-.

"

-
....
I !~'

-
-
Chapter VIII

Leverage

III

II

il

Leverage: Financial Context Income Statement of XYZCompany Ltd.

II
Leverage in the general sense means influence of power
i.e. utilizing the existing resources to attain something
else. To define leverage in terms of financial analysis-
II
Leverage is the influence which an independent
~II
financial variable has over a dependent! related financial
variable. When leverage is measured between two
financial variables it explains how the dependent 'III
variable responds to a particular change in the
independent variable. To explain further, let X be an ~I
independent financial variable and Y its dependent Hence,
variable, then the leverage which Y has with X can be
assessed by the percentage change in Y to a percentage EBIT = Q x S -
Q x V - F = Q(S-V}--F (i)
change in X. EPS = [(EBIT - I)(I-T)-Dp]/N (ii) J(;~\

= ~ Y/y - [Q(S-V)-F-I] (I-T)-Dp ~r !

LY/LX - N . (iii)
~XIx ~i
j I
where =
where N No. of, Equity Shareholders
LY/LX The above three equations (i),(ii) and (iii)] which Ii
measure of the leverage which
establish the relationship between the various items of
dependent Y has with independent X the Income Statement form the base for the
AX change in X measurement of the different leverages.
I:1Y change in Y
OPERATING LEVERAGE
A X.-x percentage change in X
Operating leverage examines the effect of the change
A Y/y percentage change in Y in the quantity produced on the EBIT of the company
and is measured by calculating the Degree of Operating
Measures of Leverage Leverage (DO~).
To better understand the importance of leverage in =
DOL Percentage change in EBIT/ Percentage change
financial analysis, it is imperative to understand the in Output
three measures of leverage.
. Operating Leverage
= t. EBITJEBIT

t. QlQ
. Financial Leverage From Eq(i) EBIT = Q(S - V) - F
.. CoinbinedJ Total Leverage Substituting for EBIT, we get
These three measures of leverage depend to a large DOL = [Q(S - V)] / [Q(S - V) - F] ( i\')
extent on the various income statement items and the Illustration 1
relationship that exists between them. Given below is
Calculate the DOL for XYZ Company Ltd. given ti;,;
the Income Statement of XYZ Company Ltd. and the
following additional information:
relatiqnship that exits between the various items of the
statement: Quantity produced = 5,000
Variable cost per unit = Rs.200
Selling price per unit = Rs.500
Fixed Asset = Rs.90,OOO
 .,

Financial Management ~

DOL of XYZ Company LId. Tnblc 8.1

. = [5.00)(500 - 200)]/[5CXX)(500
- 2(x) - 9OO,OOOJ
Cost and Profit Schedules for
= 2.50
Bell Metal Works nnd Fibre Glass Ltd.
Application and Utility of the Operating Leverage
.BeUMelalWorks'.,.,.,;.. ,..f'. ,Rm! Glass LknIted. .
,
III It is important to know how the operating leverage is
measured, but equally essential is to understand its ~;.:SaIes TotaJ,<',!:m..Ti.:..UjIISt~j.,SaI!IS A;';ToIal:. EBJ;1:(
Prod.ii:OOl. Ope ti1g'.' .1"".1~ piOOi~(I;}""'Y');:"~'i8tiOg. ..," >;;~
application and utility in financial analysis. To
understand the application of DOL one has to ~;~~~PQ ..f~4...).!~~~~l*~1~';~.";C~'~,~
understand the behavior of DOL vis-a-vis the changes
in the output by calculating the DOL at the various
levels of Q. }~};,..00G1.J'~ ;;,~~~{~lIi~~~
20.000. 2.00,000 .2.30.000 ~'(30,ooo) /'20.000; 2.00'00()~'OOO :'(90.000),
3O.ooo~.00.OOO '~oo,ocx)::'i~){o ""~"'3.oo:000~:40;OOb~(~ooi;
40.000 . 4,00.000 3.70,000, :3),000.,1: -40;000';4.00.000 :;,~:oo,ooo '.~';1'0.000
50;000,:5.00.000 4.40.000})~.E01m p'r,qMo~'~:oOO~'4.~»JOWi:W~

