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)

EBIT 1,20,000 1,20,000

Less interest (31.25%)

0 37,500

PBT 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%

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 0.98Average 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 YadavRaghav VashistSaurabh Kamra Vinod Kumar Meena Mandeep Singh