Financing Decisions-Leverages – CA Inter FM Study Material is designed strictly as per the latest syllabus and exam pattern.
Financing Decisions-Leverages – CA Inter FM Study Material
Theory Questions
Question 1.
Distinguish between business risk and financial risk or “Operating risk is associated with cost structure, whereas financial risk is associated with capital structure of a business concern.” Critically examine this statement. (4 Marks Nov. 2012, May 2013, Nov. 2014)
Answer:
Business Risk: Business risk refers to the risk associated with the firm’s operations. It is an unavoidable risk because of the environment in which the firm has to operate. The business risk is represented by the change in earnings before interest and tax (EBIT).The change in turn is influenced by revenues and expenses. Revenues and expenses are affected by demand of firm’s products, changes in prices and proportion of fixed cost in total cost.
Financial Risk: Financial risk refers to the additional risk associated with use of debt or preference share capital. If company raise higher amount from Debt or/and Preference share capital then such company have higher financial risk than companies financed through equity. Financial risk is measured through financial leverage, total debt to assets ratio etc.
Practical Problems
Question 1.
You are the given two financial plans of a company which has two financial situations. The detailed information are as under:
Installed capacity : 10,000 units
Actual production and sales : 60% of installed capacity
Selling price per unit : ₹ 30
Variable cost per unit : ₹ 20
Fixed Cost:
Situation A : ₹ 20,000
Situation B : ₹ 25,000
Capital structure of the company is as follows:
You are required to calculate operating leverage and financial leverage of both the plans. (4 Marks May 2011)
Answer:
Statement Showing Operating & Financial leverage
Question 2.
Alpha Ltd. has furnished the following Balance Sheet as on March 31, 2011:
Additional information:
- Annual Fixed Cost other than Interest : ₹ 28,00,000
- Variable Cost Ratio : 60% of sales
- Total Assets Turnover Ratio : 2.5 times
- Tax Rate : 30%
You are required to calculate:
(i) Earning per Share (EPS), and
(ii) Combined Leverage.
Answer:
(i) Combined leverage = Contribution ÷ EBT = 48 lacs ÷ 15.80 lacs
= 3.04
(ii) Calculation of EPS:
Question 3.
The capital structure of JCPL Ltd. is as follows:
Equity share capital of ₹ 10 each : ₹ 8,00,000
8% Preference share capital of ₹ 10 each : ₹ 6,25,000
10% Debenture of ₹ 100 each : ₹ 4,00,000
Additional Information:
Profit after tax (tax rate 30%) : ₹ 1,82,000
Operating expenses (including depreciation ₹ 90,000) : 1.50 times of EBIT
Equity share dividend paid : 15%
Market price per equity share : ₹ 20.00
Required to calculate:
(i) Operating and financial leverage.
(ii) Cover the preference and equity share dividends.
(iii) The earning yield and price earning ratio. (8 Marks May 2012)
Answer:
(i) Operating & Financial leverage:
(ii) calculation of cover the preference & equity share dividends:
(iii) Earning yield & price earning ratio.
Earning Yield Ratio \(=\frac{\text { EPS }}{\text { MPS }}\) × 100 = \(\frac{1.65}{20.00}\) × 100 = 8.25
(iv) Net fund flow:
Net fund flow = PAT – Preference dividends – Equity dividends + Depreciation
= 1,82,000 – 50,000 – 1,20,000 + 90,000 = ₹ 1,02,000
Calculation of contribution:
Question 4.
X Limited has estimated that for a new product its break-even point is 20,000 units if the item is sold for ₹ 14 per unit and variable cost ₹ 9 per unit. Calculate the degree of operating leverage for sales volume 25,000 units and 30,000 units. (5 Marks Nov. 2012)
Answer:
Statement of Operating Leverage
Calculation of operating fixed cost:
Contribution at BEP = Fixed Cost
₹ 5 × 20,000 Units = ₹ 1,00,000
Question 5.
The following information related to XL company Ltd. for the year ended 31st March, 2013 are available to you:
Equity share capital of ₹ 10 each : ₹ 25,00,000
11 % Bonds of ₹ 1,000 each : ₹ 18,50,000
Sales : ₹ 42,00,000
Fixed cost (Excluding Interest) : ₹ 3,48,000
Financial leverage : 1.39
Profit Volume Ratio : 25.55%
Income Tax Rate : 35%
You are required to calculate:
(i) Operating Leverage;
(ii) Combined Leverage; and
(iii) Earning Per Share. (6 Marks May 2013)
Answer:
(i) Operating Leverage \(=\frac{\text { Contribution }}{\text { EBIT }}\) = \(\frac{10,73,100}{7,25,100}\) = 1.48 times
(ii) Combined Leverage = OL × FL = 1.48 × 1.39 = 2.06 times
(iii)
Working Notes:
(1) Contribution = Sales × PV Ratio
= 42 Lacs × 25.55% = 10,73,100
(2) EBIT = Contribution – Operating Fixed Cost
= 10,73,100 – 3,48,000 = 7,25,100
(3) Profit after tax = (EBIT- Interest) (1 – t)
= (7,25,100- 11% of 18,50,000) (1 – 0.35)
= 3,39,040
Question 6.
Calculate the degree of operating leverage, degree of financial leverage and the degree of combined leverage for the following firms:
(5 Marks Nov. 13)
Answer:
Statment of the Degree of OL, Degree of FL and the Degree of CL
Question 7.
