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Liberalization globalization and privatization are the important issues to the entrepreneur
and corporate threatening the existence of a firm. In such a complex corporate
environment, it is the challenge to the finance manager to survive the firm in long run
perspective with the objective of maximizing the owner's wealth. With a view to achieve
this objective finance manager is required to pay his due attention on investment
decision, financing decision and dividend decision.
Assuming that sound investment policy and opportunity are there, it is the intention of
this dissertation to optimize the financing decision and dividend decision in the context of
achieving the stated objective. Financing decision refers to the selection of appropriate
financing mix and so it relates to the capital structure or leverage.
Capital structure refers to proportion of long-term debt capital and equity capital required
to finance investment proposal. There should be an optimum capital structure, which can
be attained by the judicious exercise of financial leverage.
In order to run and manage a company funds are needed. Right from the promotional
stage, finance plays an important role in a companys life. If funds are inadequate and not
properly manage the entire organization suffers, it is therefore necessary that correct
estimation of the current and future need of capital be made to have an optimal capital
structure which shall help the organization to run smoothly.
The capital structure is made up of debt and equity securities and refers to permanent
financing of a firm.
On the other hand a general dictionary meaning of the term Leverage refers to an increase
of accomplishing some purpose. In Financial Management the term leverage is used to
describe the firms ability to use fixed cost assets or funds to increase the returns to its
owners.
This dissertation mainly concentrates on the exercise of impact of leverage and capital
structure on company profitability.
RESEARCH METHODOLOGY:
1) To study the methods of raising finance and financial leverages used by the company.
4) To assess the inter relationship between degree of financial leverage (DFL), earning
per share (EPS) and dividend per share (DPS).
5) To summarize main finding of the study and offer some suggestion, if any, for
improving EPS by the use of financial leverage.
Hypothesis
2) DFL and EPS are positively correlated in such a manner that increases in financial
leverage leads to increase in EPS.
Collection of data:
This project is totally based on the Secondary Data, So all the data of Birla Cotsyn India
Ltd. have been collected from -
The data collected from this source have been used and complied with due care as per
requirement of the study.
Period of study:
Techniques of analysis:
For analyzing the degree of association between DFL, EPS and DPS. The study has been
made by converting the collected data into relative measure such as ratios, percentage
rather than absolute one.
Limitation of study:
1) The study is limited to five year only. Generally twenty years data is ideal to form
trend analysis.
2) This is based on secondary data collected from the annual report of the company. It
was not possible to collect the primary data from the company's office.
CHAPTER 3
THE THEORETICAL
ASPECTS OF
LEVERAGE ANALYSIS
Leverage:
Leverage is using given resources in such a way that the potential positive or negative
outcome is magnified in finance, this generally refers to borrowing. If the firm's return on
assets (ROA) is higher than the interest on the loan, then its return on equity (ROE) will
be higher than if it did not borrow. On the other hand, if the firm's ROA is lower than the
interest rate, then its ROE will be lower than if it did not borrow.
In other words may be defined, as the employment of an asset or sources of fund has to
pay fixed cost or fixed return.
Types of leverage
There are three type of leverage:
1. Financial Leverage.
2. Operating leverage.
3. Combined or composite leverage.
Financial leverage:
Is primarily concern with the financial activities in which involve rising of funds from the
sources from which a firm has to bear fixed charges. These sources include long-term
dept (e.g.: bonds, debentures, etc) & preferences share etc. Long-term debt carries a
contractual fixed rate of interest & obligatory. As the debt providers have Prior claim on
income &assets of a firm over equity shareholders their rate of interest is generally lower
than expected return of the equity shareholders.
Further interest on debt capital is tax-deductible expenses. These two-phenomenon lead
to magnification of rate of return on equity capital & hence E.P.S goes without saying
that effects of changes in E.B.I.T on the earning per share are shown by the financial
leverage. Financial leverage can best be described as the ability of firm to use fixed
financial charges in E.B.I.T. on the firm earning per share.
Financial leverage helps to know the responsiveness of E.P.S. to change in the EBIT. It
involves use of funds obtained at fixed cost in the capital structure in such a way that it
increase the return for common shareholders.
It is referred to a state at which a firm has to bear fixed financing cost arising from the
use of debt capital. The firm with high financial leverage will have a relatively high fixed
financing cost compared with low financial leverage. Financial leverage occurs when a
company employ the fixed cost of funds debt or preference share capital with a view to
maximizing earning available to equity shareholder by a way of a higher income of
funds. This technique also called Trade on equity. Financial leverage influence the
financial risk as long as the companys earnings are greater than its fixed cost it will
enjoy a favorable financial leverage position and make earning available to equity
shareholders.
