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Dr.Reddys used both financial leverage and operating leverage to increase its profitability and
hence both financial risk and operating risk is high. Companies with high operating leverage
are vulnerable to sharp economic and business cycle swings. Hence, Dr.Reddys reduced its
business risk gradually from 2005-2009.
WACC is high and debt to equity ratio is also high and hence the financial risk is high
Sales exceeded the BEP sales in 2005. It retained on 80% of its earnings on an average
and paid dividends to its shareholders during all the five years under study.
It maintained more of current assets and is able to generate sales from the investments on
fixed assets.
High DOL and comparatively low DFL and hence high business risk is higher than financial
WACC is lower compared to Dr.Reddys but Ranbaxy financed most of its assets using equity.

Ranbaxys sales are close to its BEP sales in the year 2009. The firm did not pay dividends
for the past 2 years and retained all its earnings for further investments.
Ranbaxys investment in fixed assets increased during the given period and its FATR

Aurobindo used both financial and operating leverage. But the DOL is higher than DFL .
Hence business risk is higher than financial risk.
WACC is comparable to that of Ranbaxys.The firm used both debt and equity to an equal
extent to finance its assets
Its sales were higher than BEP sales during the five year period under study. It retained nearly
90% of its earnings and paid dividends with the remaining earnings.
It maintained more of fixed assets and its FATR is also high.


DFL is negative during 2008-09 .It implies that EBIT during this year is less than the BEP.

IDEA financed most of it assets using debt and hence high financial risk exists.

Low earnings per share and IDEA did not pay any dividends during the period under study.
The firm retained all its earnings for further investment.

IDEA invested more on fixed assets than on current assets.


EPS is high compared to other 2 firms and Airtel retained 100% of its earnings during 200507 and hence could not pay any dividends to its shareholders during that period.

Airtel financed most of its assets using equity

Value of the company is high


EPS is low until 2006-07 and increased suddenly almost 9 times for the year 2007-08.

Low debt/ equity ratios compared to others two companies under study. Hence we can say
that TATA financed most of its assets using equity.

Value of the company doubled in the past five years.


An empirical study is conducted to analyze the differences in leveraging practices within and
between Pharmaceutical industry (manufacturing) and Telecommunications industry (service).
Key players in both the industries are chosen for study. Dr.Reddys, Aurobindo and Ranbaxy are
chosen from pharmaceutical industry and Idea Cellular, Airtel, TATA Telecommunications from
Telecommunications industry.
The degree of financial, operating leverage and combined leverage are calculated using the
information published in the annual reports of the companies.
Service and manufacturing firms differ fundamentally in overall structure and growth dynamics.
In service firms relative to manufacturing firms entry costs and capital requirements lower
because investment in machinery and equipment is almost non-existent. If service firms lease
their facilities (buildings), then their total capital invested is mainly working capital. They rely
less on physical infrastructure and machines but more on human capital. Hence they cannot
leverage on fixed costs.

Financial leverage has a positive effect on the firm's profitability but the use of excessive
debt creates agency problems among shareholders and creditors, which in turn, lead to negative
relationship between leverage and profitability.
The existence of agency costs of debt may cause firms to take riskier investment after the
issuance of debt to expropriate wealth from the firms bondholders because the firm equity is
effectively a stock option.
The degree of financial, operating leverage and combined leverage are calculated using the
information published in the annual reports of the companies.
DFL, DOL,DCL,EBIT and EPS are calculated for the companies chosen and the trend is
observed for a period of 5 years. Effect of degree of leverage on the EPS and EBIT is
analyzed.An important observation is that DOL will be maximum when the firm operates close to
the break even. This is proved by calculating BEP sales and comparing with the actual sales.
Since service firms cannot use operating leverage to increase the profitabililty as most of the
capital is predominantly working capital. So, only DFL leverage is calculated and its effect on
EPS during the given time period is analysed.So, companies in service industry are expected to
use high degree of financial leverage to increase the profitability.
But from the empirical study it is found that Debt to Equity ratio is comparatively lower for
companies in service industry. Two out of three firms (TATA and AIRTEL) chosen for study
financed most of their assets using equity and hence did not use financial leverage to increase the
profitability. On the other hand IDEA used financial leverage and pooled high financial risk.
During 2008-09 when the world suffered from recession IDEA ended up with negative DFL i.e.
EBIT is lower than BEP.
An interesting phenomenon is observed in case of firms in manufacturing industry, operating
leverage decreases as a companys sales increases and shifts away from the break-even point of
sales.( Dr.Reddys, Ranbaxy). Also, shareholders of the firms that financed most of their assets
using equity could benefit from high EPS.
There are many factors that affect the enterprise value or the firm value. One of the important
factor which not only effects the value of the firm but also acts an indicator of nature of financing
is debt to equity ratio. So, debt to equity ratio and value of the companies are calculated and
Ranbaxy with comparatively low debt to equity ratio has high value of the firm. Value of the firm
can be calculated by subtracting Interest cost from Earnings before interest and tax. It implies
that the enterprise value is inversely proportional to interest cost which is in turn directly

