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Impact of financial leverage on cost of capital and valuation of firm: a study of 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 (1977), and Elliott (1980). 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 (1983) 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 (1985) 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 financial 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 Capitaline 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:

Financial Leveraqe = EBT/EBT

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 low-levered 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 [not equal to] 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 of t-test (Table 2).

The computed value of t 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.

To test this belief the researcher has divided the sampled companies into two groups on the basis of the median value (1.68) of the financial leverage of the sampled companies. The first group contains 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-levered companies respectively.

The details of low-levered companies and high-levered companies along with their cost of capital are listed in Table 3 and Table 4 respectively.

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

It can be seen from Table 5 that positive coefficient of correlation was found in the 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 t-test at 5 per cent 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 the Impact of Financial Leverage on Price Earning Ratio

Debt is considered to be the cheapest source of fund. As earlier explained, if the interest on debt capital is less than the rate of earnings of a firm, the remaining profit will increase the earnings of equity shareholders without any increase in their investments. Thus, increase in profit may lead to increase in the Earnings per Share (EPS) and thereby the market price of shares. Hence the impact of financial leverage on Price Earning ratio was calculated with the help of the coefficient of correlation at 5 per cent level of significance through t-test (Table 6).

The statistical hypothesis: The financial leverage has an impact on the Price Earning Ratio.

[H.sub.0]: r = 0

[H.sub.1]: r [not equal to] 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 these two phenomena. The results of the study are presented in Table 7.

The computed value of t is less than its critical value 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 Price Earning ratio within the cement industry.

The results show that negative correlation exists between the financial leverage and Price Earning ratio, which is very low in the sampled companies. The result of t-test suggests that the leverage has no impact on the Price Earning ratio of the sample companies.

Analysis of Financial Leverage and Valuation of Firm

The researcher examines here the relationships between the degree of financial leverage and the valuation of a firm. It is largely believed that levered companies have comparatively higher valuation as compared to unlevered companies and this view was also eventually supported by the Modigliani and Miller approach (1958).

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 used the following formula to calculate the market value of debt and the 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

The result are presented in Table 8.

In the light of the above data, the study has tried to test whether there exists any relationship between these two variables or not Karl Pearson's coefficient of correlation was used and the results were tested at 5 per cent level of significance.

The statistical hypothesis:

[H.sub.0]: r = 0

[H.sub.1]: r [not equal to] 0

The null hypothesis is that there is no correlation between degree of financial leverage and the total valuation of the firm, while the alternative hypothesis is that there is significant correlation between these two variables. The result of the study in this regard is presented in Table 9.

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

Analysis of Capital Structure vis-a-vis Total Valuation, Financial Leverage, Overall Cost of Capital, and Price Earning Ratio in Cement Industry:

As an integrated approach, the researcher subsequently has tried to know the functional relationship of capital structure (financial leverage), cost of capital, earning per share (in the form of Price Earning ratio) with that total valuation as per the following approach:

Total valuation = f (FL, Ko, Price Earning Ratio)

To examine the relationship and interrelated effect between financial leverage, cost of capital, earning per share, and total valuation, the researcher has used the correlation and multiple correlation among the different variables. Results are presented in Table 10.

As per the analysis the value of multiple correlation between these two variables in cement industry was 0.57 (R1.23 = 0.57) indicating a positive multiple correlation among the variables. It is concluded that the independent variables Financial Leverage (FL) and Overall Cost of Capital (Ko) were positive and affected the total valuation of the firm. R1.34 = 0.51 indicates the positive correlation between these variables and it may be concluded that the independent variables Overall Cost of Capital (Ko) and Price Earning ratio are affected positively to the total valuation of the firm.

Findings of the Study

* 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 per cent level of significance with t-test does not show any correlation between these two variables.

* The financial leverage has not effect on Price Earning ratio in the cement industry.

* There is no correlation between the financial leverage and total valuation within the cement industry and whatever positive correlation is there is due to sampling fluctuations, i.e. financial leverage does not affect the total valuation of the firms in the cement industry.