Financial leverage can measure with the help of the following formula:Financial leverage will have a favorable impact on earnings per share a return of equity
only. When the firms return on investment exceeds the interest cost of debt. The impact
will be unfavorable if the return on investment is less than interest.
The financial leverage measures the relationship between the E.B.I.T. & E.P.S. and it
reflect the effect of change in E.B.I.T. On the level of E.P.S. The financial leverage
measures the responsiveness of the E.P.S. to charge in E.B.I.T. If defined as dividend by
% change in E.B.I.T.
Operating leverage:Operating leverage associated with investment activities (Assets acquisition). It occurs
anytime when firm has fixed costs that must be met regardless of volume in operating
leverage, when fixed cost remain constant the percentage change in profit accompanying
a change in volume is greater than the percentage change in volume A firm with high
operating leverage will have a relatively high fixed cost in comparison with a firm with
low operating leverage. If a company employs operating leverage then its operating profit
will increase at a faster rate for any given increase in sale. However I sales fall the firm
with high operating leverage will suffer more loss than the firm with the no or low
operating leverage. Therefore operating leverage called 2-edged sword. It can be
ascertained by the help of following formula
Degree of operating leverage;A high degree of operating leverage shows the greater impact on the operating income of
the company due to variability in its sales, which is also responsible for variability in its
operating profit. It is an important determinant of operation risk.
It can be measured by % change in E.B.I.T. due to percentage change in sale.
Favorable leverage is said to occur when the firm earns more on the assets purchased
with the funds than their opportunity use. It is unfavorable when firm doesnt earn
equivalent to the cost of funds.
Significance:A proper combination of both financial & operating leverage is blessing for firm growth,
while improper combination of both leverage may prove curse for the growth of
company. So company should try to achieve balance of both leverage.
greater than its fixed costs, It will enjoy a favorable financial leverage position and a
make use of the earnings available to equity shareholders.
Financial leverage can be measured with the help of the following formula:
Financial leverage will have a favorable impact on earnings per share and return on
equity only when the firms return on investment exceeds the interest cost of debt. The
impact will be unfavorable if the return on investment is less than the interest cost.
The financial leverage measures the relationship between the EBIT and EPS and it
reflects the effects of change in EBIT on the level of EPS. The financial leverage
measures the responsiveness of the EPS to a change in EBIT and is defined as a %
change in EPS divided by the % change in EBIT. Symbolically,
The behaviors of DFL reveals that:1) Each level of EBIT has distinct DFL.
2) DFL is undefined at financial BEP.
3) DFL will be negative when the EBIT level goes below the financial BEP.
4) DFL will be positive for all values of EBIT that are above the financial Break
even point. This will however starts to decline as EBIT increases and will reach to
a limit of one (1).
By assembling DFL one can understand the impact of a change in EBIT on the EPS of
the company. It helps in assessing the financial risk of the company. It also explain the
impact of market risk on financial risk.
Greater the financial leverage, wider the fluctuation in return on equity and greater is the
financial risk.
IMPLICATIONS
1) High operating leverage combined with high financial leverage will consolidate
risky situation.
2) Normal situation is one should be high and another should be low. If a company
has a low operating leverage, financial leverage can be higher and vice versa.
3) Ideal situation is when both the leverages are low.
4) If quantity is greater than BEP the DOL will be positive (but there is no such
direct relationship. DOL may start declining after an increasing quantity beyond
certain level and will limit to one (1).)
5) A large DOL indicates that small fluctuation in the level of operation will produce
large fluctuation in the level of operating income.
INCOME STATEMENT:
Total Revenue
-
Variable cost
Fixed Expenses
= EBIT
-
Interest on Debt
Tax
Preference Dividend
= Equity Earnings
QUANTITY
Levels of operation
Op. leverage
EBIT
Earning capacity
EPS
Fin. leverage
Total Leverage
CHAPTER 5
CAPITAL
STRUCTURE
AND THEORIES
MEANING
Capital Structure:-
Capital Structure of the firm is the combination of different permanent longterm financing like debt, preference capital etc.
Mainly there are two different views regarding capital structure of the firm. One view
states that capital structure is relevant for any given firm. It emphasis the determination
of the optimum capital structure of a firm at which over all concept of capital for a firm is
minimum they are increasing the total value of the firm.