A company had the following Balance Sheet as on 31st March, 2014:
The additional information given is as under:
Fixed cost per annum (excluding interest) : 4 crores
Variable operating cost ratio : 65%
Total assets turnover ratio : 2.5
Income Tax rate : 30%
Required:
(i) Earnings Per Share
(ii) Operating Leverage
(iii) Financial Leverage
(iv) Combined Leverage
Answer:
(i) Calculation of EPS:
EPS \(=\frac{\text { EAT }}{\text { No. of Shares }}\) \(=\frac{840 \text { Lakhs }}{50 \text { Lakhs }}\) = ₹ 16.80
(ii) Calculation of OL:
OL \(=\frac{\text { Contribution }}{\text { EBIT }}\) \(=\frac{17.50 \text { Crores }}{13.50 \text { Crores }}\) = 1.296 times
(iii) Calculation of FL:
FT \(=\frac{\text { EBIT }}{\text { EBT }}\) \(=\frac{13.50 \text { Crores }}{12.00 \text { Crores }}\) = 1.125 times
(iv) Calculation of CL:
CL = OL × FL = 1.296 × 1.125 = 1.458 times
Working Notes:
Income Statement
Question 8.
The capital structure of RST Ltd. is as follows:
Equity share capital of ₹ 10 each : ₹ 8,00,000
10% Preference share capital of ₹ 100 each : ₹ 5,00,000
12% Debenture of ₹ 100 each : ₹ 7,00,000
Additional Information:
Profit after tax (tax rate 30%) : ₹ 2,80,000
Operating expenses (including depreciation ₹ 96,800)
Equity share dividend paid : 15%
Market price per equity share : ₹ 23.00
Required to calculate:
(i) Operating and financial leverage.
(ii) Cover the preference and equity share dividends.
(iii) The earning yield and price earning ratio.
(iv) The net fund flow.
Note: All operating expenses (excluding depreciation) are variable. (8 Marks Nov. 2014)
Answer:
(i) Operating & Financial leverage:
(ii) Calculation of cover the preference & equity share dividends:
(iii) Earning yield & price earning ratio:
(iv) Net fund flow:
Net fund flow = PAT – Preference dividends – Equity dividends + Depreciation
= 2,80,000 – 50,000 – 1,20,000 + 96,800
= ₹ 2,06,800
Calculation of contribution
Question 9.
Following information are related to four firms of the same industry:
Find out:
(i) Degree of operating leverage, and
(ii) Degree of combined leverage of all the firms. (5 Marks May 2015)
Answer:
(i)
(ii)
Question 10.
The capital structure of the ABC Ltd. as at 51.03.15 consists of ordinary share capital of ₹ 5,00,000 (face value ₹ 100 each) and 10% debentures of ₹ 5,00,000 (₹ 100 each). In the year ended March 15, sales decreased from 60,000 units to 50,000 units. During the year and in the previous year, the selling price is ₹ 12 per unit; variable cost stood at ₹ 8 per unit and fixed expenses were at ₹ 1,00,000 p.a. The income tax rate was 30%.
You are required to calculate the following:
(i) The percentage decrease in earnings per share.
(ii) The degree of operating leverage at 60,000 units and 50,000 units.
(iii) The degree of financial leverage at 60,000 units and 50,000 units. (5 Marks June 2015)
Answer:
(i) Calculation of % decrease in EPS
% Decrease in EPS = \(\frac{12.60-7.00}{12.60}\) × 100 = 44.44%
(ii) Degree of Operating Leverage \(=\frac{\text { Contribution }}{\text { EBIT }}\)
At 60,000 units = \(\frac{2,40,000}{1,40,000}\) = 1.71 times
At 50,000 units = \(\frac{2,00,000}{1,00,000}\) = 2 times
(iii) Degree of Financial Leverage \(=\frac{\mathrm{EBIT}}{\mathrm{EBT}}\)
At 60,000 units = \(\frac{1,40,000}{90,000}\) = 1.56 times
At 50,000 units = \(\frac{1,00,000}{50,000}\) = 2 times
Question 11.
From the following details of X Ltd., prepare the Income Statement for the year ended 31st December 2014:
Financial Leverage : 2
Interest : ₹ 2,000
Operating Leverage : 3
Variable cost as a % of sales : 75%
Income tax rate : 30%
(5 Marks Nov. 2015)
Answer:
Income Statement for the year ended 31st December, 2014
Working Notes:
(a) Calculation of EBIT:
(b) Calculation of Contribution:
(c) Calculation of Sales
Question 12.
A company had the following Balance Sheet as on 31st March, 2015.
The additional information given is as under:
Fixed cost per annum (excluding interest) : ₹ 32,00,000
Variable operating cost ratio : 70%
Total assets turnover ratio : 2.5
Income Tax rate : 30%
Required:
(i) Operating Leverage,
(ii) Financial Leverage,
(iii) Combined Leverage and
(iv) Earnings Per Share (5 Marks May 2016)
Answer:
(i) Calculation of OL:
OL \(=\frac{\text { Contribution }}{\text { EBIT }}\) = \(\frac{1,20,00,000}{88,00,000}\) = 1.364 times
(ii) Calculation of FL:
FL \(=\frac{\mathrm{EBIT}}{\mathrm{EBT}}\) = \(\frac{88,00,000}{76,00,000}\) = 1.158 times
(iii) Calculation of CL:
CL = OL × FL = 1.364 × 1.158 = 1.579 times
(iv) Calculation of EPS
EPS \(=\frac{\text { EAT }}{\text { No. of Shares }}\) = \(\frac{53,20,000}{4,00,000}\) = ₹ 13.30
Working Notes:
Income Statement
Question 13.
