CONCEPTS OF LEVERAGES & COST OF CAPITAL

8/8/2019 CONCEPTS OF LEVERAGES & COST OF CAPITAL

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FINANCIAL MANAGEMENT

CONCEPTS OF

LEVERAGES &

COST OF CAPITAL

DATE OF SUBMISSION: - 25th MARCH08

Submitted To: - Submitted By: -Dr. Gurendra Nath Bhardwaj Vivek Jain (55)Faculty, Financial Management IIndSemesterABSAU. MBA (Mkt & Sales)

Section C


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ACKNOWLEDGEMENT

The satisfaction and euphoria that accompanies the successful completion of any

task would be incomplete without mentioning the names of the people who

made it possible, whose constant guidance and encouragement crown all the

efforts with success.

Im deeply indebted to all people who have guided, inspired and helped us in the

successful completion of this project. I owe a debt of gratitude to all of them,

who were so generous with their time and expertise.

I would like to thank Dr. Gurendra Nath Bhardwaj for his continuous guidance

and support.

Last but not the least, I thank everybody, who helped directly or indirectly in

completing the project that will go a long way in my career, the project is really

knowledgeable & memorable one.

VIVEK JAIN


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CONTENTS

INTRODUCTION TO MAHINDRA & MAHINDRA LTD

MAHINDRA GROUPS CONSOLIDATED RESULTS

AN OVERVIEW OF THE CONCEPT OF COST OF CAPITAL.

AN OVERVIEW OF THE CONCEPT OF LEVERAGE.

PRACTICAL APPLICATION OF THE CONCEPTS OF COST

OF CAPITAL & LEVERGE ON M&M LTD.


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INTRODUCTION TO MAHINDRA & MAHINDRA LTD .

The US $4.5 billion Mahindra Group is among the top 10 industrial houses in

India. Mahindra & Mahindra is the only Indian company among the top four

tractor manufacturers in the world and is the market leader in multi-utility

vehicles in India. The Group has a leading presence in key sectors of the

Indian economy, including trade and financial services (Mahindra Intertrade,

Mahindra & Mahindra Financial Services Ltd.), automotive components,

information technology & telecom (Tech Mahindra, Bristlecone), and

infrastructure development (Mahindra GESCO, Mahindra Holidays & Resorts

India Ltd., Mahindra World City). With over 60 years of manufacturing

experience, the Mahindra Group has built a strong base in technology,

engineering, marketing and distribution which are key in its evolution as acustomer-centric organization. The Group employs over 40,000 people and has

several state-of-the-art facilities in India and overseas. The Mahindra Group

has ambitious global aspirations and has a presence in five continents.

Mahindra products are today available in every continent except Antarctica.

M&M has one tractor manufacturing plant in China and three assembly plants

in the United States.M&M has entered into partnerships with international companies like Renault

SA, France, and International Truck and Engine Corporation, USA. The Group

recently made a milestone entry into the passenger car segment with Logan, a

product of its JV with Renault SA. Forbes has ranked the Mahindra Group in its

Top 200 list of the Worlds Most Reputable Companies and in the Top 10 list of

Most Reputable Indian companies.


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Mahindra Groups Consolidated Results:

The Gross Revenues and Other Income for the quarter ended 30 th June 2007 of

the Consolidated Mahindra Group at Rs.5879.2 crores (USD 1.4 billion) grewby 40.7% over Rs.4179.5 crores (USD 905.8 million) for Q1 last year. The

profit before exceptional items and tax for the current quarter is Rs. 535.7

crores (USD 131.3 million) as compared to Rs.479.7 crores (USD 104.0

million) in Q1 F2007 a growth of 11.7%. This is due to a good performance

by both the parent company and group companies. The consolidated group

Profit for the current quarter after considering exceptional items, tax and after

deducting minority interests is Rs.299.6 crores (USD 73.4 million) as against

Rs.290.0 crores (USD 62.9 million) earned in Q1 last year.


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AN OVERVIEW OF COST OF CAPITAL

The cost of capital for a firm is a weighted sum of the cost of equity and the costof debt. It is also known as the "hurdle rate" or "discount rate". Firms finance

their operations by external financing, issuing stock (equity) and issuing debt,and internal financing, reinvesting prior earnings.

