Solvency

1
Solvency
2
issues

• Ability to meet the long liabilities
• EMI or EYI
• Interest
• Capital
• Ability to raise to debt
• Financing of asset
• We will answer the above by the following
• Composition of capital employed

3
Debt Equity Ratio (financial leverage )

• Debt Equity Debt/Equity
• Debt Long Term interest bearing liabilities
• Equity OF Cap RS DTL -DTA
• DER interprete
• Standard ratio
• Inter and intra-firm comparison

4
DER

• DER affects the following
• EPS Earning Per share
• ICR Interest coverage Ratio
• WaCC Weighted Average Cost of Capital

5
WaCC
6
DER

• Debt
• Interest is compulsory
• Interest is an expense
• Interest is allowable expense while determining
  the taxable profit
• Cost of Debt Kd

• Equity (Capital)
• Dividend is not compulsory
• Dividend is not an expense
• Dividend is not an tax deductible expenses
• Cost of equity Ke

Ke gt Kd
7
Cost of capital

• Kd cost of debt
• 10 loan 10,000
• Interest 1000
• Tax rate p 40
• Tax benefits of interest 400
• Net cost of debt 1000 -400 600
• Kd post tax interest rate i(1-t)
• I rate of interest
• T rate of tax

• Ke Reflection of shareholders expectation
• Risk Free Return Premium of the risk taken
• Ke Rf Beta (Rf-RM)
• Rf Risk Free Return
• Beta Volatality
• Rm Market Return

8
DER and WaCC

• Higher the DER lower is the WaCC

• WaCC depends
• Ke
• Kd
• DER

9
DER and EPS

• PBIT is independent of DER
• PAT depends on dER
• EPS depends on DER
• Higher the DER higher the EPS provided the ROCE gt
  rate of interest

10
Capital employed

• CE OF Debt FA WC TA CL
• CE TA Investments -CL