WHETHER FLOATING RATE OF INTEREST IS A FIXED CHARGE

SOURCE OF FUND OR NOT?DISCUSS

Presented byNeha Agarwal

(7BS2460)

Concept

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

Causing a deeper effect on the EPS of the share holder

Causing a variation in the debt-equity mix

What is floating rate and spread of an interest rate?

Floating interest rate a variable or adjusting rate Refers to any type of loan or mortgage or

credit ----not having fixed life Uses an index or base rate 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)

Spread of interest rate

Margin over the base rate. Floating interest rate ={ base rate +spread ; if interest rate rises base rate -spread ; if interest rate falls } Consider eg. A 5 yr. loan is priced at 6month LIBOR + 2.5%. at the end of each 6month period, the rate for the following period= LIBOR at that point + (/- )

spread

Importance of floating rate

Banks prefer to lend money at floating interest rate

(They raise funds through deposits ,bond issues , other banks ,money markets)

Floating interest rate loan will cost less to the borrower than the fixed interest rate loan.

A borrower takes the interest rate risk by paying for a lower interest rate , the interest rates may go up in future.

Factors affecting the floating rate of interest

government policies production units market conditions-- Demand is more, production is

less, price increases. Hence,

high inflation. RBI measures- taming Inflation- CRR hike to control

liquidity in the market .Hence,

interest rate is risen.

Slow economic growth- High interest rate means demand

and investment are adversely

affected.means decreases.Hence,

Slow Economic Growth.

What is financial leverage?

Is the leverage that occurs due to the presence of fixed financial charges in a firm.

Due to interest rates to bonds ,debentures and preference dividends.

Here,Fixed charges do not vary with EBIT. Quantitatively, DFL= % change in

EPS/%changeinEBIT

Relationship between financial leverage and interest rate

Rise in interest rate implies rise in fixed cost and hence rise in financial leverage.

DFL rises ,EPS falls

Have you ever thought what will happen to financial

leverage if interest rate is floating ?

Remember before coming to ICFAI hyderabad, we had to take a loan …

Hardly, 9 months …. Interest rates in banks was floating with full vigor……..what could be the leverage then………

Effects on companies and investors of rising interest rates

Companies suffer -on account of higher interest costs -able to take loans till their cost of funds is not locked in.

investors leverage- hope of getting higher returns on higher interest rates ,they leverage .

leverage position is unwound- cascading effect on decline in stock prices

investors invest more in Bonds than in shares Debt-equity proportion changes

…contd

financial leverage exists to cover fixed costs such as interest rate.

bond value increases with rising interest rate

interest rate = bond value* rising interest rate

Effect of foating interest rate on Bond value

scenario1

Monthly base rate(%)

spread (%) Floating rate (%)

jan 5 0.75 5.75

feb 5 1 6

march 5 1.8 6.8

april 5 3.4 8.4

…contd.

A company worth Rs. 10,00,000 shares Rs. 8,00,000 bonds Rs. 2,00,000 bonds interest rate ---- floating EBIT (expected value) 50,000 tax @35% on PBT No preference shares issued no. of outstanding shares 5000

jan feb

march april

EBIT 50,000 50,000 50,000 50,000less@floating interst rate

5.75% 6% 6.8% 8.4%

interest rate 11,500 12,000 13,600 16,800

PBT 38,500 38,000 36,400 33,200

tax @35%

13,475 13,300 12,740

11,620

PAT 25,025

24,700 23,660 21,580

less pref.div.

0 0 0 0

Ee (Equity earinings)

25,025

24,700 23,660 21,580

/ no.of O/S shares

5,000 5,000 5,000 5,000

EPS 5.005 4.94 4.732 4.316

Inference from scenario 1 Interest rate changes monthly from 5.75% to

8.4%. Interest rises from 11,500 to 16,800 EBIT level kept same Investors will be more interested to invest

in debts than in shares debt- equity proportion rises 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.

Hence , EPS declines from 5.005 to 4.316 Rate of fall of EPS is 13.76%

scenario2

company issues more bonds than share bonds Rs. 6,00,000 shares Rs. 4,00,000 EBIT(expected value) RS.1,50,000 (rising in the same proportion as bond

value)

May june july

EBIT 1,50,000 1,50,000 1,50,000Less@ interest rate

8.56% 9% 10

interest 51,360 54,000 63,000

PBT 98,640 96,000 87,000

Less tax@35%

34,524 33,600 30,450

PAT 64,116 62,400 56,550Less pref div 0 0 0

Ee(equity earnings)

64,116

62,400 56,550

/no. of O/Sshares

5000 5000 5000

EPS 12.8232 12.48 11.31

Inference of scenario2

Interest rate rises from 8.56% to 10.5% Interest rises from 51,360 to 63,000 EPS falls from 12.8232 to 11.31 Rate of fall of EPS is 11.8%

Inference of Scenarios 1 &2

Debt-equity proprtion changes from 1:4 to 3:2 Firm’s expected earnings increase in same

proportion. Highly floating rate- rises from 5.75% to 10.5% Interest- fixed cost rises from 11,500 to 87,000 EPS falls with a rate of 13.76% in scn.1 while

falls with a rate of 11.8% in scn.2 Hence, as interest rate rises, EPS falls

with a falls with a falling rate.

Case 2 base case1

EBIT 30,000 50,000 70,000Less @floating rate

4.8% 5% 5.2%

interest 1440 2500 3640

PBT 28,560 47,500 66,360

Less tax@35%

9,996 16,625 23,226

PAT 18,564 30,875 43,134

less pref.div.

0 0 0

Ee 18,564 30,875 43,134

/O/S shares 5000 5000 5000

EPS 3.7128 6.175 8.6268

…contd.

Case 1 % change in EBIT =+ 40% % change in EPS = +39.7052%

DFL = % change in EPS/%change in EBIT

= 39.7/40 = 0.9925

case 2 % change in EBIT= -40% % change in EPS = -39.87% DFL = % change in EPS/ % change in

EBIT 39.87/40 = 0.9965

…contd.

EBIT in case 1 & 2 is changed by 40% to the +ve and -ve side

Interest rate is also increased or decreased by 40% to both sides.

% change in EPS from base is not the same.

However ,if fixed interest rate is taken it remains same

DFL increases with increasing interest rate DFL decreases with decreasing interest

rate DFL is not same for both cases.

…contd.

Inference

DFL exists with floating interest rate DFL affected by a larger amount by change

in rate. % change in DFL =(0.9965-0.9925)/0.9925

= 0.403% Whether you increase or decrease the EBIT

by the same proportion ,if a floating rate exists then DFL in both cases doesnot remains same.

0.403% is highly significant.