5

LEVERAGE

Question 1
Calculate the operating leverage, financial leverage and combined
leverage from the following data under Situation I and II and
Financial Plan A and B:
Installed Capacity 4,000 units
Actual Production and Sales 75% of the
Capacity
Selling Price Rs. 30 Per Unit
Variable Cost Rs. 15 Per Unit
Fixed Cost:
Under Situation I Rs. 15,000
Under Situation-II Rs.20,000
Capital Structure:
Financial
Plan
A B
Rs. Rs.
Equity 10,000 15,000
Debt (Rate of Interest 10,000 5,000
at 20%)
20,000 20,000

(Final-May 1996) (14 marks)

Answer
Operating Leverage: Situation-I Situation-II
Rs. Rs.
Sales (s) 90,000 90,000
3000 units @ Rs. 30/- per unit
Less: Variable Cost (VC) @ Rs. 45,000 45,000
15 per unit
5.2 Financial Management

Contribution (C) 45,000 45,000

Less: Fixed Cost (FC) 15,000 20,000
Operating Profit (OP) 30,000 25,000
(EBIT)

Operating Leverage:
C 45,000 45,000
= Rs. Rs.
OP 30,000 25,000
= 1.5 1.8
(ii) Financial Leverages:

A B
(Rs.) (Rs.)
Situation 1
Operating Profit (EBIT) 30,000 30,000
Less: Interest on debt 2,000 1,000
PBT 28,000 29,000

OP 30,000 30,000
Financial Leverage = = Rs. = 1.07 Rs. =1.04
PBT 28,000 24,000

A B
(Rs.) (Rs.)
Situation-II
Operating Profit (OP) 25,000 25,000
(EBIT)
Less: Interest on debt 2,000 1,000
PBT 23,000 24,000

OP 25,000 25,000
Financial Leverage = = Rs. = 1.09 Rs. = 1.04
PBT 23,000 24,000
(iii) Combined Leverages :
A B
(Rs.) (Rs.)
(a) Situation I 1.5 x 1.07 =1.6 1.5 x 1.04 =
1.56
(b) Situation II 1.8 x 1.09 1.8 x 1.04
=1.96 =1.87
 Leverage 5.3

Question 2
A firm has sales of Rs. 75,00,000 variable cost of Rs. 42,00,000 and
fixed cost of
Rs. 6,00,000. It has a debt of Rs. 45,00,000 at 9% and equity of Rs.
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 asset turnover is 3, does
it have a high or low asset leverage?
(iv) What are the operating, financial and combined leverages of the
firm?
(v) If the sales drop to Rs. 50,00,000, what will be the new EBIT?
(vi) At what level the EBT of the firm will be equal to zero? (Final-May
1997) (11 marks)
Answer
Workings:
Rs.
Sales 75,00,000
Less: Variable cost 42,00,000
Contribution 33,00,000
Less: Fixed costs 6,00,000
EBIT 27,00,000
Less: 9% interest on Rs. 4,05,000
45,00,000
EBT 22,95,000
EBIT EBIT 27,00,000
(i) ROI = Investme = Debt + Equity = Rs.1,00,00,0000
= 27% nt

(ii) Since the return on investment (27%) is higher than the interest
payable on debt at 9%, the firm has a favourable financial
leverage.

Net Sales
(iii) Asset Turnover =
Total assets = Total Investment
75,00,00
Firm’s Asset Turnover is =0 = 0.75
1,00,00,
000
5.4 Financial Management

The industry average is 3. Hence the firm has low asset

leverage.
Contributi
33,00,000
(iv) Operating leverageon = = = 1.2222
27,00,000
EBIT
EBIT 27,00,000
Financial leverage = EBT =
22,95,000 = 1.1764

