Published on: **Mar 4, 2016**

- 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. 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. Causing a deeper effect on the EPS of the share holder
- 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. 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. 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. 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. production units
- 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. 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. 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. 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. 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. Debt-equity proportion changes</li></li></ul><li>…contd<br /><ul><li>financial leverage exists to cover fixed costs such as interest rate.
- 15. bond value increases with rising interest rate
- 16. interest rate = bond value* rising interest rate</li></li></ul><li>Effect of foating interest rate on Bond valuescenario1<br />
- 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.
- 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. 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.
- 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. 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.
- 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. 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. …contd.<br /><ul><li>EBIT in case 1 & 2 is changed by 40% to the +ve and -ve side
- 28. Interest rate is also increased or decreased by 40% to both sides.
- 29. % change in EPS from base is not the same.
- 30. However ,if fixed interest rate is taken it remains same
- 31. DFL increases with increasing interest rate
- 32. DFL decreases with decreasing interest rate
- 33. DFL is not same for both cases.</li></li></ul><li>Inference<br /><ul><li>DFL exists with floating interest rate
- 34. DFL affected by a larger amount by change in rate.
- 35. % change in DFL =(0.9965-0.9925)/0.9925 = 0.403%
- 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. 0.403% is highly significant.</li>