the systematic risk associated with the equity, but it shows its effect through leverage, which is significantly related with the leverage. 2. The mangers should develop alternative strategies for financing sources other than external borrowing because increase in leverage level increases the systematic risk. 3. The firms mangers has to take steps to keep market value of equity at specific level because results shows that the market value of equity is positively related to systematic risk. So, increasing market value of equity increases systematic risk. 4. The mangers has to increase the total assets level, because increasing return on assets shows that either the operating earnings are increasing at a higher rate and amount than total assets or total assets level is same as previous years or decreasing . So, managers should develop strategies to increase total assets level, because with increasing assets investors confidence increase in the firm, hence resulting in lowering of systematic risk. POLICY IMPLICATIONS AND RECOMMENDATIONS The results of this study have some close association with the issues of financial reporting. The main aim of the financial reporting is providing information relating the firms performance and other decision making indicators to the investors. The information given is used by investor