Sanjay J Bhayani. Paradigm. Ghaziabad:Jul-Dec 2009. Vol. 13, Iss. 2, p.43-49(7pp.)
Abstract (Summary)
In corporate finance, financing decision has gained greater importance because the optimal capital structure can be created through 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 financial leverage in its capital structure because the right use of financial leverage can increase the shareholders' wealth whereas its improper use would adversely affect the interest of shareholders. This study examines the empirical effects of corporate capital structure (financial leverage) on cost of capital and the market value of selected firms of Indian Cement Industry for the period from 2000-01 to 2007-08. The research evidence of the study indicates that no impact of financial leverage on cost of capital was found in the cement industry in India, i.e. no significant linear relationship between the financial leverage and cost of capital exists, and there is no correlation between the financial leverage and total valuation within the cement industry. Or in other words, financial leverage does not affect the total valuation of a firm in the cement industry in India. [PUBLICATION ABSTRACT]
Full Text(3613 words)
Copyright Paradigm Jul-Dec 2009
[Headnote]In corporate finance, financing decision has gained greater importance because the optimal capital structure can be created through 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 financial leverage in its capital structure because the right use of financial leverage can increase the shareholders' wealth whereas its improper use would adversely affect the interest of shareholders. This study examines the empirical effects of corporate capital structure (financial leverage) on cost of capital and the market value of selected firms of Indian Cement Industry for the period from 2000-01 to 2007-08. The research evidence of the study indicates that no impact of financial leverage on cost of capital was found in the cement industry in India, i.e. no significant linear relationship between the financial leverage and cost of capital exists, and there is no correlation between the financial leverage and total valuation within the cement industry. Or in other words, financial leverage does not affect the total valuation of a firm in the cement industry in India.
Key words : Financial Leverage, Cost of Capital, Valuation of Firm, Price Earning Ratio, Indian Cement Industry.
Introduction
In running business activities smoothly every industrial organization must have adequate amount of capital at its disposal. As capital is regarded as the lifeblood of an organization and are available in a limited quantity, an industrial organization must acquire and is spend the same in a planned and systematic manner. In general, the potential sources of capital are owner's equity, retained earning, undistributed profit, and borrowed money. For most large business operations, borrowed money from banks and other specialized financial institutions is used. The policy of supplementing owner's equity with borrowed money can only be supported when the return on investment (ROI) is sufficiently large and a bigger margin of income is available after meeting all fixed charges including cost of capital. It has been observed that a large number of industrial organizations have a propensity of making a lavish use of borrowed money without considering its earning potential; such a policy can spell disaster for the enterprise leading to failure and bankruptcy in the long run. Another policy often adopted by industrial undertakings is the unplanned and indiscriminate use of borrowed money and other modes of financing which totally distorts its capital structure. The ultimate implications of such policies on the financial position of an industrial organization can be very both in the short-term and long-term perspective.
Many financial managers argue that the financial leverage is the most important among the leverage concepts. It is particularly applicable in capital structure management. A firm's capital structure is the relation between debt and equity capital that makes up the firm's financing of the assets. A firm using no debt capital is said to have an all-equity capital structure. Since most firms have a capital structure comprising both debt and equity, such a firm's financial manager is highly concerned with the right choice of debt and equity. It determines the relationship that should exist between debt and equity capital at a given point of time. A firm which makes no use of fixed-charge securities have a purely equity capital structure and thus have no financial leverage at all. Thus it is very much imperative that every successful industrial organization must pay adequate consideration to the vital question of financial leverage, cost of capital, and value of firm.
Review of Literature
The question 'Is there an optimum debt level?' has occupied a central place in the corporate finance research. The optimum debt level represents the debt level that maximizes firm value. This optimum requires a trade-off between the benefits of debt use and the costs associated with it, for example, the trade-off between tax advantages of debt and bankruptcy costs, or the trade-off between the reduction of free cash flow agency problems and the increase of under investment problems. In an empirical framework, the trade-off argument predicts that firms adjust (increase or decrease) their actual debt ratios towards a target debt level. This means that the debt financing decisions are not residuals of other financing, investment, and strategic decisions.