The following information related to YZ company Ltd. for the year ended 31st March, 2016 are available to you:
Equity share capital of ₹ 10 each : ₹ 50,00,000
12% Bonds of ₹ 1,000 each : ₹ 37,00,000
Sales : ₹ 84,00,000
Fixed cost (Excluding Interest) : ₹ 6,96,000
Financial leverage : 27.55%
Profit Volume Ratio : 40%
Income Tax Rate :
You are required to calculate:
(a) Operating Leverage;
(b) Combined Leverage; and
(c) Earning Per Share [upto two decimal points] (5 Marks Nov. 2016)
Answer:
(a) Operating Leverage \(=\frac{\text { Contribution }}{\text { EBIT }}\) = \(\frac{23,14,200}{16,18,200}\) = 1.43 times
(b) Combined Leverage = OL × FL = 1.43 × 1.49 = 2.13 times
(c)
Working Notes:
1. Contribution = Sales × PV Ratio = 84 Lacs × 27.55%
= 23,14,200
2. EBIT = Contribution – Operating Fixed Cost
= 23,14,200 – 6,96,000 = 16,18,200
3. Profit after tax = (EBIT – Interest) (1 – t)
= (16,18,200 – 12% of 37,00,000) (1 – 0.40)
= 7,04,520
Author Note: Calculation of interest through financial leverage will provide different interest, therefore this question alternatively can be solved by taking interest on the basis of following calculation:
Financial Leverage = EBIT ÷ EBT = 16,18,2004 ÷ EBT = 1.49
EBT = 16,18,200 ÷ 1.49 = 10,86,040
Interest = EBIT – EBT = 16,18,200 – 10,86,040
= 5,32,160
Question 14.
You are given the following information of 5 firms of the same industry:
Firm | Change in Revenue | Change in Operating Income | Change in EPS |
M | 28% | 26% | 32% |
N | 27% | 34% | 26% |
P | 25% | 38% | 23% |
Q | 23% | 43% | 27% |
R | 25% | 40% | 28% |
Find out:
(a) Degree of operating leverage, and
(b) Degree of combined leverage of all the firms. (5 Marks May 2017)
Answer:
(a) Degree of Leverage \(=\frac{\% \text { Change in operating income }}{\% \text { Change in revenue }}\)
M = 26% ÷ 28% = 0.93
N = 34% ÷ 27% = 1.26
P = 38% ÷ 25% = 1.52
Q = 43% ÷ 23% = 1.87
R = 40% ÷ 25% = 1.60
(b) Degree of Combined Leverage \(=\frac{\% \text { Change in EPS }}{\%_0 \text { Change in revenue }}\)
M = 32% ÷ 28% = 1.14
N = 26% ÷ 27% = 0.96
P = 23% ÷ 25% = 0.92
Q = 27% ÷ 23% = 1.17
R = 28% ÷ 25% = 1.12
Question 15.
The following details of a company for the year ended 31 March, 2017 are given below:
Operating leverage : 2 times
Combined leverage : 2.5 times
Fixed Cost (Excluding interest) : ₹ 3.04 lakhs
Sales : ₹ 50.00 lakhs
8% Debentures of ₹ 100 each : ₹ 30.25 lakhs
Equity Share Capital of ₹ 10 each ₹ 34.00 lakhs
Income tax rate 30 per cent
Required:
(i) Calculate Financial Leverage.
(ii) Calculate P/V ratio and Earning Per Share (EPS).
(iii) If the company belongs to an industry, whose assets turnover is 1.5, does it have a high or low assets turnover?
(iv) At what level of sales the Earning before Tax (EBT) of the company will be equal to zero? (8 Marks Nov. 2017)
Answer:
(i) Calculation of Financial Leverage:
Financial Leverage = CL ÷ OL = 2.50 ÷ 2 = 1.25
(ii) P/V Ratio and EPS:
Calculation of contribution
Operating leverage \(=\frac{\text { Contribution }}{\text { Contribution }-\mathrm{FC}}\) \(=\frac{\text { Contribution }}{\text { Contribution }-3,04,000}\) = 2 times
2 Contribution – 6,08,000 = Contribution = 6,08,000
Calculation of PAT:
Profit after tax = (Contribution – fixed cost – interest) (1 – t)
= (6,08,000 – 3,04,000 – 8% of 30,25,000)(1 – 0.30)
= 43,400
Author Note: Calculation of interest through financial leverage will provide different interest, therefore this question alternatively can be solved by taking interest on the basis of following calculation:
Financial Leverage EBIT ÷ EBT = 6,08,000 – 3,04,000 ÷ EBT
= 1.25 = 3,04,000 ÷ EBT
EBT = 3,04,000 ÷ 1.25 = 2,43,200
Interest = EBT – EBT = 3,04,000 – 2,43,200
= 60,800
(iii) Assets turnover:
Assets turnover \(=\frac{\text { Sales }}{\text { Total Assets }}\) = \(\frac{50,00,000}{64,25,000}\) = .778
0.778 < 1.5 means lower than industry assets turnover.
