Financing Decisions 4.

56

R equir ed:
Calculate pe r centage change in ea rnings pe r sha r e, if sales inc r ease by 5%.
Answer
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  2.25 = 2.475
Percentage Change in Earnings per share
% change in EPS
DCL =
% change in Sales

% change in EPS
2.475 =
5%
% change in EPS = 12.375%.
Hence if sales is increased by 5%, EPS will be increased by 12.375%.
Question 2
A company ope r ates at a production level of 5,000 units. The contribution is ` 60 pe r unit,
ope r ating leve r age is 6, combined leve r age is 24. If tax r ate is 30%, what would be its ea rnings
afte r tax?
Answer
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)
\ 6 FL = 24 \ FL = 4

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 4.57 Financial Management

Contributi on ` 3 ,00 ,000

\ OL = \ 6= \ EBIT = ` 50, 000
EBIT EBIT
EBIT ` 50 ,000
FL = \ 4= \ 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
A firm has S ales of ` 40 lakhs; Va riable cost of ` 25 lakhs; Fixed cost of ` 6 lakhs; 10% debt of
` 30 lakhs; and Equity Capital of ` 45 lakhs.
R equir ed:
Calculate ope r ating and financial leve r age.
Answer
Calculation of Operating and Financial Leverage
(`)
Sales 40,00,000
L ess: Variable cost 25,00,000
Contribution (C) 15,00,000
L ess: Fixed cost 6,00,000
EBIT 9,00,000
L ess: Interest 3,00,000
EBT 6,00,000
C ` 15,00,000
Operating leverage = = = 1.67
EBIT ` 9,00,000
EBIT ` 9,00,000
Financial leverage = = = 1.50
EBT ` 6,00,000

Question 4
The following data r elate to RT Ltd:
(`)
Ea r nings befor e inte r est and tax ( EBIT) 10,00,000
Fixed cost 20,00,000
Ea r nings Befor e Tax ( EBT) 8,00,000
Required: Calculate combined leverage.

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 Financing Decisions 4.58

Answer
Contribution:
C = S – V and
EBIT =C–F
10,00,000 = C – 20,00,000
C = 30,00,000
[C- Contribution, S- Sales, V- Variable cost, F- Fixed Cost]
Operating leverage (OL) = C / EBIT = 30,00,000/10,00,000 = 3 times
Financial leverage (FL) = EBIT/EBT = 10,00,000/8,00,000 = 1.25 times
Combined leverage (CL) = OL FL = 3 1.25 = 3.75 times
Question 5
A company ope r ates at a production level of 1,000 units. The contribution is ` 60 pe r unit,
ope r ating leve r age is 6, and combined leve r age is 24. If tax r ate is 30%, what would be its
ea rnings afte r tax?
Answer
Computation of Earnings after tax
Contribution = ` 60  1,000 = ` 60,000
Operating Leverage (OL)  Financial Leverage (FL) = Combined Leverage (CL)
6  Financial Leverage = 24
 Financial Leverage =4
Contribution ` 60,000
Operating Leverage = = =6
EBIT EBIT
60,000
\ EBIT = = `10,000
6
EBIT
Financial Leverage = =4
EBT
EBIT 10,000
\ EBT = = = ` 2,500
4 4
EBIT- Earnings before Interest and tax.
EBT- Earnings before tax.
Since tax rate = 30%

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 4.59 Financial Management

Earnings after Tax (EAT) = EBT (1 − 0.30) [ 30% is tax rate]

= `2,500 (0.70)
 Earnings after Tax (EAT) = `1,750
Question 6
X Limited has estim ated that for a new product its br eak-even point is 20,000 units if the ite m is
sold for ` 14 pe r unit and va riable cost ` 9 pe r unit. Calculate the degr ee of ope r ating leve r age
for sales volum e 25,000 units and 30,000 units.
Answer
Computation of Operating Leverage (OL)
Selling Price = ` 14 per unit
Variable Cost = ` 9 per unit
Fixed Cost = BEP (Selling price – Variable cost) = 20,000 (14 - 9) = 20,000 5 = 1,00,000
Particulars For 25,000 units (`) For 30,000 units (`)
Sales ( @ `14 /unit) 3,50,000 4,20,000
Less: Variable Cost (@ 9 unit ) 2,25,000 2,70,000
Contribution 1,25,000 1,50,000
Less: Fixed Cost 1,00,000 1,00,000
Earnings before Interest and tax (EBIT) 25,000 50,000
æ Contribution ÷ö æ1,25,000 ö÷ æ1,50,000 ÷ö
OL çç çç çç
çè EBIT ÷÷ø çè 25,000 ø÷÷ çè 50,000 ÷÷ø