.
6O.000:'.6.00.0005.10,OOOl:.;i,~:~.
.,ro. ~::i7,Oo.oood5,80
.
~ioPoJ;6,OO;ooO~1,9O.000".j.10,OOO
.000:~~I::?o.oQQ.~i70r~ ': "
", ~'~~,~,.4P.QOO.,;1:60":~909.
. . .
J
-80:OOO~8,00.000 ,'i;;So;oo6'$i;Sb';ooo .~ '{S';90',oOO;;:60.000 ~

ifs~:iiitl~~i
~
,~
From the table, we can see [hat Bell Metal Works has ~,
Q = F/(S - V) lower fixed costs and higher variable cost per unit when.
compared to Fibre Glass Limited. The selling price per I
For XYZ Company LId.: ~
unit (P) of both firms is the same, viz., Rs.lO. An
Q = 9,00,000/(500 - 200) = 3,000 interesting point we notice that at an output of 50,000 ~
units both firms have the same profit i.e. Rs.60,000.
,
After measuring the DOL for a particular company at
varying levels of output the following observations can However, as sales fluctuate. the EBIT of Bell Metal .-
~
be made: Works fluctuates for less than the EBIT of Fibre
. Glass Limited. This brings us to the conclusion that ~

. Each level of output has a distinct DOL.

the DOL of Fibre Glass Limited is greater than the
,

. DOL is undefined at the operating break-even point.

If Q is less than the operating break-even point,
DOL of Bell Metal Works. Let us compute the DOL
of these two firms at an output of 50,000 units.
~
~

then DOL will be negative (which does not imply For Bell Metal \-Vorks:

. that an increase in Q leads to a decrease in EBIT).

If Q is greater than the operating break-even point.
DOL = [50.CXX>(10 -
= 2.5
7)] 1 [50,CXX>]0 - 7) - 90.000]
"
~

then the DOL will be positive. However, the DOL

will start to decline as the level of output increases
For Fibre Glass Limited: .
11
and will reach a limit of I. DOL = [50.000 (10 - - 5) - 190,000]
5)J 1 [50.CXXXJO

IMPLICATIONS
= 4.17 .
\0
The figures prove our conclusion to be right.
Determining behavior of EstT . Measurement of Business Risk ,.
DOL answers the following type of question: If We know that the greater the DOL. the more sensitive
output (quantity produced and sold) is increased by \
is EBIT to a given change in unit sales. i.e. the greater
10 percent by what percentage will the operating is the risk of exceptional losses if sales become ..
income increase? If the DOL of a firm is say. 2, then depressed. DOL is therefore a measure of the firm's \.
a 10% increase in the level of output will increase business risk. Business risk refers to the uncertainty or .
operating income by 25%. A large DOL indicates variability of the firm' s EB IT. So, every thing else ~
that small fluctuations in the levcl of output will being equal, a higher DOL means higher business risk 4

produce large fluctuations in the Icvel of operating and vice-versa. "

Income.
In Table-8.1. two firms with different cost structures
. Production Planning AO

~
DOL is also important in production planning. For
are compared. ..
instance. thc finn may have the opportunity to change
'!o
its cost structure by introducing labor - saving
.,
"
,1'i1J
'E
'"
'"
~
\

......
 Ilf
ill
Leverage !I
"il!
i
II
mach Ii, 'y, thereby reducing variable labor overhead ~:
while liI'reasing the fixed costs. Such a situation will 'Ii
increase DOL. Any method of production which 'I'
I
increase s DOL is justified only if there is a very great II
probahillty that sales will be high so that the firm can
enjoy :he increased earnings of increased DOL.
!I~J
FINANCIAL LEVERAGE
While operating leverage measures the change in the The DFL at EBIT levci of 175000 is undefined and I~
EBlT of a company to a particular change in the this point is the Financial Break-even Point. It can be
Jefined as follows: 1'1
outpU( i,he financial leverage measures the effect of
,\
the change in EBIT on the EPS of the company. = I + Dp/(l
Financial leverage also refers to the mix of debt and
EBIT - T) I
equity in the capital structure of the company. The The following observations can also be made from
studying the behavior of DFL.
measure of financial leverage is the Degree of
Financia! Leverage (DFL) and it can be calculated . Each level of EBIT has a distinct DFL.
as follows: . DFL is undefined at the financial Break-even Point.
DFL = (percentage change in EPS)/ (percentage
change in EBIT)
. DFL will be negative when the EBIT level goes.
below the Financial Break-even Point.
DFL = (L\ EPSIEPS)/(6
Substituting Eq(ii) for EPS we get,
EBITIEBIT) . DFL will be positive fof .all values of EBIT that
are above the Financial Break-even Point. This will
:!I'