(iv) Level of saks ro earn zero EBT:
EBT = Sales – Variable cost – Fixed cost – Interest
Nil = Sales – 87.84% sales – 3,04,000 – 2,42,000
12.16% of sales = 5,46,000
Sales = 44,90,132
Question 16.
Following are the selected financial information of A Ltd. and B Ltd. for the year ended March 31, 2018:
You are required to find out:
(1) EBIT
(2) Sales
(3) Fixed cost
(4) Identify the company which is better placed with reasons based on leverages. (5 Marks May 2018)
Answer:
(1) Financial Leverage \(=\frac{\text { EBIT }}{\text { EBIT – Interest }}\)
Financial Leverage (A Ltd.) \(=\frac{\text { EBIT }}{\text { EBIT }-20,000}\) = 3 times
EBIT = ₹ 30,000
Financial Leverage (B Ltd.) \(=\frac{\text { EBIT }}{\text { EBIT }-1,00,000}\) = 2 times
EBIT = ₹ 2,00,000
(2) Operating Leverage \(=\frac{\text { Contribution }}{\text { EBIT }}\)
Operating Leverage (A Ltd.) \(=\frac{\text { Contribution }}{30,000}\) = 5 times
Contribution = ₹ 1,50,000
Sales = ₹ 1,50,000 ÷ 40% (PV) = ₹ 3,75,000
Operating Leverage (B Ltd.) \(=\frac{\text { Contribution }}{2,00,000}\) = 2 times
Contribution = ₹ 4,00,000
Sales = ₹ 4,00,000 ÷ 50% (PV) = ₹ 8,00,000
(3) Contribution = EBIT + Fixed Cost
Contribution (A Ltd.) = 30,000 + Fixed Cost = ₹ 1,50,000
Fixed cost = ₹ 1,20,000
Contribution (B Ltd.) = 2,00,000 + Fixed Cost = ₹ 4,00,00
Fixed cost = ₹ 2,00,000
(4) Comment based on leverage: B Ltd. is better than A Ltd. having lower degree of Business risk, Financial risk and overall risk.
Question 17.
The following data have been extracted from the books of LM Ltd:
Sales : ₹ 100 Lakhs
Interest payable per annum : ₹ 10 Lakhs
Operating leverage : 1.2
Combined leverage : 2.16
You are required to find out:
(1) The Financial leverage
(2) Fixed cost and
(3) P/V ratio (5 Marks May 2018)
Answer:
(1) Financial Leverage = Combined leverage ÷ Operating leverage
= 2.16 ÷ 1.2 = 1.8 times
(2) Calculation of fixed cost:
Financial Leverage \(=\frac{\text { EBIT }}{\text { EBIT – Interest }}\) = 1.8 times
\(=\frac{\text { EBIT }}{\text { EBIT }-10,00,000}\) = 1.8 times
EBIT = ₹ 22,50,000
Operation Leverage \(=\frac{\text { Contribution }}{\text { EBIT }}\) = 1.2 times
Contribution = ₹ 2,50,000 × 1.2 = ₹ 27,00,000
Fixed cost = Contribution – EBIT
= ₹ 27,00,000 – 2,50,000 = ₹ 4,50,000
(3) P/V ratio = Contribution ÷ Sales
= 27,00,000 ÷ 1,00,00,000 = 27%
Question 18.
Following is Balance Sheet of Soni Ltd. as on 31st March, 2018.
Additional information:
Fixed cost per annum (excluding interest) : ₹ 20,00,000
Variable operating cost ratio : 60%
Total assets turnover ratio : 5 times
Income Tax rate : 25%
You are required to:
(1) Prepare Income Statement
(2) Calculate the following and comment:
(a) Operating Leverage
(b) Financial Leverage
(c) Combined Leverage (10 Marks Nov. 2018)
Answer:
(1) Income Statement
(2) Calculation of OL:
OL \(=\frac{\text { Contribution }}{\text { EBIT }}\) = \(\frac{2,00,00,000}{1,80,00,000}\) = 1.11 times
It indicates fixed cost in cost structure. It indicates sensitivity of earnings before interest and tax (EBIT) to change in sales at a particular level.
Calculation of FL:
FL \(=\frac{\mathrm{EBIT}}{\mathrm{EBT}}\) = \(\frac{1,80,00,000}{1,74,00,000}\) = 1.03 times
The financial leverage is very comfortable since the debt service obli-gation is small vis-a-vis EBIT.
Calculation of CL:
CL = OL × FL = 1.11 × 1.03 = 1.15 times
The combined leverage studied the choice of fixed cost in cost struc-ture and choice of debt in capital structure. It studies how sensitive the change in EPS is vis-a-vis change in sales.
Question 19.
A company has sales of ₹ 1,00,00,000; variable cost is 55% of sales and fixed cost is ₹ 6,00,000. The capital structure of the company is: Equity ₹ 20,00,000 and 8% Debt ₹ 80,00,000.
Calculate:
(1) Operating, Financial and Combined Leverages.
(2) If the sales amount is increased by 12%, by what percentage EBIT will increase? (5 Marks Nov. 2018)
Answer:
(1) Operating Leverage \(=\frac{\text { Contribution }}{\text { EBIT }}\)
= \(\frac{1,00,00,000 \times 45 \%}{45,00,000-6,00,000}\) = 1.154 times
Financial Leverage \(=\frac{\mathrm{EBIT}}{\mathrm{EBT}}\)
= \(\frac{39,00,000}{39,00,000-8 \% \text { of } 80,00,000}\) = 1.196 times
Combined Leverage = OL × FL
= 1.154 × 1.196 = 1.38 times
(2) % increase on EBIT:
Δ EBIT (in %) = Δ sales × DOL
= 12% × 1.154
= 13.84%
Question 20.
