Whether floating rate of interest is a fixed charge source of fund or not?discuss<br />Presented by<br />NehaAgarwal<br />...
Concept<br /><ul><li>Basic framework of this study conducted-----How the market fluctuations will affect  the floating rat...
Causing a deeper effect on the EPS of the share holder
 Causing a variation in the debt-equity mix</li></li></ul><li><ul><li>What is floating rate  and spread of an interest rat...
Spread of interest rate<br />Margin over the base rate.<br />Floating interest rate ={ base rate +spread ; if interest rat...
Importance of floating rate <br /><ul><li>Banks prefer to lend money at floating interest rate</li></ul>(They raise funds ...
A borrower takes the interest rate risk by paying for a lower interest rate , the interest rates may go up in future.</li>...
production units
market conditions--  Demand is more, production is</li></ul>                                        less, price increases....
What is financial leverage?<br />Is the leverage that occurs due to the presence of fixed  financial charges in a firm.<br...
Relationship between financial leverage and interest rate<br />Rise in interest rate implies rise in fixed cost and hence ...
Have you ever thought what will happen to financial leverage if interest rate  is floating ?<br />Remember  before coming ...
Effects on companies and investors of rising interest rates<br />Companies  suffer -on account of higher interest costs -a...
Debt-equity proportion changes</li></li></ul><li>…contd<br /><ul><li>financial leverage exists to cover fixed costs such a...
bond value increases with rising  interest rate
 interest rate = bond value* rising interest rate</li></li></ul><li>Effect of foating interest rate on Bond valuescenario1...
…contd.<br />A company  worth Rs. 10,00,000<br />       shares      Rs. 8,00,000<br />       bonds       Rs. 2,00,000<br /...
Inference from scenario 1<br />Interest rate changes monthly from 5.75% to 8.4%.<br />Interest  rises from 11,500 to 16,80...
scenario2<br />company  issues more bonds than share<br />     bonds                                 Rs. 6,00,000<br />   ...
Inference of scenario2<br />Interest rate rises from 8.56% to 10.5%<br />Interest  rises from   51,360 to 63,000<br />EPS ...
Inference of Scenarios 1 &2<br />Debt-equity proprtion changes from 1:4  to 3:2<br />Firm’s expected earnings increase in ...
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Prez.floatleverage

