Analysis Of Value Of Firm Select Automobile Companies Under Net Income Approach And Analyzed Financial Leverage

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1 Analysis Of Value Of Firm Select Automobile Companies Under Net Income Approach And Analyzed Financial Leverage Dr. M. Maheswaran M.Com., M.Phil., Ph.D. Lecturer in Accounting & Finance, Blue Hora University, Ethiopia Abstract: Capital structure is defined as the proportion of the equity and debt capital. The capital structure/leverage of should be examined from the view point of its impact on the value of the firm. It can be expected that if the capital structure decision affects the total value of the firm, a firm should select such a financing mix which maximizes the shareholders wealth. Such a capital structure is referred to as the optimum capital structure. The optimum capital structure is one that minimizes the overall cost capital of the firm and maximizes the value of the firm with an optimum debt-equity mix, the cost of capital is minimum and the market price per share is maximum. The capital structure can affect the value of the company either by its expected earnings or by the cost of capital or by the both. According to the Net Income approach, the capital structure is relevant to the valuation of a firm. A change in the capital structure or the financial leverage will lead to a corresponding change in the overall cost of capital as well as the total value of the company. It can influence the value of the firm through the earnings available to the shareholders. But the leverage can largely influence the value of the firm through the cost of capital. Key Words: Capital Structure, Net Income Approach, Leverage and Weighted Average Capital. INTRODUCTION This approach is given by Durand David. According to this approach, the capital structure is relevant to the valuation of the firm. As such a change in the capital structure causes an overall change in the cost of capital and also in the total value of the firm. Higher debt content in the capital structure means a high financial leverage and capital structure means a high financial leverage. This results in decline in the overall or weighted average cost of capital. This results in the increase in the value of the equity shares. Assumptions: There are usually three basic assumptions of this approach. Corporate taxes do not exist Debt content does not change the risk perception of the investors. Cost of debt is less than cost of equity i.e. debt capitalization rate is less than the equity capitalization rate. According to net income approach, the value of the firm and the value of equity are determined as given below: Value of Firm (V) = S + B Where, S = Market value of equity B = Market value of debt Market value of equity = NI /Ke Where, NI = Net income available for equity shareholders. Ke = Equity capitalization rate. An attempt has been made to evaluate the impact on the value of the firm due to change in financing mix. The EBIT EPS analysis, Ratio analysis, Ratio analysis and Net Income approach method have been used to evaluate the value of the selected companies. 287

2 NET INCOME APPROACH METHOD According to the Net Income approach, the capital structure is relevant to the valuation of a firm. A change in the capital structure or the financial leverage will lead to a corresponding change in the overall cost of capital as well as the total value of the company. Financial leverage means the ability of a firm to use fixed financial charges to magnify the effect of the EBIT on the earning per share of the firm. According to Net Income Approach, financial leverage is an important variable to the capital structure of a firm. With a judicious mixture of debt and equity a firm can evolve an optimum capital structure which will be the one at which the value of the firm is the highest and the overall cost of capital is the lowest. If the firm uses no debt or financial leverage is zero level, the overall cost of capital will be equal to the equity Capitalization rate (Ke). FINANCIAL LEVERAGE Financial leverage refers to debt in the capital structure. It multiplies the effective of equity but odds risk. Financial leverage refers to using borrowed money to multiply the effectiveness of the equity invested in a business enterprise. The use of debt or financial leverage, concentrates the firm s business risk on its stockholders. This concentration of business risk occurs because a debt holder, who receives fixed interest payments bear none of the risk. MEASURES OF FINANCIAL LEVERAGE: Financial leverage measures the degree of the use of the debt and the other fixed cost sources of funds to finance the assets the firm has acquired. It can be said that the higher the proportion of debt in the capital structure the higher is the financial leverage and vice versa. Financial leverage can be measured in two ways. They are as follows i) stock term and ii) flow terms. STOCK TERMS: It can be measured by a) a simple ratio of debt to equity, or b) by the ratio of long term debt plus preference share to total capitalization. Each of these measures indicates the relative proportion of the funds to the total funds of the firm on which it is to pay fixed financial charges. FLOW TERMS: The financial leverage can be measured by a) the ratios of the EBIT to interest payment or b) the ratio of cash flows to interest payment, popularly called the debt service capacity / coverage. These coverage ratios are useful to the suppliers of the funds as they assess the degree of risk associated with lending to the firm. In general, the higher the stock ratios and lower the flow ratios, the risk is greater and lower the stock ratios and higher the flow ratios, the risk is less. Table 1, 2, 3 and 4 shows the degree of financial leverage or use of debt of selected companies in Auto Industry. EBIT Financial Leverage = EAIT 288

3 Table - 1 Financial Leverage Ashok Leyland Ltd Particulars Year Ended 1. EBIT Interest Profit after Tax (1-2) 4. Degree of (1/3) Financial Leverage Table - 2 Financial Leverage Bajaj Auto Ltd Particulars Year Ended 1. EBIT Interest PAT (1-2) DFL (1/3) Table 4.47 shows that the financial leverage of the Ashok Leyland is stable and very low from the year 2013 to It explains that the company has no fixed financial costs and the financial risk of the company is too low. Table 4.48 shows that the financial leverage of Bajaj Auto Ltd is stable for the study period for to Table - 3 Financial Leverage Tata Motors Particulars Year Ended 1. EBIT Interest PAT (1-2) DFL (1/3)