The capital structure of the Shiva Ltd. consists of an ordinary share capital of ₹ 20,00,000 (share of ₹ 100 par value) and ₹ 20,00,000 of 10% debentures.
Sales increased by 20% from 2,00,000 units to 2,40,000 units, the selling price is ₹ 10 per unit; variable cost amounts to ₹ 6 per unit and fixed expenses amount to ₹ 4,00,000.
The income tax rate is assumed to be 50%.
You are required to calculate the following:
(1) The percentage increase in earnings per share;
(2) Financial leverage at 2,00,000 units and 2,40,000 units.
(3) Operating leverage at 2,00,000 units and 2,40,000 units.
(4) Comment on the behaviour of operating and financial leverages in relation to increase in production from 2,00,000 units to 2,40,000 units. (10 Marks May 2019)
Answer:
(1) Calculation of % increase in EPS
% increase in EPS = \(\frac{9.00-5.00}{5.00}\) × 100 = 80%
(2) Financial Leverage \(=\frac{\text { EBIT }}{\text { EBT }}\)
At 2,00,000 units = \(\frac{4,00,000}{2,00,000}\) = 2 times
At 2,40,000 units = \(\frac{5,60,000}{3,60,000}\) = 1.56 times
(3) Operating Leverage \(=\frac{\text { Contribution }}{\text { EBIT }}\)
At 2,00,000 units = \(\frac{8,00,000}{4,00,000}\) = 2 times
At 2,40,000 units = \(\frac{9,60,000}{5,60,000}\) = 1.71 times
(4) Increase in production and sales will result in decrease in risk
Question 21.
The balance sheet of Gitashree Ltd. is given below:
The company’s total assets turnover ratio is 4 times, its fixed operating cost is ₹ 2,00,000 and its variable operating cost ratio is 60%. The income tax rate is 30%.
You are required to:
1. (a) Degree of Operating Leverage.
(b) Degree of Financial Leverage.
(c) Degree of Combined Leverage.
2. Determine the likely level of EBIT if EPS is
(A) ₹ 1.00,
(B) ₹ 2.00 and
(C) ₹ Nil. (10 Marks Nov. 2019)
Answer:
1.
(a) Operating Leverage \(=\frac{\text { Contribution }}{\text { EBIT }}\) = \(\frac{96,000}{76,000}\) = 1.26
(b) Financial Leverage \(=\frac{\text { EBIT }}{\mathrm{EBT}}\) = \(\frac{76,000}{7,36,000}\) = 1.03
(c) Combined Leverage = OL × FL = 1.26 × 1.03 = 1.30
2. Calculation of likely level of EBIT:
Earnings Per Share \(=\frac{(\mathrm{EBIT}-\mathrm{I})(1-\mathrm{t})}{\mathrm{N}}\)
Working Note:
Income statement
Question 22.
The following data is available for Stone Ltd.:
Using the concept of leverage, find out:
(i) The percentage change in taxable income if EBIT increases by 10%.
(ii) The percentage change in EBIT if sales increases by 10%.
(iii) The percentage change in taxable income if sales increases by 10%. Also verify the results in each of the above case. (10 Marks Nov. 2020)
Answer:
(i) % change in taxable income (EBT) = % increase in EBIT × FL
= 10% × 1.333 times = 13.33%
(ii) % change in EBIT = % increase in Sales × OL
= 10% × 3 times = 30%
(iii) % change in taxable income (EBT) = % increase in Sales × CL
= 10% × 4 times = 40%
Verification in each case:
(i) % change in taxable income if EBIT increases by 10%:
Revised taxable income (EBT) = EBIT + 10% – Interest
= 1,00,000 + 10% – 25,000 = 85,000
% change in taxable income = \(\frac{85,000-75,000}{75,000}\) × 100 = 13.33%
(ii) % change in EBIT if Sales increases by 10%:
Revised EBIT = (Sales + 10%) – Variable cost @ 40% – Fixed cost
= (5,00,000 + 10%) – 40% of 5,50,000 – 2,00,000
= 1,30,000
(iii) % change in taxable income if Sales increases by 10%:
Revised taxable income (EBT)
= (Sales+10%) – Variable cost@40% – Fixed cost – Interest
= (5,00,000 + 10%) – 40% of 5,50,000 – 2,00,000 – 25,000
= 1,05,000
% change in taxable income = \(\frac{1,05,000-75,000}{75,000}\) × 100 = 40%
Working Note:
(a) Operating Leverage \(=\frac{\text { Contribution }}{\text { EBIT }}\)
= \(\frac{3,00,000}{1,00,000}\) = 3 times
(b) Financial Leverage \(=\frac{\mathrm{EBIT}}{\mathrm{EBT}}\)
= \(\frac{1,00,000}{75,000}\) = 1.333 times
(c) Combined Leverage = OL × FL
= 3 × 1.333 = 4 times
Question 23.