OL 5 times 3 times

Question 7
Conside r the following inform ation for Strong Ltd:
` in lakh
EBIT 1,120
PBT 320
Fixed Cost 700
Calculate the pe r centage of change in ea rnings pe r sha r e, if sales inc r eased by 5 pe r cent.

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 Financing Decisions 4.60

Answer
Percentage change in earning per share to the percentage change in sales is calculated through
degree of combined leverage,.
Hence, Computation of percentage of change in earnings per share, if sales increased by 5%
% change in Earning per share (EPS)
Degree of Combined leverage(DCL) =
% change in sales
Moreover, Degree of operating leverage (DOL) Degree of Financial Leverage (DFL) = Degree
of combined leverage (DCL)
Or, DOL DFL = % change in Earning per share (EPS)
% change in sales

Or, 1.625 3.5 [R efe r to wor king notes (i) and ( ii)] = % change in Earning per share (EPS)
5
% change in Earning per share (EPS)
Or, 5.687 =
5
Or, % change in EPS = 5.687 5= 28.4375%
So, If sales is increased by 5 percent, Percentage of change in earning per share will be 28.4375 %
Working Notes:
Contributi on (` 1,120 + `700 lakhs)
(i) Degree of operating leverage (DOL) = = = 1.625
EBIT ` 1,120 lakhs
EBIT ` 1,120
(ii) Degree of financial leverage (DFL) = = = 3.5
PBT ` 320
Question 8
The data r elating to two companies a r e as given below:
Company A Company B
Equity Capital ` 6,00,000 ` 3,50,000
12% D ebentur es ` 4,00,000 ` 6,50,000
Output (units) pe r annum 60,000 15,000
S elling price / unit ` 30 ` 250
Fixed Costs pe r annum ` 7,00,000 ` 14,00,000
Va riable Cost pe r unit ` 10 ` 75
You a r e r equir ed to calculate the Ope r ating leve r age, Financial leve r age and Combined
leve r age of two Companies.

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 4.61 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
(`) (`)
Selling price / unit 30 250
Sales revenue 18,00,000 37,50,000
(60,000 units  ` 30) (15,000 units  ` 250)
L ess: Variable costs 6,00,000 11,25,000
(60,000 units  ` 10) (15,000 units  ` 75)
Contribution (C) 12,00,000 26,25,000
L ess: Fixed costs 7,00,000 14,00,000
EBIT (Earnings before Interest and tax) 5,00,000 12,25,000
L ess: Interest @ 12% on debentures 48,000 78,000
PBT 4,52,000 11,47,000

Contribution 2.4 2.14

Operating Leverage =
EBIT (` 12,00,000/ 5,00,000) (` 26,25,000 / ` 12,25,000)
EBIT 1.11 1.07
Financial Leverage =
PBT (` 5,00,000/ ` 4,52,000) (` 12,25,000 / ` 11,47,000)
Combined Leverage = DOL  DFL 2.66 2.29
(2.4 1.11) (2.14 1.07)
Question 9
The net sales of A Ltd. is ` 30 c ror es. Ea rnings befor e inte r est and tax of the company as a
pe r centage of net sales is 12%. The capital e mployed comprises ` 10 c ror es of equity,
` 2 c ror es of 13% Cumulative Pr efe r ence Sha r e Capital and 15% D ebentur es of ` 6 c ror es.
Incom e-tax r ate is 40%.
(i) Calculate the R eturn-on-equity for the company and indicate its segm ents due to the
pr esence of Pr efe r ence Sha r e Capital and Borrowing (D ebentur es) .
(ii) Calculate the Ope r ating L eve r age of the Company given that combined leve r age is 3.

