`12,00,000 = 2.4 `5,00,000 `5,00,000 = 1.11 `4,52,000

Transcription

1 CHAPTER3 LEVERAGES Question 9: XYZ Ltd. has an average selling price of `10 per unit. Its variable unit costs are `7, and fixed costs amount to `1,70,000. It finances all its assets by equity funds. It pays 35% tax on its income. ABC Ltd. is identical of XYZ Ltd. except in the pattern of financing. The latter finances its assets 50% by debt, the interest on which amounts to `20,000. Determine the degree of operating, financial and combined leverage at `7,00,000 sales for both the firms, and interpret the results. Solution: Statement showing Computation of Leverages Particulars XYZ Ltd. (`) ABC Ltd. (`) Sales Revenue 7,00,000 7,00,000 Less: Variable Cost (70%s) (4,90,000) (4,90,000) Contribution 2,10,000 2,10,000 Less: Fixed Costs (1,70,000) (1,70,000) (Operating Profits) 40,000 40,000 Less : Interest NIL (20,000) EBT 40,000 20,000 Less: Taxes (35%) (14,000) (7,000) EAT 26,000 13,000 DOL = (Contribution/ DFL = (/EBT) 1 2 DCL = Contribution/EBT Or (DOL x DFL) The DCL of the ABC Ltd. is higher due to higher financial leverage. Its total risk is, therefore higher although its DOL (operating risk) is equal to that of the XYZ Ltd. Question 10: The data relating to two Companies are as given below: Particulars Company A Company B Equity Capital `6,00,000 `3,50,000 12% Debentures `4,00,000 `6,50,000 Output (units) per annum 60,000 15,000 Selling Price/ unit `30 `250 Fixed Costs per annum `7,00,000 `14,00,000 Variable Cost per unit `10 `75 You are required to calculate the Operating leverage, Financial leverage and Combined leverage of two Companies. (CA PE II Nov 2002) Solution: Computation of Degree of Operating Leverage, Financial Leverage & Combined Leverage: Particulars Company A (`) Company B (`) Sales Revenue (60,000 units x `30) (15,000 units x `250) 18,00,000 37,50,000 Less: Variable Costs (60,000 units x `10) (15,000 units x `75) (6,00,000) (11,25,000) Contribution 12,00,000 26,25,000 Less: Fixed Costs (7,00,000) (14,00,000) 5,00,000 12,25,000 Less: 12% on Debentures (48,000) (78,000) EBT 4,52,000 11,47,000 DOL= Contribution DFL = EBT `12,00,000 = 2.4 `5,00,000 `5,00,000 = 1.11 `4,52,000 `26,25,000 = 2.14 `12,25,000 `12,25,000 = 1.07 `11,47,000 DCL = DOL x DFL (2.4 x 1.11) = 2.66 (2.14 x 1.07) = 2.29

2 LEVERAGES By: CA Ashish Kalra ADVANCED PROBLEMS: DOL & DFL Question 11: You are 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: (Amount in `) Particulars Financial Plans XY XM Equity 12,000 35,000 Debt (Cost of Debt 12%) 40,000 10,000 52,000 45,000 You are required to calculate Operating Leverage and Financial Leverage of both the plans. (CA IPCC May 2011) Solution: Statement Showing Computation of Operating Leverage (Amount in `) Particulars Situation A Situation B Sales (6,000 `30 per unit) 1,80,000 1,80,000 Less: Variable Cost (6,000 `20 per unit) (1,20,000) (1,20,000) Contribution 60,000 60,000 Less: Fixed Costs (20,000) (25,000) Operating Profit () 40,000 35,000 Operating Leverage = Contribution `60,000 = 1.5 `40,000 `60,000 = `35,000 Statement showing Computation of Financial Leverage Financial Plan Situation A Situation B Plan XY Plan XM Plan XY Plan XM Operating Profit () 40,000 40,000 35,000 35,000 Less: Interest on Debt (4,800) (1,200) (4,800) (1,200) Profit Before Tax (PBT) 35,200 38,800 30,200 33,800 Financial Leverage = PBT = `40,000 `35,200 = = `40,000 `38,800 =1.031 = `35,000 `30,200 = Question 12: (i) You are required to calculate the Operating Leverage from the following data: Sales `50,000 Variable Costs 60% Fixed Costs `12,000 (ii) You are required to calculate the Financial Leverage from the following data: Net Worth `25,00,000 Debt/Equity 3:1 Interest Rate 12% Operating Profit `20,00,000 Solution: (i) Calculation of Operating Leverage: (Amount in `) Sales 50,000 Less: Variable Cost (60% of Sales) (30,000) Contribution 20,000 Less: Fixed Costs (12,000) Operating Profit () 8,000 Operating Leverage = Contribution = `20,000 = 2.5 Operating Profit `8,000 = `35,000 `33,800 = 1.036

3 LEVERAGES By: CA Ashish Kalra (ii) Calculation of Financial Leverage: Calculation of Debt and Interest thereon: (a) Debt = `25,00,000 x 3 = `75,00,000 (b) Interest on Debt = `75,00,000 x 12/100 = `9,00,000 Particulars Amount in ` Operating Profit 20,00,000 Less Interest on Debt (9,00,000) Profit Before Tax 11,00,000 Financial Leverage = Operating Profit/Profit Before Tax = 20,00,000/11,00,000 = 1.82 Question 13: From the following details of X Ltd., prepare the Income Statement for the year ended 31 st December 2014: Financial Leverage 2 Interest `2,000 Operating Leverages 3 Variable cost as a percentage of sales 75% Income tax rate 30% Solution: Income Statement (Amount in `) Sales 48,000 Less: Variable Costs (75% x `48,000) (36,000) Contribution 12,000 Less: Fixed Costs (Bal. fig.) (8,000) 4,000 Less: Interest (2,000) EBT 2,000 Less: Income Tax (30%) (600) EAT 1,400 Working Notes: DFL = =. EBT Interest 2 =. `2,000 2 `4,000 = = `4,000 EBT = `4,000 `2,000 = `2,000 DOL = Contribution 3 = Contribution `4,000 Contribution = `12,000 P/V ratio = 100% Variable Cost ratio = 100% 75% = 25% Sales = Contribution = `12,000 = `48,000 P/V ratio 25% ADVANCED PROBLEM: DOL (CA IPCE Nov 2015) Question 14: Calculate the Operating Leverage for each of the four firms A, B, C and D from the following price and cost data. Particulars Firms A (`) B (`) C (`) D (`) Sale Price per unit Variable Cost per unit Fixed Operating Cost 80,000 40,000 2,00,000 Nil

