INTRODUCTION

Leverage:

Leverage is a business term that refers to borrowing. If a business is "leveraged," it means

that the business has borrowed money. If the company has too much borrowing, it may not be
able to pay back all of its debts.

Types of leverage

• Operating leverage

• Financial leverage

• Combined leverage

Financial leverage:

The degree to which an investor or business is utilizing borrowed money. The ability of a
company to earn more on its assets by taking on debt that allows it to buy or invest more in
order to grow its business.

High Leverage:

It is more risky for a company to have a high ratio of financial leverage. Companies that are
highly leveraged may be at risk of bankruptcy if they are unable to make payments on their
debt; they may also be unable to find new lenders in the future.

Low Leverage:

It is less risky for a company to have a low ratio of financial leverage. With a low leverage
companies can meet its debt obligations and there is an opportunity for it to find new lenders
in the future.

Effects of Financial Leverage

One of the best ways in which company increases its profit is through financial leverage.
Financial leverage uses debt instruments so that the anticipated level return on the company's
equity would increase. The level of financial leverage of a certain company is determined by
getting the total value of debt and the equity and the ratio of debt.

There are four positions which show a relationship with the level of financial leverage. First,
is the relation of equity and debt, for instance, the rate of capital. Another is the influences on
business production and cycle of financial leverage. Then the company's industry and branch
whole financial

Leverage level. And also the correlation between the current financial leverage ratio of the
company and the middle leverage level. Lastly, the conformity of company's mission and
philosophy with the situation connected to the relation of financial leverage.

The outcome of the financial leverage can also be utilized to boost income and growth
however, it is much common for business industries in the phase of the young and teens.
Financial leverage ratio is relative to variability of profit and contrary to stability. Company's
profits with high rate leverage level differ with the same condition as with the company's
profits with lesser leverage level.

Another factor that affects leverage ratio is the company's flexibility, its dynamics and
openness that concerns on the changes and development of technology, possibilities and
industry. Companies having high leverage levels has lower flexible procedure because of the
fact that they are more accountable for all the creditors and sometimes must fill some
restrictions and agreements on their investments and capital use.

Companies with high leverage level usually become less successful due to situation of
transforming environment and the need of taking uncertain decisions. Because of this, they
might not able to apply or utilize growth opportunities or expansion of business.

One more risk of using financial leverage as a tool to increase revenue is the reality that the
change between profits and company's debt remains positive. If the company's profit relative
amount to equity is higher, the debt exceeds the amount of the profit then the effect of
leverage is gone and the debt remains.

It is therefore that the level of financial leverage must have a good understanding of financial
or business management. To determine the return rate upon return of leverage simply
calculate the difference among the rate of interest on assets and debts, then multiply the
difference to the relative amount of liability or debt to the equity and add up the anticipated
return on assets

Literature Review

Summary:

This article provides important contributions to the literature and policy debates concerning
corporate governance implications of various ownership patterns. In this paper the aim to
close some of these gaps between fixed-claim holders and dominant shareholders, and
develop a conceptual framework that analyses the effects of possible collusion between
concentrated shareholders and fixed claim holders, in countries with relatively low protection
of minority investor.

This paper also underlines the joint problematic of the existence of private benefits and the
one of the choice of debt are linked in the framework of financial governance. Also want to
evidence the interrelations and balances that result in complementary and shared logics
between majority and minority shareholders. The asymmetry of information between these
two groups of actors leads complex behaviors.

In this paper, the managers and the controlling shareholders elaborate and take the strategic
decisions of the firm and appropriate for themselves a part of the gross economic profit. The
concept of private benefits is associated with the concentration of the power by the dominant
shareholders. The appropriation of a part of the economic cash flow introduces a conflict with
outside shareholders who endure an expropriation. This situation finality is to protect the
investors.

Ownership concentration may result in lower efficiency, measured as a ratio of a firm's debt
to investment, and this effect depends on the identity of the largest shareholder.