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 Financing Decisions 4.62

Answer
(i) Net Sales : ` 30 crores
EBIT = 12% on sales = ` 3.6 crores
EBIT 3.6
Return on Capital Employed (pre-tax) = = 100 = 20%
Capital Employed 10 + 2 + 6
After tax it will be = 20% (1 - 0.4)= 12 %.
Particulars ` in crores
5B

EBIT 3.6
L ess: Interest on Debt (15% of 6 crores) 0.9
EBT 2.7
L ess : Tax @ 40% 1.08
EAT 1.62
L ess : 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
(ii) Preference shares 2/18 13.00 1.44
(iii) Debt 6/18 9.00 3.00
Total 12.00
EBIT 3.6
(ii) Financial Leverage = = = 1.33
EBT 2.7
Combined Leverage = FL OL
3
3 = 1.33 OL Or, OL = Or, Operating Leverage = 2.26
1.33

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 4.63 Financial Management

Question 10
The following summ a rises the pe r centage changes in ope r ating incom e, pe r centage changes in
r evenues, and betas for four pha rm aceutical firms.
Firm Change in revenue Change in operating income Beta
PQ R Ltd. 27% 25% 1.00
RST Ltd. 25% 32% 1.15
TUV Ltd. 23% 36% 1.30
WXY Ltd. 21% 40% 1.40
R equir ed:
(i) Calculate the degr ee of ope r ating leve r age for each of these firms. Comm ent also.
(ii) Use the ope r ating leve r age to explain why these firms have diffe r ent beta.
Answer
% Change in Operating income
(i) Degree of operating leverage =
% Change in Revenues

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 11
A Company had the following Balance Sheet as on Ma r ch 31, 2006:
Liabilities and Equity ` (in crores) Assets ` (in crores)
Equity Sha r e Capital Fixed Assets (N et) 25
(one c ror e sha r es of ` 10 each) 10
R ese rves and Surplus 2 Curr ent Assets 15
15% D ebentur es 20
Curr ent Liabilities 8
40 40

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 Financing Decisions 4.64

The additional inform ation given is as unde r:

Fixed Costs pe r annum ( excluding inte r est) ` 8 cror es
Va riable ope r ating costs r atio 65%
Total Assets turnove r r atio 2.5
Incom e-tax r ate 40%
R equir ed:
Calculate the following and comm ent:
(i) Ea rnings pe r sha r e
(ii) Ope r ating L eve r age
(iii) Financial L eve r age
(iv) Combined L eve r age.
Answer
Total Assets = ` 40 crores
Total Sales
Total Asset Turnover Ratio i.e. = 2.5
Total Assets
Hence, Total Sales = 40  2.5 = ` 100 crores
Computation of Profits after Tax (PAT)
(` in crores)
Sales 100
L ess: Variable operating cost @ 65% 65
Contribution 35
L ess: Fixed cost (other than Interest) 8
EBIT(Earning before interest and tax) 27
L ess: Interest on debentures (15%  20) 3
EBT(Earning before tax) 24
L ess: Tax 40% 9.6
EAT (Earning after tax) 14.4

(i) Earnings per share

` 14.4 crores
\ EPS = = ` 14.40
1 crore equity shares

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 4.65 Financial Management

(ii) Operating Leverage

Contribution 35
Operating leverage = = = 1.296
EBIT 27
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
EBIT 27
Financial Leverage = = = 1.125
EBT 24
The financial leverage is very comfortable since the debt service obligation is small vis-à-
vis EBIT.
(iv) Combined Leverage
Contribution EBIT
Combined Leverage = = 1.296  1.125 = 1.458
EBIT EBT
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 12
Annual sales of a company is ` 60,00,000. S ales to va riable cost r atio is 150 pe r cent and Fixed
cost othe r than inte r est is ` 5,00,000 pe r annum . Company has 11 pe r cent debentur es of
` 30,00,000.
You a r e r equir ed to calculate the ope r ating, Financial and combined leve r age of the company.
Answer
Calculation of Leverages
Particulars (`)
Sales 60,00,000
æ 100 ö÷ 40,00,000
L ess: Variable Cost ççSales ÷÷
çè 150 ø
Contribution 20,00,000
L ess: Fixed Cost 5,00,000
EBIT 15,00,000
L ess: Interest on Debentures 3,30,000
EBT 11,70,000