4 LEVERAGES By: CA Ashish Kalra What conclusions can you draw with respect to levels of fixed cost and the degree of operating leverage result? Explain. Assume number of units sold is 5,000. Solution: Computation of : Particulars Firms A (`) B (`) C (`) D (`) Sales (units) 5,000 5,000 5,000 5,000 Sales Revenue (Units sold x Sale Price) 1,00,000 1,60,000 2,50,000 3,50,000 Less: Variable Cost (30,000) (80,000) (1,00,000) (2,50,000) Contribution 70,000 80,000 1,50,000 1,00,000 Less: Fixed Operating Costs (80,000) (40,000) (2,00,000) Nil (10,000) 40,000 (50,000) 1,00,000 DOL = Contribution `70,000 (`10,000) = 7 times `80,000 `40,000 = 2 times `1,50,000 (`50,000) = 3 times `1,00,000 `1,00,000 = 1 time The impact of Operating Leverage will exist only when there are fixed costs. In the case of Firm D, there is no magnified effect on the due to change in sales. A 20% increase in sales will result in a 20% increa se in. Practically, it is very difficult to find a firm having DOL = 1, as all business organisations have an exposure of fixed operating costs. In the case of all other firms, Operating Leverage exists. It is maximum in Firm A, followed by Firm C & minimum in Firm B. The maximum DOL is 7 meaning that 1% change in sales will result in 7% change in level in the direction of the change of sales level of Firm A. ADVANCED PROBLEM: DFL Question 15: (a) Compute DFL from the following information:- `50,000 8% Debentures `2,50,000 10% Preference Share Capital `1,00,000 Tax rate 35%. (b) Compute DFL if becomes `1,50,000 Solution: (a) DFL = = `50,000 = `50,000 = `50,000 = Int Pref. div `50,000 `20,000 `10,000 `30,000 `15,385 `14,615 (1 t) 0.65 (b) DFL = = `1,50,000 = `1,50,000 = Int Pref. Div `1,50,000 `20,000 `15,385 `1,14,615 (1 t) DFL & FINANCIAL BREAK EVEN POINT. Question 16: The following information is available for AMD Ltd. PBDIT `830 Cr Depreciation `6 Cr Effective Tax Rate 30% EPS `4 Book Value `30 per share Number of Outstanding Shares 33 Cr D/E ratio 1.5 : 1 Find: (a) Degree of Financial Leverage. (b) Financial Break even point. Solution: = PBDIT Depreciation = `830 Cr - 6 Cr = `824 Cr EPS = EAE No. of Equity Shares EAE = EPS x No. of Equity Shares = `4 x 33 Cr. = 132 Cr EBT = `132 Cr x EBT = ` Cr (a) DFL = = `824 Cr = 4.37

5 LEVERAGES By: CA Ashish Kalra EBT ` Cr (b) Financial Break Even Point = Interest on Debt = EBT = `824 Cr ` Cr = ` Cr PREPARATION OF INCOME STATEMENT FROM VARIOUS LEVERAGES Question 17: From the following financial data of Company A and Company B: Prepare their Income Statements. Particulars Company A (`) Company B (`) Variable Cost 56,000 60% of sales Fixed Cost 20, Interest Expenses 12,000 9,000 Financial Leverage 5 : 1 -- Operating Leverage -- 4 : 1 Income Tax Rate 30% 30% Sales -- 1,05,000 (CA PCC Nov 2009) Solution: Income Statements of Company A and Company B (Amount in `) Particulars Company A Company B Sales 91,000 1,05,000 Less: Variable cost (56,000) (63,000) Contribution 35,000 42,000 Less: Fixed Cost (20,000) (31,500) Earnings before Interest and Tax () 15,000 10,500 Less: Interest (12,000) (9,000) Earnings Before Tax (EBT) 3,000 1,500 Less: 30% (900) (450) Earnings After Tax (EAT) 2,100 1,050 Working Notes: Company A (i) Financial Leverage = - Interest 5 = `12,000 5 ( `12,000) = 4 = `60,000 = `15,000 (ii) Contribution = + Fixed Cost = `15,000 + `20,000 = `35,000 (iii) Sales = Contribution + Variable Cost = `35,000 + `56,000 = `91,000 Company B (i) Contribution = 40% of Sales (as Variable Cost is 60% of Sales) = 40% of `1,05,000 = `42,000 (ii) Operating Leverage = Contribution 4 = `42,000 = `42,000 = `10,500 4 (iii) Fixed Cost = Contribution = `42,000 `10,500 = `31,500 EPS & DCL Question 18: Alpha Ltd. has furnished the following Balance Sheet as on March 31, 2011: Liabilities Amount in ` Assets Amount in ` Equity Share Capital (1,00,000) 10,00,000 Fixed Assets 30,00,000 (Equity share of `10 each) Current Assets 18,00,000 General Reserve 2,00,000 15% Debentures 28,00,000 Current Liabilities 8,00,000 48,00,000 48,00,000

6 LEVERAGES Additional Information: (1) Annual Fixed Cost other than Interest `28,00,000 (2) Variable Cost Ratio 60% (3) Total Assets Turnover Ratio 2.5 (4) Tax Rate 30% By: CA Ashish Kalra You are required to calculate: (i) Earnings per share (EPS), and (ii) Combined Leverage. (CA IPCC Nov 2011) Solution: Total Assets = `48,00,000 Total Assets Turnover Ratio = 2.5 Total Sales = `48,00,000 x 2.5 = `1,20,00,000 Computation of Profit After Tax (PAT) Particulars Amount in ` Sales 1,20,00,000 Less: Variable Cost (60% of Sales Contribution) (72,00,000) Contribution 48,00,000 Less: Fixed Cost (other than Interest) (28,00,000) 20,00,000 Less: Interest on Debentures (15% of 28,00,000) (4,20,000) PBT 15,80,000 Less: (4,74,000) PAT 11,06,000 (i) EPS = PAT = `11,06,000 = `11.06 No. of Equity Shares 1,00,000 (ii) DCL = Contribution = `48,00,000 = 3.04 PBT `15,80,000 DOL, DCL & EPS Question 19: The following information to XL Company Ltd. for the year ended 31 st March, 2013 are available to you: Equity Share Capital of `10 each `25 lakh 11% Bonds of `1,000 each `18.5 lakh Sales `42 lakh Fixed Cost (Excluding Interest) `3.48 lakh Financial Leverage 1.39 Profit-Volume Ratio 25.55% Income Tax Ratio Applicable 35% You are required to calculate (i) Operating Leverage (ii) Combined Leverage and (iii) Earning Per Share (CA IPCC May 2013) Solution: P/V Ratio = Contribution Sales Contribution = 25.55% `42 lakhs Contribution = ` lakhs Income Statement Particulars Amount in ` Sales 42,00,000 Less: Variable Cost (31,26,900) Contribution 10,73,100 Less: Fixed Cost (3,48,000) 7,25,100 Less: Interest (2,03,500)