* No linear correlation is found between the financial leverage and the total valuation of the firms and the result does not support the Modigliani and Miller approach about the levered companies having comparatively higher valuation than the un-levered companies.

* The independent variables--financial leverage and cost of capital as well as cost of capital and Price Earning ratio--jointly affect the total valuation positively within the cement industry.

* The total valuation of a firm may increase through different combination of the three variables, viz., cost of capital, financial leverage, and Price Earning ratio.

References

Barnes, A. James, (1964), 'A Pedagogic Note on Cost of Capital', Journal of Finance, March, pp. 65-85.

Baumol, William, and Durton G. Michael, 1967, 'The Firm's Optimal Debt-Equity Combination and the Cost of Capital', Quarterly Journal of Economics, November, pp. 60-75.

Bhat, Ramesh, (1980), 'Determinants of Financial Leverage: Some Further Evidence', The Chartered Accountant, December, pp. 451-6.

Bhayani, S.J., (2006), 'Financial Leverage and Its Impact on Shareholders' Return: A Study of Indian Cement Industry', International Journal of Management Science, 2(1), July, pp. 31-42.

Shekhar, Chandra, (1997), 'Financial Leverage: Its Determinants and its Impact on Cost of Capital and Shareholders' Return', Journal of Accounting and Finance, XI(2), pp. 82-93.

Durand, David, (1960), 'The Use of Debt and Equity Fund in Business: Trends and problems of measurement', in Ezra Solomon (ed.), The Management of Corporate Capital, New York: The Free Press of Glencoe, pp. 230-45.

Eliott, J.V., (1980), 'The Cost of Capital and U.S. Capital Investment: A Test of Alternative Concepts', Journal of Finance, September, pp. 110-25.

Haley, Charles W., (1966), 'A note on the Cost of Debt', Journal of Financial and Statistical Analysis, December, pp. 160-80.

Modigliani F., and M. Miller, (1958), 'The Cost of Capital, Corporate Finance and the Theory of Investment', American Economic Review, 48, pp. 261-97.

Pandey, I.M., (1985), 'The Financial Leverage in India: A Study', Indian Management, March, pp. 21-34.

Rose, T., (1975), The Internal Finance of Industrial Undertaking, London: Pitman and Sons Ltd, pp. 221-32.

Roy, C.D., (1972), 'The Concept of Cost of Capital', The Management Accountant, September, pp. 554-5.

Sharma, L., and K. Rao, (1969), 'Leverage and Value of the Firm', Journal of Finance, September, pp. 25-30.

Solomon, Ezra, (1963), 'Leverage and the Cost of Capital', Journal of Finance, May, pp. 330-65.

Scott, J.J., (1997), 'Bankruptcy, Secured Debt and Optimal Capital Structure', Journal of Finance, March, pp. 60-72.

Schell, Lawrence D., and Charles W. Harley, (1977), Introduction to Financial Management, 2nd ed., New York: McGraw-Hill Book Company.

Venkatesan, S., (1983), 'Determinants of Financial Leverage: An Empirical Extension', The Chartered Accountant, January, pp. 519-27.

Sanjay J. Bhayani, Associate Professor, Department of Business Management (MBA Programme), Saurashtra University, Rajkot, India. Email: sanjaybhayani@yahoo.com
Table 1: Financial Leverage and Cost of Capital
in Cement Industry

 Average Average Cost
 Financial of Capital
Name of Company Leverage (%) Ko (%)

Ambuja Cements Ltd 1.33 7.63
Associated Cement Co Ltd 1.88 10.02
Birla Corporation Ltd -5.66 12.46
Dalmia Cement (Bharat) Ltd 1.68 8.38
India Cements Ltd 1.96 10.98
Madras Cements Ltd 2.14 8.80
Prism Cement Ltd 0.41 13.57
Shree Cement Ltd 2.82 9.48
UltraTech Cement Ltd 0.51 7.11
Average 0.78 9.82

Table 2: Analysis of Coefficient of Correlation and t-test
of the Sample Companies in Cement Industry

 t-test
 Coefficient
Details of Degree of Computed Table Result
 Correlation Freedom Value Value