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 Financing Decisions 4.66

Contribution ` 20,00,000
Operating Leverage = = = 1.3333
EBIT ` 15,00,000

EBIT ` 15,00,000
Financial Leverage = = = 1.2821
EBT ` 11,70,000
Contribution
Combined Leverage = OL FL or
EBT
` 20,00,000
= 1.3333 1.2821 or = 1.7094
` 11,70,000

Question 13
D elta Ltd. curr ently has an equity sha r e capital of ` 10,00,000 consisting of 1,00,000 Equity
sha r e of ` 10 each. The company is going through a m ajor expansion plan r equiring to r aise
funds to the tune of ` 6,00,000. To finance the expansion the m anage m ent has following plans:
Plan-I : Issue 60,000 Equity sha r es of ` 10 each.
Plan-II : Issue 40,000 Equity sha r es of ` 10 each and the balance through long-te rm
borrowing at 12% inte r est p.a.
Plan-III : Issue 30,000 Equity sha r es of ` 10 each and 3,000, 9% D ebentur es of
` 100 each.
Plan-IV : Issue 30,000 Equity sha r es of ` 10 each and the balance through 6%
pr efe r ence sha r es.
The EBIT of the company is expected to be ` 4,00,000 p.a. assum e corpor ate tax r ate of 40%.
R equir ed:
( i) Calculate EPS in each of the above plans.
(ii) Asce rtain financial leve r age in each plan.
Answer

Sources of Capital Plan I Plan II Plan III Plan IV

Present Equity Shares 1,00,000 1,00,000 1,00,000 1,00,000
New Issue 60,000 40,000 30,000 30,000
Equity share capital (`) 16,00,000 14,00,000 13,00,000 13,00,000
No. of Equity shares 1,60,000 1,40,000 1,30,000 1,30,000
12% Long term loan (`)  2,00,000  

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 4.67 Financial Management

9% Debentures (`)   3,00,000 

6% Preference Shares (`)    3,00,000

Computation of EPS and Financial Leverage

Sources of Capital Plan I Plan II Plan III Plan IV
EBIT (`) 4,00,000 4,00,000 4,00,000 4,00,000
Interest on 12% Loan (`)  24,000  
Interest on 9% debentures (`)   27,000 
EBT (`) 4,00,000 3,76,000 3,73,000 4,00,000
L ess : Tax@ 40% 1,60,000 1,50,400 1,49,200 1,60,000
EAT (`) 2,40,000 2,25,600 2,23,800 2,40,000
L ess: Preference Dividends (`)    18,000
(a)Net Earnings available for 2,40,000 2,25,600 2,23,800 2,22,000
equity shares (`)
(b) No. of equity shares 1,60,000 1,40,000 1,30,000 1,30,000
(c) EPS (a  b) ` 1.50 1.61 1.72 1.71
Financial leverage-
æ EBIT ÷ö æç EBIT ÷ö 1.00 1.06 1.07 1.08
çç or
çè EBIT-I ÷÷ø ççè EBT* ÷÷ø

* EBT is Earnings before tax but after interest and preference dividend in case of Plan IV.

Comments: Since the EPS and financial leverage both are highest in plan III, the management
could accept it.
Question 14
Z Limited is conside ring the installation of a new project costing ` 80,00,000. Expected annual
sales r evenue from the project is ` 90,00,000 and its va riable costs a r e 60 pe r cent of sales.
Expected annual fixed cost othe r than inte r est is ` 10,00,000. Corpor ate tax r ate is 30 pe r cent.
The company wants to a rr ange the funds through issuing 4,00,000 equity sha r es of ` 10 each
and 12 pe r cent debentur es of ` 40,00,000.
You a r e r equir ed to:
(i) Calculate the ope r ating, financial and combined leve r ages and Ea rnings pe r Sha r e ( EPS) .
(ii) D ete rmine the likely level of EBIT, if EPS is ` 4, or ` 2, or Ze ro.