7 LEVERAGES By: CA Ashish Kalra EBT 5,21,600 Less: 35% (1,82,560) Earnings Available for Equity Shareholders (EAE) 3,39,040 (i) Operating Leverage = Contribution = `10,73,100 = 1.48 `7,25,100 (ii) Combined Leverage = Contribution = `10,73,100 = 2.06 EBT `5,21,600 (iii) Earnings per share (EPS) = EAE = `3,39,040 = ` No. of Equity Shares 2,50,000 DOL, DFL, DCL & EPS Question 20: 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% of sales. Expected annual fixed cost other than interest is `10,00,000. Corporate tax rate is 30%. The company wants to arrange the funds through issuing 4,00,000 equity shares of `10 each and 12% 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, if EPS is (1) `4, (2) `2, (3) `0. (CA PE II Nov 2009) Solution: (i) Calculation of Leverages and Earnings per Share (EPS) Income Statement (Amount in `) Sales Revenue 90,00,000 Less: Variable 60% (54,00,000) Contribution 36,00,000 Less: Fixed Costs other than Interest (10,00,000) Earnings before Interest and Tax () 26,00,000 Less: Interest (12% on `40,00,000) (4,80,000) Earnings Before Tax (EBT) 21,20,000 Less: 30% (6,36,000) Earnings After Tax (EAT) 14,84, DOL = Contribution = `36,00,000 = `26,00, DFL = = `26,00,000 = EBT `21,20, DCL = DOL x DFL = 1.38 x 1.23 = EPS = EAT = `14,84,000 = `3.71 No. of Equity Shares 4,00,000 (ii) Calculation of likely levels of at different EPS: EPS = ( I) (1 t) Number of Equity Shares (1) 4 = ( `4,80,000) (1 0.3) 4,00,000 `4,80,000 = `16,00, `4,80,000 = `22,85,714 = `27,65,714 (2) 2 = ( `4,80,000) ( 1 0.3) 4,00,000 `4,80,000 = `8,00, = `4,80,000 + `11,42,857 = `16,22,857 (3) 0 = ( `4,80,000) (1 0.3) 4,00,000 = `4,80,000 Question 21: A company had the following Balance Sheet as on March 31, 2006: Liabilities and Equity (` in Crores) Assets (` in Crores)

8 LEVERAGES By: CA Ashish Kalra Equity Share Capital (1 crore shares of `10 each) 10 Fixed Assets (Net) 25 Reserves and Surplus 2 Current Assets 15 15% Debentures 20 Current Liabilities The additional information given is as under: Fixed Costs per Annum (Excluding Interest) `8 crores Variable Operating Costs Ratio 65% Total Assets Turnover Ratio 2.5 Income-Tax Rate 40% Required: Calculate the following and comment: (i) Earnings per share (ii) Operating Leverage (iii) Financial Leverage (iv) Combined Leverage (CA PE II Nov 2006, CA IPCC May 2014 Adapted) Solution: Total Assets = `40 crores Total Asset Turnover Ratio = 2.5 Hence, Total Sales = `40 crores x 2.5 = `100 crores Computation of Profits after Tax (PAT) (` in Crores) Sales 100 Less: Variable operation 65% (65) Contribution 35 Less: Fixed cost (other than Interest) (8) 27 Less: Interest on debentures (15% x 20) (3) PBT 24 Less: Tax 40% (9.6) PAT 14.4 (i) EPS = PAT = `14.4 crores = `14.40 No. of Equity Shares 1 crore equity shares (ii) Operating Leverage = Contribution = `35 crores = `27 It indicates the choice of technology and fixed cost in cost structure. It is level specific. When firm operates beyond operating break-even level, then operating leverage is low. It indicates sensitivity of earnings before interest and tax () to change in sales at a particular level. (iii) Financial Leverage = = `27 crores = PBT `24 crores The financial leverage is very comfortable since the debt service obligation is small vis-a-vis. (iv) Combined Leverage = DOL x DFL = x = 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 22: P Ltd. has the following balance sheet and income statement information: Balance Sheet as on March 31 st Liabilities Amount in ` Assets Amount in ` Equity Capital (`10 per share) 8,00,000 Net Fixed Assets 10,00,000 10% Debt 6,00,000 Current Asset 9,00,000 Retained Earnings 3,50,000 Current Liabilities 1,50,000 19,00,000 19,00,000 Income Statement for the year ending March 31 st (Amount in `) Sales 3,40,000 Less: Operating Expenses (including `60,000 depreciation) (1,20,000) 2,20,000 Less: Interest (60,000)

9 LEVERAGES By: CA Ashish Kalra Earnings Before Tax 1,60,000 Less: Taxes (56,000) Net Earnings (EAT) 1,04,000 (a) Determine the degree of operating, financial and combined leverages at the current sales level, if all operating expenses, other than depreciation, are variable costs. (b) If total assets remain at the same level, but sales (i) increase by 20% and (ii) decrease by 20%, what will be the earnings per share at the new sales level? Solution: (a) Calculation of Degree of Operating (DOL), Financial (DFL) and Combined leverages (DCL). DOL = Sales Variable Costs = `3,40,000 `60,000 = `2,20,000 DFL = = `2,20,000 = EBT `1,60,000 DCL = DOL x DFL = x = 1.75 (b) Earnings per share at the new sales level Particulars Increase by 20% Decrease by 20% (`) (`) Sales Level 4,08,000 2,72,000 Less: Variable Expenses (72,000) (48,000) Less: Fixed Cost (60,000) (60,000) Earnings Before Interest and Taxes 2,76,000 1,64,000 Less: Interest (60,000) (60,000) Earnings Before Taxes 2,16,000 1,04,000 Less: Taxes (75,600) (36,400) Earnings After Taxes (EAT) 1,40,400 67,600 Number of Equity Shares 80,000 80,000 EPS DOL, DFL & PERCENTAGE INCREASE IN EPS Question 23: The Share Capital of X Ltd. is `16,00,000 with shares of face value of `10. It has a Debt Capital of `5,00,000 at 12% interest rate. The sales of the firm are 2,50,000 units p.a. at a selling price of `6 p.u. and the variable cost p.u. is `3. The fixed cost amount to `1,00,000 and the company pays 50%. If the sales increases by 20%, calculate: (a) Percentage increases in EPS. (b) Degree of Operating Leverage at the two levels. (c) Degree of Financial Leverage at the two levels. Solution: (a) Income Statement (Amount in `) Particulars 2,50,000 units 3,00,000 units Sales Less: Variable Cost Contribution Less: Fixed Cost Less: Interest EBT Less: 50% 15,00,000 (7,50,000) 7,50,000 (1,00,000) 6,50,000 (60,000) 5,90,000 (2,95,000) 18,00,000 (9,00,000) 9,00,000 (1,00,000) 8,00,000 (60,000) 7,40,000 (3,70,000) EAT 2,95,000 3,70,000 No. of Equity Shares 1,60,000 1,60,000 EPS % change in EPS = ` ` x 100 = % ` (b) DOL = Contribution At Same Level At Incresed Level = `7,50,000 = = `9,00,000 = 1.125

