Impact of Financial Leverage on Cost of Capital

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DEPARTMENT OF BUSINESS ADMINISTRATION

A TERM PAPER ON –

IMPACT OF FINANCIAL LEVERAGE ON COST OF CAPITAL AND VALUATION OF FIRM: A STUDY OF CEMENT INDUSTRY

NAME- DIPANNITA GHOSH
DEPT- MBA
ROLL- 11

INTRODUCTION
In corporate finance, financing decisions has greater importance because the optimal capital structure can be created trough proper mix of finance. Corporate managers generally prefer borrowings over other means of financing. Management of a company has to be very careful while deciding the extent of financing leverage in its capital structure because the right use of financial leverage can increase the share holder’s wealth whereas its improper use would adversely affects the interest of share holders. This study examine the empirical effects of corporate capital structure (Financial leverage) on cost of capital and market value of selected firms of Indian Cement Industries for the period from 2001-01 to 2007-08.The research evidence of the study indicates that no impact of financing leverage on cost of capital was found in the cement industry in India, i.e. no significant linear relationship between the Financial leverage and total valuation within the cement industry. Many financial managers argue that the financial leverage is the most important among the leverage concepts. It is particularly applicable in capital structures management. A Firm’s capital structures are 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 firm has a capital structure comprising debt and equity, such a firms’ financial managers is highly concerned with right choice of debt and equity. It determines the relationship that should exist between dept and equity capital at a given point of time. A firms which makes no use of fixed-charge security have a purely equity capital structure and thus have no financial leverage at all. Thus it is very much imperative that every successful industrial organizations must pay adequate consideration to the vital question of financial leverage, cost of capital, and value of firm.

OBJECTIVE OF THE STUDY
* To analyze the trend of financial leverage,

* To study the impact of financial leverage on average cost of capital,

* To analyze the impact of financial leverage on total valuation of firm,

* To examine the correlation of financial leverage with cost of capital and valuation of firm.

HYPOTHESIS OF THE STUDY
The broader hypothesis of the study as under:
* The financial leverage has an important impact on the cost of capital. * The financial leverage has an impact on valuation of firm.

METHODOLOGY OF STUDY
For this study, the necessary data have been collected from the capitaline data base 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 positions of the selected companies and throw ample light on their respective financial policies. In these studies top nine performing companies on the basis of sales in the cement industry have been selected as sample for the study. The reason behind selection of the cement industry is that it is a fast developing industry, and in this industries some companies are performing well whereas others are loss making. Even the uses of dept component in the financial structure in the industry are highly fluctuating. For the purpose of analysis various data from the selected company 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 technique like mean, median, and Karl Pearson’s coefficient of correlation have been used in the study. For testing of Hypotheses t-test...
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