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 Financing Decisions 4.68

Answer
(i) Calculation of Leverages and Earnings per Share (EPS)
Income Statement
Particulars (`)
Sales Revenue 90,00,000
L ess: Variable Cost @ 60% 54,00,000
Contribution 36,00,000
L ess: Fixed Cost other than Interest 10,00,000
Earnings before Interest and Tax (EBIT) 26,00,000
L ess: Interest (12% on ` 40,00,000) 4,80,000
Earnings before tax (EBT) 21,20,000
L ess: Tax @ 30% 6,36,000
Earnings after tax (EAT)/ Profit after tax (PAT) 14,84,000
1. Calculation of Operating Leverage (OL)
Contributi on ` 36,00,000
Operating Leverage = = = 1.3846
EBIT 26,00,000
2. Calculation of Financial Leverage (FL)
EBIT ` 26,00,000
Financial Leverage = = = 1.2264
EBT ` 21,20,000
3. Calculation of Combined Leverage (CL)
Combined Leverage = OL FL = 1.3846 1.2264 = 1.6981
Contribution ` 36,00,000
Or, = = 1.6981
EBT ` 21,20,000
4. Calculation of Earnings per Share (EPS)
EAT / PAT ` 14,84,000
EPS = = = 3.71
Number of Equity Shares 4,00,000
(ii) Calculation of likely levels of EBIT at Different EPS
(EBIT - I)(1- T)
EPS =
Number of Equity Shares
(1) If EPS is ` 4

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 4.69 Financial Management

(EBIT - 4,80,000) (1 - 0.3) `16 ,00 ,000

4= Or, EBIT – ` 4,80,000 =
4,00,000 0 . 70
EBIT – ` 4,80,000 = ` 22,85,714 Or, EBIT = ` 27, 65,714
(2) If EPS is ` 2
(EBIT - ` 4,80,000) (1- 0.3)) ` 8 ,00 ,000
2= Or, EBIT – ` 4,80,000 =
` 4,00,000 0 .70
EBIT – ` 4,80,000 = ` 11,42,857 Or, EBIT = ` 16, 22,857
(3) If EPS is ` Zero
(EBIT - ` 4,80,000) (1- 0.3)
0= Or, EBIT = ` 4,80,000
` 4,00,000

Question 15
The following details of RST Limited for the yea r ended 31st Ma r ch, 2015 a r e given below:
Ope r ating leve r age 1.4
Combined leve r age 2.8
Fixed Cost ( Excluding inte r est) ` 2.04 lakhs
S ales ` 30.00 lakhs
12% D ebentur es of ` 100 each ` 21.25 lakhs
Equity Sha r e Capital of ` 10 each ` 17.00 lakhs
Incom e tax r ate 30 pe r cent
R equir ed:
(i) Calculate Financial leve r age
(ii) Calculate P/V r atio and Ea rning pe r Sha r e ( EPS)
(iii) If the company belongs to an industry, whose assets turnove r is 1.5, does it have a high
or low assets turnove r?
(iv) At what level of sales the Ea rning befor e Tax ( EBT) of the company will be equal to ze ro?
Answer
(i) Financial leverage
Combined Leverage = Operating Leverage (OL)  Financial Leverage (FL)
2.8 = 1.4  FL Or, FL = 2
Financial Leverage =2

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 Financing Decisions 4.70

(ii) P/V Ratio and EPS

Contribution (C)
Operating leverage = 100
C - Fixed Cost (FC)
C
1.4 = Or, 1.4 (C – 2,04,000) = C
C - 2,04,000
` 2,85,600
Or, 1.4 C – 2,85,600 = C Or, C = = C = 7,14,000
0.4
Contribution (C) ` 7,14,000
Now, P/V ratio = 100 = 100 = 23.8%
Sales (S) ` 30,00,000

Therefore, P/V Ratio = 23.8%

Profit after tax
EPS =
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
` 1,78,500
EPS = = 1.05
` 1,70,000
(iii) Assets turnover
Sales ` 30,00,000
Assets turnover = = = 0 .784
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  (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 16
F rom the following financial data of Company A and Company B: Pr epa r e their Incom e
State m ents.