10 LEVERAGES `6,50,000 (c) DFL = EBT At Same Level = `6,50,000 = `5,90,000 `8,00,000 At Incresed Level = `8,00,000 = `7,40,000 By: CA Ashish Kalra DOL, DFL, DTL & OVERALL BREAK EVEN POINT Question 24: Coke (India), sells 5,00,000 bottles of soft drinks a year. Each bottle produced has a variable cost of `2.50 and sells for `4.50. Fixed operating costs are 5,00,000. The company has current interest charges of `60,000 and preferred dividends of `24,000. The corporate tax rate is 40%. (a) Calculate the degree of operating leverage, the degree of financial leverage, and the degree of total leverage. (b) Do part (a) at the 750,000 bottle sales level. (c) What generalisation can you make comparing (a) to (b) after first finding the Overall break even point? Solution: (a) Contribution = `2 x 5,00,000 bottles = `10,00,000 = `5,00,000 Interest = `60,000 Preference Dividend = `24,000 Tax rate = 40% DOL = Contribution = `10,00,000 = 2 times `5,00,000 DFL = = ` 5,00,000 = `5,00,000 = 1.25 times EBT PD `4,40,000 `24,000 `4,00,000 (1 t) 0.6 DTL = DOL x DFL = 2 x 1.25 = 2.5 (b) Contribution = Contribution per unit x Sales Volume = `2 x 7,50,000 bottles = `15,00,000 = `10,00,000 DOL = Contribution = `15,00,000 = 1.5 `10,00,000 DFL = = `10,00,000 = `10,00,000 = 1.11 EBT PD `9,40,000 `24,000 `9,00,000 (1 t) 0.6 DTL = DOL x DFL = 1.5 x 1.11 = 1.66 Overall BEP = Operating FC + Interest + PD (1 t) Contribution per unit Case I Case II `5,00,000 + `60,000 + `40,000 `2 `5,00,000 + `60,000 + `40,000 `2 = `6,00,000 = 3,00,000 units `2 = `6,00,000 = 3,00,000 units `2 As sales move away from overall BEP, riskiness both operational & financial reduces, thus situation II is better for firm. TRADING ON EQUITY Question 25: You are a Finance Manager in Big Pen Ltd. The degree of operating leverage of your company is 5.0. The degree of financial leverage of your company is 3.0. Your Managing Director has found that the degree of operating leverage and the degree of financial leverage of your competitor Small Pen Ltd. are 6.0 and 4.0 respectively. In his opinion, the Small Pen Ltd. is better than that of Big Pen Ltd. because of higher value of degree of leverages. Do you agree with the opinion of you Managing Director? Give Reasons. Solution: Comparative statement of Leverages Particulars Big Pen Ltd. Small Pen Ltd. 1. Operating Leverage = Contribution 5 6

11 LEVERAGES By: CA Ashish Kalra 2. Financial Leverage = EBT Combined Leverage = Contribution EBT The operating leverage of Big Pen Ltd. is 5 and of Small Pen Ltd. is 6. It means in the level of sales will have more impact on of Small Pen Ltd. than that of Big Pen Ltd. The volume of fixed cost may be higher in case of Small Pen Ltd. than that of Big Pen Ltd. The business risk of Small Pen Ltd. is also more as compared to Big Pen Ltd. The Financial Leverage of Big Pen Ltd. is 3, and of Small Pen Ltd. is 4. It means the interest burden of Small Pen Ltd. is higher than Big Pen Ltd. Financial Risk of Small Pen Ltd. is higher as compared to Big Pen Ltd. The degree of combined leverage of Big Pen Ltd. is 15 and that of Small Pen Ltd. is 24. It means any change in sales will show more impact on EPS in case of Small Pen Ltd. In view of the above, the Managing Directors opinion about Small Pen Ltd. is wrong. Big Pen Ltd. carries less business risk and financial risk as compared to Small Pen Ltd. Question 26: Lovedove Ltd. and Lovelee Ltd. are both in the same business, having same Capital employed. Their capital structure & extracts of Income Statement are as follows: (Amount in `) Particulars Lovedove Ltd. Lovelee Ltd. Equity share capital of `10 each 16,00,000 6,00,000 12% Debentures 1,00,000 11,00,000 Net Capital Employed 17,00,000 17,00,000 Earnings Before Interest and Taxes () 5,10,000 5,10,000 Less: Debenture Interest (12,000) (1,32,000) Profit Before Tax (PBT) 4,98,000 3,78,000 Less: 35% (1,74,300) (1,32,300) Profit After Tax (PAT) 3,23,700 2,45,000 Number of Shares 1,60,000 60,000 Show the impact of Trading on Equity by comparing EPS & DFL of the two companies. Solution: Computation of ROI & Debt-Equity Ratio ROI = x 100 Capital Employed Debt Equity Ratio = Debt. Equity Lovedove Ltd. `5,10,000 x 100 = 30% `17,00,000 `1,00,000 = : 1 `16,00,000 Lovelee Ltd. `5,10,000 x 100 = 30% `17,00,000 `11,00,000 = : 1 `6,00,000 Since ROI for both the companies is more than the rate of interest, therefore it can be concluded that both the companies have a favourable financial leverage. Also, Debt/Equity ratio for Lovelee is more; this is will earn more earnings for its shareholders. DFL = EBT `5,10,000 = `4,98,000 `5,10,000 = `3,78,000 Lovelee Ltd. has a higher exposure of financial risk (as can be interpreted from DFL) and is using more debt in its capital structure, this will help the company in magnifying the return for its equity shareholders. EPS = EAT. `3,23,700 = `2.02 `2,45,000 = `4.08 No. of equity shares 1,60,000 60,000 Question 27: ABC Limited has an average cost of debt at 10% and tax rate is 40%. The Financial leverage ratio for the company is Calculate Return on Equity (ROE) if its Return on Investment (ROI) is 20%. (CA PCC May 2007) Solution: ROE = [ROI + {(ROI r) x D/E}] (1 t) = [20% + {(20% 10%) x 0.60}] (1 0.40) = [20% + 6%] x 0.60 = 15.60% IMPACT OF DCL ON EPS Question 28: Consider the following information for Omega Ltd.: Particulars (` in Lakhs) (Earnings before Interest and Tax) 15,750 Earnings before Tax (EBT) 7,000