Contributi
33,00,000
Combined leverage = on = = 1.438
22,95,000
EBT
(OR)
Combined leverage = Operating leverage x Financial leverage
= 1.2222 x 1.1764 =1.438
(v) If the sales drop to Rs. 50,00,000 from Rs. 75,00,000, the fall is
by 33.33% Hence EBIT will drop by 40.73%
(%Fall in sales x operating leverage)
Hence the new EBIT will be Rs. 27,00,000 x (1- 40.73%)
= Rs. 16,00,290 or rounded upto Rs. 16,00,000
(vi) EBT to become zero means 100% reduction in EBT. Since the
combined leverage is 1.438, sales have to drop by 100/1.438 i.e.
69.54%. Hence the new sales will be Rs. 75,00,000 x (1- 69.54%)
= Rs. 22,84,500 (approx.)
Question 3
From the following, prepare Income Statement of Company A, B and
C. Briefly comment on each company’s performance:
Company A B C
Financial leverage 3:1 4:1 2:1
Interest Rs. 200 Rs. 300 Rs. 1,000
Operating leverage 4:1 5:1 3:1
Variable Cost as a
Percentage to
Sales 2 75% 50%
66 %
3
Income tax Rate 45% 45% 45%
(Final-Nov. 1997) (12 marks)
Answer
 Leverage 5.5

Working Notes:
Company A
EBIT 3
Financial leverage EBT
= = = or EBIT = 3 x EBT …….
1
(1)

Again EBIT – Interest = EBT

Or EBIT-200 = EBT ……..(2)
Taking (1) and (2) we get 3EBT-200 = EBT
or 2 EBT = 200 or EBT = Rs. 100
Hence EBIT = 3EBT = Rs. 300

Contribution
Again we have operating leverage = 4 =
EBIT 1

EBIT = Rs. 300, hence we get

Contribution = 4 x EBIT =Rs. 1,200
2
Now variable cost = 66 % on sales
3
2 1
Contribution = 100- 66 % i.e. 33 % on sales
3 3

1200
Hence sales = 1 = Rs. 3,600
33 %
3
Same way EBIT, EBT, contribution and sales for company B and C can
be worked out.
Company B
EBIT 4
Financial leverage = = or EBIT = 4 EBT
EBIT 1
…….(3)
Again EBIT – Interest = EBT or EBIT – 300 =EBT
…….(4)
Taking (3) and (4) we get, 4EBT-300=EBT
or 3EBT = 300 or EBT=100
5.6 Financial Management

Hence EBIT = 4 x EBT=400

Contribution 5
Again we have operating leverage EBT
= 1 =

EBIT= 400 ; Hence we get contribution = 5 x EBIT =2000

Now variable cost =75% on sales
Contribution = 100- 75% i.e. 25% on sales

2,000
Hence Sales =25% = Rs. 8,000

Company C
EBIT 2
Final leverage = = = or EBIT = 2EBT
EBIT 1
……….. (5)

Again EBIT- Interest = EBT or EBIT– 1000=EBT

……….. (6)

Taking (5) and (6) we get, 2EBT-1000 =EBT or EBT =1,000

Hence EBIT = 2 x EBT = 2 x 1,000= 2,000

Contributi
on 3
Again we have operating leverage = =
EBIT 1
EBIT=2,000, Hence we get contribution = 3 x EBIT =6,000
Now variable cost = 50% on sales
Contribution = 100-50=50% on sales
6,000
Hence sales = = Rs. 12,000
50%
Income Statement
A B C
Rs. Rs. Rs.
Sales 3,600 8,000 12,000
Less: Variable 2,400 6,000 6,000
cost
 Leverage 5.7

Contribution 1,200 2,000 6,000

Less: Fixed cost 900 1,600 4,000
EBIT 300 400 2,000
Less: Interest 200 300 1,000
EBT 100 100 1,000
Less: Tax 45% 45 45 450
EAT 55 55 550

Comments on Company’s Performance:

The financial position of company C can be regarded better than
that of other Companies A & B because of the following reasons:
(i) Financial leverage is the measure of financial risk. Company C
has the least financial risk as it has minimum degree of financial
leverage. No doubt it is true that there will be a more magnified
impact on earnings per share on A and B companies than that of
C due to change in EBIT but their EBIT level due to low sales is
very low suggesting that such an advantage is not great.
(ii) Degree of combined leverage is maximum in company B - 20, for
Company A - 12 and for Company C – 6. Clearly, the total risk
(business and financial) complexion of Company C is the lowest,
while that of the other firms are very high.
(iii) The ability of Company C to meet interest liability is better than
that of Companies A and B.