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 4.71 Financial Management

Company A (`) Company B (`)

Va riable Cost 56,000 60% of sales
Fixed Cost 20,000 -
Inte r est Expenses 12,000 9,000
Financial L eve r age 5:1 -
Ope r ating L eve r age - 4:1
Incom e Tax R ate 30% 30%
S ales - 1,05,000
Answer
Income Statements of Company A and Company B
Company A (`) Company B (`)
Sales 91,000 1,05,000
L ess: Variable cost 56,000 63,000
Contribution 35,000 42,000
L ess: Fixed Cost 20,000 31,500
Earnings before interest and tax (EBIT) 15,000 10,500
L ess: Interest 12,000 9,000
Earnings before tax (EBT) 3,000 1,500
L ess: Tax @ 30% 900 450
Earnings after tax (EAT) 2,100 1,050
Working Notes:
Company A
EBIT
(i) Financial Leverage =
EBT i.e EBIT - Interest
EBIT
So, 5 =
EBIT -12,000
Or, 5 (EBIT – 12,000) = EBIT
Or, 4 EBIT = 60,000
Or, EBIT = `15,000
(ii) Contribution = EBIT + Fixed Cost
= ` 15,000 + ` 20,000 = ` 35,000

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 Financing Decisions 4.72

(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
Contribution ` 42,000
(ii) Operating Leverage = Or, 4=
EBIT EBIT
` 42 ,000
EBIT = = `10,500
4
(iii) Fixed Cost = Contribution – EBIT = 42,000 – 10,500 = ` 31,500
Question 17
Calculate the ope r ating leve r age, financial leve r age and combined leve r age for the following
firms and inte rpr et the r esults:
P Q R
Output (units) 2,50,000 1,25,000 7,50,000
Fixed Cost (`) 5,00,000 2,50,000 10,00,000
Unit Va riable Cost (`) 5 2 7.50
Unit S elling Price (`) 7.50 7 10.0
Inte r est Expense (`) 75,000 25,000 -
Answer
Estimation of Degree of Operating Leverage (DOL), Degree of Financial Leverage (DFL)
and Degree of Combined Leverage (DCL)
P Q R
Output (in units) 2,50,000 1,25,000 7,50,000
` ` `
Selling Price (per unit) 7.50 7 10
Sales Revenues (Output Selling Price) 18,75,000 8,75,000 75,00,000
L ess: Variable Cost (Output Variable Cost ) 12,50,000 2,50,000 56,25,000
Contribution Margin 6,25,000 6,25,000 18,75,000
L ess: Fixed Cost 5,00,000 2,50,000 10,00,000
Earnings before Interest and Tax (EBIT) 1,25,000 3,75,000 8,75,000

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 4.73 Financial Management

L ess: Interest Expense 75,000 25,000 -

Earnings before Tax (EBT) 50,000 3,50,000 8,75,000
Contribution 5 1.67 2.14
DOL =
EBIT
EBIT 2.5 1.07 1.00
DFL =
EBT
DCL = DOL DFL 12.5 1.79 2.14
Comment Aggressive Moderate Moderate
Policy Policy Policy with
no financial
leverage

Question 18
Calculate the ope r ating leve r age, financial leve r age and combined leve r age for the following
firms:
Particulars N S D
Production (in units) 17,500 6,700 31,800
Fixed costs (`) 4,00,000 3,50,000 2,50,000
Inte r est on loan (`) 1,25,000 75,000 Nil
S elling price pe r unit (`) 85 130 37
Va riable cost pe r unit (`) 38.00 42.50 12.00
Answer
Computation of Degree of Operating Leverage (DOL), Degree of Financial Leverage (DFL) and
Degree of Combined Leverage (DCL)
Particulars Firm N Firm S Firm D
Output (Units) 17,500 6,700 31,800
` ` `
Selling Price/Unit 85 130 37
Sales Revenue (Output x 14,87,500 8,71,000 11,76,600
Selling Price per Unit) (A)
Variable Cost/Unit 38.00 42.50 12.00

