Association of Financial Leverage with Cost of Capital and Shareholder Value: An empirical study of BSE Sensex Companies

Author

BHARGAV PANDYA

Abstract

Purpose – The paper aims to examine the impact of financial leverage on cost of capital and shareholder value. The primary objective of the paper is to offer empirical evidence to establish whether there exists any association between financial leverage and cost of capital, and between financial leverage and shareholder value.

Design / Methodology / Approach – An empirical analysis of 28 companies included in the Bombay Stock Exchange’s flagship index ‘Sensex’ was conducted for a period of three years ranging from 2013 to 2015. A multiple step-wise regression method was used to analyze the association between financial leverage and cost of capital as well as financial leverage and shareholder value.

Findings – The study reveals that financial leverage and cost of capital are negatively correlated. The debt-equity ratio is found┬áto have a statistically significant negative association with market value added, residual income and refined economic value added (EVA). Interest cover is found to have a statistically significant positive correlation with residual income and refined economic value added; however, it is not significantly correlated to market value added.

Implications – The study implies that by raising debt in the capital structure of the company, managers can reduce the overall cost of capital; however, a higher proportion of debt need not necessarily increase shareholder value.

Introduction

Investigating the relationship between financial leverage and cost of capital has always attracted the attention of academics and practitioners alike. They have also been keen to ascertain how changing the amount of debt in the capital structure of the firm affects its cost of capital and finally, whether it leads to maximization of shareholders’ wealth. The traditional approach of capital structure hypothesized that raising the proportion of debt in the capital structure up to a point does lower cost of capital and subsequently maximizes value of the firm. On the other hand, there are arguments against the traditional approach claiming that capital structure decision is irrelevant for the firm’s value. Earlier, Brigham and Jordon (1968) showed that the cost of capital of a firm depends on how the firm is financing its capital and the value of its stock is dependent on its financing policy. Intuitively, it is quite appealing to use debt given the benefit of interest tax deductibility attached to it. However, increasing the amount of debt also increases financial risk and thus increases the chances of bankruptcy. In this case, it does not
pay well to use an excessive amount of debt to maximize the value of the firm. Rather, beyond a point, the benefit of cheaper cost of debt is more than offset by increased cost of equity, resulting in an increase in overall cost of capital. This, in turn, will negatively affect the firm’s value.

In this paper, an attempt has been made to examine the impact of financial leverage on cost of capital and on shareholder value. The remainder of the paper is structured as follows: the second section discusses the literature review; the third section specifies the research methodology; the fourth section presents results and the discussion, and the fifth section offers the conclusion and summary.

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