however start to decline as EBIT increases and will

DFL = EBIT Eq(v) reach a limit of I.
EBIT - I - ~ By assessing the DFL one can understand the impact ~Ii
(i-T)
of a change in EBIT on the EPS of the company. In ,' "
Taking the example of XYZ Company Ltd., which has addition to this it also helps in assessing the financial
an EB IT of Rs.6,00,OOOat 5,000 level of production. risk of the firm. i'
The capital structure of the company is as follows: :.J II
Impact of Financial leverage on Investor's I' ~II
Capital. SIr.JCtJre, .' ,;'n i/', ,( ~ , "~'0:fr;;.j ,/:i;;ds\AmOOnt.(Rs.) II
Rate of Return
Let us see with th~ help of a very simple example, how
~d;:=.~~~~!,~:j~J!!!i~!
1O'Y.Preferaoce.Sharns ':.,'.i;~.' ': ".,,,,-i".:p:,:i',:.:,.
financial leverage affects return on equity. A company
needs a capital of Rs.IO,OOO to operate. This money
t
5000 PI8I~,ceShares CIRs.100'h/~~:'. ,;"':"':i~':j'Z"}/,.:..5,oo,OOO may be brought in by the shareholders of the company.
Total ,;6,00,0000 . Alternatively, a part of this money may also be brought ill

in through debt financing. If the management raises

Let us now calculate the DFL of XYZ Company Ltd.
Rs.lO,Ooo from shareholders, the company is not
Earnings Before Interest and Tax (EBIT) =Rs.6,00,000 financially leveraged and would have the foHowing
Interest on Long-term Debt (I) = Rs.75.oo0 balance sheet.
LiabiUtles As.
Preference Dividend (Dp) = Rs.50,OOO 10,000 . Cash .' ,--
EquitY
Capita! I ~~ 'j .".:.',-10,000
Rs."1
Corporate Tax (T) = 50%
The company commences operations which leads to
DFL = 600,000
the preparation of the following simplified version of
6,00.000 - 75,000 - 50,000
1-0.5
its income statement.
Rs.
= 1.41 Sales '10.000
i Expoo* -',7.000
Application and Utility of the Financial EBIT :" ; , -. 3.ooQ
Tax 0 50% ~
leverage Net Profrt 1.500'
Financial leverage when measured for various levels
What is the return the company has earned on the
of EBIT will aid in understanding the behavior of DFL
owner's investment? We see that the return on equity
and also ex(>lain its utility in financial decision making. is 15%. The net profit of Rs.1.500 may be paid fully
Consider the case of XYZ Company Ltd. to measure
or partly to the shareholders as dividends or may be
DFL for varying levels of EBIT.
retained to finance future activities of the company.
Either way the Return on Equity is 15%.

147
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Financial Management

What happens to the owner's rate of the return if the Debt Equity Ratio? The answer is that as the company
becomes more financially leveragcJ, it becomes riskier,
~
managc'TIent decides to finance a part of thi total
investment required of Rs.IO,OOO through debt i.e., increased use of debt financing will lead to
financing? The answer to this question depends on increased financial risk which leads to:

. . Increased fluctuations in Ihe return on equity, ~

the proportion of total investment which the
management decides to finance through debt (Debt . Increase in the interest rate on debts.
Equity Ratio the finn aspires to), and ~
. the interest rate on borrowed funds.
Increased fluctuations in returns
In the previous example, let us assume that sales decline J
If the management has decided on a Debt Equity Ratio