The second view states that there is no optimal capital structure for any firm. the
market value of the firm is same for any capital structure (any debt/equity ratio) thus
capital structure of the firm is irrelevant.
There are four theories /approaches of expanding the relationship between capital
structure and cost of capital and value of the firm. These are as follows-
1) NI approach
2) NOI approach
3) MM approach
4) Traditional approach.
Assumptions:-
1) The firm employs only two types of capital ie debt and equity. there are also no
preference share.
3) The firm pays 100 % of its earning as dividend. Thus there is no returned.
4) The firms total assets are given and they do not change, in other words the
investment decisions are assumed constants.
5) The firms total financing remain constant. the firm can change its capital structure
either by redeeming the debentures by issue of share or by raising debt and reduce
equity share capital.
Interest payment.
NI
Ko
Ke
NI Approach:-
Durand has suggested NI Approach. According to this approach capital structure decision
is relevant to the valuation of the firm. In other words a change in the capital structure
causes a corresponding change in the overall cost of capital as well as the total value of
the firm.
2) The debt content does not change he risk perception of the investor.
V=S+B
Where S = Ni/Ke.
NOI Approach:-
Durand has also suggested this approach. This approach is just opposite of NI
Approach. According do this approach the market value of firm is not at all affected
by capital structure changes. The market value of the firm ascertained by capitalizing
the NOI at overall cost of capital (Ko) which is considered to be constant. The market
value of equity is ascertained by deducting the market value of debt from market
value of firm.
This approach is based on following assumptions1) the overall cost of capital (Ko) remains constant for all degrees of debt equity of
leverage.
2) The marked capitalization value of the firm as a whole and the spilt between debt
and equity is no relevant.
3) The use of debt having low cost increase in equity capitalization rate (Ke) Thus
the advantage of debt is set off exactly by increase in capitalization rate(Ke).
4) There is no corporate tax.
The following formula can ascertain according to this approach the value of the firm:-
V = EBIT/Ko
And value of equity (S) = V-B
M-M Approach;-
This is Modigliani and Miller approach. According to this approach the value of the firm
is independence of its capital structure however there is basic difference between the two.
The NOI approach is purely definitional and conceptual. It does not provide operational
justification for relevance of capital structure in valuation of the firm. While MM
approach support the NOI approach providing behavioral justification for irrelevance of
total valuation and cost of capital of the firm from its capital structure, in other words
MM approach maintaining that the average cost of capital does not change with the
change in the debt weighed equity mix or capital structure of the firm.
Basic Propositions;-
The overall cost of capital (Ko) and value of firm (V) are constant for all level of
debt equity mix. The total market value of the firm is given by capitalizing expected net
operating income (NOI) by the rate appropriate for risk classes.
The cost of equity (Ke) is equal to capitalization rate of pure equity steam plus
premium of financial risk. The financial risk increases with more debt content in capital
structure, as a result cost of equity (Ke) increase in manner to off set greatly the use of
less expensive source of funds represented by debt.
The cost of rate of investment purpose is completely independent of the way in which
investment is financed.
Assumptions-
1) Investors are rational. They evaluate risk and return of each investment proposal
rationally before investing. They are able to maximize their return at minimum
cost.
3) The firm pay no any income tax thus loses its tax advantages.
4) Expected earning are definite and constant so future earning of firm are known
and definite.
Traditional Approach:-
CHAPTER 6
Earning per share is the reward of an investor for making his investment and it is
the best measure of performance of a firm. "The bottom line of income statement is an
indictor of performance of "think tank" or "top level" of the company. Ordinary investors
lacking in depth knowledge and inside information mainly based on EPS to make their
investment decision. So it should be the objective of financial management to maximize
the EPS from the viewpoint of both the investor and investee.
The forms with a history of taking on good project and the potential for more good
projects in the future acquire much more control over their dividend policy. In particular,
these firms can pay much less in dividend than they have available as cash profits and
hold on to the surplus cash because the shareholder trusts them to reinvest these profits
wisely In contrast, shareholders of firms having history of poor projects wish to have less
retention of profits because of the fear that the profits will be invested in poor projects.
The dividend policy of a firm affects the market price of the share. In general, the
stability of dividend seems to increase the marker price of the share. However the
dividend policy may affect the market price indirectly by affecting the investors
expectations of growth and risk associated with the stream of dividend. The dividend
policy of a firm determines the amount of retained earnings, which can be reinvested by
the firm to ultimately result in growth of the firm and subsequent increase in dividends in
later years.