Financial Leverage Illustrate

Current Situation - Cost of Debt = 6%

Share of Debt
Total Capital (Rs. Crore)
Debt
Equity

0%
5000
0
5000

10%
5000
500
4500

20%
5000
1000
4000

Profit Before Interest and Tax (Rs. Crore)

500

500

500

(-) Interest
Profit Before Tax

0
500

30
470

60
440

Tax @ 30%

150

141

132

Profit After Tax

350

329

308

7.00%

7.31%

7.70%

Return on Equity

85.00%

Levera

75.00%
65.00%
55.00%
45.00%
35.00%
25.00%
15.00%
5.00%

Why is more Debt Risky?

a) Assume that PBIT increases by 20%
Share of Debt
Total Capital (Rs. Crore)
Debt
Equity

0%
5000
0
5000

10%
5000
500
4500

20%
5000
1000
4000

Profit Before Interest and Tax (Rs. Crore)

600

600

600

(-) Interest
Profit Before Tax

0
600

30
570

60
540

Tax @ 30%

180

171

162

Profit After Tax

420

399

378

Return on Equity

8.40%

8.87%

9.45%

Increase in ROE

1.40%

1.56%

1.75%

0%
5000
0
5000

10%
5000
500
4500

20%
5000
1000
4000

Profit Before Interest and Tax (Rs. Crore)

400

400

400

(-) Interest
Profit Before Tax

0
400

30
370

60
340

Tax @ 30%

120

111

102

Profit After Tax

280

259

238

Return on Equity

5.60%

5.76%

5.95%

Decrease in ROE

-1.40%

-1.56%

-1.75%

b) Assume that PBIT decreases by 20%

Share of Debt
Total Capital (Rs. Crore)
Debt
Equity

40.00%

Leverage & Change

30.00%
20.00%
10.00%
0.00%
-10.00%
-20.00%
-30.00%
-40.00%

More Realistically - Interest rate paid on debt increase

Share of Debt
Total Capital (Rs. Crore)
Debt
Equity
Interest Rate

0%
5000
0
5000
9.00%

10%
5000
500
4500
9.25%

20%
5000
1000
4000
9.50%

Profit Before Interest and Tax (Rs. Crore)

500

500

500

(-) Interest
Profit Before Tax

0
500

46
454

95
405

Tax @ 30%

150

136

122

Profit After Tax

350

318

284

7.00%

7.06%

7.09%

5.60%
8.40%

5.50%
8.61%

5.34%
8.84%

Cost of Equity
Cost of Debt

12.00%
9.00%

12.25%
9.25%

12.50%
9.50%

WACC

12.00%

###

11.90%

Return on Equity
ROE if PBIT drops to 400
ROE if PBIT increases to 600

20.00%

-40.00%
-60.00%
-80.00%
ROE if PBIT drops to 400
-100.00%

Size of Total Capital

Share of Equity (%)
Share of Debt (%)

5000
40%
60%

5500
40%
60%

6000
40%
60%

60%

50%

40%

30%

20%

-20.00%

10%

0%

0.00%

Cost of Equity (%)

Cost of Debt (%)
WACC

12.00%
9.00%

12.25%
9.25%

12.50%
9.50%

10.20%

10.45%

10.70%

14.00%

WACC & Increase in To

13.50%
13.00%
12.50%
12.00%
11.50%
11.00%
10.50%
10.00%
5000

5500

6000

6500

7000

nancial Leverage Illustrated

30%
5000
1500
3500

40%
5000
2000
3000

50%
5000
2500
2500

60%
5000
3000
2000

70%
5000
3500
1500

80%
5000
4000
1000

90%
5000
4500
500

500

500

500

500

500

500

500

90
410

120
380

150
350

180
320

210
290

240
260

270
230

123

114

105

96

87

78

69

287

266

245

224

203

182

161

8.20%

8.87%

9.80%

11.20%

13.53%

18.20%

32.20%

Leverage Effect

Why is more Debt Risky?