It provides further support for the case of strong regulatory and capital market

This article shows that the protection of minority shareholders from the block holders’
opportunism is as important for enterprise restructuring and development of an efficient
system of corporate governance as protection against entrenched management. In addition,
we extend this conclusion to an environment where debt finance is predominant and equity
finance plays a minor role. We demonstrate that in such an environment, the collusion
between dominant owners and financial institutions may lead to further efficiency distortions.

Summary:

This article discuss the introduction of financial leverage concepts using examples based on
accounting rates of return. This article basically describe about the art and science of
Financial Leverage. It describes the concept of financial leverage in detail.

The use of financial leverage to impact corporate rates of returns and corporate values is one
of the clear examples in which financial management theory has found its way out of
academia and has become an established technique of financial management in practice.
Experience has shown the impact of financial leverage to be one of the more difficult
concepts for beginning students of corporate financial. Basically many introductory financial
management course outlines, the use of financial ratios to analyze financial statements is
presented before the financial leverage module is presented.

In the case of the financial leverage course module, beginning the presentation with a short,
self-contained numerical example serving as the “hook” can bridge the gap between the
student’s preferred cognitive style and the need to present a detailed comprehensive example
to explain the full complexity of the management issue.

Finance educators have developed various approaches to introduce the topic of financial
leverage. Clearly, the dominant approach is to present the student with two sets of sample
income statements and balance sheets. These representative financial statements are
structured so that the impact of adding financial leverage can be clearly seen to increase both
the expected level of, and volatility of, equity returns as measured by EPS or ROE. These
examples are also used in various textbooks for finance students to understand financial
Leverage. In some text books to make understanding of financial leverage, operating leverage
is also linked with financial leverage. An admiration and general understanding of the impact
debt financing is also linked with financial leverage.

Author also discussed that it is important, since the idea is to clearly convey that the
difference in shareholder return is based on financial leverage alone. The goal is to
demonstrate that something important is occurring and to capture the attention of the
students.

Summing up This article has discussed the qualities of using an updated alternative
presentation as an introductory “hook” for a course module on the topic of financial leverage.

Summary:

This article discussed the importance of financial leverage in the selection of risk
management strategies. These results indicate that risk-management decisions should not be
made without considering the impact of financial leverage. While we consider the importance
to financial leverage in selection of risk-management strategies, risk aversion is also very
important. By combining these two assumptions the company can reduce the set of strategies
that merit managerial attention.

The result of these strategies shows that the level of the risk-free return is an important
consideration. Because lower levels of the risk-free return make borrowing a more attractive
alternative, this is especially important when evaluating risk-management strategies that
present the decision maker with a reduced risk for decreased expected return trade-off.

This article addresses the problem of choice among risk-management strategies and applies
the stochastic dominance with risk-free asset (SDRA) criteria to address the choice problem.
SDRA incorporates financial leverage into ordinary stochastic dominance (SD) and can
significantly improve SD discriminatory power. This article gives an indication of the
importance of alternative assumptions about economic behavior in risk-management contexts
and gives directions for future work in risk-management research and education.

Most risk-management tools are designed to control business risks, for example, price
hedging and output insurance. Financial risks are adjusted by varying the proportion of debt
funds used to finance the business. Debt funds "leverage" the return to equity funds by
magnifying both positive and negative returns. Thus, a producer might use risk-management
tools to reduce business risk and consequently reduce expected return.

According to this article, Decision makers who are risk averse and do not willing to take risk,
are able to adjust financial leverage, would choose from the second-degree SDRA efficient
set which contained three of the twenty-three strategies. Each individual decision maker
would leverage these strategies according to their own risk preferences. However, no risk
averse decision maker able to make this leverage adjustment would select a strategy not
contained in this set.

Summary:

In this article the writer quantify the effect of financial leverage on stock return volatility in a
dynamic general equilibrium economy with debt and equity claims. The effect of financial
leverage is studied both at a market and a firm level where the firm is exposed to both
idiosyncratic and market risk.

They study two different economies. In both economies, the cash flows generated by a firm’s
assets are specified exogenously, have a constant volatility, and are split into an exogenously
specified risk less debt service and a dividend stream to equity holders. They derive the
equilibrium prices and dynamics of all financial claims and identify the economic forces
behind the dynamics of stock volatility and quantify the effect of financial leverage on the
dynamics of stock volatility

In the first economy the study is consistent with the assumptions macroeconomic conditions
are fixed and financial leverage is the only driving force behind the dynamics of stock
volatility. Financial leverage generates little variation at the market level where cash flow
volatility is low, and significant variation at the firm level where cash flow volatility is
higher.