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 Financing Decisions 4.74

Less: Total Variable Cost 6,65,000 2,84,750 3,81,600

(Output x Variable Cost per
Unit) (B)
Contribution (C) (A-B) 8,22,500 5,86,250 7,95,000
Less: Fixed Cost 4,00,000 3,50,000 2,50,000
Earnings before Interest 4,22,500 2,36,250 5,45,000
and Tax (EBIT)
Less: Interest on Loan 1,25,000 75,000 Nil
EBT 2,97,500 1,61,250 5,45,000
Operating Leverage (OL) = 8,22,500 5,86,250 7,95,000
C 4,22,500 2,36,250 5,45,000
EBIT
= 1.95 = 2.48 = 1.46
Financial Leverage (FL) 4,22,500 2,36,250 5,45,000
EBIT 2,97,500 1,61,250 5,45,000
=
PBT
= 1.42 = 1.47 = 1.00
Combined Leverage (CL) = 1.95 x 1.42 2.48 x 1.47 1.46 x 1
OL x FL
OR = 2.77 = 3.65 = 1.46
Contribution 8,22,500 5,86,250 7,95,000
CL = = 2.77 = 3.64 = 1.46
EBT 2,97,500 1,61,250 5,45,000

Question 19
The following inform ation r elated to XL Company Ltd. for the yea r ended 31st Ma r ch, 2016 a r e
available to you:
Equity sha r e capital of ` 10 each ` 25 lakh
11% Bonds of ` 1000 each ` 18.5 lakh
S ales ` 42 lakh
Fixed cost ( Excluding Inte r est) ` 3.48 lakh
Financial leve r age 1.39
Profit-Volum e R atio 25.55%
Incom e Tax R ate Applicable 35%

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 4.75 Financial Management

You a r e r equir ed to calculate:

(i) Ope r ating L eve r age;
(ii) Combined L eve r age; and
(iii) Ea rning pe r Sha r e.
Answer
Contribution
Profit Volume Ratio = 100
Sales
Contribution
So, 25.55 = x100 Or, Contribution = 42,00,000´25.55
` 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
Contribution
(i) Operating Leverage =
Earnings before interest and tax(EBIT)
Contribution ` 10,73,100
Or, =
Contribution - Fixed Cost ` 10,73,100 - ` 3,48,000
` 10,73,100
= = 1.48
` 7, 25,100
(ii) Combined Leverage = Operating Leverage x Financial Leverage
= 1.48 x 1.39 = 2.06
Contribution ` 10, 73, 100
Or, i.e. = 2.06
EBT ` 5, 21, 600

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 Financing Decisions 4.78

= ` 3,76,800 – ` 1,70,000
Net Funds Flow = ` 2,06,800
Question 21
Following inform ation a r e r elated to four firms of the sa m e industry:
Firm Change in Revenue Change in Operating Change in Earning per
Income Share
P 27% 25% 30%
Q 25% 32% 24%
R 23% 36% 21%
S 21% 40% 23%
Find out:
(i) degr ee of ope r ating leve r age, and
(ii) degr ee of combined leve r age for all the firms.
Answer
Calculation of Degree of Operating leverage and Degree of Combined leverage
Firm Degree of Operating Leverage (DOL) Degree of Combined Leverage (DCL)
% change inOperatingIncome % change inEPS
= =
% change inRevenue % change inRevenue
25% 30%
P = 0.926 = 1.111
27% 27%
32% 24%
Q = 1.280 = 0.960
25% 25%
36% 21%
R = 1.565 = 0.913
23% 23%
40% 23%
S = 1.905 = 1.095
21% 21%

Question 22
The capital structur e of ABC Ltd. as at 31.3.15 consisted of ordina ry sha r e capital of ` 5,00,000
(face value ` 100 each) and 10% debentur es of ` 5,00,000 (` 100 each) . In the yea r ended
with Ma r ch 15, sales dec r eased from 60,000 units to 50,000 units. During this yea r and in the

