Discussion On Leverage And Unleveraged Firm

Objective To understand the concept of leveraging. What effect does it have on the capital structure of the

company.

Purpose of leveraging. Effect of beta of leveraging firm for decision making. Lastly analysis of the industry in order see how beta

helps in decision making of levered and unlevered firm.

Meaning : leverage Leverage or financial leverage is the use of

funds, such as debt and preference capital along with owners equity in the capital structure. Financial leverage employed by the company

helps in earning more return on fixed charge rather than their cost.

Measure of financial leverage Debt ratio Debt equity ratio Interest ratio

How leveraging effect company Unlevered (All Equity)

Levered (Debt Equity)

1,20,000

1,20,000

0

37,500

1,20,000

82,500

Less taxes (50%)

60,000

41,250

PAT

60,000

41,250

Total Earning (PAT + INT)

60,000

78,750

No. of ordinary shares

50,000

25,000

EPS

1.20

1.65

ROE

12%

16.5%

EBIT

Less interest (31.25%) PBT

Beta  Beta is the mode of measuring risk. It is being used in financial market more often

in order to ascertain the returns. In the valuation term it can be defined as variance that cannot be mitigated by the diversification of the portfolio. Beta can be estimated for individual companies using regression analysis against a stock market index.

Determinants of BETA Type of business Degree of operating leverage Degree of financial leverage

Allen candy inc. Privately owned firm in Delaware. Specialized in candy making. Wants to go public Wants to find the cost of equity in both cases

when company will be levered or unlevered

Finding the beta food processing industry less than 250 million

Market capitalisation is taken. Regression beta 0.98 Average debt to equity is 43%(30-70 debt equity) Tax is assumed on an average to be 40% Risk free rate is 4.50% Risk premium is 4%

Beta of levered=Beta of unlevered(1+(1-

tax)Debt/Equity) Unlevered beta

0.98/(1+(1-0.4)(30/70))= 0.78 Total unlevered beta =market beta/sqrt R-squared

0.78/sqrt .1112= 2.34

Since we have unlevered beta so levered beta

is 0.98 0.78(1+(1-0.4)(30/70)) Cost of equity = 4.5%+0.98(4%)=8.42%

Total beta

2.34(1+(1-0.4)30/70)=2.94 Cost of equity= 4.5%+2.94(4%)=16.26%

Conclusion These two beta represents the two

dimensions for investments. Levered beta and cost ascertains talks of the cost and risk which is to be kept in mind by the institutional investors when co. comes with IPO in the market. Unlevered beta talks of individual investors who plan to invest all the wealth in this company..

Presented by Varun Kumar Bachhawandia Mohit Yadav Raghav Vashist Saurabh Kamra Vinod Kumar Meena Mandeep Singh