DEPARTMENT OF BUSINESS ADMINISTRATION

A TERM PAPER ON

IMPACT OF FINANCIAL LEVERAGE ON COST OF CAPITAL AND VALUATION OF FIRM:

A STUDY OF CEMENT INDUSTRY

NAME- DIPANNITA GHOSH DEPT- MBA ROLL- 11

INTRODUCTION
In corporate finance, financing decisions has greater importance because the optimal capital structure can be created trough proper mix of finance. Corporate managers generally prefer borrowings over other means of financing. Management of a company has to be very careful while deciding the extent of financing leverage in its capital structure because the right use of financial leverage can increase the share holders wealth whereas its improper use would adversely affects the interest of share holders. This study examine the empirical effects of corporate capital structure (Financial leverage) on cost of capital and market value of selected firms of Indian Cement Industries for the period from 2001-01 to 2007-08.The research evidence of the study indicates that no impact of financing leverage on cost of capital was found in the cement industry in India, i.e. no significant linear relationship between the Financial leverage and total valuation within the cement industry. Many financial managers argue that the financial leverage is the most important among the leverage concepts. It is particularly applicable in capital structures management. A Firms capital structures are the relation between debt and equity capital that makes up the Firms financing of the assets. A firm using no debt capital is said to have an all equity capital structure. Since most firm has a capital structure comprising debt and equity, such a firms financial managers is highly concerned with right choice of debt and equity. It determines the relationship that should exist between dept and equity capital at a given point of time. A firms which makes no use of fixed-charge security have a purely equity capital structure and thus have no financial leverage at all. Thus it is very much imperative that every successful industrial organizations must pay adequate consideration to the vital question of financial leverage, cost of capital, and value of firm.

OBJECTIVE OF THE STUDY

To analyze the trend of financial leverage, To study the impact of financial leverage on average cost of capital, To analyze the impact of financial leverage on total valuation of firm, To examine the correlation of financial leverage with cost of capital and valuation of firm.

HYPOTHESIS OF THE STUDY

The broader hypothesis of the study as under: The financial leverage has an important impact on the cost of capital. The financial leverage has an impact on valuation of firm.

METHODOLOGY OF STUDY
For this study, the necessary data have been collected from the capitaline data base of the capital market. These data have been used in computing certain specific ratios mentioned in the accounting literature. These ratios help in evaluating the financial positions of the selected companies and throw ample light on their respective financial policies. In these studies top nine performing companies on the basis of sales in the cement industry have been selected as sample for the study. The reason behind selection of the cement industry is that it is a fast developing industry, and in this industries some companies are performing well whereas others are loss making. Even the uses of dept component in the financial structure in the industry are highly fluctuating. For the purpose of analysis various data from the selected company for the period from 2000-01 to 2007-08 have been used. For the purpose of meaningful analysis the eight years average ratios on different variables have been taken for the period of the study. For analysis of data simple statistical technique like mean, median, and Karl Pearsons coefficient of correlation have been used in the study. For testing of Hypotheses t-test has been used.

ANALYSIS OF FINANCIAL LEVERAGE AND COST OF CAPITAL

A company has to employ its owner fund as well as outsiders fund to finance its projects so as to make the capital structure of the company balanced and try to maximize the return on investment (ROI) and also increase the return to its shareholders. The total cost of the capital is the aggregate of cost of funds from specific sources. The companies cost of all types of capital lies between the least and the most expensive funds. Financial leverage has been calculated by using the following formula: Financial leverage =EBIT/EBT The researcher used the following formula to calculate WACC WACC = (net worth/total asset)* Ke + (total external liabilities/total asset)* Kd. Where WACC = Weightage average cost of capital EBIT = Earnings before Interest and Tax Ke = Cost of equity Kd = Cost of Debt WACC, Weighted to Ke and Kd is computed by book value as well as market value. If there is a difference between book value and market value rates, the WACC would differ. Hence, in practice the market value weights cannot be used as they are difficult to ascertain. Even if they are ascertained, they fluctuate according to the market conditions. In the study the researcher has calculated weight on the basis of book value. In assigning weight to cost of equity, the total net worth was divided by the total assets for finding out the relative weights to be assigned to equity capital and debt capital. The impact of leverage on cost of capital was tested by using the Karl Pearsons coefficient of correlation in the following manner:

Table 1: Financial Leverage and Cost of capital in cement industry

Name of company Ambuja cement Ltd Associated cement Co Ltd Birla corporation Ltd Dalmia cement (Bharat)Ltd India cement Ltd Madras cements Ltd Prism cement Ltd Shree cement Ltd Ultra tech cement Ltd Average

Average Financial leverage(%) 1.33 1.88 -5.66 1.68 1.96 2.14 0.41 2.82 0.51 0.78

Average cost of capital Ko(%) 7.63 10.02 12.46 8.38 10.98 8.80 13.57 9.48 7.11 9.82

Table 2: Analysis of coefficient of correlation and t test of the samples companies in cement industry

Details

Coefficient of correlation

Degree of freedom

Result T test Computed Table value value 1.397 2.37

All sampled companies

-0.467

insignificant

ANALYSIS OF IMPACT OF FINANCIAL LEVERAGE ON COST OF CAPITAL

The statistical hypothesis: The financial leverage has an important impact on the cost of capital. Ho : r = 0 H1 : r 0 The null hypothesis is that there is no correlation between these two phenomena; while the alternative hypothesis is that there is significant correlation between the two phenomena. The computed value of t is less than the critical value of t at 5% level of significance for DOF-7.So, the hypothesis Ho is accepted and it may be concluded that there is no significant relationship between the financial leverage and the cost of capital within the cement industry and whatever negative relation is there is due to sampling fluctuations

ANALYSIS OF IMPACT OF HIGH-LEVERED AND LOWLEVERED COMPANIES ON COST OF CAPITAL

As per as the traditional approach, it is believed that initially, with the increase in the degree of financial leverage the overall cost of capital declines, and after reaching a certain level of degree of financial leverage, the financial leverage continues to increase faster than the cost of capital. Here, very low degree of financial leverage in the relationship between the financial leverage and cost of capital is believed to be negative, and in High degree of financial leverage, the relationship between the financial leverage and the cost of capital should be positive. To test the belief the researcher has divided sampled companies into two groups on the basis of the median value (1.68) of financial leverage of the sampled companies. The first groups the number of companies having the degree of financial leverage below the median value, while the second group includes companies having their degree of financial leverages higher than the median value. Hence, these two groups are known as low levered companies and high companies respectively.

Table 3: Low financial leverage and cost of capital Name of company Ambuja cement Ltd Birla corporation Ltd Prism cement ltd Ultra tech cement Ltd Average financial leverage 1.33 -5.66 0.41 0.51 Average cost of capital 7.63 12.46 13.57 9.82

Table 4: High Financial leverage and cost of capital Name of company Associated cement company Ltd Dalmia cement(Bharat)Ltd India cement Ltd Madras cement Ltd Shree cement Ltd Average Financial leverage 1.88 1.68 1.96 2.14 2.82 Average cost of capital 10.02 8.38 10.98 8.80 9.48

To test the impact of financial leverage on the cost of capital in low-levered and high-levered companies Karl Pearsons coefficient of correlation was used and the results were tested at 5% level of significance. The results are presented in Table 5.

Table 5: Analysis of coeffient of correlation and t-test of the sample companies Details Coefficient correlation 0.13 0.15 of DOF t test Computed Table value value 0.18 4.3 0.26 3.18 Result

Low-levered companies High-levered companies

2 3

Insignificant insignificant

It can be seen from table 5 that positive coefficient of correlation was found in case of both low and high levered companies. The result supports the traditional approach, but these apparent results were subject to hypothesis testing to know if these are simply because of sampling fluctuations or not. For this the test at 5% level of significance was used and it may be concluded that the null hypothesis is accepted in both the cases of low and high-levered companies and that there is no linear correlation between high and low financial leverage and cost of capital within the industry.

