Amity Business School

Amity University
Uttar Pradesh

FINANCIAL MANAGEMENT

Project
On

LEVERAGE AND C0ST OF CAPITAL

ANALYSIS OF BHEL

SUBMITTED TO: SUBMITTED BY:

Mr. G.N. Bhardawaj Himanshu (14)
Faculty, Financial Management MBA (M&S)-2009
A-14
A0102207064

Date of Submission: 25/03/2008

 INDEX

PARTICULAR PAGE NO.

Acknowledgement 3
Leverage analysis 4
DFL 5
DOL 6
DTL 7
Cost of capital 8
Cost of debt 8
Cost of equity capital 9
Annexure 10-12
 ACKNOWLEGEMENT
I would like to take this opportunity to express my deep gratitude to all those who
directly or indirectly made this project possible.

I thank my Faculty of Financial Management, Mr. G. N. Bhardawaj

who gave me such project and showed us the right path to reach the final destination.
It was a great learning experience to understand the subject.

March 25, 2008

Himanshu
LEVERAGE (OR GEARING):

Meaning of Financial Leverage

 The use of the fixed-charges sources of funds, such as debt and preference capital
along with the owners’ equity in the capital structure, is described as financial
leverage or gearing or trading on equity.
 The financial leverage employed by a company is intended to earn more return on
the fixed-charge funds than their costs. The surplus (or deficit) will increase (or
decrease) the return on the owners’ equity. The rate of return on the owners’
equity is levered above or below the rate of return on total assets.

Measures of Financial Leverage

Debt ratio
Debt–equity ratio
Interest coverage
The first two measures of financial leverage can be expressed either in terms of book
values or market values. These two measures are also known as measures of
capital gearing.
The third measure of financial leverage, commonly known as coverage ratio. The
reciprocal of interest coverage is a measure of the firm’s income gearing.

Financial Leverage and the Shareholders’ Return

The primary motive of a company in using financial leverage is to magnify the

shareholders’ return under favourable economic conditions. The role of financial
leverage in magnifying the return of the shareholders’ is based on the assumptions
that the fixed-charges funds (such as the loan from financial institutions and banks
or debentures) can be obtained at a cost lower than the firm’s rate of return on net
assets (RONA or ROI).
EPS, ROE and ROI are the important figures for analysing the impact of financial
leverage.

Pro
fit afte
rtax
E
arn
ing
s p
er sh
are =
Number of sh a
res
P
A T ( EBIT −IN
T )( 1 −T)
E
PS = =
N N

Pro
fit af
terta
x
R
etu
rn o
n e
quity =
Value o
f equ
ity
(
E BI
T − INT)
( 1 −T)
R
OE =
S
CALCULATION PART:

1. Total Debt to equity ratio

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

Total Debt-to-equity ratio =

Application of concept to the balance sheet of BHEL (balance sheet enclosed)

Total Debt to equity ratio = 88.93 / 8788.26 (figures in Crores)

= 0.01

2. Debt-to-value ratio = = Debt-to-assets

= 88.93/ (88.93+ 8788.26)

= 88.93/8877.19

= 0.01

3. Interest coverage ratio =

= 3779.4/ 43.33

= 87.22

DEGREE OF FINANCIAL LEVERAGE (DFL)

Financial Leverage affects the EPS of the firm. Financial Leverage acts as a double-
edged sword. If the economic conditions are favorable and EBIT is increasing, a
higher financial leverage 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 in EBIT. Debt acts like a lever in the sense that using it
can greatly magnify both gains and losses. The DFL can increase rewards to
shareholders in terms of greater return on equity (roe), but it can also increase
financial distress or business failure. So as her DFL is less than one more debt should
be used to take the advantage of leverage.
 Symbolically,

DFL = Change in EPS/EPS

Change in EBIT/EBIT
Here in the case of SAIL the respective figures are:
2006-07 2005-06
Interest & Finance charges 43.33 58.75
Profit before tax (PBT) 3736.07 2564.35
EBIT 3779.4 2623.1

CHANGE= 1156.3
CHANGE IN EPS=98.66- 68.6
= 30.06
Therefore DFL= 30.66/98.66
1156.3/3779.4
= 0.3107/0.3059
= 1.015

For different applications of leverage, analysts may include or exclude certain items,
such as non-tangible balance sheet items, non-financial liabilities, and similar items, or
may adjust the carrying value of other items. It is not uncommon to use only financial
liabilities (long-term and short-term borrowings), thereby excluding, for example,
accounts payable.