The second economy has a representative more realistic asset prices than in the first
economy. The driving force in this economy is counter-cyclical risk aversion caused by
external habit formation in the representative agent’s preferences. The model is calibrated to
several features of empirical asset prices, including the level and variation of the equity
premium, the risk less rate, and the market price of risk. We simulate the economy and
explore the time-series behavior of a firm’s stock returns and volatility allowing for both debt
and equity. In an economy that generates time-variation in interest rates and the price of risk,
there is significant variation in stock return volatility at the market and firm level. In such an
economy, financial leverage has little effect on the dynamics of stock return volatility at the
market level. Financial leverage contributes more to the dynamics of stock return volatility
for a small firm.

Overall, our analysis provides some support that financial leverage drives the dynamics of
stock volatility at the firm level. This feature is driven by individual risk influencing the
firm’s equity value and not the firm’s debt value. Hence, the firm’s financial leverage can
move independent of market conditions in contrast to our market-wide analysis.

Summary:

In a financial system where balance sheets are continuously marked to market, asset price
changes show up immediately as changes in net worth, and obtain responses from financial
intermediaries who adjust the size of their balance sheets. Aggregate liquidity can be seen as
the rate of change of the aggregate balance sheet of the financial intermediaries.

The focus in this paper is on the reactions of the financial intermediaries to changes in their
net worth, and the market-wide consequences of such reactions. If financial intermediaries
were passive and did not adjust their balance sheets to changes in net worth, then leverage
would fall when total assets rise. Change in leverage and change in balance sheet size would
then be negatively related. The evidence points to financial intermediaries adjusting their
balance sheets actively, and doing so in such a way that leverage is high during booms and
low during recession.

From the point of view of each institution, decision rules that result are readily
understandable. However, there are aggregate consequences of such behavior for the
financial system as a whole that might not be taken into consideration by individual
institutions. The discussion focuses on the intermediaries balance sheets. However, the added
insight from discussions is on the way that marking to market enhances the role of market.

Aggregate liquidity can be understood as the rate of growth of the aggregate financial sector
balance sheet. When asset prices increase, financial intermediaries’ balance sheets generally
become stronger, and–without adjusting asset holdings–their leverage tends to be too low.
The financial intermediaries then hold surplus capital, and they will attempt to find ways in
which they can employ their surplus capital. In analogy with manufacturing firms, we may
see the financial system as having “surplus capacity”. For such surplus capacity to be utilized,
the intermediaries must expand their balance sheets. On the liability side, they take on more
short-term debt. On the asset side, they search for potential borrowers. Aggregate liquidity is
intimately tied to how hard the financial intermediaries search for borrowers.

RESEARCH DESIGN

TITLE

“ To study the affect of financial leverage on companies”

STATEMENT OF THE PROBLEM

Companies always face a trade off between whether they should go for equity financing or
debt financing. This project tries to find out the affect of financial leverage on companies, its
profits and its future aspects.

OBJECTIVES

• To find out the financial leverage of companies that why it resorts to debt financing
and not equity only.
• Our research is based on results that how financial leverage effects the company’s
business operations.
• Burden of debt on company’s financial
• To find the relation of equity and debt, for instance, the rate of capital.
• Financial leverage ratio is relative to variability of profit and contrary to stability.
• To find out whether the affect of financial leverage varies with the sector.

DATA ANALYSIS METHOD

For analysising the data I have selected a five companies which belong to different sectors.
Companies selected have undertaken some major investment or have requisited to debt
financing as there sector is not performing well. The companies selected are :

1. Jet Airways
 2. Ispat Industries
3. Bharti Airtel
4. Suzlon
5. ESSAR STEEL

I am going to analyse the balance sheet of the past five years of the companies and use the
debt equity ratio of the company and the interest they are paying to find out the affect of
financial leverage on the company and its business operations.