A survey of the literature shows that a large number of researches have been carried out in the area of capital structure and cost of capital. Notable among them are those by David Durand (1960), Ezra Solomon (1963), Barnes (1964), Baumol and Michael (1967), Scott (1997), Haley (1966), Schall and Harley (1 977), and Elliott (1 980). They came up with important findings. However, these studies were mostly based on data available in the advanced countries like the UK, the USA, etc.
The foregoing resume of research work shows that no systematic study has yet been made to test the validity of these important concepts in the context of the industrial undertakings operating in developing countries. So far as India is concerned, very few studies have been conducted in the area of capital structure practices. Among them are Bhat (1980) who found that business risk, profitability, dividend pay-out and debt-service capacity are significant determinants of leverage. Venkatesan (1 983) has tried to study the impact of sales, cash flow coverage, and business risk on financial leverage in mining, paper, chemical, and steel industries in India. He finds that cash flow coverage has significant impact in determining the leverage ration in the industry under study. Pandey (1 985) examined the industrial patterns, trends and volatility of leverage, and the impact of size, profitability, and growth on leverage for a group of eighteen industries. Sharma and Rao (1969) conducted a study on capital structure and cost of capital, and found that the cost of capital was affected by debt apart from tax advantages. This result was again supported by another study conducted by Pandey (1985). Chandra (1997) has conducted a study to find out the effect of leverage on shareholders' return. This study has suggested that profitability has strong influence on the financial leverage and on shareholders' return in engineering industry in India. Bhayani (2006) has conducted a study on financial leverage and its impact on shareholders' return in Indian cement industry. He finds that the profitability of a firm is positively related to its financial leverage. But no researcher has tried to study the impact of financial leverage on cost of capital and valuation of firm and thus the present paper seeks to make a humble beginning in this respect.
Objectives of the Study
The objectives of this study are:
* To analyse the trend of financial leverage,
* To study the impact of fina nei a I leverage on average cost of capital,
* To analyse the impact of financial leverage on price-earning ratio and total valuation of firm, and
* To examine the correlation of financial leverage with cost of capital, price earning ratio, and valuation of firm.
Hypothesis of the Study
The broader hypotheses of the study are as under:
* The financial leverage has an important impact on the cost of capital.
* The financial leverage has an impact on the Price Earning ratio.
* The financial leverage has an impact on valuation of the firm.
Methodology of the Study
For this study, the necessary data have been collected from the Capitoline database 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 position of the selected companies and throw ample light on their respective financial policies. In this study, top nine performing companies on the basis of sales in the cement industry have been selected as sample for study. The reason behind selection of the cement Industry is that it is a fast developing industry, and in this industry some companies are performing well whereas others are loss making. Even the uses of debt component in the financial structure in the industry are highly fluctuating. For the purpose of analysis various data from the selected companies 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 techniques like mean, median, and Karl Pearson's 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 owners' funds as well as outsiders' funds 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 the its shareholders. The total cost of capital is the aggregate of costs of funds from specific sources. The composite 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:
The researcher used the following formula to calculate the WACC
WACC = (net worth / total assets) * Ke + (total external liabilities /total assets) * Kd.
Where
WACC = Weightage Average Cost of Capital
EBIT = Earnings before Interest and Tax
EBT = Earnings before 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 Pearson's coefficient of correlation in the following manner:
1. The impact of financial leverage on cost of capital of the sampled company of cement industries.
2. The impact of high-levered companies and lowlevered companies of the sampled groups on cost of capital.
Analysis of Impact of Financial Leverage on Cost of Capital
The data on financial leverage and cost of capital of the sampled companies are presented in Table 1.
The statistical hypothesis: The financial leverage has an important impact on the cost of capital.
H^sub 0^: r = 0
H^sub 1^: 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.
As a part of analysis in this study, to find out if there is any relationship between the financial leverage and the cost of capital of the sampled companies in cement industry, the coefficient of correlation was calculated and tested with the help oft-test (Table 2).
The computed value oft is less than the critical value of t at 5 per cent 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 Low-levered Companies on Cost of Capital
As per 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 the degree of financial leverage, the financial leverage continues to increase faster than the cost of capital. Hence, very low degree of financial leverage in the relationship between the financial leverage and the 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.