All sampled -0.467 7 1.397 2.37 Insignificant
companies

Table 3: Low Financial Leverage (FL) and
Cost of Capital (Ko)

Name of Company Average Average
 FL Ko

Ambuja Cements Ltd 1.33 7.45
Birla Corporation Ltd -5.66 6.03
Prism Cement Ltd 0.41 6.38
UltraTech Cement Ltd 0.51 4.53

Table 4: High Financial Leverage and
Cost of Capital (Ko)

Name of Company Average Average
 FL Ko

Associated Cement 1.88 5.44
Co. Ltd

Dalmia Cement 1.68 4.15
(Bharat) Ltd

India Cements Ltd 1.96 3.43

Madras Cements Ltd 2.14 3.95

Shree Cement Ltd 2.82 4.69

Table 5: Analysis of Coefficient of Correlation and
t-test of the Sample Companies

Details Coefficient Degree of
 of Freedom
 Correlation

Low-levered 0.13 2
companies

High-levered 0.15 3
companies

Details t-test Result

 Computed Table
 Value Value

Low-levered 0.18 4.3 Insignificant
companies

High-levered 0.26 3.18 Insignificant
companies

Table 6: Financial Leverage and Price
Earning Ratio of Sample Companies

Name of Company Average Average
 FL P.E.
 Ratio

Ambuja Cements Ltd 1.33 15.73
Associated Cement 1.88 33.35
Co Ltd
Birla Corporation Ltd -5.66 76.80
Dalmia Cement 1.68 4.93
(Bharat) Ltd
India Cements Ltd 1.96 136.98
Madras Cements Ltd 2.14 19.53
Prism Cement Ltd 0.41 16.89
Shree Cement Ltd 2.82 141.11
UltraTech Cement Ltd 0.51 967.51

Table 7: Analysis of Coefficient of Correlation and
t-test of the Sample Companies

 t-test
 Coefficient Degree
 of of Computed Table
Details Correlation Freedom Value Value Result

All -0.04 7 0.15 2.37 Insignificant
sampled
companies

Table 8: Financial Leverage and the Total Valuation
of Firms

Name of Company Average Average Total
 FL Valuation
 (Rs in Crore)

Ambuja Cements Ltd 1.33 1550.52

Associated Cement 1.88 1701.47
Co Ltd

Birla Corporation Ltd -5.66 264.16

Dalmia Cement 1.68 1022.31
(Bharat) Ltd

India Cements Ltd 1.96 1898.97

Madras Cements Ltd 2.14 2693.47

Prism Cement Ltd 0.41 241.72

Shree Cement Ltd 2.82 468.87

UltraTech Cement Ltd 0.51 1165.37

Table 9: Analysis of Coefficient of Correlation
and t-test of Sample Companies

 Coefficient Degree
 of of
Details Correlation Freedom

All 0.49 7
sampled
companies
 t-test

 Computed Table
Details Value Value Result

All 1.52 2.37 Insignificant
sampled
companies

Table 10: Average Valuation, Financial Leverage, Overall Cost
of Capital and Price Earning Ratio in Cement Industry

Name of Company Average Average Ko P.E.
 Valuation FL Ratio

Ambuja Cements Ltd 1550.52 1.33 7.63 15.73
Associated Cement Co Ltd 1701.47 1.88 10.02 33.35
Birla Corporation Ltd 264.16 -5.66 12.46 76.80
Dalmia Cement (Bharat) Ltd 1022.31 1.68 8.38 4.93
India Cements Ltd 1898.97 1.96 10.98 136.98
Madras Cements Ltd 2693.47 2.14 8.80 19.53
Prism Cement Ltd 241.72 0.41 13.57 16.89
Shree Cement Ltd 468.87 2.82 9.48 141.11
UltraTech Cement Ltd 1165.37 0.51 7.11 967.51
Average 1222.98 0.79 9.82 156.98
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Author:Bhayani, Sanjay J.
Publication:Paradigm
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Date:Jul 1, 2009
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