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Prez.floatleverage

  1. 1. Whether floating rate of interest is a fixed charge source of fund or not?discuss<br />Presented by<br />NehaAgarwal<br />(7BS2460)<br />
  2. 2. Concept<br /><ul><li>Basic framework of this study conducted-----How the market fluctuations will affect the floating rate which is an interest rate---considered to be a fixed cost which will further affect the financial leverage of the company
  3. 3. Causing a deeper effect on the EPS of the share holder
  4. 4. Causing a variation in the debt-equity mix</li></li></ul><li><ul><li>What is floating rate and spread of an interest rate?</li></ul>Floating interest rate <br />a variable or adjusting rate<br />Refers to any type of loan or mortgage or credit ----not having fixed life<br />Uses an index or base rate<br />LIBOR –most common rate used as a BASIS for applying interest rate (London Interrelated Bank Rate..Banks prefer to lend each other at this rate)<br />
  5. 5. Spread of interest rate<br />Margin over the base rate.<br />Floating interest rate ={ base rate +spread ; if interest rate<br /> rises<br /> base rate -spread ; if interest rate<br /> falls }<br />Consider eg. A 5 yr. loan is priced at 6month LIBOR + 2.5%.<br /> at the end of each 6month period, <br /> the rate for the following period= LIBOR at that point<br /> + (/- ) spread<br />
  6. 6. Importance of floating rate <br /><ul><li>Banks prefer to lend money at floating interest rate</li></ul>(They raise funds through deposits ,bond issues , other banks ,money markets)<br /><ul><li>Floating interest rate loan will cost less to the borrower than the fixed interest rate loan.
  7. 7. A borrower takes the interest rate risk by paying for a lower interest rate , the interest rates may go up in future.</li></li></ul><li>Factors affecting the floating rate of interest<br /><ul><li>government policies
  8. 8. production units
  9. 9. market conditions-- Demand is more, production is</li></ul> less, price increases. Hence, <br />high inflation.<br /><ul><li> RBI measures- taming Inflation- CRR hike to control </li></ul>liquidityin the market .Hence, <br />interest rate is risen.<br /><ul><li>Slow economic growth-High interest rate means demand</li></ul>and investment are adversely <br />affected.meansdecreases.Hence,<br />Slow Economic Growth.<br />
  10. 10. What is financial leverage?<br />Is the leverage that occurs due to the presence of fixed financial charges in a firm.<br />Due to interest rates to bonds ,debentures and preference dividends.<br />Here,Fixed charges do not vary with EBIT.<br />Quantitatively, DFL= % change in EPS/%changeinEBIT<br />
  11. 11. Relationship between financial leverage and interest rate<br />Rise in interest rate implies rise in fixed cost and hence rise in financial leverage.<br />DFL rises ,EPS falls<br />
  12. 12. Have you ever thought what will happen to financial leverage if interest rate is floating ?<br />Remember before coming to ICFAI hyderabad, we had to take a loan …<br />Hardly, 9 months …. Interest rates in banks was floating with full vigor……..what could be the leverage then………<br />
  13. 13. Effects on companies and investors of rising interest rates<br />Companies suffer -on account of higher interest costs -able to take loans till their cost of funds is not locked in.<br />investors leverage- hope of getting higher returns on higher interest rates ,they leverage .<br />leverage position is unwound- cascading effect on decline in stock prices<br /><ul><li>investors invest more in Bonds than in shares
  14. 14. Debt-equity proportion changes</li></li></ul><li>…contd<br /><ul><li>financial leverage exists to cover fixed costs such as interest rate.
  15. 15. bond value increases with rising interest rate
  16. 16. interest rate = bond value* rising interest rate</li></li></ul><li>Effect of foating interest rate on Bond valuescenario1<br />
  17. 17. …contd.<br />A company worth Rs. 10,00,000<br /> shares Rs. 8,00,000<br /> bonds Rs. 2,00,000<br /> bonds interest rate ---- floating<br /> EBIT (expected value) 50,000<br /> tax @35% on PBT <br /> No preference shares issued <br /> no. of outstanding shares 5000 <br />
  18. 18.
  19. 19. Inference from scenario 1<br />Interest rate changes monthly from 5.75% to 8.4%.<br />Interest rises from 11,500 to 16,800<br />EBIT level kept same<br />Investors will be more interested to invest in debts than in shares<br /> debt- equity proportion rises<br />As the company now pays more money as returns to the financial institutions or bond/debenture holders, hence less money is left with the company to pay to the shareholders.<br />Hence , EPS declines from 5.005 to 4.316<br />Rate of fall of EPS is 13.76%<br />
  20. 20. scenario2<br />company issues more bonds than share<br /> bonds Rs. 6,00,000<br /> shares Rs. 4,00,000<br /> EBIT(expected value) RS.1,50,000<br /> (rising in the same proportion as bond value)<br />
  21. 21.
  22. 22. Inference of scenario2<br />Interest rate rises from 8.56% to 10.5%<br />Interest rises from 51,360 to 63,000<br />EPS falls from 12.8232 to 11.31<br />Rate of fall of EPS is 11.8%<br />
  23. 23. Inference of Scenarios 1 &2<br />Debt-equity proprtion changes from 1:4 to 3:2<br />Firm’s expected earnings increase in same proportion.<br />Highly floating rate- rises from 5.75% to 10.5%<br />Interest- fixed cost rises from 11,500 to 87,000<br />EPS falls with a rate of 13.76% in scn.1 while falls with a rate of 11.8% in scn.2<br />Hence, as interest rate rises, EPS falls with a falls with a falling rate.<br />
  24. 24.
  25. 25. …contd.<br />Case 1<br /> % change in EBIT =+ 40%<br /> % change in EPS = +39.7052%<br /> DFL = % change in EPS/%change in EBIT<br /> = 39.7/40 = 0.9925<br />
  26. 26. case 2 <br /> % change in EBIT= -40%<br /> % change in EPS = -39.87%<br /> DFL = % change in EPS/ % change in EBIT<br /> 39.87/40 = 0.9965<br />…contd.<br />
  27. 27. …contd.<br /><ul><li>EBIT in case 1 & 2 is changed by 40% to the +ve and -ve side
  28. 28. Interest rate is also increased or decreased by 40% to both sides.
  29. 29. % change in EPS from base is not the same.
  30. 30. However ,if fixed interest rate is taken it remains same
  31. 31. DFL increases with increasing interest rate
  32. 32. DFL decreases with decreasing interest rate
  33. 33. DFL is not same for both cases.</li></li></ul><li>Inference<br /><ul><li>DFL exists with floating interest rate
  34. 34. DFL affected by a larger amount by change in rate.
  35. 35. % change in DFL =(0.9965-0.9925)/0.9925 = 0.403%
  36. 36. Whether you increase or decrease the EBIT by the same proportion ,if a floating rate exists then DFL in both cases doesnot remains same.
  37. 37. 0.403% is highly significant.</li>

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