30%
5000
1500
3500

40%
5000
2000
3000

50%
5000
2500
2500

60%
5000
3000
2000

70%
5000
3500
1500

80%
5000
4000
1000

90%
5000
4500
500

600

600

600

600

600

600

600

90
510

120
480

150
450

180
420

210
390

240
360

270
330

153

144

135

126

117

108

99

357

336

315

294

273

252

231

10.20%

11.20%

12.60%

14.70%

18.20%

25.20%

46.20%

2.00%

2.33%

2.80%

3.50%

4.67%

7.00%

14.00%

30%
5000
1500
3500

40%
5000
2000
3000

50%
5000
2500
2500

60%
5000
3000
2000

70%
5000
3500
1500

80%
5000
4000
1000

90%
5000
4500
500

400

400

400

400

400

400

400

90
310

120
280

150
250

180
220

210
190

240
160

270
130

93

84

75

66

57

48

39

217

196

175

154

133

112

91

6.20%

6.53%

7.00%

7.70%

8.87%

11.20%

18.20%

-2.00%

-2.33%

-2.80%

-3.50%

-4.67%

-7.00%

-14.00%

verage & Changes in ROE

Decrease in
ROE

rate paid on debt increases with proportion borrowed

30%
5000
1500
3500
9.75%

40%
5000
2000
3000
10.00%

50%
5000
2500
2500
10.25%

60%
5000
3000
2000
10.50%

70%
5000
3500
1500
11.00%

80%
5000
4000
1000
11.50%

90%
5000
4500
500
12.00%

500

500

500

500

500

500

500

146
354

200
300

256
244

315
185

385
115

460
40

540
-40

106

90

73

56

35

12

-12

248

210

171

130

81

28

-28

7.08%

7.00%

6.83%

6.48%

5.37%

2.80%

-5.60%

5.08%
9.08%

4.67%
9.33%

4.03%
9.63%

2.98%
9.98%

0.70%
10.03%

-4.20%
9.80%

-19.60%
8.40%

12.75%
9.75%

13.00%
10.00%

13.25%
10.25%

13.50%
10.50%

13.75%
11.00%

14.00%
11.50%

14.25%
12.00%

11.85%

11.80%

11.75%

11.70%

11.83%

12.00%

12.23%

8500
40%
60%

9000
40%
60%

9500
40%
60%

96%

90%

80%

70%

60%

50%

40%

30%

20%

10%

0%

%
ROE if PBIT drops to 400

ROE if PBIT increases to 600

6500
40%
60%

7000
40%
60%

7500
40%
60%

8000
40%
60%

12.75%
9.75%

13.00%
10.00%

13.25%
10.25%

13.50%
10.50%

13.75%
11.00%

14.00%
11.50%

14.25%
12.00%

10.95%

11.20%

11.45%

11.70%

12.10%

12.50%

12.90%

WACC & Increase in Total Financing Requirements

5500

6000

6500

7000

7500

8000

8500

9000

9500

10000

96.00%
5000
4800
200
500
288
212
64
148
74.20%

96.00%
5000
4800
200
600
288
312
94

218
109.20%
35.00%

96.00%
5000
4800
200
400
288
112
34
78
39.20%
-35.00%

ROE(inc)
ROE(dec)

8.40%
5.60%

8.87%
5.76%

9.45%
5.95%

96.00%
5000
4800
200
13.00%
500
624
-124
-37

13.50%

-87
-43.40%
-78.40%
-8.40%
14.50%
13.00%
13.06%

10000
40%
60%

13.00%

12.50%

12.00%

11.50%

WACC & C

14.50%
13.00%
13.60%

10.20%
6.20%

120.00%

11.20%
6.53%

12.60%
7.00%

14.70%
7.70%

18.20%
8.87%

25.20%
11.20%

Leverage & Change in Profitability

100.00%
80.00%
60.00%
40.00%
20.00%
0.00%
ROE(inc)

ROE(dec)

46.20%
18.20%

109.20%
39.20%

13.50%

13.00%

12.50%

12.00%

11.50%

WACC & Changes in Capital Structure

Finding the Cost of Debt

Par Value
Flotation Costs (% of Par)
Flotation Costs ($)
Issue Price
Net Proceeds Price
Coupon Interest (%)
Coupon Interest ($)
Time to maturity

(1,000.00)
2.00%
(20.00)
980.00
960.00
9.00%
(90.00)
20.00

Cost of debt
(Pre-Tax)

9.45%

Cost of debt
(Post-Tax= Pre-Tax *(1-Tax Rate))

6.62%