The following information related to XYZ Company Ltd. for the year ended 31st March, 2020 are as follows:
Equity share capital of ₹ 100 each : ₹ 50 Lakhs
12% Bonds of ₹ 1,000 each : ₹ 30 Lakhs
Sales : ₹ 84 Lakhs
Fixed cost (Excluding Interest) : ₹ 7.5 Lakhs
Financial leverage : 1.39
Profit Volume Ratio : 25%
Market Price per Equity Share : ₹ 200
Income Tax Rate Applicable : 30%
You are required to calculate:
(i) Operating Leverage
(ii) Combined Leverage
(iii) Earning Per Share
(iv) Earning Yield (10 Marks Jan. 2021)
Answer
(i) Operating Leverage \(=\frac{\text { Contribution }}{\text { EBIT }}\)
= \(\frac{21,00,000}{13,50,000}\) = 1.56 times
(ii) Combined Leverage = OL × FL
= 1.56 × 1.39 = 2.16 rimes
(iii) Earnings Per Share \(=\frac{\text { PAT }}{\text { No of Equity shares }}\)
= \(\frac{6,93,000}{50,000}\) = ₹ 13.86
(iv) Earnings Yield \(=\frac{E P S}{\text { MPS }}\) × 100
= \(\frac{13.86}{200}\) × 100 = 6.93%
Working Notes:
(1) Contribution Sales × PV Ratio
= 84 Lakhs × 25% = 21,00,000
(2) EBIT = Contribution – Fixed Cost
= 21,00,000 – 7,50,000 = 13,50,000
(3) Profit after tax = (EBIT – Interest) (1 – t)
= (13,50,000 – 12% of 30,00,000) (1 – 0.30)
= 6,93,000
Important Questions
Question 1.
Z Limited is considering the installation of a new project costing ₹ 80,00,000. Expected annual sales revenue from the project is ₹ 90,00,000 and its variable costs are 60 per cent of sales. Expected annual fixed cost other than interest is ₹ 10,00,000. Corporate tax rate is 30 per cent. The company w’ants to arrange the funds through issuing 4,00,000 equity shares of ₹ 10 each and 12 per cent debentures of ₹ 40,00,000.
You are required to:
(i) Calculate the operating, financial and combined leverages and Earnings per Share (EPS).
(ii) Determine the likely level of EBIT, if EPS is ₹ 4, or ₹ 2, or Zero.
Answer:
(i)
(ii) Calculation of likely level of EBIT:
Question 2.
Calculate the operating leverage, financial leverage and combined leverage from the following data under situations I and II and financial plans A and B:
Installed capacity : 4,000 units
Actual production and sales : 75% of the Capacity
Selling price : ₹ 30 per unit
Variable cost : ₹ 15 per unit
Fixed cost:
Under situation I : ₹ 15,000
Under situation II : ₹ 20,000
Answer:
Statement of showing OL, FL and CL
Question 3.
The capital structure of the Progressive Corporation consists of an ordi nary share capital of ₹ 1,00,00,000 (share of ₹ 100 par value) and ₹ 10,00,000 of 10% debentures.
Sales increased by 20% from 1,00,000 units to 1,20,000 units, the selling price is ₹ 10 per unit; variable cost amounts to ₹ 6 per unit and fixed expenses amount to ₹ 2,00,000.
The income tax rate is assumed to be 50%.
You are required to calculate the following:
(i) The percentage increase in earnings per share;
(ii) The degree of operating leverage at 1,00,000 units and 1,20,000 units.
(iii) The degree of financial leverage at 1,00,000 units and 1,20,000 units.
(iv) Comment on the behaviour of operating and financial leverages in relation to increase in production from 1,00,000 units to 1,20,000 units.
Answer:
(i) Calculation of % increase in EPS
% increase in EPS = \(\frac{0.90-0.50}{0.50}\) × 100 = 80%
(ii) Degree of Operating Leverage \(=\frac{\text { Contribution }}{\text { EBIT }}\)
At 1,00,000 units = \(\frac{4,00,000}{2,00,000}\) = 2 times
At 1,20,000 units = \(\frac{4,80,000}{2,80,000}\) = 1.71 times
(iii) Degree of Financial Leverage \(=\frac{\mathrm{EBIT}}{\mathrm{EBT}}\)
At 1,00,000 units = \(\frac{2,00,000}{1,00,000}\) = 2 times
At 1,20,000 units = \(\frac{2,80,000}{1,80,000}\) = 1.56 times
(iv) Increase in production and sales will result in decrease in risk.
Question 4.
A company had the following Balance Sheet as on March 31, 2006
The additional information given is as under:
Fixed costs per annum (excluding interest) : ₹ 8 Crores
Variable operating costs ratio : 65% of sales
Total Assets turnover ratio : 2.5 times
Income tax rate : 40%
Calculate
(i) Earnings per share,
(ii) Operating Leverage,
(iii) Financial Leverage,
(iv) Combined Leverage and comment on all leverages.
Answer:
(i) Statement of EPS
(ii) Operating Leverage \(=\frac{\text { Contribution }}{\text { EBIT }}\) \(=\frac{35 \text { Crores }}{27 \text { Crores }}\) = 1.296 times
It indicates fixed cost in cost structure. It indicates sensitivity of earnings before interest and tax (EBIT) to change in sales at a particular level.
(iii) Financial Leverage \(=\frac{\mathrm{EBIT}}{\mathrm{EBT}}\) \(=\frac{27 \text { Crores }}{24 \text { Crores }}\) = 1.125 times
The financial leverage is very comfortable since the debt service obli-gation is small vis-a-vis EBIT.