4 Table - 4 Financial Leverage Mahindra & Mahindra Ltd Particulars Year Ended 1. EBIT Interest PAT (1-2) DFL (1/3) Table 4.49 shows that the financial leverage of the Tata Motors is in the year and it increased to 5.64 in the year It implies financial leverage has a positive impact on Earning per share of a company. Table 4.50 shows that the financial leverage of the Mahindra & Mahindra Ltd was increased from 1.02 in to 1.06 in It explains that the company increased debt in their capital structure. NET INCOME APPROACH According to Net Income approach method, a change in the capital structure or financial coverage will lead to a corresponding change in the overall cost of capital as well as the total value of the company. Tables 5 and 6 shows the analysis of capital structure of selected companies by applying Net Income Approach Method. Table - 5 Value of the Company Tata Motors Year Year Ended EBIT 3, , , , Interest 1, , , , , Net Income (earnings to equity shareholders) 2, , (1-2) Equity Capitalisation rate (ke in percent) Market value of equity (3/4 ) Market Value of debt 7, , , , , Total value of the company (5+6) 7, , , , , Overall cost of capital in percentage (1/7x100) The above table 5 presents that the overall cost of capital from the Tata Motors was high (48.18%) in the year and low (-40.41%) in the year during the study period. The optimum debt equity mix of Tata Motors is 6:94 and it is a prudent level of debt equity mix which maximizes the wealth of the shareholders and ensures future financial flexibility. It shows the company s consciousness towards the use of debt and it tries to avoid additional risk placed on the common stockholders as a result of the decision of the firm to use debt. 290

5 And the company follows suggestion mentioned by Modigliani and Miller in their trade off theory, that, the companies try to avoid issuing stock by maintaining a reserve borrowing capacity, and this means using less debt in normal times. It reveals the fact that the automobile companies may not be able to service a large amount of debt because the firm employs a heavy component of fixed cost resources. This in inherently risky because the obligation to make payments remains regardless of the condition of the company or the economy. Therefore, the Tata Motors used equity financing instead of debt. Table - 6 Value of the Company Mahindra & Mahindra Ltd Year Year Ended EBIT Interest Net Income (earnings to equity shareholders) (1-2) Equity Capitalisation rate (ke in percent) Market value of equity (3/4 x 100) Market Value of debt Total value of the company (5+6) Overall cost of capital in percentage (1/7x100) Table 4.72 shows that the overall cost of capital of Mahindra & Mahindra was high (1.51%) in the year and low (1.14%) in the year The optimum debt equity mix of Mahindra & Mahindra Ltd is 3:97 and it is a judicious mixture of debt and equity which maximizes the shareholders wealth and keeps financial risk at a manageable level. It protects the company against financial distress and allows the firm to maintain a desirable credit rating. Both the automobile industries use equity financing instead of borrowing. Both the companies are low-geared therefore they could not reap the benefit of trading on equity. A decrease in the leverage will cause an increase in the overall cost of capital and a decline both in the value of the firm as well as in the market price of equity shares. If the firm increases the use of debt it will magnify the earnings of the shareholders and thereby, the market value of ordinary shares. The capital structural policy followed by the selected industrial undertakings was unsatisfactory. Because they adopted the same policy without any change in their financial structure both in the boom as well as in the recession period. At times of boom, it would be easier for the firm to raise equity, but the times of recession, the equity investors will not show much of interest in investing. Therefore, the firm is to rely in raising debt. From the study it could be understood that the industrial undertakings under study using too much equity funds instead of borrowing. It is not good for the investors, because the Earnings Per Share gets diluted with an increase in the equity capital. If the firm uses no debt or leverage, then the overall cost of capital will increase and value of the firm and the market price of equity shares will decline. It is advisable for the companies to increase their debt-equity ratios for to multiply the effectiveness of equity invested in a business enterprise. 291

6 CONCLUSION The firm should select a financing mix which will help in achieving the objective of financial management and the objective of the firm to maximize the value of equity shares and wealth maximization of firm. Identifying the precise percentage of debt that will maximize price per share is almost impossible. It is possible to determine the approximate proportion of debt to use in the financial plan in conformity with the objective of maximizing share prices. Establishing the right capital structure is an imprecise process at best, and it should be based on both the informed judgment and the quantitative analysis. The firm should to increase outsider fund rather than equity because of lowest interest in compare with equity dividend. Therefore, during the study period is not high satisfactory level of firm growth in automobile industry. BIBLIOGRAPHY 1. C. R. Kothari, Research Methodology Methods and Techniques, New Age international (p) Limited Publication, New Delhi., Dr. P. C. Tulsian, Financial Management, S. Chand & Co. Ltd, New Delhi, Gupta R. L., Financial Statement Analysis, Sultan Chand & Sons, New Delhi, I. M. Pandey, Financial Management theory and practices, Vikas publishing house Pvt. Ltd., New Delhi Annual reports of Ashok Leyland Limited, Annual reports of Bajaj Autos Limited, Annual reports of Tata Motors Limited, Annual reports of Mahindra and Mahindra Limited, Journals of Finance, the Managerial Accounting, Finance India. WEBSITES control.com economic times.com 292