FINANCIAL MANAGEMENT

CONCEPTS OF
LEVERAGES &
COST OF CAPITAL

DATE OF SUBMISSION: - 25th MARCH’08

Submitted To: - Submitted By: -

Dr. Gurendra Nath Bhardwaj Vivek Jain (55)
Faculty, Financial Management IInd Semester
ABSAU. 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 Leverage-

If 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%