(iv) Combined Leverage = OL × FL = 1.296 × 1.125 = 1.458 times
The combined leverage studies the choice of fixed cost in cost structure and choice of debt in capital structure. It studies how sensitive the change in EPS is vis-a-vis change in sales.
Question 5.
From the following information, prepare Income Statement of Company A & B:
Particulars | Company A | Company B |
Margin of safety | 0.20 | 0.25 |
Interest | ₹ 3.000 | ₹ 2,000 |
Profit volume ratio | 25% | 33.33% |
Financial Leverage | 4 | 3 |
Tax rate | 45% | 45% |
Answer:
Income Statement
(a) Company A:
Financial Leverage = EBIT/(EBIT – Interest)
= EBIT/(EBIT – ₹ 3,000) = 4 times
EBIT = 4 EBIT – ₹ 12,000
EBIT = ₹ 4,000
Company B:
Financial Leverage = EBIT/(EBIT – Interest)
= EBIT/(EBIT – ₹ 2,000) = 3 times
EBIT = 3 EBIT – ₹ 6,000
EBIT = ₹ 3,000
(b) Company A:
Operating Leverage = 1/Margin of Safety
1/0.20 = 5 times
Operating Leverage = Contribution/EBIT
= Contribution/₹ 4,000 = 5 times
Contribution = ₹ 20,000
Company B:
Operating Leverage = 1/ Margin of Safety
= 1/0.25 4tirncs
Operating Leverage = Contnbution/EBIT
= Contribution/₹ 3,000 = 4 times
Contribution = ₹ 12,000
(c) company A:
Sales = Contribution/PV Ratio
= ₹ 20,000/0.25 = ₹ 80,000
company B:
Sales = Contribution/PV Ratio
= ₹ 20,000/0.3333 = ₹ 36,000
Question 6.
A firm has sales of ₹ 75,00,000 variable cost is 56% and fixed cost is ₹ 6,00,000. It has a debt of ₹ 45,00,000 at 9% and equity of ₹ 55,00,000.
(i) What is the firm’s ROI?
(ii) Does it have favourable financial leverage?
(iii) If the firm belongs to an industry whose capital turnover is 3, does it have a high or low capital turnover?
(iv) What are the operating, financial and combined leverages of the firm?
(v) If the sales is increased by 10% by what percentage EBIT will increase?
(vi) At what level of sales the EBT of the firm will be equal to zero?
(vii) If EBIT increases by 20%, by what percentage EBT will increase?
Answer:
Income Statement
(i) ROI \(=\frac{\text { EBIT }}{\text { Capital Employed }}\) × 100
= \(\frac{27,00,000}{45,00,000+55,00,000}\) × 100 = 27%
(ii) ROI is 27% and Interest on debt is 9%, hence, it has a favourable financial leverage.
(iii) Capital Turnover \(=\frac{\text { Net Sales }}{\text { Capital }}\) = \(\frac{75,00,000}{1,00,00,000}\) = 0.75
Firm has very low capital turnover as compared to industry average of 3.
(iv) Calculation of Operating, Financial and Combined leverages:
Operating Leverage \(=\frac{\text { Contribution }}{\text { EBIT }}\) = \(\frac{33,00,000}{27,00,000}\) = 1.222
Financial Leverage \(=\frac{\text { EBIT }}{\text { EBT }}\) = \(\frac{27,00,000}{22,95,000}\) = 1.176
Combined Leverage = OL × FL = 1.222 × 1.176 = 1.437
(v) Operating leverage is 1.22. So if sales is increased by 10% then EBIT will be increased by 1.222 × 10 i.e. 12.22% (approx)
(vi) EBT = Sales – Variable cost – Fixed cost – Interest
Nil = Sales – 56% sales – 6,00,000 – 4,05,000
44% of sales = 10,05,000
Sales = 22,84,091
Hence at ₹ 22,84,091 sales level EBT of the firm will be equal to Zero.
(vii) Financial leverage is 1.176. So, if EBIT increases by 20% then EBT will increase by 1.18 × 20% = 23.52% (approx)
Question 7.
You are given the following information of 5 firms of the same industry:
Finn | Change in Revenue | Change in Operating Income | Change in EPS |
M | 28% | 26% | 32% |
N | 27% | 34% | 26% |
P | 25% | 38% | 23% |
0 | 23% | 43% | 27% |
R | 25% | 40% | 28% |
Find out:
(a) Degree of operating leverage, and
(b) Degree of combined leverage of all the firms.
Answer:
(a) Degree of Operating Leverage \(=\frac{\% \text { Change in operating income }}{\% \text { Change in revenue }}\)
M = 26% ÷ 28% = 0.93
N = 34% ÷ 27% = 1.26
P = 38% ÷ 25% = 1.52
Q = 43% ÷ 23% = 1.87
R = 40% ÷ 25% = 1.60
(b) Degree of Combined Leverage \(=\frac{\% \text { Change in EPS }}{\% \text { Change in revenue }}\)
M = 32% ÷ 28% = 1.14
N = 26% ÷ 27% = 0.96
P = 23% ÷ 25% = 0.92
Q = 27% ÷ 23% = 1.17
R = 28% ÷ 25% = 1.12
Question 8.