of 2:1, total borrowings will amount to I0.000 x = j

by 10% (from Rs.IO,OOO to Rs.9.000), expenses
remaining the same. What happens to return on equity?
1,.
Rs.6,667. Assuming that the company is able to raise The income statements for the financially unleveraged, i
this amount at an interest rate of say, 15%, the and leveraged firms will appear as follows: ,..
company's balance sheet will appear as follows: 'Uole'ieraood .'.\leveraged R.m '"1
:,;~~i~;J.~1~:i;Jit~~:?~~#;~:
.:,;;','" '"
,.
::C:~tAI ,',",:}~;J~, ,3.~i~~';"""A~i~L,;}~.~
Debt Capital: '- ',;~i: !<I..ti@~'1~i!.' "6,667r\"'\1:!o.>
, ' , ,,~>. " 10:000 ~"
I~l, >'<;\j~"':>-~?"f'
'~";'To:ooo
;" ''..\
~';;;1; ..~L;,."'t~~~~
EBIT)~,?,'>,.I,t('r.",A:~.
,,;",' . . 2000,:.; , ,,' 2.000
~
"1
,
lrite~,'q;~s"'~:~Y ':",' ",,::t':"~:;~'I! '..~'I.ooo
The company now has an added financial burden of I ""hf.<""~\""'" "",,', ' . . '" ... (6667 015) ,.
payment of interest on the amount it has borrowed. The ~~~¥;~(:;;:sL:"V';~;i,i';t'~~~S~' ,'. :.:' .."..~,:,:,l~:~;L:.,!;i;; ", ~-I.ooo ~
income statement wil! now show as follows: I'"

~nses
1-£BIT, ",' , ,
" ;'"

-'t-.., '-;:':, ' . ,. ",

.,', '7.000

. ." "pro
'
Rs,

~'OOO
;i~ ~/,
ROE-:iit~oIRs.10,OOO'
ROEat Sales01RS.9,OOO
,'~~
,; .15%i
1()%
,: r,
'I
.,

Interest Charges ',~'-- ", "1;000

,, I
r.
"'i
Profit before Tax (PaT),\;::" :, .;', , ,>', ',' ,:; ;'2,000 We seethat a 10% decline in sales produces substantial
Tax Q 50% ,,:;1,~,f:,';'.' ,'::', 1,POO,
Net Profrt . ' 1:000 ' declines in earnings and the rates of return on owner's 1"1
equity in both cases. But the decline is greater for the "'1
Th~ use of debt in the company's capita! structure has
caused. the net profit to decline from Rs.I,500 to financially leveraged firm than for the financiaIly ,..
Rs.I,OOO. But has the return on owner's capital un leveraged firm. Why is this so? The reason can be "'t
declined? Return on Equity now works out to 30%, as traced to .the fact that once a firm borrows capital,
I')
the owner's have invested only Rs.3,333 now which interest payments become obligatory and hence fixed ....
earned them Rs.I,OOO. What were the factors which in nature. The same interest payment which was the
~
contributed to this additional return? We can trace out cause for increase in owner's equity when sales was
two sources of this additional return: Rs.'IO,OOO is now the cause for its more than
~
. though the company has to pay interest at 15% on
borrowed capital, the company's operations have
proportional decline when sales declines. Helice, the
greater the use of financial leverage. the greater the
~
....

potential fluctuation in return on equity. ,..

been able to generate more than 15% which is being ~
transferred on to the owners.
. the reduction in PBT has brought about a reduction
in the amount of tax paid, as interest is a tax deductible
Increase in interest rates
Firms' that are highly financially leveraged are
.....
"-t

1ft
perceived by lenders of debt as risky. Creditors may
expense, to the extent of Interest (I - tax rate) i.e.,
refuse to lend to a highly leveraged firm or may do so
~
Rs.500. The greater the tax rate, the more is the tax '"'
only at higher rates of interest or more stringent loan
shield available to a company which is financially conditions. As the interest rate increases. the return on ~
leveraged. ...
equity decreases. However, even though the rate of
As was seen in the above example, a company may return diminishes, it might still exceed the rate of return \i
increase the return on equity by the use of debt i.e., obtained when no debt was used. in which case financial ~
the use of financial leverage. By increasing the leverage would still be favorable. ~
proportion of debt in the pattern of financing i.e.. by At
increasing the debt equity ratio, the company should be Implications 4et
able to increase the return on equity. Let us again refer to our earlier example. In the firsl ....
situation, the company was unleveraged, in the 'i
Financial leverage and Risk
second situation the debt-equity ratio was 2: I. The ."
If increased financial leverage leads to increased return balance sheet and income statements are reproduced ~
on equity, why do companies not resort to ever helow:
increasing amounts of debt financing'! Why do financial .....
'"
and othCf tCfin lending ::1st:t!.!!i0!1~!!1~islon norms Jor
.".
'i
14H
.....