SOURCES OF FINANCING AND THEIR COST

The company in order to do business raises capital from multiple sources. Thesesources can be classified into three types ,viz

Equity Shares

Debt

Preference Shares

Equity is the residual interest in the assets of the enterprise after deducting all itsliabilities. Equity refers to the amount of funds that belong to the owners.Debt, on the other hand, refers to the sum obligations due to others. Each firmhas its capital structure that it might find to be optimum.Since equity holders are eligible for residual portion of the income of thecompany after payment of obligations of debt holders, Equity is a riskierinvestment and hence the equity holders would expect higher returns on

their investments. The cost of capital comprises of the costs from the threesources of finance. Hence, estimating the cost of equity and cost of debtcorrectly therefore becomes very important to arrive at a fair valuation of thecompany. Capital (money) used to fund a business should earn returns for thecapital owner who risked their saved money. For an investment to beworthwhile the projected return on capital must be greater than the cost ofcapital. Otherwise stated, the risk-adjusted return on capital (that is,incorporating not just the projected returns, but the probabilities of those

projections) must be higher than the cost of capital.

The cost of debt is relatively simple to calculate, as it is composed of the rate ofinterest paid. In practice, the interest-rate paid by the company will include therisk-free rate plus a risk component, which itself incorporates a probable rate ofdefault (and amount of recovery given default). For companies with similar riskor credit ratings, the interest rate is largely exogenous.Cost of equity is more challenging to calculate as equity does not pay a setreturn to its investors. Similar to the cost of debt, the cost of equity is broadlydefined as the risk-weighted projected return required by investors, where thereturn is largely unknown. The cost of equity is therefore inferred by comparing

the investment to other investments with similar risk profiles to determine the"market" cost of equity.


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COST OF DEBT

The cost of debt is computed by taking the rate on a non-defaulting bond whoseduration matches the term structure of the corporate debt, then adding a default

premium. This default premium will rise as the amount of debt increases (sincethe risk rises as the amount of debt rises). Since in most cases debt expense is adeductible expense, the cost of debt is computed as an after tax cost to make itcomparable with the cost of equity (earnings are after-tax as well). Thus, for

profitable firms, debt is discounted by the tax rate. Basically this is used forlarge corporations only.

COST OF EQUITY

Cost of equity = risk free rate of return + premium expected for risk

EXPECTED RETURN

The expected return can be calculated as the "dividend capitalization model",which is (dividend per share / price per share) + growth rate of dividends (thatis, dividend yield + growth rate of dividends).

CAPITAL ASSET PRICING MODEL

The capital asset pricing model (CAPM) is used in finance to determine atheoretically appropriate price of an asset such as a security. The expected returnon equity according to the capital asset pricing model. The market risk is

normally characterized by the parameter. Thus, the investors would expect (ordemand) to receive:

Where:Es = the expected return for a securityRf = The expected risk-free return in that market (government bond yield)s = The sensitivity to market risk for the securityRM = The historical return of the equity market

(RM-Rf) = The risk premium of market assets over risk free assets.

The expected return (%) = risk-free return (%) + sensitivity to market risk *(historical return (%) - risk-free return (%))

Put another way the expected rate of return (%) = the yield on the treasury noteclosest to the term of your project + the beta of your project or security * (themarket risk premium)


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COMMENTS

The model states that investors will expect a return that is the risk-free returnplus the security's sensitivity to market risk times the market risk premium.

The risk free rate is taken from the lowest yielding bonds in the particularmarket, such as government bonds.The risk premium varies over time and place, but in some developed countriesduring the twentieth century it has averaged around 5%. The sensitivity tomarket risk () is unique for each firm and depends on everything frommanagement to its business and capital structure. This value cannot be known"ex ante" (beforehand), but can be estimated from "ex post" (past) returns and

past experience with similar firms.Note that retained earnings are a component of equity, and therefore the cost ofretained earnings is equal to the cost of equity. Dividends (earnings that are paidto investors and not retained) are a component of the return on capital to equityholders, and influence the cost of capital through that mechanism.

WEIGHTED AVERAGE COST OF CAPITAL

The Weighted Average Cost of Capital (WACC) is used in finance to measure afirm's cost of capital.The total capital for a firm is the value of its equity (for afirm without outstanding warrants and options, this is the same as the company'smarket capitalization) plus the cost of its debt (the cost of debt should be

continually updated as the cost of debt changes as a result of interest ratechanges). Notice that the "equity" in the debt to equity ratio is the market valueof all equity, not the shareholders' equity on the balance sheet.

