Determinants of Expected Rate of Return on Common Stock: An Empirical Study in Sri Lanka

Abstract

Identifying the factors related to the expected rate of return on common stock is a puzzle for investors in an increasingly competitive market. To solve this puzzle, this study investigates how the market risk premium, firm size, price-earning ratio, and industry effect affect the expected rate of return on common stock of publicly listed companies in Sri Lanka. The study was based on fifteen publicly listed companies over six years for the period from 2006 to 2011 in Hotel and Travel, and Chemical and Pharmaceutical industry of the Colombo Stock Exchange in Sri Lanka. The findings of the study revealed that the market risk premium has a significant positive relationship with the expected rate of return on common stock. Moreover, firm size and PE ratio negatively correlate with the expected rate of return on common stock. However, The findings of the study revealed that industry effect is not important in determining the expected rate of return on common stock. Therefore, market risk premium, firm size, and PE ratio can be considered as determinants of the expected rate of return on common stock. The study provides valuable insights for financial managers and investors to develop finance and investment strategies that may enable them to gain an optimal return from their investment in the increasingly competitive market settings.