1
~
""
110 ,
"-I
 II
Lev'Jrage

r~ Balance Sheets CaIoJtaIing !he OTllor XYZ Co. lid. given !he IoIowing inlOl11\llioo:
EquityEamings = Rs.I,62.500
Quantity
Produced
(a) = 5000 1.Ir1i1s
VariableCostper unitM = Rs.200
SellIngPriceperIII~(S) = Rs.500
t!
Number 01equityShareholders
(N) = 5,00,000
FixedExpenses(F) = Rs.9,OO,O'X>
Inleresl(I) = Rs.75.000
PrelerenceDividend(Op) = Rs.50,000
Income Statements CoqxualeTax(T) = 50%
'I
DTL .
5,000 (5,000 - 2(0) t
5 000 (500 - 200) - 9 000- 75 000 - 50,000
, "(I - 0.5) II!
= 3.53
II
DTL = DOL x DFL
= 2.5 X 1.41 = 3.53
Thus, when the oUtput is 5,000 units, a one percent
change in Q will result in 3.5% change in EPS.
EBIT "'I
DFL =
D Appli.cations and Utility of Total Leverage
EBIT-I-~
I-T Before understanding what application the total
3000 leverage has in the financial analysis of a company, let
Unleveraged = us make a few more observations by studying its
3000 = 1
behavior. Let us calculate the overall break-even point
= 3000 =
Leveraged 1.5 and the DTL for the various levels of Q, given the
3000 - 1000 following information:
What do these figures imply? This implies that if F = RS.8,OO,ooo
EBIT is changed by 1%, EPS will also change by I = Rs.80,ooo
I %, the company uses no debt and by 1.5% when it
uses debt in the ratio of2:1 (66.67% o£total capital). Dp = Rs.60,OOO
This is proof of what we have stated earlier: The S = Rs.I,OOO ;J

greater the leverage, the wider are fluctuations in the V = Rs.600

return on equity and the greater is the financial risk the
The overall break-even point is that level of output at
company is exposed to. Through an EBIT-EPS analysis,
which the DTL will be undefined and EPS is equal to
we can evaluate various financing plans or degrees of
zero. This level of output can be calculated as follows:
financial leverage with respect to their effect on EPS.
D
F+I+~
TOTAL LEVERAGE -
Q = (I T)
A combination of the operating and financial (8 - V)
leverages is the total or combined leverage. Thus, = [8.00,(0) + 80,(0) + ro,OOY(I- 05)Y(I,OXJ- (ill)
the degree of total leverage (DTL) is the measure of
= 2,500.
the output and EPS of the company. DTL is the
product of DOL and DFL and can be calculated as Thus, the overall break-even point is at 2500 units.
. follows: Calculating DTL for various levels of output with the
DTL= % change in EPS / % change in output given information:
a DTl"
: (bEPSIEPS)/(i\Q/Q) ".' ,1000 .(J!J7.
DTL: DOL x DFL '2000 ..4.00
. 2500
= ([Q(S - V)]I[Q(S- V) - F]} X .~ 6.00,-'.
5000 2.00,.:;
([Q(S- V) - FVQ(S- V) - F - I - [Dp'1- 1)))
The following observations can be made from the above
- Q (S - V) calculations:
-
Q(S- V)-F-I-~
D
. There is a unique DTL for every level of output.
. (I - T)
. At the overall break-even point of output the DTL
is undefined.