© The Institute of Chartered Accountants of India

 4.79 Financial Management

pr evious yea r , the selling price was ` 12 pe r unit; va riable cost stood at ` 8 pe r unit and fixed
expenses we r e at ` 1,00,000 p.a. The incom e tax r ate was 30%.
You a r e r equir ed to calculate the following:
(i) The pe r centage of dec r ease in ea rnings pe r sha r e.
(ii) The degr ee of ope r ating leve r age at 60,000 units and 50,000 units.
(iii) The degr ee of financial leve r age at 60,000 units and 50,000 units.
Answer
Sales in units 60,000 50,000
(`) (`)
Sales Value 7,30,000 6,00,000
Variable Cost (4,80,000) (4,00,000)
Contribution 2,40,000 2,00,000
Fixed expenses (1,00,000) (1,00,000)
EBIT 1,40,000 1,00,000
Debenture Interest (50,000) (50,000)
EBT 90,000 50,000
Tax @ 30% (27,000) (15,000)
Profit after tax (PAT) 63,000 35,000
63,000 35,000
(i) Earnings per share (EPS) = = ` 12.6 =`7
5,000 5,000
Decrease in EPS = 12.6 – 7 = 5.6
5.6
% decrease in EPS =  100 = 44.44%
12.6
Contribution ` 2,40,000 ` 2,00,000
(ii) Operating leverage = =
EBIT ` 1,40,000 ` 1,00,000
= 1.71 2
EBIT ` 1,40,000 ` 1,00,000
(iii) Financial Leverage = =
EBT ` 90,000 ` 50,000
= 1.56 2

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 Financing Decisions 4.80

Question 23
F rom the following details of X Ltd., pr epa r e the Incom e State m ent for the yea r ended 31st
D ece mbe r , 2014:
Financial L eve r age 2
Inte r est ` 2,000
Ope r ating L eve r age 3
Va riable cost as a pe r centage of sales 75%
Incom e tax r ate 30%
Answer
Workings:
EBIT EBIT
(i) Financial Leverage = Or, 2 =
EBIT  Interest EBIT  ` 2,000
Or, EBIT = ` 4,000
Contribution Contribution
(ii) Operating Leverage = Or, 3 =
EBIT ` 4,000
Or, Contribution = ` 12,000
Contribution ` 12,000
(iii) Sales = = = ` 48,000
P / V Ratio 25%
(iv) Fixed Cost = Contribution – Fixed cost = EBIT
= `12,000 – Fixed cost = `4,000 Or, Fixed cost = ` 8,000
Income Statement for the year ended 31st December 2014
Particulars Amount (`)
Sales 48,000
Less: Variable Cost (75% of ` 48,000) (36,000)
Contribution 12,000
Less: Fixed Cost (Contribution - EBIT) (8,000)
Earnings Before Interest and Tax (EBIT) 4,000
Less: Interest (2,000)
Earnings Before Tax (EBT) 2,000
Less: Income Tax @ 30% (600)
Earnings After Tax (EAT or PAT) 1,400

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 4.81 Financial Management

Question 24
A firm has sales of ` 75,00,000 va riable 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 favour able financial leve r age?
(iii) If the firm belongs to an industry whose capital turnove r is 3, does it have a high or low
capital turnove r?
(iv) What a r e the ope r ating, financial and combined leve r ages of the firm?
(v) If the sales is inc r eased by 10% by what pe r centage EBIT will inc r ease?
(vi) At what level of sales the EBT of the firm will be equal to ze ro?
(vii) If EBIT inc r eases by 20%, by what pe r centage EBT will inc r ease?
Answer
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
Earnings before tax (EBT) 22,95,000
EBIT EBIT
(i) ROI = 100 = 100
Capital employed Equity + Debt
` 27,00,000
= 100 = 27%
` (55,00,000 + 45,00,000)
(ROI is calculated on Capital Employed)
(ii) ROI = 27% and Interest on debt is 9%, hence, it has a favourable financial leverage.
Net Sales
(iii) Capital Turnover =
Capital

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 Financing Decisions 4.82

Net Sales ` 75,00,000

Or = = = 0.75
Capital ` 1,00,00,000
Which is very low as compared to industry average of 3.
(iv) Calculation of Operating, Financial and Combined leverages
Contribution ` 33,00,000
(a) Operating Leverage = = = 1.22 (approx)
EBIT ` 27,00,000
EBIT ` 27,00,000
(b) Financial Leverage = = = 1.18 (approx)
EBT ` 22,95,000
Contribution ` 33,00,000
(c) Combined Leverage = = = 1.44 (approx)
EBT ` 22,95,000
Or = Operating Leverage Financial Leverage = 1.22 1.18 = 1.44 (approx)
(v) 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)
(vi) 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.
(vii) 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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