FINANCIAL MANAGEMENT

CONCEPTS OF LEVERAGES & COST OF CAPITAL

DATE OF SUBMISSION: - 25th MARCH’08

Submitted To: Dr. Gurendra Nath Bhardwaj Faculty, Financial Management ABSAU.

Submitted By: Vivek Jain (55) IInd Semester MBA (Mkt & Sales) Section – C

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. I’m 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

CONTENTS  INTRODUCTION TO MAHINDRA & MAHINDRA LTD  MAHINDRA GROUP’S 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.

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 a customer-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 World’s Most Reputable Companies and in the Top 10 list of Most Reputable Indian companies.

Mahindra Group’s Consolidated Results: The Gross Revenues and Other Income for the quarter ended 30th June 2007 of the Consolidated Mahindra Group at Rs.5879.2 crores (USD 1.4 billion) grew by 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.

AN OVERVIEW OF COST OF CAPITAL The cost of capital for a firm is a weighted sum of the cost of equity and the cost of 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. These sources 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 its liabilities. 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 firm has its capital structure that it might find to be optimum. Since equity holders are eligible for residual portion of the income of the company after payment of obligations of debt holders, Equity is a riskier investment and hence the equity holders would expect higher returns on their investments. The cost of capital comprises of the costs from the three sources of finance. Hence, estimating the cost of equity and cost of debt correctly therefore becomes very important to arrive at a fair valuation of the company. Capital (money) used to fund a business should earn returns for the capital owner who risked their saved money. For an investment to be worthwhile the projected return on capital must be greater than the cost of capital. 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 of interest paid. In practice, the interest-rate paid by the company will include the risk-free rate plus a risk component, which itself incorporates a probable rate of default (and amount of recovery given default). For companies with similar risk or credit ratings, the interest rate is largely exogenous. Cost of equity is more challenging to calculate as equity does not pay a set return to its investors. Similar to the cost of debt, the cost of equity is broadly defined as the risk-weighted projected return required by investors, where the return 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.

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. 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 (that is, dividend yield + growth rate of dividends). CAPITAL ASSET PRICING MODEL The capital asset pricing model (CAPM) is used in finance to determine a theoretically appropriate price of an asset such as a security. The expected return on equity according to the capital asset pricing model. The market risk is normally characterized by the β parameter. Thus, the investors would expect (or demand) to receive: Where: Es = the expected return for a security Rf = The expected risk-free return in that market (government bond yield) βs = The sensitivity to market risk for the security RM = 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 note closest to the term of your project + the beta of your project or security * (the market risk premium)

COMMENTS The model states that investors will expect a return that is the risk-free return plus 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 particular market, such as government bonds. The risk premium varies over time and place, but in some developed countries during the twentieth century it has averaged around 5%. The sensitivity to market risk (β) is unique for each firm and depends on everything from management 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 of retained earnings is equal to the cost of equity. Dividends (earnings that are paid to investors and not retained) are a component of the return on capital to equity holders, 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 a firm's cost of capital.The total capital for a firm is the value of its equity (for a firm without outstanding warrants and options, this is the same as the company's market 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 rate changes). Notice that the "equity" in the debt to equity ratio is the market value of all equity, not the shareholders' equity on the balance sheet. FORMULA The cost of capital is then given as: Kc= (1-δ) Ke+δKd Where: Kc = The weighted cost of capital for the firm δ = The debt to capital ratio, D / (D + E) Ke = The cost of equity Kd = The after tax cost of debt D = The market value of the firm's debt, including bank loans and leases E = 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

CONCEPT AND APPLICATION OF LEVERAGE
In finance, leverage (or gearing) is using given resources in such a way that the potential positive or negative outcome is magnified. It generally refers to using borrowed funds, or debt, 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 with owner’s equity in the capital structure, is described as financial leverage. 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 owner’s equity. The rate of return on the owner’s equity is levered above or below the rate of return on total asset. A firm with no debt in its capital structure is said to be unlevered firm and a form with both equity 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))

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. 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 are utilized 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 units sold. To the extent that one goes with a heavy commitment to fixed costs in the operation of a firm, the firm has operating leverage.

DOL = (%change in EBIT/ % change in Sales) Or = (EBIT + Fixed cost)/EBIT Combined LeverageIf both operating and financial leverage allow us to magnify our returns, then we will get maximum leverage through their combined use in the form of combined leverage. Operating leverage affects primarily the asset and operating expense structure of the firm, while financial leverage affects the debt-equity mix. From an income statement viewpoint, operating leverage determines return from operations, while financial leverage determines how the “fruits of labor” will be divided between debt holders (in the form of payments of interest and principal on the debt) and stockholders (in the form of dividends). Degree of combined 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 degree of financial leverage are, in effect, being combined. DCL = DOL*DFL

COST OF CAPITAL OF M&M LTD.
• Every resource has some price or that has its cost. Funds also have a price. Supplier of Funds wants some compensation which we may call as interest. • If one pays the appropriate interest the supplier will release the funds otherwise 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 of capital. However, in some cases this may be different. The rate of interest 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%

Sign up to vote on this title
UsefulNot useful