149

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---II.
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J

J
.J
Financial Management
J
. If the level of '.Jutput is less than the overall change in Q. For example, if DTL for Q of 3000
break-even point. then the DTL will be negative. units is 6 and there is a 10% increase in Q. the ~
II
. If the level of output is greater than the overall
break-even point. then the DTL will be positive.
affect on EPS is 60%.
Percentage change in EPS = DTL (Q = 3000) x J
DTL decreases as Q increases and r~aches a limit Percent change in Q
of I. : ",,6 x 10% ~
Further. the, DTL' .has the follow)ng applications in = 60%
analyzing the financial performance o(a company:
'

J
2. Measures Total Risk: DTL measures the total '1
1. Measures changes in EPS: DTL measures the
changes in EPS to a percentage change in Q. Thus,
risk of the company since it is a measure of bo.th ,...
operating risk and total risk. Thus. by measuring
the percentage change in EPS can be easily total risk, it measures the variability of EPS for 1
'."'i
assessed as the product of DTL and the percentage a given error in forecasting Q.
,..,
"'i
11
....
,.
"""
I
".
...
r"1
1'1
"1
1"
""I
,.
"1
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~
~
~
...
....
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iii
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60
~
~
:1
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J.
150 ...
,.-
L.
 ,,:
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'li
,

Self-Evaluation Exercises i:l,'",

II,
nl
Section I Ik

Choose fthe. right answer from the alternatives given.

The 1Ota1revenue of Saturn Ltd. for the year 1995-96 was Rs.12.5 lakhs. This was obtained on the sale of
500 units al a price of Rs.2,5oo each. The variable and the fixed expense:; were Rs.I,500 per unit and
~RS.2,OO,OOO respectively. The company has leveraged its capital structure to the extent of Rs.3,OO,OOO@
1:5%1'.11.Sa~urn Ltd. has 50000 equity shareholders holding th~ shares at par. In addition to this the firm
also has issued 12% preference shares @ Rs.IOO each amounting to Rs.2 lakhs. The corporate tax rate is
given as 40%.
Arnt')w(!J.r
questions from 8.1-8.6 on the basis of the information provided:
1, SaltEl} Ltd. has an EBIT of - and thus its EPS has been calculated to be -'
a. Rs.I0.5 lakhs and Rs.l1.58
b. Rs. J0.5 lakhs and Rs.7.56
c. Rs.3 iakhs and Rs.2.58
d Rs.3 lakhs and Rs.J.56
e. Insufficient data.
2. The degree of operating leverage of the company is .1

a. 4.17 'II
~.
b. 1.67
c. -1.67
jl
d. -4.67
e. Undefined.
3. The degree of financial leverage of the firm is :1:
a. 4.41
b. 1.39 :111

c. 1.09
,
'1
d. -1.09 1II
.
~I
e. -1.39. im
itl
4. The degree of total leverage of Saturn Ltd. is
fi

a. 6.13 m
b. 2.32
c. 1.82
d. -1.82
e. -2.32.
5. The levels of output at which DOL and D11.. are undefined
a. 215 and 115 .
'I[
I

b. 200 and 285

c. 200 and 215
...
d. 200 and 95
c. 115 and 200.

151
 'Ill
f.
C
(:
Financial Management ,..
...
6. The financial break-even point for the finn is
a. Rs.3.00.000 ,
b. Rs.2.85.000
(
c. Rs.l.15.000
I!
d. Rs.l.05.000 (

I
7.
e. Rs. 85.000
Operating leverage measures the sensitivity of th~ to changes in qu!ntity.
c
I
a. Earnings per share c
II b. Profit after tax
c. Earnings before interest and tax
~
Ii
d. Earnings before tax but after interest ,.
'"
e. Expenditure. .
8. l'
Degree of financial leverage can be given by which of the following fonnula taking '"
EBIT = Earnings before interes~ and tax; Dp =
Dividend on preference shares; T = Tax rate;
I = Interest ,
EBIT
a. I
- Dp ..

EBIT - I - l=-T
EBIT
,
~

b.
Dp ~
EBIT + I + ! - T
Dp ~
c.
~
EBIT + I
EBIT
d.
EBIT + I - 1 ~p T
e. None of the above.
9. Degree of financial leverage is below the financial break-even point.
a. Undefined
b. Positive
c. Negative
d. Zero
e. Has no relationship.
10. Degree of total leverage (DTL) can be calculated by which of the following formula given Degree
of operating leverage (DOL) and Degree of tinancialleverage (DFL).
a. DOL + DFL
b. DOL + DFL
c. DFL - DOL
d. DOL x DFL
e. None of the above.
11. The following data are available for age group electronics.

Unit ~elling Price (P) = Rs.150

Unit Variable Price (Y) = Rs.80
Total Fixed Cost (F) = Rs.3.00.000.