EBIT/Interest ratio for three companies:

2,000
C= =2
1,000
400
B= = 1.33
300
300
A= = 1.5
200
Question 4
Consider the following information for Strong Ltd:
EBIT 1,120 Rs. in lakh
PBT 320 Rs. in lakh
Fixed Cost 700 Rs. in lakh
Calculate the percentage of change in earnings per share, if sales
increased by 5 per cent.
5.8 Financial Management

(Final-Nov. 2001) (6 marks)

Answer
Computation of percentage of change in earnings per share, if sales
increased by 5%

%change
inEarning
pershare
(EPS)
Degree of Combined leverage =
%change insales

or Degree of operating leverage x Degree of financial leverage =

%change
inEarning
pershare
(EPS)
%change insales

or 1.625 x 3.5 (Refer to working notes (i) and (ii) =

%change inEarning
pershare
(EPS)
5
%change inEarning
pershare
(EPS)
or 5.687 =
5
or % change in EPS = 5.687 x 5
= 28.4375%
Working Notes:
Contributi
on
(i) Degree of operating leverage (DOC) =
EBIT
( Rs.1,120+ Rs.700lakhs
)
=
Rs.1,120lakhs
= 1.625
EBIT
(ii) Degree of financial leverage (DOF) =
PBT
Rs.1,120
=
Rs.320
= 3.5
Question 5
The net sales of A Ltd. is Rs. 30 crores. Earnings before interest and
tax of the company as a percentage of net sales is 12%. The capital
employed comprises Rs. 10 crores of equity, Rs. 2 crores of 13%
Cumulative Preference Share Capital and 15% Debentures of Rs. 6
crores. Income-tax rate is 40%.
 Leverage 5.9

(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.
(Final-May 2002) (6 marks)
Answer
(i) Net Sales : Rs. 30 crores
EBIT Rs. 3.6 crores @ 12% on sales
EBIT 3.6
ROI = = × 100= 20%
Employed10+ 2+ 6
Capital
Rs. in

EBIT 3.6
Interest on Debt 0.9
EBT 2.7
Less : Tax @ 40% 1.08
EAT 1.62
Less : Preference dividend 0.26
Earnings available for Equity 1.36
Shareholders
Return on equity = 1.36/10x
100=13.6%

Segments due to the presence of Preference Share

capital and Borrowing (Debentures)
Segment of ROE due to preference capital : [.20(1-.4)-.13] x .2
=-.002
Segment of ROE due to Debentures: [.20 (1-.4) - .15 (1-.4)] x .6
=-.018
or -.2% + 1.8% =1.6%
5.10 Financial Management

The weighted average cost of capital is as follows

Source Proportion Cost (%) WACC(%)
(i) Equity 10/18 13.60 7.56
(ii) Preference 2/18 13.00 1.44
shares
(iii) Debt 6/18 9.00 3.00
Total 12.00

EBIT
(ii) Degree of Financial Leverage =
EBIT- Interest
- Preference
dividend
3.6
= = 1.4757
3.6– .9 – .26

Degree of Combined Leverage = DFL x DOL

3 = 1.4754 x DOL
3
∴ DOL =
1.4754

Degree of Operating Leverage =2.033

Question 6
The data relating to two Companies are as given below:

Company Company
A B
Equity Capital Rs.6,00,00 Rs.3,50,00
0 0
12% Debentures Rs.4,00,00 Rs.6,50,00
0 0
Output (units) per annum 60,000 15,000
Selling price/ unit Rs.30 Rs.250
Fixed Costs per annum Rs.7,00,00 Rs.14,00,0
0 00
Variable Cost per unit Rs.10 Rs.75
 Leverage 5.11

You are required to calculate the Operating leverage, Financial

leverage and Combined leverage of two Companies. (PE-II-Nov.
2002) (4 marks)
5.12 Financial Management

Answer
Computation of degree of Operating leverage, Financial
leverage
and Combined leverage of two companies

Company A Company B
Output units per annum 60,000 15,000
Rs. Rs.
Selling price / unit 30 250
Sales revenue 18,00,000 37,50,000
(60,000 units × (15,000 units ×
Rs.30) Rs.250)
Less: Variable costs 6,00,000 11,25,000
(60,000 units × (15,000 units ×
Rs.10) Rs.75)
Contribution (C) 12,00,000 26,25,000
Less: Fixed costs 7,00,000 14,00,000
EBIT 5,00,000 12,25,000
Less: Interest @ 12% on 48,000 78,000
debentures
PBT 4,52,000 11,47,000

C 2.4 2.14
DOL =
EBIT (Rs.12,00,000 / (Rs.26,25,000 /
Rs.5,00,000) Rs.12,25,000)
EBIT 1.11 1.07
DFL =
PBT (Rs.5,00,000 / (Rs.12,25,000 /
Rs.4,52,000) Rs.11,47,000)
DCL = DOL × 2.66 2.29
DFL
(2.4× 1.11) (2.14× 1.07)

Question 7
The following summarises the percentage changes in operating
income, percentage changes in revenues, and betas for four
pharmaceutical firms.
Firm Change in Change in operating Beta
revenue income
PQR Ltd. 27% 25% 1.00
 Leverage 5.13

RST Ltd. 25% 32% 1.15

TUV Ltd. 23% 36% 1.30
WXY 21% 40% 1.40
Ltd.
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.
(PE-II-Nov. 2004) (6 marks)
Answer
%Change
inOperating
income
(i) Degree of operating leverage =
%ChangeinRevenues
PQR Ltd . = 25% / 27% = 0.9259
RST Ltd. = 0.32 / 0.25 = 1.28
TUV Ltd. = 0.36 / 0.23 = 1.5652
WXY Ltd. = 0.40 / 0.21 = 1.9048
It is level specific.
(ii) High operating leverage leads to high beta. The sources of risk
are the cyclic nature revenues, operating risk and financial risk.
Question 8
A Company had the following Balance Sheet as on March 31, 2006:
Liabilities and Equity Assets Rs. (in
Rs. (in crores) crores)
Equity Share Capital Fixed Assets 25
(one crore shares of Rs. 10 (Net) 15
10 each) Current Assets
Reserves and Surplus 2
15% Debentures 20
Current Liabilities 8 ___
40 40
The additional information given is as under:
Fixed Costs per annum (excluding interest) Rs. 8 crores
Variable operating costs ratio 65%
5.14 Financial Management

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. (PE-II-Nov. 2006)
(8 marks)
 Leverage 5.15

Answer
Total Assets = Rs. 40 crores
Total Asset Turnover Ratio = 2.5
Hence, Total Sales = 40 × 2.5 = Rs. 100
crores
Computation of Profits after Tax (PAT)
(Rs. in crores)
Sales 100
Less: Variable operating cost @ 65% 65
Contribution 35
Less: Fixed cost (other than Interest) 8
EBIT 27
Less: Interest on debentures (15% × 20) 3
PBT 24
Less: Tax 40% 9.6
PAT 14.4
(i) Earnings per share
Rs.14.4crores
∴ EPS = = Rs. 14.40
1croreequity shares
(ii) Operating Leverage
Contribution 35
Operatingleverage= = =1.296
EBIT 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 (EBIT) to
change in sales at a particular level.
(iii) Financial Leverage
EBIT 27
FinancialLeverage= = =1.125
PBT 24
The financial leverage is very comfortable since the debt service
obligation is small vis-à-vis EBIT.
(iv) Combined Leverage
Contribution EBIT
CombinedLeverage= ×
EBIT PBT
5.16 Financial Management

= 1.296 × 1.125
= 1.458
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-à-vis change in sales.
The leverages − operating, financial and combined are measures
of risk.
Question 9
Consider the following information for Omega Ltd.:
Rs. in
lakhs
EBIT (Earnings before Interest and Tax) 15,750
Earnings before Tax (EBT): 7,000
Fixed Operating costs: 1,575
Required:
Calculate percentage change in earnings per share, if sales increase
by 5%.
(PE-II-Nov. 2007) (3 marks)
Answer
Degree of Operating Leverage (DOL)
on EBIT+ Fixed
Contributi Cost
= =
EBIT EBIT
+ 1,575
15,750
= = 1.1
15,750
Degree of Financial Leverage (DFL)
EBIT 15,750
= = = 2.25
EBT 7,000
Degree of Combined Leverage (DCL)
= DOL × DFL
= 1.1 × 2.25
= 2.475
Percentage Change in Earnings per share
 Leverage 5.17

%changeinEPS
DCL=
%change
inSales
%change
inEPS
=
2.475
5%
∴ % change in EPS = 12.375%.
Question 10
Delta Ltd. currently has an equity share capital of Rs. 10,00,000
consisting of 1,00,000 Equity share of Rs. 10 each. The company is
going through a major expansion plan requiring to raise funds to the
tune of Rs. 6,00,000. To finance the expansion the management has
following plans:
Plan-I : Issue 60,000 Equity shares of Rs. 10 each.
Plan-II: Issue 40,000 Equity shares of Rs. 10 each and the
balance through long- term borrowing at 12%
interest p.a.
Plan-III : Issue 30,000 Equity shares of Rs.10 each and
3,000 Rs.100, 9% Debentures.
Plan-IV : Issue 30,000 Equity shares of Rs. 10 each and the
balance through 6% preference shares.
The EBIT of the company is expected to be Rs. 4,00,000 p.a. assume
corporate tax rate of 40%.
Required:
(i) Calculate EPS in each of the above plans.
(ii) Ascertain the degree of financial leverage in each plan. (PE-II-
May 2008) (8 marks)
Answer
Computation of EPS and Financial Leverage

PLAN I PLAN II PLAN III PLAN IV

Present Equity Shares 1,00,00 1,00,000 1,00,000 1,00,000

0

New Issue 60,000 40,000 30,000 30,000

Equity share capital (Rs.) 16,00,0 14,00,00 13,00,00 13,00,00

00 0 0 0

No. of Equity shares 1,60,00 1,40,000 1,30,000 1,30,000

5.18 Financial Management

12% Long term loan (Rs.) − 2,00,000 − −

9% Debentures (Rs.) − − 3,00,000 −

6% Preference Shares − − − 3,00,000

(Rs.)

EBIT (Rs.) 4,00,00 4,00,000 4,00,000 4,00,000

0

Interest on 12% Loan − 24,000 − −

(Rs.)

Interest on 9% − − 27,000 −
debentures (Rs.)

EBT (Rs.) 4,00,00 3,76,000 3,73,000 4,00,000

0

Less : Tax@ 40% 1,60,00 1,50,400 1,49,200 1,60,000

0

EAT (Rs.) 2,40,00 2,25,600 2,23,800 2,40,000

0

Less: Preference − − − 18,000

Dividends (Rs.)

(a) Earnings for equity 2,40,00 2,25,600 2,23,800 2,22,000

shares (Rs.) 0

(b) No. of equity shares 1,60,00 1,40,000 1,30,000 1,30,000

0

(c) EPS (a ÷ b) Rs. 1.50 1.61 1.72 1.71

Degree of Financial
leverage- 1.00 1.06 1.07 1.00
 EBIT   EBIT
  or  
 EBIT− I   EBT
Comments:
Since the EPS and degree of financial leverage both are highest in
plan III, the management could accept it
Question 11
 Leverage 5.19

Annual sales of a company is Rs. 60,00,000. Sales to variable cost

ratio is 150 per cent and Fixed cost other than interest is Rs.
5,00,000 per annum. Company has 11 per cent debentures of Rs.
30,00,000.
You are required to calculate the operating, Financial and combined
leverage of the company. (PE-II-Nov. 2008) (3 marks)
Answer
Calculation of Leverages
Rs.
Sales 60,00,000
 100 40,00,000
×
Less: Variable Cost  Sales 
 150
Contribution 20,00,000
Less: Fixed Cost 5,00,000
EBIT 15,00,000
Less: Interest on Debentures 3,30,000
EBT 11,70,000
Contributi
on
Operating =
Leverage
EBIT
Rs.20,00,000
=
Rs.15,00,000
= 1.3333
EBIT
Financial =
Leverage
EBT
Rs.15,00,000
=
Rs.11,70,000
= 1.2821
Contributi
on
Combined = OL× FLor
Leverage
EBT
Rs.20,00,000
= 1.3333
× 1.2821
or
Rs.11,70,000
= 1.7094.
Question 12
5.20 Financial Management

Discuss the impact of financial leverage on shareholders wealth by

using return-on-assets (ROA) and return-on-equity (ROE) analytic
framework. (PE-II-May 2003 & May 2004) (3 marks)
Answer
The impact of financial leverage on ROE is positive, if cost of debt
(after-tax) is less than ROA. But it is a double-edged sword.
NOPAT Sales
ROA = ×
Sales Capital
employed

D
ROE = ROA + (ROA − Kd)
E
Where
NOPAT = EBIT * ( 1 − Tc)
Capital employed = Shareholders funds + Loan funds
D = Debt amount in capital structure
E = Equity capital amount in capital structure
Kd = Interest rate * ( 1 − Tc) in case of fresh loans of a company.
Kd = Yield to maturity *(1−Tc) in case of existing loans of a
company.