12 LEVERAGES By: CA Ashish Kalra Fixed Operating Costs 1,575 Required: Calculate percentage change in earnings per share, if sales increase by 5%. (CA PE II Nov 2007) Solution: Contribution = + Fixed Operating Cost = `15,750 + `1,575 = `17,325 DCL = Contribution = `17,325 = EBT `7,000 For every one percent change in sales, EPS will change by 2.475%. Hence, for 5% increase in sales, EPS will increase by %. PERCENTAGE INCREASE IN EPS, DOL AND DFL AT DIFFERENT SALES LEVEL Question 29: The capital structure of the Progressive Corporation consists of an ordinary share capital of `10,000,000 (shares 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 financial leverage at 1,00,000 units and 1,20,000 units. (iii) The degree of operating leverage at 1,00,000 units and 1,20,000 units. 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. Solution: Income Statement (Amount in `) Particulars 1,00,000 units 1,20,000 units Sales 10,00,000 12,00,000 Less: Variable Costs (6,00,000) (7,20,000 Contribution 4,00,000 4,80,000 Less: Fixed Costs (2,00,000) (2,00,000) 2,00,000 2,80,000 Less: Interest (1,00,000) (1,00,000) EBT 1,00,000 1,80,000 Less: Tax (50,000) (90,000) EAT 50,000 90,000 Number of Equity Shares 1,00,000 1,00,000 EPS `0.5 `0.9 (i) Percentage increase in EPS = ( ) x 100 = 80% 0.5 (ii) DFL = EBT At 1,00,000 units At 1,20,000 units = `2,00,000 = 2 times `1,00,000 (iii) DOL = Contribution At 1,00,000 units = `4,00,000 = 2 times `2,00,000 = `2,80,000 = `1,80,000 At 1,20,000 units = `4,80,000 = 1.71 times `2,80,000 As production increases from 1,00,000 units to 1,20,000 units, the DOL & DFL decreases implying risk decreases. RELATIONSHIP BETWEEN DOL & DCL Question 30: Following information are related to four firms of the same industry: Firm Change in Revenue Change in Operating Income Change in Earning per share P 27% 25% 30% Q 25% 32% 24% R 23% 36% 21% S 21% 40% 23% Find out: (i) Degree of Operating Leverage, and

13 LEVERAGES By: CA Ashish Kalra (ii) Degree of Combined Leverage for all the firms. (CA IPCE May 2015) Solution: Firm P Q R S Degree of Operating Leverage (DOL) = % Change in Operating Income % Change in Revenue 25% = % 32% = % 36% = % 40% = % Question 31: The following summarizes the percentage changes in operating income, percentage changes in revenues, and betas for four pharmaceutical firms. Firm Change in Revenue Change in Operating Income Beta PQR Ltd. 27% 25% 1.00 RST Ltd. 25% 32% 1.15 TUV Ltd. 23% 36% 1.30 WXY Ltd. 21% 40% 1.40 Required: (i) Calculate the degree of operating leverage for each of these firms. Comment also. (ii) Use the operating leverage to explain why these firms have different beta. (CA PE II Nov 2004) Solution: (i) Degree of operating leverage is computed as % Change in operating Income/ % Change in Revenue. Firm Degree of Operating Leverage Beta PQR Ltd. RST Ltd. TUV Ltd. WXY Ltd. Degree of Combined Leverage (DCL) = % Change in EPS. % Change in Revenue 30% = % 24% = % 21% = % 23% = % 25%/27% = %/25% = %/23% = %/21% = 1.90 (ii) There is a clear relationship between the degree of operating leverage and the beta. The greater the degree of operating leverage, the more responsive income (and presumably stock returns) will be to changes in revenue which are correlated with changes in market movements. MIXED CONCEPTS OF LEVERAGES & RATIOS Question 32: The following details of RST Limited for the year ended 31st March, 2006 are given below: Operating Leverage 1.4 Combined Leverage 2.8 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% 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 leverage? (iv) At what level of sales the Earning before Tax (EBT) of the company will be equal to zero? (CA PCC May 2007) Solution: (i) DCL = DOL x DFL 2.8 = 1.4 x DFL DFL = 2 (ii) Operating Leverage = Contribution or C. Contribution or C Fixed Cost or F 1.4 = C. C `2,04,

14 LEVERAGES By: CA Ashish Kalra 1.4 (C `2,04,000) = C 1.4 C `2,85,600 = C C = `2,85,600 = `7,14, P/V Ratio = Contribution x 100 = `7,14,000 x 100 = 23.8% Sales `30,00,000 EBT = Sales VC FC Interest = `30,00,000 `22,86,000 `2,04,000 `2,55,000 = `2,55,000 PAT = EBT Tax = `2,55,000 `76,500 = `1,78,500 EPS = Profit After Tax = `1,78,500 = `1.05 No. of Equity Shares `1,70,000 (iii) Assets turnover = Sales = `30,00,000 = Total Assets `38,25, < 1.5 means lower than industry turnover. (iv) Overall BEP = Operating FC + Interest = `2,04,000 + `2,55,000 = `19,28,571 P/V Ratio 23.8% Therefore, at 19,28,571 level of sales, the Earnings before Tax of the company will be equal to zero. Question 33: X Ltd. details are as under: Sales (@ 100 per unit) `24,00,000 Variable Cost 50% Fixed Cost `10,00,000 It has borrowed 10% p.a. and its equity share capital is `10,00,000 (`100 each). The company is in a tax bracket of 50%. Calculate: (a) Operating Leverage (b) Financial Leverage (c) Combined Leverage (d) Return on Equity (e) If the sales increases by `6,00,000; what will the new? Solution: Income Statement (Amount in `) Sales 24,00,000 Less: Variable Cost (12,00,000) Contribution 12,00,000 Less: Fixed Cost (10,00,000) 2,00,000 Less: Interest (1,00,000) EBT 1,00,000 Less: Tax (50%) (50,000) EAT 50,000 No. of equity shares 10,000 EPS 5 (a) Operating Leverage = Contribution = 12,00,000 = 6 times 2,00,000 (b) Financial Leverage = = 2,00,000 = 2 times EBT 1,00,000 (c) Combined Leverage = DOL x DFL = 6 x 2 = 12 times. (d) ROE = EAT x 100 = `50,000 x 100 = 5% Equity Funds `10,00,000 (e) Operating Leverage = % change in % change in Sales 6 x 25% = % change in % change in = 150% Increase in = `2,00,000 x 150% = `3,00,000 New = `5,00,000 Question 34: The following data are available for the ABC Ltd. and XYZ Ltd.:-