FORMULA

The cost of capital is then given as:Kc= (1-) Ke+Kd

Where:

Kc = The weighted cost of capital for the firm = The debt to capital ratio, D / (D + E)Ke = The cost of equityKd = The after tax cost of debtD = The market value of the firm's debt, including bank loans and leasesE = The market value of all equity (including warrants, options, and the equity

portion of convertible securities)

WACC = (1 - debt to capital ratio) * cost of equity + debt to capital ratio * cost

of debt


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CONCEPT AND APPLICATION OF LEVERAGE

In finance, leverage (or gearing) is using given resources in such a way that the potentialpositive or negative outcome is magnified. It generally refers to using borrowed funds, ordebt, so as to attempt to increase the returns to equity.

Types of Leverage:-

1) Financial leverage

2) Operating leverage

3) Combined leverage

Financial Leverage:-

The use of the fixed-charges sources of funds, such as debt and preference capital along withowners equity in the capital structure, is described as financial leverage. The financialleverage employed by a company is intended to earn more return on the fixed charge fundsthan their costs. The surplus (or deficit) will increase (or decrease) the return on ownersequity. The rate of return on the owners equity is levered above or below the rate of return ontotal asset.A firm with no debt in its capital structure is said to be unlevered firm and a form with bothequity and debt is termed as levered firm.

Measures of financial leverage

Debt-to-equity

Debt to equity is generally measured as the firm's total liabilities (excluding shareholders'equity) divided by shareholders' equity, where D = liabilities, E = equity and A = total assets:

Debt-to-Equity Ratio = Debt/Equity

Debt-to-Equity Ratio= (Debt/(Debt+Equity))


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Degree Of Financial Leverage (DFL)

Financial Leverage affects the EPS of the firm. Financial Leverage acts as a double-edgedsword. If the economic conditions are favorable and EBIT is increasing, a higher financialleverage has a positive impact on the EPS. The DFL captures this relationship between EBIT

and EPS. DFL is defined as the percentage change in EPS for a given percentage change inEBIT.

DFL = (%change in EPS / %change in EBIT)Or

= EBIT / (EBIT - INT)

Operating Leverage:-

Operating leverage reflects the extent to which fixed assets and associated fixed costs areutilized in the business. Degree of operating leverage (DOL) may be defined as the

percentage change in operating income that occurs as a result of a percentage change in unitssold. To the extent that one goes with a heavy commitment to fixed costs in the operation of afirm, the firm has operating leverage.

DOL = (%change in EBIT/ % change in Sales)Or

= (EBIT + Fixed cost)/EBIT

Combined Leverage-

If both operating and financial leverage allow us to magnify our returns, then we will getmaximum leverage through their combined use in the form of combined leverage. Operatingleverage affects primarily the asset and operating expense structure of the firm, whilefinancial leverage affects the debt-equity mix. From an income statement viewpoint,operating leverage determines return from operations, while financial leverage determineshow the fruits of labor will be divided between debt holders (in the form of payments ofinterest and principal on the debt) and stockholders (in the form of dividends). Degree ofcombined leverage (DTL) uses the entire income statement and shows the impact of a change

in sales or volume on bottom-line earnings per share. Degree of operating leverage and degreeof financial leverage are, in effect, being combined.

DCL = DOL*DFL


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COST OF CAPITAL OF M&M LTD.

Every resource has some price or that has its cost. Funds also have aprice. Supplier of Funds wants some compensation which we may call asinterest.

If one pays the appropriate interest the supplier will release the fundsotherwise not.

So the Cost of Capital is the return that is enough to motivate him

(Lender) to provide his funds.

Types of Funds

DEBT : In this type of fund the supplier (lender) wants fixed return.

So, in general we can say the interest paid to the lender is cost ofcapital. However, in some cases this may be different. The rate ofinterest is expressed in percentage term. In a simple case of lending& borrowing.

1.) Kd= Interest amount /Borrowed amt or net receipt x 100

For 2007= 6745/155810 x 100= 4.3289%For 2006= 1840/83718 x 100= 2.1978%

2.) Ke= EPS/M.V x 100

For 2007=45.15/147.98 x 100 =30.51%For 2006=38.07/123.29 x 100 =30.87%

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CONCEPTS OF LEVERAGES & COST OF CAPITAL