The net Sales of A Ltd. is ₹ 30 crores. Earning before interest and tax of the company as a percentage of net sales is 12%. The capital employed comprises ₹ 10 crores of Equity, ₹ 2 crores of 13% Cumulative Preference Share Capital and 15% Debentures of ₹ 6 crores. Income tax rate is 40%.
Required:
(i) Calculate the Return on Equity (ROE) for the Company and indicate its segments due to the presence of Preference Share Capital and Bor rowing (Debentures).
(ii) Calculate the Operating Leverage of the Company given that its Combined Leverage is 3.
Answer:
(i) Calculation of ROE :
ROE \(=\frac{\text { Earnings for Equity Shareholders }}{\text { Equity Shareholder’s Fund }}\) × 100
\(=\frac{1.36 \text { Crores }}{10 \text { Crores }}\) × 100 = 13.60%
Segment:
ROCE/ROI \(=\frac{\text { EBIT }}{\text { Capital Employed }}\) × 100
\(=\frac{3.60 \text { crores }}{18 \text { crores }}\) × 100 = 20%
Segment due to Preference Share Capital
= [20% (1 – 40) – 13%] × \(\frac{2}{10}\) = -20%
Segment due to Debentures
= [(20% – 15%) (1 -40)] × \(\frac{6}{10}\) = 1.80%
Return on Equity with segment effect
= ROI (1-t) -.20% + 1.80%
= [20% (1-.40)] -.20% + 1.80% = 13.60%
(ii) Operating Leverage = Combined Leverage ÷ Financial Leverage
= 3 times ÷ 1.59 times = 1.89 times
Working Notes:
1. Calculation of Earnings Available for Equity Shareholders
2. Calculation of Financial Leverage:
Financial Leverage \(=\frac{\text { EBIT }}{\text { EBT }-\frac{\text { Preference Dividend }}{1-\text { Tax }}}\)
\(=\frac{3,60,00,000}{2,70,00,000-\frac{26,00,000}{1-0.40}}\) = 1.59 times
Question 9.
The following details of RST Limited for the year ended 31 March, 2006 are given below:
Operating leverage : 1.4 times
Combined leverage : 2.8 times
Fixed Cost (Excluding interest) : ₹ 2.04 lakhs
Sales : ₹ 30.00 lakhs
12% Debentures of ₹ 100 each : ₹ 21.25 lakhs
Equity Share Capital of ₹ 10 each : ₹ 17.00 lakhs
Income tax rate : 30 per cent
Required:
(i) Calculate Financial Leverage.
(ii) Calculate P/V ratio and Earning Per Share (EPS).
(iii) If the company belongs to an industry, whose assets turnover is 1.5, does it have a high or low assets turnover?
(iv) At what level of sales the Earning before Tax (EBT) of the company will be equal to zero?
Answer:
(i) Calculation of Financial Leverage:
Financial Leverage = CL ÷ OL = 2.80 ÷ 1.40 = 2 times
(ii) P/V Ratio and EPS:
p/v ratio \(=\frac{\text { Contribution }}{\text { Sales }}\) × 1oo = \(\frac{7,14,000}{30,00,000}\) × 100 = 23.80%
EPS \(=\frac{\text { PAT }}{\text { No. of Shares }}\) = \(\frac{1,78,500}{1,70,000}\) = ₹ 1.05
Calculation of contribution:
Operating leverage \(=\frac{\text { Contribution }}{\text { Contribution }-\mathrm{FC}}\)
\(=\frac{\text { Contribution }}{\text { Contribution }-2,04,000}\) = 1.4 times
1.4 Contribution – 2,85,600 = Contribution = 7,14,000
Calculation of PAT:
Profit after tax (Contribution – fixed cost – interest) (1 – t)
= (23.80% of 30 lacs – 2.04 lacs – 12% of 21.25 lacs)(1 – 0.30)
= 1,78,500
(iii) Assets turnover:
Assets turnover \(=\frac{\text { Sales }}{\text { Total Assets }}\) = \(\frac{30,00,000}{38,25,000}\) = .784
0.784 < 1.5 means lower than industry assets turnover.
(iv) Level of sales to earn zero EBT:
EBT = Sales – Variable cost – Fixed cost – Interest
Nil = Sales – 76.20% sales – 2,04,000 – 2,55,000
23.80% of sales = 4,59,000
Sales = 19,28,571
Question 10.
The capital structure of JCPL Ltd. is as follows:
Equity share capital of ₹ 10 each : ₹ 8,00,000
8% Preference share capital of ₹ 10 each : ₹ 6,25,000
10% Debenture of ₹ 100 each : ₹ 4,00,000
Additional Information:
Profit after tax (tax rate 30%) : ₹ 1,82,000
Operating expenses (including depreciation ₹ 90,000) : 1.50 times of EBIT
Equity share dividend paid : 15%
Market price per equity share : ₹ 20.00
Required to calculate:
(i) Operating and financial leverage.
(ii) Cover the preference and equity share dividends.
(iii) The earning yield and price earning ratio.
(iv) The net fund flow.
Answer:
(i) Operating & Financial leverage:
(ii) Calculation of cover the preference & equity share dividends:
Cover the Preference Share Dividend
Cover the Equity Share Dividend
(iii) Earning yield & price earning ratio:
(iv) Net fund flow:
Net fund flow = PAT – Preference dividends – Equity dividends + Depreciation
= 1,82,000 – 50,000 – 1,20,000 + 90,000 = ₹ 1,02,000
Calculation of contribution: