Financial Decisions - Leverage By: CA PRAKSAH PATEL

Chapter- 2: Financial Decisions

Unit- I Leverage
A. QUESTION FROM STUDY MATERIAL
ILLUSTRATION 1
A Company produces and sells 10,000 shirts. The selling price per shirt is ₹ 500. Variable cost is ₹
200 per shirt and fixed operating cost is ₹ 25,00,000.
(a) CALCULATE operating leverage.
(b) If sales are up by 10%, then COMPUTE the impact on EBIT?
Hints:
(a) 6 times
(b) 60%
ILLUSTRATION 2
CALCULATE the operating leverage for each of the four firms A, B, C and D from the following
price and cost data:
Firms
Particulars
A (₹) B(₹) C(₹) D(₹)
Sale price per unit 20 32 50 70
Variable cost per unit 6 16 20 50
Fixed operating cost 60,000 40,000 1,00,000 Nil
What calculations 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.
Hints:
DOL(A) = 7 times
DOL(B) = 2 times
DOL(C) = 3 times
DOL(D) = 1 times
ILLUSTRATION 3
A firm’s details are as under:
Sales (@100 per unit) ₹ 24,00,000
Variable Cost 50%
Fixed Cost ₹ 10,00,000
It has borrowed ₹ 10,00,000 @ 10% p.a. and its equity share capital is ₹ 10,00,000 (₹ 100 each)
CALCULATE:
(a) Operating Leverage
(b) Financial Leverage
(c) Combined Leverage
(d) Return on Investment
(e) If the sales increases by ₹ 6,00,000; what will the new EBIT?
Hints:
(a) 6 times
(b) 2 times

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(c) 12 times.
(d) 5%
(e) ₹5,00,000

TEST YOUR KNOWLEDGE

Question-1 (Study Material Q-1)
The Sale revenue of TM excellence Ltd. @ Rs.20 Per unit of output is Rs.20 lakhs and Contribution
is Rs.10 lakhs. At the present level of output the DOL of the company is 2.5. The company does
not have any Preference Shares. The number of Equity Shares are 1 lakh. Applicable corporate
Income Tax rate is 50% and the rate of interest on Debt Capital is 16% p.a. What is the EPS (At
sales revenue of ₹ 20 lakhs) and amount of Debt Capital of the company if a 25% decline in Sales
will wipe out EPS.
Hints:
EPS = ₹1.25, Debt = ₹9,37,500

Question-2 (Study Material Q-2)

Betatronics Ltd. has the following balance sheet and income statement information:

Balance Sheet as on March 31st 2019

Liabilities ₹ Assets ₹
Equity capital (₹ 10 per share) 8,00,000 Net fixed assets 10,00,000
10% Debt 6,00,000 Current assets 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 31st 2019

Particulars ₹
Sales 3,40,000
Operating expenses (including ₹ 60,000 depreciation) (1,20,000)
EBIT 2,20,000
Less: Interest (60,000)
Earnings before tax 1,60,000
Less: Tax (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 percent and (ii) decrease
by 20 percent, COMPUTE the earnings per share at the new sales level?
Hints:
(a) 1.27, 1.38, 1.75
(b) ₹1.76, ₹0.85

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Question-3 (Study Material Q-3)

A company had the following Balance Sheet as on 31stMarch, 2019:

Liabilities (₹in crores) Assets (₹ in crores)

Equity Share Capital (50 lakhs 5
shares of ₹ 10 each) Fixed Assets (Net) 12.5
Reserves and Surplus 1
15% Debentures 10
Current Assets 7.5
Current Liabilities 4
20 20
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:
CALCULATE the following and comment:
(i) Earnings Per Share
(ii) Operating Leverage
(iii) Financial Leverage
(iv) Combined Leverage
Hints:
(i) ₹16.8
(ii) 1.296 times
(iii) 1.125 times
(iv) 1.458 times

Question- 4 (Study Material Q-4)

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 ₹ 30 Per Unit
Variable Cost ₹ 15 Per Unit
Fixed Cost:
Under Situation I ₹ 15,000
Under Situation-II ₹20,000
Capital Structure:
Financial Plan
A (₹) B (₹)
Equity 10,000 15,000
Debt (Rate of Interest at 20%) 10,000 5,000
20,000 20,000

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Hints:
I II
OL 1.5 1.8
FL 1.07, 1.034 1.09, 1.04
CL 1.61, 1.55 1.96, 1.872

B. PAST YEAR QUESTION

Nov 19 Q-2 (10 Marks)

The Balance Sheet of Gitashree Ltd. is given below:
Liabilities (₹ )
Shareholders’ fund
Equity share capital of ₹ 10 each ₹ 1,80,000
Retained earnings ₹ 60,000 2,40,000
Non-current liabilities 10% debt 2,40,000
Current liabilities 1,20,000
6,00,000
Assets
Fixed Assets 4,50,000
Current Assets 1,50,000
6,00,000
The company's total asset turnover ratio is 4. Its fixed operating cost is ₹ 2,00,000 and its variable
operating cost ratio is 60%. The income tax rate is 30%.
Calculate:
(i) (a) Degree of Operating leverage.
(b) Degree of Financial leverage.
(c) Degree of Combined leverage.
(ii) Find out EBIT if EPS is (a) ₹ 1 (b) ₹ 2 and (c) ₹ 0.

Solution:
Working Note:
Total Assets = ₹6,00,000
Total Asset Turnover Ratio i.e. = Total Sales =4
Total Assets
Hence, Total Sales = ₹6,00,000 x 4 = ₹24,00,000

Computation of Profits after Tax (PAT)

Particulars (₹)
Sales 24,00,000
Less: Variable operating cost @ 60% 14,40,000
Contribution 9,60,000

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Less: Fixed operating cost (other than Interest) 2,00,000

EBIT (Earning before interest and tax) 7,60,000
24,000
EBT (Earning before tax) 7,36,000
Less: Tax 30% 2,20,800
EAT (Earning after tax) 5,15,200

i. (a) Degree of Operating Leverage

Degree of Operating leverage = Contribution = ₹9,60,000 = 1.263 (approx.)
EBIT ₹7,60,000
(b) Degree of Financial Leverage
Degree of Financial leverage = EBIT = ₹7,60,000 = 1.033 (approx.)
EBT ₹7,36,000
(c) Degree of Combined Leverage
Degree of Combined leverage = OL x FL = ₹9,60,000 = 1.304 (approx.)
₹7,60,000
Or,
= 1.263 x 1.033 = 1.304 (approx.)
ii. (a) If EPS is Re. 1
EPS = (EBIT – Interest) (1-tax)
No. of Equity Share
Or, 1 = (EBIT - ₹24,000) (1-0.3)
18,000
Or, EBIT = ₹49,714 (approx.)

(b) If EPS is ₹ 2
2 = (EBIT - ₹24,000) (1-0.3)
18,000
Or, EBIT = ₹75,429 (approx.)

(c) If EPS is ₹ 0
0 = (EBIT - ₹24,000) (1-0.3)
18,000
Or, EBIT = ₹24,000 (approx.)
Alternatively, if EPS is 0 (zero), EBIT will be equal to interest on debt i.e. ₹ 24,000.

May 19 Q-4 (10 Marks)

The capital structure of the Shiva Ltd. consists of equity share capital of ₹ 20,00,000 (Share of
₹ 100 per 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 costs amount to ₹ 6 per unit and fixed
expenses amount to ₹ 4,00,000. The income tax rate is assumed to be 50%.

(a) You are required to calculate the following:

(i) The percentage increase in earnings per share;
(ii) Financial leverage at 2,00,000 units and 2,40,000 units.

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(iii) Operating leverage at 2,00,000 units and 2,40,000 units.

(b) 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.
Solution:
(a)
2,00,000 2,40,000
Sales in units
(₹) (₹)
Sales Value @ ₹ 10 Per Unit 20,00,000 24,00,000
Variable Cost @ ₹ 6 per unit (12,00,000) (14,40,000)
Contribution 8,00,000 9,60,000
Fixed expenses (4,00,000) (4,00,000)
EBIT 4,00,000 5,60,000
Debenture Interest (2,00,000) (2,00,000)
EBT 2,00,000 3,60,000
Tax @ 50% (1,00,000) (1,80,000)
Profit after tax (PAT) 1,00,000 1,80,000
No of Share 20,000 20,000
Earnings per share (EPS) 5 9
(i)The percentage Increase in EPS 4
×100 = 80%
5
EBIT ₹ 4,00,000 ₹ 5,60,000
(ii) Financial Leverage = =2 =1.56
EBT ₹ 2,00,000 ₹ 3,60,000
Contribution ₹ 8,00,000 ₹ 9,60,000
(iii) Operating leverage= =2 =1.71
EBIT ₹ 4,00,000 ₹ 5,60,000

(b) When production is increased from 2,00,000 units to 2,40,000 units both financial leverage
and operating leverages reduced from 2 to 1.56 and 1.71 respectively. Reduction in financial
leverage and operating leverages signifies reduction in business risk and financial risk.

Nov 18 Q-2 (10 Marks)

Following is the Balance Sheet of Soni Ltd. as on 31st March, 2018 :
Liabilities Amount in ₹
Shareholder's Fund
Equity Share Capital (₹ 10 each) 25,00,000
Reserve and Surplus 5,00,000
Non-Current Liabilities (12 Debentures) 50,00,000
Current Liabilities 20,00,000

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Total 1,00,00,000
Assets Amount in ₹
Non-Current Assets 60,00,000
Current Assets 40,00,000
Total 1,00,00,000
Additional Information:
(i) Variable Cost is 60% of Sales.
(ii) Fixed Cost p.a. excluding interest ₹ 20,00,000.
(iii) Total Asset Turnover Ratio is 5 times.
(iv) 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
Solution:
Working:
Total Assets = 1 Crore
Total Asset Turnover Ratio i.e. Total Sales = 5
Total Assets
Hence, Total Sales = ₹ 1 Crore x 5 = ₹ 5 crore
(1) Income Statement
Particulars (₹ in crore)
Sales 5
Less: Variable cost @ 60% 3
Contribution 2
Less: Fixed cost (other than Interest) 0 .2
EBIT (Earnings before interest and tax) 1.8
Less: Interest on debentures (12% x 50 lakhs) 0 .06
EBT (Earning before tax) 1.74
Less: Tax 25% 0.435
EAT (Earning after tax) 1.305

(2) (a) Operating Leverage

Operating leverage = Contribution = 2 = 1.11
EBIT 1.8
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.

(b) Financial Leverage

Financial leverage = EBIT = 1.8 = 1.03
EBT 1.74

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The financial leverage is very comfortable since the debt service obligation is small
vis-à-vis EBIT.

(a) Combined Leverage

Combined leverage = Contribution x EBIT = 1.11 x 1.03 = 1.15
EBIT EBT
Or,
Contribution = 2 = 1.15
EBT 1.74
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.

C. ADDITIONAL QUESTIONS FOR PRACTICE (PAST YEAR EXAM)

Question- 1
Consider the following information for Omega Ltd.:
₹ 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%.

Solution:
Operating Leverage (OL)
= Contribution = EBIT + Fixed Cost = ₹15,750 + ₹1,575 = 1.1
EBIT EBIT 15,750

Financial Leverage (FL)

= EBIT = 15,750 = 2.25
EBT 7,000

Combined Leverage (CL)

= 1.1 x 2.25 = 2.475

Percentage Change in Earnings per share

DCL = % Change in EPS
% Change in Sales
2.475 = % Change in EPS
5%
 % change in EPS = 12.375%.
Hence if sales is increased by 5%, EPS will be increased by 12.375%.

Question-2

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Financial Decisions - Leverage By: CA PRAKSAH PATEL

A company operates at a production level of 5,000 units. The contribution is ₹ 60 per unit, operating
leverage is 6, combined leverage is 24. If tax rate is 30%, what would be its earnings after tax?
Solution:
Computation of Earnings after tax (EAT) or Profit after tax (PAT)
Total contribution = 5,000 units x ₹ 60/unit = ₹ 3,00,000
Operating leverage (OL) x Financial leverage (FL) = Combined leverage (CL)
xFL = 24 FL = 4
OL = Contribution 6 = ₹3,00,000 EBIT = ₹50,000
EBIT EBIT
FL = EBIT 4 = ₹50,000 EBT = ₹12,500
EBT EBT
Since tax rate is 30%, therefore, Earnings after tax = 12,500 x 0.70 = ₹ 8,750
Earnings after tax (EAT) = ₹ 8,750.

Question-3
The net sales of A Ltd. is ₹ 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.

Solution:
(i) Net Sales : ₹ 30 crores
EBIT = 12% on sales = ₹ 3.6 crores
Return on Capital Employed (pre-tax) = EBIT = 3.6 x 100 = 20%
Capital Employed 10+2+6
After tax it will be = 20% (1 - 0.4)= 12 %.
Particulars ₹ in crores
EBIT 3.6
Less: Interest on Debt (15% of 6 crores) 0.9
EBT 2.7
Less : Tax @ 40% 1.08
EAT 1.62
Less : Preference dividend 0.26
Earnings available for Equity Shareholders 1.36
Return on equity = 1.36/10 × 100 = 13.6%
Segments due to the presence of Preference Share capital and Borrowing (Debentures)
Segment of ROE due to preference capital : (12% - 13%) × ₹ 2 Crore = - 2%
Segment of ROE due to Debentures: (12% - 9%) × ₹ 6 Crores = 18 %
Total= -2 % +18 % = 16 %
Cost of debenture (after tax) = 15% (1- 0.4) = 9 %
The weighted average cost of capital is as follows:
Source Proportion Cost (%) WACC
(%)
(i) Equity 10/18 13.60 7.56

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(ii) Preference shares 2/18 13.00 1.44

(iii) Debt 6/18 9.00 3.00

Total 12.00

(ii) Financial Leverage = EBIT = 3.6 = 1.33

EBT 2.7
Combined Leverage = FL x OL
3 = 1.33 x OL Or, OL = 3 Or, Operating Leverage = 2.26
1.33

Question-4
The following summarises 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.
Solution:
(i) Degree of operating leverage = % Change in Operating Income
% Change in Revenue

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. So when operating leverage is lowest i.e. 0.9259,
Beta is minimum (1) and when operating leverage is maximum i.e. 1.9048, beta is highest i.e.
1.40

Question-5
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 percent of sales.
Expected annual fixed cost other than interest is ₹ 10,00,000. Corporate tax rate is 30 percent.
The company wants to arrange the funds through issuing 4,00,000 equity shares of ₹ 10 each and
12 percent 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.

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Solution:
(i) Calculation of Leverages and Earnings per Share (EPS)

Income Statement
Particulars (₹)
Sales Revenue 90,00,000
Less: Variable Cost @ 60% 54,00,000
Contribution 36,00,000
Less: Fixed Cost other than Interest 10,00,000
Earnings before Interest and Tax (EBIT) 26,00,000
Less: Interest (12% on ₹ 40,00,000) 4,80,000
Earnings before tax (EBT) 21,20,000
Less: Tax @ 30% 6,36,000
Earnings after tax (EAT)/ Profit after tax (PAT) 14,84,000

1. Calculation of Operating Leverage (OL)

Operating Leverage = Contribution = ₹36,00,000 = 1.3846
EBIT 26,00,000
2. Calculation of Financial Leverage (FL)
Financial leverage = EBIT = ₹26,00,000 = 1.2264
EBT ₹21,20,000
3. Calculation of Combined Leverage (CL)
Combined Leverage = OL × FL = 1.3846 × 1.2264 = 1.6981
Or, Contribution = ₹36,00,000 ₹= 1.6981
EBT ₹21,20,000
4. Calculation of Earnings per Share (EPS)
EPS = EAT/PAT = ₹14,84,000 = 3.71
No. of Equity Shares 4,00,000

(ii) Calculation of likely levels of EBIT at Different EPS

EPS = (EBIT) (1-T)
Number of Equity Shares

(1) If EPS is ₹ 4
4 = (EBIT- 4,80,000)(1-0.3) Or, EBIT-4,80,000 = ₹16,00,000
4,00,000 0.7
EBIT – ₹ 4,80,000 = ₹ 22,85,714 Or, EBIT = ₹ 27, 65,714

(2) If EPS is ₹ 2
2 = (EBIT- 4,80,000)(1-0.3) Or, EBIT-4,80,000 = ₹8,00,000
4,00,000 0.7
EBIT – ₹ 4,80,000 = ₹ 11,42,857 Or, EBIT = ₹ 16,22,857

(3) If EPS is ₹ 0
0 = (EBIT- 4,80,000)(1-0.3) Or, EBIT = 4,80,000

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4,00,000
Question-6
The following details of RST Limited for the year ended 31st March, 2015 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:
1. Calculate Financial leverage
2. Calculate P/V ratio and Earning per Share (EPS)
3. If the company belongs to an industry, whose assets turnover is 1.5, does it have a
high or low assets turnover?
4. At what level of sales the Earning before Tax (EBT) of the company will be equal to
zero?

Solution:
(i) Financial leverage
Combined Leverage= Operating Leverage (OL) x Financial Leverage (FL)
2.8 = 1.4 x FL Or, FL = 2
Financial Leverage =2
(ii) P/V Ratio and EPS
Operating Leverage = Contribution (C ) x 100
C – Fixed Cost (FC)
1.4 = C Or, 1.4 (C – 2,04,000) = C
C – 2,85,600
Or, 1.4 C – 2,85,600 = C Or, C = ₹2,85,000 = C = 7,14,000
0.4
Now, P/V Ratio = Contribution x 100 = ₹7,14,000 x 100 = 23.8%
Sales (S) ₹30,00,000
Therefore, P/V Ratio = 23.8%
EPS = PAT
No. of Equity Shares
EBT = Sales – V – 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 = ₹1,78,500 = 1.05
₹1,70,000
(iii) Assets Turnover
Assets Turnover = Sales = ₹30,00,000 = 0.784

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Total Assets ₹38,25,000

0.784 < 1.5 means lower than industry turnover.
(iv) EBT zero means 100% reduction in EBT. Since combined leverage is 2.8, sales have to
be dropped by 100/2.8 = 35.71%. Hence new sales will be
₹ 30,00,000 x (100 – 35.71) = ₹19,28,700.
Therefore, at ₹19,28,700 level of sales, the Earnings before Tax of the company will be
equal to zero.
Question-7
From the following financial data of Company A and Company B: Prepare their Income
Statements.
Company A (₹) Company B (₹)
Variable Cost 56,000 60% of sales
Fixed Cost 20,000 -
Interest Expenses 12,000 9,000
Financial Leverage 5:1 -
Operating Leverage - 4:1
Income Tax Rate 30% 30%
Sales - 1,05,000

Solution:
Income Statements of Company A and Company B
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 (EBIT) 15,000 10,500
Less: Interest 12,000 9,000
Earnings before tax (EBT) 3,000 1,500
Less: Tax @ 30% 900 450
Earnings after tax (EAT) 2,100 1,050
Working Notes:
Company A
1. Financial Leverage = EBIT
EBT i.e. EBIT – Interest
So, 5= EBIT
EBIT – 12,000
Or, 5 (EBIT – 12,000) = EBIT Or, 4 EBIT = 60,000
Or, EBIT = ₹15,000

2. Contribution = EBIT + Fixed Cost

= ₹ 15,000 + ₹ 20,000 = ₹ 35,000

3. Sales = Contribution + Variable cost

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= ₹ 35,000 + ₹ 56,000
= ₹ 91,000
Company B
1. Contribution = 40% of Sales (as Variable Cost is 60% of Sales)
= 40% of 1,05,000 = ₹ 42,000
2. Operating Leverage = Contribution Or, 4 = ₹42,000
EBIT EBIT
EBIT = ₹42,000 = ₹10,500
4
3. Fixed Cost = Contribution – EBIT = 42,000 – 10,500 = ₹ 31,500

Question-8
The following information related to XL Company Ltd. for the year ended 31st March, 2016 are
available to you:
Equity share capital of ₹ 10 each ₹ 25 lakh
11% Bonds of ₹ 1000 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 Rate Applicable 35%
You are required to calculate:
(i) Operating Leverage;
(ii) Combined Leverage; and
(iii) Earning per Share.
Solution:
Profit Volume Ratio = Contribution x 100
Sales
So, 25.55 = Contribution x 100
₹42,00,000
Contribution = ₹10,73,100
Income Statement
Particulars (₹)
Sales 42,00,000
Variable Cost (Sales - Contribution) 31,26,900
Contribution 10,73,100
Fixed Cost 3,48,000
EBIT 7,25,000
Interest 2,03,500
EBT(EBIT – Interest) 5,21,600
Tax 1,82,500
Profit after Tax (EBT – Tax) 3,39,040

1. Operating Leverage = Contribution

EBIT
Or, Contribution = ₹10,73,100
Contribution – Fixed Cost ₹10,73,100 - ₹3,48,000
= ₹10,73,100 = 1.48

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Financial Decisions - Leverage By: CA PRAKSAH PATEL

₹7,25,100
2. Combined Leverage = Operating Leverage x Financial Leverage
= 1.48 x 1.39 = 2.06
Or, Contribution i.e. ₹10,73,100 = 2.06
EBT ₹5,21,600
3. Earnings per Share (EPS)
EPS = PAT = ₹3,39,040 = 1.3561
No. of Share ₹2,50,000
EPS = 1.36

Question-9
The Capital structure of RST Ltd. is as follows:
(₹)
Equity Share of ₹ 10 each 8,00,000
10% Preference Share of ₹ 100 each 5,00,000
12% Debentures of ₹ 100 each 7,00,000
20,00,000
Additional Information:
- Profit after tax (Tax Rate 30%) are ₹ 2,80,000
- Operating Expenses (including Depreciation ₹ 96,800) are 1.5 times of EBIT
- Equity Dividend paid is 15%
- Market price of Equity Share is ₹ 23
Calculate:
(i) Operating and Financial Leverage
(ii) Cover for preference and equity dividend
(iii) The Earning Yield Ratio and Price Earning Ratio
(v) The Net Fund Flow
Solution:
Working Notes:
Particulars (₹)
Net Profit after Tax 2,80,000
Tax @ 30% 1,20,000
EBT 4,00,000
Interest on Debentures 84,000
EBIT 4,84,000
Operating Expenses (1.5 times of EBIT) 7,26,000
Sales 12,10,000

1. Operating Leverage
= Contribution = (₹12,00,000 - ₹6,29,200) = ₹5,80,800 = 1.2 times
EBIT ₹4,84,000 ₹4,84,000
Financial leverage = EBIT = 4,84,000 = 1.21 times
EBT 4,00,000

2. Cover for Preference Dividend

= PAT
Pref. Share Dividend
= ₹2,80,000 = 5.6 times
₹ 50,000

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Financial Decisions - Leverage By: CA PRAKSAH PATEL

Cover for Equity Dividend

= (PAT – Pref. Dividend) = (₹2,80,000 – 50,000)
Equity Share Dividend ₹1,20,000
= ₹2,30,000 = 1.92 times
₹1,20,000

3. Earning Yield Ratio

= EPS x 100
Market Price
= (2,30,000/80,000) x 100
23
= 2.875 x 100 = 12.5%
23

Price – Earnings Ratio (PE Ratio)

= Market Price = 23
EPS 2.875
= 8 times

4. Net Funds Flow

= Net PAT + Depreciation-Total Dividend
= ₹ 2,80,000 + ₹ 96,800 – ₹ (50,000 + 1,20,000)
= ₹ 3,76,800 – ₹ 1,70,000
Net Funds Flow = ₹ 2,06,800

Question-10
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?

Solution:
Income Statement
Particulars Amount (₹)
Sales 75,00,000
Less: Variable cost (56% of 75,00,000) 42,00,000
Contribution 33,00,000
Less: Fixed costs 6,00,000
Earnings before interest and tax (EBIT) 27,00,000
Less: Interest on debt (@ 9% on ₹ 45 lakhs) 4,05,000

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Financial Decisions - Leverage By: CA PRAKSAH PATEL

Earnings before tax (EBT) 22,95,000

1. ROI = EBIT x 100 = EBIT x 100

Capital Employed Equity + Debt

= ₹27,00,000 x 100 = 27%

(₹55,00,000 + 45,00,000)
(ROI is calculated on Capital Employed)

2. ROI = 27% and Interest on debt is 9%, hence, it has a favourable financial leverage.

3. Capital Turnover = Net Sales

Capital
Or, Net Sales = ₹75,00,000 =0.75
Capital ₹1,00,00,000
Which is very low as compared to industry average of 3.

4. Calculation of Operating, Financial and Combined leverages.

a. Operating Leverage = Contribution = ₹33,00,000 = 1.22 (Approx.)
EBIT ₹27,00,000
b. Financial Leverage = EBIT = ₹27,00,000 = 1.18 (Approx.)
EBT ₹22,95,000
c. Combined Leverage = Contribution = ₹33,00,000 = 1.44 (Approx.)
EBT ₹22,95,000
Or = Operating Leverage × Financial Leverage = 1.22 × 1.18 = 1.44 (approx)

5. Operating leverage is 1.22. So if sales is increased by 10%. EBIT will be increased

by 1.22 × 10 i.e. 12.20% (approx)

6. Since the combined Leverage is 1.44, sales have to drop by 100/1.44 i.e. 69.44% to
bring EBT to Zero
Accordingly, New Sales = ₹ 75,00,000 × (1 - 0.6944)
= ₹ 75,00,000 × 0.3056
= ₹ 22,92,000 (approx)
Hence at ₹ 22,92,000 sales level EBT of the firm will be equal to Zero.

7. Financial leverage is 1.18. So, if EBIT increases by 20% then EBT will increase by
1.18 × 20 = 23.6% (approx)

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