Capital structure and abnormal returns

► Following Proposition 2 of Modigliani and Miller's capital structure theorem, this paper examines the relation between gearing and its effect on stock returns of listed firms in the UK. ► This study contributes to the literature on gearing and its effect on stock returns by taking into account the industry characteristics such as industry concentration, regulation and the sector the firms belong to. ► Our results suggest that industry characteristics are vital in explaining the performance of firms and hence provide plausible reasons for the relation between returns and gearing to be negative or positive. This paper examines the relation between capital structure and abnormal returns for UK equities. A firm's industry matters when examining this relation. Abnormal returns decline in firm gearing, however, abnormal returns increase as the average industry gearing in a risk class increases. Separating the average level of external financing in an industry from that in a particular firm is important. This study focuses on industry characteristics. Firms in nonregulated and competitive industries with low concentration ratios exhibit this behavior. In contrast, in the utilities risk class, abnormal returns increase in firm gearing which is similar to the findings of Modigliani and Miller (1958) which was unique to the utilities sector.