15 LEVERAGES By: CA Ashish Kalra Particulars ABC Ltd. XYZ Ltd. Sales Volume 10,000 units 10,000 units Selling Price per unit of output `200 `200 Variable Cost per unit of output `120 `150 Fixed Operating Cost per unit of output `60 `30 Equity `3,00,000 `6,00,000 Preference Shares `1,00,000 Debt `6,00,000 `4,00,000 Interest Rate on Debt 16.25% 15% Dividend Rate on Preference Share 13% Tax Rate 60% 60% (a) Calculate the ROE, DOL, DFL, DCL, Operating Break Even Point, Financial Break Even Point & Overall Break Even Point for each company. (b) As a financial analyst which of the two companies would you described as more risky? Give reasons. Solution: (a) Income Statement (Amount in `) Particulars ABC Ltd. XYZ Ltd. Sales Less: Variable Cost Contribution Less: Fixed Cost Les: Interest EBT Less: Tax EAT Less: Preference Dividend 20,00,000 (12,00,000) 8,00,000 (6,00,000) 2,00,000 (97,500) 1,02,500 (61,500) 41,000 (13,000) 20,00,000 (15,00,000) 5,00,000 (3,00,000) 2,00,000 (60,000) 1,40,000 (84,000) 56,000 - EAT 28,000 56,000 (i) ROE = EAE x 100 Equity Share Holder s Fund ABC Ltd. `28,000 x 100 = 9.33% `3,00,000 (ii) DOL = Contribution ABC Ltd. `8,00,000 = 4 Times `2,00,000 (iii) DFL = XYZ Ltd. `56,000 x 100 = 9.33% `6,00,000 XYZ Ltd. `5,00,000 = 2.5 Times `2,00,000 EBT - Preference Dividend (1 - t) ABC Ltd. = `2,00,000 = `1,02,500 `13, (iv) DCL = DFL x DOL ABC Ltd. XYZ Ltd. = 4 x = = 2.5 x = (v) Operating BEP = Operating Fixed cost Contribution per unit ABC Ltd. XYZ Ltd. = `6,00,000 = 7,500 units 80 XYZ Ltd. = `2,00,000 = 1,428 `1,40,000 0 `3,00,0000 = 6,000 units 50 (vi) Financial BEP = Interest + Preference Dividends

16 LEVERAGES 1 - t ABC Ltd. XYZ Ltd. = `97,500 + `13,000 = `1,30,000 = 60, = `60,000 (1 0.6) (vii) Overall BEP = Operating F.C + Interest + Pre. Dividend 1 t. Contribution per unit ABC Ltd. = 6,00, , ,000 (1 0.6) = 9,125 Units `80 XYZ Ltd. = `3,00,000 + `60, = 7,200 Units `50 By: CA Ashish Kalra (b) ABC Ltd. is more risky than XYZ Ltd. because its operating & financial leverage is higher than XYZ Ltd. and his combined leverage is also higher. SELF ASSESSMENT PROBLEMS BASIC PROBLEM: DOL, DFL & DCL Question 1: The following information is available in respect of two firms, P Ltd. and Q Ltd.: (` in Lakhs) Particulars P Ltd. Q Ltd. Sales Less: Variable Cost (200) (300) Contribution Less: Fixed Cost (150) (400) Less: Interest (50) (100) Profit Before Tax You are required to calculate different leverages for both the firms and also comment on their relative risk position. [Ans: DOL: P Ltd = 2, Q Ltd = 2.33; DFL: P Ltd = 1.5, Q Ltd = 1.5; DCL: P Ltd = 3, Q Ltd = 3.5] ADVANCED PROBLEM: DOL Question 2: Star Industries Ltd. a well established firm in plastics is considering the purchase of one of the two manufacturing companies. The financial manager of the company has developed the following information about the two companies. Both companies have total assets of `15,00,000. (Amount in `) Particulars X Ltd. Y Ltd. Sales Revenue Less: Cost of Goods Sold Selling Expenses Administration Expenses Depreciation 30,00,000 (22,50,000) (2,40,000) (90,000) (1,20,000) 30,00,000 (22,50,000) (2,40,000) (1,50,000) (90,000) 3,00,000 2,70,000 Cost break-ups Cost of Goods Sold : Variable Costs Fixed Costs 9,00,000 13,50,000 18,00,000 4,50,000 Total 22,50,000 22,50,000 (i) Prepare operating statements for both the companies, assuming that sales increase by 20%. The total fixed costs are likely to remain unchanged and the variable costs are a linear function of sales. Presume that 62.5% of selling expenses of both companies varies with sales and the remaining remains fixed. (ii) Calculate the degree of operating leverage at current level of sales. (iii) If Star Industries Ltd. wishes to buy a company which has a lower degree of business risk, which company would be purchased by it?

17 LEVERAGES By: CA Ashish Kalra [Ans: (i) : X Ltd = `6,90,000, Y Ltd : `4,80,000; (ii) DOL = X Ltd = 6.5, Y Ltd = 3.88; (iii) Y Ltd.] ADVANCED PROBLEM: DOL, DFL, DCL Question 3: XYZ and Co. has three financial plans before it, Plan I, Plan II, Plan III. Calculate operating and financial leverage for the firm on the basis of the following information and also find out the highest and lowest value of combined leverage. Production 800 units Selling Price per unit `15 Variable Cost per unit `10 Fixed Cost: Situation A `1,000 Situation B `2,000 Situation C `3,000 Capital Structure Plan I Plan II Plan III Equity Capital `5,000 `7,500 `2,500 12% Debt 5,000 2,500 7,500 [Ans: Situation A Situation B Situation C DOL Plan I Plan II Plan III Plan I Plan II Plan III Plan I Plan II Plan III DFL DCL ] PREPARATION OF INCOME STATEMENT FROM VARIOUS LEVERAGES Question 4: From the following, prepare Income Statements of Firms A, B and C. Particulars Firm A Firm B Firm C Financial Leverage 3:1 4:1 2:1 Interest `200 `300 `1,000 Operating Leverage 4:1 5:1 3:1 Variable cost as a % of sales 66.67% 75% 50% Income tax rate 45% 45% 45% [Ans: Sales - Firm A = `3,600, Firm B = `8,000, Firm C = `12,000] DOL & OPERATING BREAK EVEN POINT Question 5: Majnu Ltd. sells its `1,000 per unit. The variable cost of production is `600 per unit. The firm has a fixed cost of `50,00,000. (a) Compute the Operating BEP. (b) Compute DOL, assuming that the sales of Majnu Ltd. is (i) 12,500 units (ii) 15,000 units (iii) 20,000 units (iv) 25,000 units (v) 40,000 units [Ans: (a) Operating BEP = 12,500 units; (b) DOL = (i), (ii) 6, (iii) 2.67, (iv) 2, (v) 1.45] Question 6: X Corporation has estimated that for a new product, its operating break-even point is 2,000 units, if the item is sold for `14 per unit. The cost accounting department has currently identified variable cost of `9 per unit. Calculate the operating leverage for sales volume of `2,500 units and 3,000 units. What do you infer from the Operating Leverage of the sales volumes of 2,500 units and 3,000 units and their difference, if any? (CA IPCC Nov 2012 Adapted) [Ans: DOL (2,500 units) = 5; DOL (3,000 units) = 3] DFL & FINANCIAL BREAK EVEN POINT Question 7: Romeo Ltd. sells its `10 per unit. The variable cost of production is `4 per unit. The firm has a fixed cost of `4,00,000. The Company has 10% Bonds of `20,00,000. (a) Compute the Financial BEP. (b) Compute DFL, assuming that the sales of Romeo Ltd. is (i) 1,00,000 units