INTERPRETATION-
• For every 1% change in EBIT, EPS changes by 1.015%
• As long as DFL > 1, financial leverage exists.
Here the DFL is greater than one. So the debt funds have been utilized properly.

OPERATING LEVERAGE:

 Operating leverage affects a firm’s operating profit (EBIT).

 The degree of operating leverage (DOL) is defined as the percentage change in
the earnings before interest and taxes relative to a given percentage change in
sales.

/
DOL = % change in EBIT % change in sales
Application of operating leverage:

1. DOL measures the percentage change in EBIT, which results from a change of one
percent in the level of output.
2. DOL helps in measuring the business risk.

CALCULATION PART:
/
DOL = % change in EBIT % change in sales

= . 1156.3/3779.4
17237.53 – 13374.03/17237.53

= 0.305/0.224

= 1.361

INTERPRETATION

• For every 1% change in sales, EBIT changes by 1.361 %.

• As long as DOL > 1, operating leverage exists.

HERE THE OPERATING LEVERAGE IS OPTIMAL AND MOST SENSITIVE TO

SALES. Combined stand-alone leverage DOL is a quantitative measure of the
“sensitivity” of a firm’s operating profit to a change in the firm’s sales. The closer that a
firm operates to its break-even point, the higher is the absolute value of its DOL. When
comparing firms, the firm with the highest DOL is the firm that will be most “sensitive”
to a change in sales A firm’s sales are to its operating break-even point, the greater its
DOL (more risk).Here it is 1.361 so the company holds risk The farther a firm’s sales
are from its operating break-even point, the lower its DOL (less risk).The lower the
contribution margin, the less each product sold is able to help cover fixed operating costs,
and the closer the firm is to its operating break-even point. Therefore, the higher the DOL
for a particular firm, the closer that firm is to its operating break-even point, and the more
sensitive its operating income is to change in sales volume. Greater sensitivity implies
greater risk.
Combining Financial and Operating Leverages

 Operating leverage affects a firm’s operating profit (EBIT), while financial

leverage affects profit after tax or the earnings per share.
 The degree of operating and financial leverages is combined to see the effect of
total leverage on EPS associated with a given change in sales.

Combining Financial and Operating Leverages

CALCULATION PART:

DTL= OPERATING LEVERAGE x FINANCIAL LEVERAGE

= 1.015 X 1.361

= 1.8801

INTERPRETATION
For every 1% change in sales, EPS changes by1.8801.

For BHEL, DTL is greater than 1 so its good for company.

COST OF CAPITAL:

 The project’s cost of capital is the minimum required rate of return on funds
committed to the project, which depends on the riskiness of its cash flows.
 The firm’s cost of capital will be the overall, or average, required rate of return on
the aggregate of investment projects.

A company obtains its capital from three major sources: debt, preference shares and
equity shares. Determining cost of a specific source of capital is important because of
the differences in risk of various securities. Investors have different claims on the assets
and cash flows of the company’s assets. Debt holders have a prior claim over equity
holders on the firm’s assets and cash flows. The company is under a legal obligation to
pay them. Preference shareholders have a claim prior to equity shareholders but only after
bondholders. Equity shareholders claim the residual assets and cash flow. They may be
paid dividends from the cash remaining after interest and preference dividends are paid.
Thus equity share is riskier than both preference share and debt. Since the securities have
risk differences, investors will want different rates of return on various securities.

Significance of the Cost of Capital

 Evaluating investment decisions,

 Designing a firm’s debt policy, and
 Appraising the financial performance of top management.

COST OF DEBT

The cost of debt is computed by taking the rate on a non-defaulting bond whose
duration matches the term structure of the corporate debt, then adding a default
premium. This default premium will rise as the amount of debt increases (since the
risk rises as the amount of debt rises). Since in most cases debt expense is a
deductible expense, the cost of debt is computed as an after tax cost to make it
comparable 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 for large
corporations only.

Kdb = Interest
Net proceeds

2006-07 = 43.33 X 100

89.33
= 48.5%
 2005-06 = 58.75 X100
558.24
= 10.5 %

INTERPRETATION:

In 2005-06 cost of debt is 10.5%. but in 2006-2007 there is no secured loans so

the cost of debt is too high 48.5% which is not a favorable condition for
company.

COST OF EQUITY (Ke)

Dividend yield method

Ke = Dividend/NP

Cost of equity (Ke) =2006-07

= /10
= 31%

2005-06
=/10
= 20%

INTERPRETATION
The return to shareholders is good and has increased from 20% to 31%.Hence more
earnings to the shareholders.

There is no preference capital or debentures. So these

cannot be found.