ANALYSIS OF FINANCIAL LEVERAGE AND VALUATION OF FIRM

The researcher examines here the relationships between the degree of financial leverage and valuation of a firm. It is largely believed that levered companies have comparatively higher valuation as compared to un-levered companies and this view was also eventually supported by the M.M approach. Calculation of valuation of firm While estimating the market values of debt capital and equity capital of the sample units, the researcher has calculated first the average interest and the average earnings available to shareholders of each and every company during the period of study and then uses the following formula to calculate the market value of dept and market value of equity. Market value of debt = Average interest/cost of debt Market value of equity = average earning available to shareholders/cost of equity Total market value = market value of debt + market value of equity of the firm

Table 6: leverage and Total valuation of firms Financial Name of company Ambuja cement Ltd Associated cement Co Ltd Birla corporation Ltd Dalmia cement (Bharat)Ltd India cement Ltd Madras cements Ltd Prism cement Ltd Shree cement Ltd Ultra tech cement Ltd Average Financial leverage(%) 1.33 1.88 -5.66 1.68 1.96 2.14 0.41 2.82 0.51 Average (crore) total 1550.52 1701.47 264.16 1022.31 1898.97 2693.47 241.72 468.87 1165.37 valuation

The study has tried to test whether there exists any relationship between these two variables or not Karl Pearsons coefficient of correlation was used and the results were tested at 5% level of significance. The statistical hypothesis: Ho : r = 0 H1 : r 0 The null hypothesis is that there is no correlation between degree of financial leverage and the total valuation of firm, while the alternative hypothesis is that there is significant correlation between these two variables. The result is presented in table 7. Table 7: Analysis of coefficient of correlation and t-test sample of companies Details Coefficient of Degree correlation freedom 0.49 7 of Computed value 1.52 t-test Table value 2.37 Result

All sampled companies

Insignificant

Since the computed value of t is less than the critical value at 5% level of significance, Ho is accepted and it may be concluded that there is no significance relationship between the financial leverage and the total valuation of firm. In other words financial leverage does not affect the valuation of firms under study.

ANALYSIS OF CAPITAL STRUCTURE, TOTAL VALUATION, FINANCIAL LEVERAGE AND OVERALL COST OF CAPITAL IN CEMENT INDUSTRY
As an integrated approach, the researcher subsequently has tried to know the Functional relationship of capital structure, cost of capital, with that total valuation as per the following approach: Total valuation = f(FL, Ko ) To examine the relationship and interrelated effect between financial leverage and cost of capital, and total valuation of firm, the researcher has used the correlation and multiple correlations among the different variables. Results are presented in table 8. Table 8: Average valuation, Financial leverage, overall cost of capital in cement industry Name of company Ambuja cement Ltd Associated cement Co Ltd Birla corporation Ltd Dalmiacement(Bharat)Ltd India cement Ltd Madras cements Ltd Prism cement Ltd Shree cement Ltd Ultra tech cement Ltd Average Average Financial leverage(%) 1.33 1.88 -5.66 1.68 1.96 2.14 0.41 2.82 0.51 0.78 Average cost of capital Ko(%) 7.63 10.02 12.46 8.38 10.98 8.80 13.57 9.48 7.11 9.82 Average total valuation (crore) 1550.52 1701.47 264.16 1022.31 1898.97 2693.47 241.72 468.87 1165.37 1222.98

As per the analysis the value of multiple correlations between these two variables in cement industries was 0.57 (R1.23 = 0.57) indicating a positive multiple correlation among the variables. It is it concluded that the independent variables financial leverages and overall cost of capital were positive and affected the total valuation of the firm.R1.34 = 0.51 indicates the positive correlations between these variables and it may be concluded that independent variables overall cost of capital affected positively to the total valuation of the firm.

CONCLUSION:
No impact of financial leverage on cost of capital is found in the cement industry i.e, no significant linear relationship exists between the financial leverage and cost of capital. Positive correlation is found between High and low-levered companies with cost of capital for cement industry and the result does not support the traditional approach. Also the result at 5% level of significance with t-test does not show any correlations between these two variables. There is no correlation between the financial leverage and total valuation within the cement industry and positive correlations is there is due to sampling fluctuations, i.e. financial leverage and total valuation of the firms and result does not support the M.M approach about the levered company having comparatively higher valuation than unlevered companies. The independent variables- financial leverage and cost of capital jointly affect the total valuation positively within cement industry. The total valuation of a firm may increase through different combinations of the two variables ,viz, cost of capital and financial leverage.

BIBLIOGRAPHY
http.//on.wikipedia.com.org/wiki/leverage_(finance) www.cwu.edu/~youngm/FIN%20470/.../Chapter%2017.ppt www.thefreelibrary.com Business Paradigm July 1, 2009 http://www.thefreelibrary.com/Impact+of+financial+leverage+on+cost+of+capital+and+valuatio n+of...-a0238426584