18 LEVERAGES By: CA Ashish Kalra (ii) 1,50,000 units (iii) 2,00,000 units (iv) 2,50,000 units (v) 4,00,000 units [Ans: (a) Financial BEP = `2,00,000 (b) DFL = (i), (ii)1.67, (iii) 1.33, (iv) 1.22, (v) 1.11] DOL & OVERALL BREAK EVEN POINT Question 8: Saraju Ltd. produces electronics components with a selling price per unit of `100. Fixed cost amount to `2,00,000. 5,000 units are produced and sold each year. Annual profits amount to `50,000. The company s all equity financed assets are `5,00,000. The company proposes to change its production process, adding `4,00,000 to investment and `50,000 to fixed operational costs. The consequences of such a proposal are: (i) Reduction in variable cost per unit by `10 (ii) Increase in output by 2,000 units (iii) Reduction in selling price per unit to `95 Assuming a rate of interest on debt is 10%, examine the above proposal and advice whether or not the company should make the change. Ignore taxation. Also measure the degree of operating leverage and overall break- even- point. [Ans: Increase in NP = `45,000; DOL (Present) = 5, (Proposed) = 2.85; BEP (Present) = 4000 units, (Proposed) = 5273 units] LEVERAGES & BREAK EVEN POINTS Question 9: Compute Financial BEP, Overall BEP (in units), DFL, DCL & DOL from the following information: Sales Quantity = 30,000 units Selling Price p.u. = `150 Variable Cost p.u. = `100 Operating Fixed Cost = `5,00,000 Income Tax Rate = 40% 10% Debentures = `20,00,000 12% Preference Share Capital = `20,00,000 Retained Earnings = `20,00,000 Equity Share Capital (`10 shares) = `30,00,000 [Ans: Financial BEP = `6,00,000; Overall BEP = 22,000 units; DFL = 2.5; DCL = 3.75; DOL = 1.5] DOL, DFL, DCL & EPS Question 10: The balance sheet of Alpha Numeric Company is given below: Liabilities (Amount in `) Assets (Amount in `) Equity Capital (`10 per share) 90,000 Net Fixed Assets 2,25,000 10% Long Term Debt 1,20,000 Current Assets 75,000 Retained Earnings 30,000 Current Liabilities 60,000 3,00,000 3,00,000 The company s total assets turnover ratio is 3, its fixed operating cost is `1, 50, 000 and its variable operating cost ratio is 50%. The income tax is 50%. You are required to: (i) Calculate the different type of leverages for the company. (ii) Determine the likely level of if EPS is: (a)`1, (b) `2 & (c) `0. [Ans: (i) DOL = 1.5, DFL = 1.04, DCL = 1.56; (ii) = (a) `30,000, (b) `48,000, (c) `12,000] Question 11: The following is the income statement of XYZ Ltd. for the year 1998: (Amount in `) Sales 50 lakh Less: Variable Cost (10 lakh) Less: Fixed Cost (20 lakh) 20 lakh Less: Interest (5 lakh) Profit Before Tax 15 lakh Less: Tax at 40% (6 lakh) Profit After Tax 9 lakh

19 LEVERAGES By: CA Ashish Kalra Less: Preference Dividend (1 lakh) Profit for Equity Share Holders 8 lakh The company has 4 lakh equity shares issued to the shareholder. Find out the degree of (i) Operating leverage, (ii) Financial leverage, and (iii) Combined leverage. (iv) What would be the EPS if the sales level increases by 10% and the EPS if the sales level decreases by 20%. [Ans: (i) DOL = 2, (ii) DFL = 1.5, (iii) DCL = 3, (iv) EPS = `2.6, `0.8] DOL, DFL & ROE Question 12: The following figures are available for success & Co: Net sales `15 crores as percentage of Net Sales 12% Capital employed: (a) Equity `5 crores; (b) Preference Shares of `1 crore bearing 13% Rate of Dividend; (c) 15% `3 crores. Given that its Combined Leverage = 3 The applicable Income Tax is to be taken as 40%. You are required to calculate: (i) The Return on Equity of the company; and (ii) the Financial Leverage of the company (iii) the Operating Leverage of the company. [Ans: ROE = 13.6%, DFL = 1.588, DOL = 1.889] IMPACT OF DOL ON Question 13: If DOL is 2.5 and on 20% increase in sales from the present level, the changes to `30,00,000, what is the present level of sales & fixed cost if variable cost ratio is 50%. [Ans: Sales = `1,00,00,000; Fixed Cost = `30,00,000] IMPACT OF DFL ON EPS Question 14: Compute DFL from the following information: = `20,00,000 10% Debentures = `50,00,000 Income Tax Rate = 40% Equity Share Capital (`10 shares) = `45,00,000 (a) Using the concept of DFL, show the effect of DFL on EPS if is expected to increase by 30% from the present level. (b) If DFL is 2, determine the amount of 12% Preference Share Capital. [Ans: (a) EPS will increase by 40%; (b) Amount of 12% Preference Share Capital = `25,00,000] IMPACT OF DCL ON EPS Question 15: The following information is available for ABC & Co. `11,20,000 Profit before Tax `3,20,000 Fixed Costs `7,00,000 Calculate % change in EPS if the sales are expected to increase by 5%. [Ans: % Change in EPS = %] IMPACT OF LEVERAGES ON EARNINGS Question 16: The following data relate of Company XYZ Ltd.: (Amount in `) Sales 2,00,000 Less: Variable Expenses (30%) (60,000) Contribution 1,40,000 Fixed Operating Expenses (1,00,000) 40,000 Less: Interest (5,000) Taxable Income 35,000 (1) Using the concept of combined leverage, by what percentage will taxable income & hence EPS increase if sales increase by 6%? (2) Using the concept of operating leverage, by what percentage will increase if there is a 10% increase in sale?