proportional to debt to equity ratio and thus Ranbaxy which financed most of its assets using
equity has more Firm value. In simple words degree of financial leverage affects the firm value.
Firms asset structure affects its leverage in both positive and negative ways. Ability of Assets
to Support Debt also effects the leveraging decisions. Lower risk assets with more stable market
values provide better collateral for debt. With better collateral, the firms ability to borrow
Firms with high level of assets that can be used as collateral tend to use more debt rather than
issue new equity because costs associated with issuing equity rise due to the asymmetry of
information possessed by insiders and outsider suggests a positive relationship between debt
ratios and the firm capacity of collateralized assets.
Since service firms do not have high level of assets like manufacturing firms. Therefore, the costs
associated with this agency problem would be higher for the service firms because of the lower
level of collateralized assets.
This is clearly evident from the companies chosen for study. While Dr.Reddys, Ranbaxy and
Aurobindo has debt to equity ratios comparatively more than that of Airtel and Tata.
Theoretical research predicts positive relationship between collateralized asset and leverage.
Prior empirical studies use fixed assets as its proxy and the findings are consistent with
theoretical predictions. The findings of this paper show opposite result: leverage decreases as the
proportion of fixed asset in the total assets of the firm increases. The service industry is usually
characterized by a relatively low level of fixed assets. Current assets can more easily be
converted to cash and thus have more liquid capacity than fixed asset. Lending institutions
generally attribute more significance to the capacity to convert borrowers assets into cash and
we conjecture that in the service industry the importance of current rather than fixed assets plays
an important role in their decision to offer loans to firms with high ratio of current to total assets,
or a low ratio of fixed to total assets. This supply-side argument might explain why firms who
own relatively low ratios of fixed to total assets may have higher leverage (IDEA Cellular).
Idea Cellular maintained low fixed to total assets ratio and thus could use more debt by using
current assets as collateral. Airtel and TATA maintained more of fixed assets and so could not use
them as collateral. This is proved by very low debt to equity ratios.
Fixed asset turnover ratio of the companies is also studied. Manufacturing and other industries
requiring major-investments will often spend heavily on properties, manufacturing plants, and

equipment to push themselves ahead of the competition. A large capital investment purchases
may not immediately yield higher sales. It may take a year or more for the company to fully
utilize those investments. If a company invested in major improvements heavily one year, it
would be wise to watch the Fixed Asset Turnover closely over the next year to see if those
investments actually helped the company.
The higher the Fixed Asset Turnover ratio, the more effective the company's investments in Net
Property Plant and Equipment have become.
It is desirable that Gross Profit ratio must be high and steady because any fall in it would put the
management in difficulty in the realization of fixed expenses of the business. Net Profit ratio is
helpful to determine the operational ability of the concern.
NPR and GPR are stable in case of Airtel and halved during Idea Cellular.NPR is abnormally
low in case of Dr.Reddys during 2005 and abnormally high during 2007. Abnormal decrease may
be attributed to low sales.
Income tax, nondebt tax shield, firm size, and growth opportunities are the other factors that
determine capital structure choices of the firm which are not studied in this project. The
relationship between leverage and growth opportunities can be positive or negative, depending
on the nature of the growth opportunity.
Leverage has a significant negative effect on investment because of an agency problem between
shareholders and bondholders. If managers work in the interest of shareholders, they may give up
some positive net present value projects due to debt overhang. The other argument is based on
agency conflicts between managers and shareholders. They argue that firms with free cash flow
but low (or no) growth opportunities may nevertheless invest (overinvest) in that the manager
may take on projects with negative net present value. However, such a strategy is costly to the
manager, if the capital market takes into account such potential opportunism, or there is a
takeover of the firm by another company; managers have an incentive, therefore, to recommit
and increase leverage and pay out cash as interest and principal. These theories suggest a
negative relationship between leverage and investment but only for firms with no or little growth
Corporate income tax has important impact on debt-equity choices. Modigliani-Miller
proposition the corporate tax case - suggests that firms that face higher marginal tax rates
should use more debt to take advantage of tax shield.

In conclusion, financing choice is not a simple one-period decision but a dynamic occurrence.
Firms issue equity when their market valuations are high. Service firms and manufacturing firms
follow different leverage practices. One major difference observed is that service firms use more
of equity than manufacturing firms. This may be partly attributed to differences in the asset
structure of the firms.


High interest costs during difficult financial periods can increase the risk of
insolvency. So, the companies must not use large amount of debt.

Airtel and TATA should invest more on current assets so that they can obtain debt and
thus can use financial leverage.

Debt instruments often contain restrictions on the company's activities, preventing

management from pursuing alternative financing options and non-core business

The larger a company's debt-equity ratio, the more risky the company is considered by
lenders and investors. Accordingly, a business is limited as to the amount of debt it
can carry.

The company is usually required to pledge assets of the company to the lender as
collateral, and owners of the company are in some cases required to personally
guarantee repayment of the loan.

Growth opportunities in the economy and of the industry have to be studied before
making financing decisions.

Acquisition of new assets of heavy costs should be done with proper capital budgeting
supported by payback period.

The process of asset securitization is a new and innovative financing method used for
funding and risk management purposes.

the increased use of debt causes both the costs of debt and equity to increase.

10 Signaling theory suggests firms should use less debt than MM suggest.This unused
debt capacity helps avoid stock sales, which depress stock price because of signaling
11 Managers have better information about a firms long-run value than outside
investors.Managers act in the best interests of current stockholders. Issue stock if they
think stock is overvalued.Issue debt if they think stock is undervalued. As a result,
investors view a common stock offering as a negative signal--managers think stock is


Maheswari S.N.: Financial Management 5th Edition

Annual reports of companies

Notes on leverage by Alex Tajirian

Paper on Financial Statement Analysis of Leverage and How It Informs

About Profitability and Price-to-Book Ratios

Paper on the effect of leverage increases on real earnings management by Irina ZagersMamedova

A journal on The Determinants of Capital Structure in the Service Industry: Evidence from
United States by Amarjit Gill, Nahum Biger, Chenping Pai and Smita Bhutani

A report on telecom industry by Corporate Catalyst India

A reading on Financial Ratio Analysis prepared by Pamela Peterson Drake

Is There Room For Growth? Debt, Growth Opportunities and The Deregulation of U.S.
Electric Utilities by Laarni from IBS.
Asset Securitization and Optimal Asset Structure of the Firm by Jure Skarabot.