20 LEVERAGES By: CA Ashish Kalra (3) Using the concept of financial leverage, by what percentage the taxable income and hence EPS will increase if is increases by 7%? [Ans: (1) % Increase in EPS = 24%; (2) % Increase in = 35%; (3) % Increase in EPS = 8%] TRADING ON EQUITY Question 17: Jova Ltd., Kova Ltd. and Nova Ltd. give the following information relating to the accounting year to (` in Lakhs) Particulars Jova Ltd. Kova Ltd. Nova Ltd. Net Assets Less : Short Term Loan, Current Liabilities and Provisions (2) (2) (2) Long Term Capital Employed Consisting of: Equity Share Capital % Long Term Loan Earnings Before Interest on Long Term Loan & Tax l.5 Tax rate is 50%. Find out the effect of financial leverage. [Ans: ROE : Jova Ltd. = 11.25%, Kova Ltd. = 10.00%, Nova Ltd. = 8.33%] Question 18: A firm has sales of `75,00,000, variable cost of `42,00,000 and fixed cost of `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 R.O.I.? (ii) Does it have favorable financial leverage? (iii) What are the operating, financial, and combined leverage of the firm? (iv) If the sales drop to `50,00,000, what will be the new E.B.I.T.? (v) If the firm belongs to an industry whose capital turnover is 3, does it have a high or low capital turnover? (vi) At what level of sales the EBT of the firm will be equal to zero? (vii) If increases by 20%, by what percentage EBT will increase? [Ans: (i) R.O.I. = 27%, (ii) Favorable (iii) DOL = 1.222, DFL = 1.176, DCL = 1.435, (iv) New E.B.I.T = 16,00,000, (v) Capital Turnover = 0.75 times (low as compared to industry), (vi) `22,84,091, (vii) 23.52% ] Question 19: The net sales of A Ltd. are `30 crores. Earnings 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%. (i) Calculate the Return-on-equity for the company and indicate its segments due to the presence of Preference Share Capital and Borrowing (Debentures). (ii) Calculate the Operating Leverage of the Company given that combined leverage is 3. [Ans: (i) ROE = 13.6%, Segment due to Preference Shares = - 0.2%, Segment due to Borrowing = + 1.8%; DOL = 1.889] RELATIONSHIP BETWEEN DCL & BETA Question 20: The following summarises the percentage change in E.P.S, percentage change in revenues, & betas for four companies in automobile business. Name of Companies Change in Revenues Change in EPS Beta Tata Motors Maruti Udyog Ashok Leyland General Motors 10% 20% 25% 30% (a) Calculate the Degree of Combined Leverage for each of these companies. (b) If the Degree of operating leverage of these four companies is 2.5, 2, 2.25 & 1.2 respectively for Tata Motors, Maruti Udyog, Ashok Leyland and General Motors. Compute Degree of financial Leverage. (c) Explain why these companies have different betas. [Ans: (a) DCL = 5, 4, 3, 2.5; (b) DFL = 2, 2, 1.33, 2.083; (c) Higher the DCL, higher the Beta] MIXED CONCEPTS OF LEVERAGES & RATIOS Question 21: Calculate the Degree of Operating Leverage, Degree of Financial Leverage and Degree of Combined Leverage from the following data: Sales `1,00,00,000 50% 80% 75% 75%

21 LEVERAGES By: CA Ashish Kalra Debt/Equity 3/1 P/V Ratio 50% Interest Rate 12% Operating Profit `20,00,000 Capital Turnover Ratio 0.8 times [Ans: DOL = 2.5, DFL = 2.28, DCL = 5.7] Question 22: If the combined leverage and operating leverage figures of a company are 2.5 and 1.25 respectively, find the financial leverage and P/V ratio, given that the equity dividend per share is `2, interest payable per year is `1 lakh, Total Operating Fixed Cost `0.5 lakh and Sales `10 lakhs. [Ans: DFL = 2, P/V Ratio = 25%] Question 23: Use the following data and solve the problem: Total Sales 1,50,000 Units Selling Price `25 Fixed Cost `2,80,000 Variable Cost `20 Debt 11% interest rate Equity `20,00,000 Face Value of Each Share `10 Tax Rate 45% (a) How much the company s sale have to come down so that the earnings before taxes is equal to zero? (b) If doubles, what will be the new level of EBT? (c) What are the operating and combined leverages? (d) If the Assets turnover of the industry is 0.75, does the firm have a high or low degree of asset turnover? [Ans: (a) Sales reduce by 72,000 units; (b) EBT = `8,30,000; (c) DOL = 1.596, DCL = 2.083; (d) High degree] Question 24: Shamkeen Company is a closely held corporation with a capital structure composed entirely of common stock and retained earnings. The stock-holders have an agreement with the company that states the company will purchase the stock of a shareholder should a shareholder want to sell his or her holdings in the company. The agreement states that the stock will be purchased at a price equal to the stock s previous year-end book value per share. Early in October 2004 Mrs. Jane Vadra, a widow of one of Shamkeen s major stockholders, expressed an interest in selling her stock in accordance with the buy back pricing arrangement. Mrs. Jane Vadra owns 600,000 shares of the 3 million shares of Shamkeen Company common stock. The board of directors has concluded that the company must replace the capital used to repurchase the shares. The board has assurance that it would be able to finance the acquisition of stock by borrowing the necessary funds through private placement at an annual interest rate of 10%. Thus the company would have capital provided by debt and perhaps be able to take advantage of financial leverage. The Board and Mrs. Jane Vadra agreed that the exchange will take place on January 1, The book value per share of common stock is projected to be `50 on December 31, The controller of Shamkeen Company had prepared a forecast and Performa statements for the 2005 year. An excerpt of the forecasted earnings statement for the year ended December 31, 2005 is presented below (in thousands of `). Shamkeen used a 40% income tax rate in forecasted statement. The Performa statements do not reflect the repurchase of Mrs. Jane Vadra s shares or the new issue of debt required to pay for the shares. Particulars (` in 000) Income Before Interest & Taxes 50,000 Less: Income Taxes (40%) (20,000) Net Income 30,000 (a) Revise the excerpt from Shamkeen Company s forecasted earnings statement for the year ended December 31, 2005, to reflect the long term financing to be used to purchase Mrs. Jane Vadra s common stock. (b) Explain the impact the long-term debt financing would have on Shamkeen Company s earnings per share and return on stockholder s equity using the forecasted data for (c) Identify and discuss the advantages and disadvantages of financial leverage for a company that has a capital structure similar to that of Shamkeen Company before and after this long term debt has been added. [Ans: (a) Net Profit (` in 000s) = 28,200; (b) EPS before Buyback = `10, EPS after Buyback = `11.75; ROE before Buyback = 20%, ROE after Buyback = 23.5%; Advantage = Trading on Equity, Disadvantage = Increased financial risk & Ke]