152

..
 ,
'-

:f

levorago

The degree of operating leverage for age groups when the output (Q) is 5000 units is
a. 7 I'
b. 6
c. 5
d. 4
e. 3 I~

12. Consider the following data for Symphony Enterprises.

Interest burden (1) = Rs.150,ooo
Tax rate (T) = 50 percent
. Preference dividend (Dp) = Rs.75,ooo
When the earnings before interest and taxes are Rs.5,OO,OOO,the degree of financial leverage is ii,

a. 5.5 ':11

b. 4.5
c. 3.5
d. 2.5 lill

e. 1.5
Section II

1. Calc.1Iate th~ EBIT for the following:

a. P = Rs.20 Q = 25,000 V:;: Rs.12 F = Rs.60,ooo
= Rs.70 I'!
b. P Q = 40,000 V = Rs.40 F = RS.3,oo,OOO III
I
I
Sac manufacturing sells 100 units, contribution per unit being 400 and fixed cost Rs.80,ooo, what is the
@2. DOL of Sac manufacturing? What will be the DOL if quantity sold rises to 300 unit:>?
3. Global computers sells 10000 units of wiper-it's flagship brand. The contribution per unit is Rs.lO &
EBIT is Rs.60,ooo, what are the fixed costs?

@4. 12 company decides to sell 20,000 units of Alpha, generating EBIT of Rs.3,50,ooo. The DOL for this
level is 3.5. Find out the range of variance in EBIT if the actual sales varies between +20% and - 10%.
5. If P = 400; V = 240; F = 80,000; 1= 30,000; T = 60% and Pref. Dividend =15,000
What is degree of financial leverage when sales is 40,000.
6. The following data are available for two firms X and Y.
(in Rs.)
0'
Finn X: "
," FinnY"
"', " -c

Quantity 80,000 -;:', 50,000,

Selling Price 20 <c 30
Variable Cost (per unit) 10 10,
Fixed Costs 60,000 . 30,000:' --:- ,:

Interest 20.000 ,,'" ' 15.000, :,'

Preferred Dividend 10.000 . '. ,",

",'-',':

15,000 Ju 10,000<' .
Nutnber of Equity Shares
Tax Rate 50% 50%

-" 153

- "\

~
 I
~
rI '-:
c
c
Financial Management
I"
....
For hoth Ihe firms calculz:.: the following
,...
a. Earnings before interest and tax \-
h. Earnings per share (:
e. Operating break-even point
II
d. Finar.cial break-even point
r....
e. Over-all break-even poinl r....
r. Degree of operating leverage
r....
g. Degree of financial leverage
h. Degree of tolal leverage ,.....
7. The following data is given for Plaza Limited: P = Rs.50, V = Rs.30, F = Rs.l ,00,000, I = Rs.50,OOO,
T = 50 percent, and D = Rs.20,OOO. What is the DFL for Plaza Limited when the !evel of output is ,
.....
10,000?
" p
The following data are available for the Broadway and Midway Companies: ....
@8. ,
, ' " , ,
'BfQadwa~,Co.
,',,"'>",' "",J,,,,,, ,
Midway Co. p
'.. ' .....
10,000 units
Rs.200 #'
...
~;:!:f~~i~:!'~~!;:r1!::I;u,":r~'... . RS.150
~ Fixed operating cost p~r1~riitofoutput .Rs.6Q Rs.30
F
...
Rs.6;00,000
~~« Equity R'S.3,oo,OOO "
f'
...

~\f/
Preferen~:~?at~s<'"
Debt, ' .':'
. Rs.l,oo,ooo
Rs.6,OO,OOO
Jj' ;S.4,OO,OOO. ( P'

,...
...
Interesrrate~br{'debt, 16.25% 15% ",,;
r...
Di viden~:fate'~n; prefer~nce share";,,. :13% 'd' ,,','
Tax rate"'"';''' ,.:'- ,60% 60%'':;
r
...
Required:
...
i. Calculate the ROE, DOL, DFL, DTL, operating break-even point, financial break-even point and ....
overall break-even point for each company. /'
...
ii. As a financial analyst which of the two companies would you describe as more risky? Give reasons.
9. /"
The sales revenue of Leveret Company @ Rs.20 per unit of output is RS.20 lakhs and contribution is '"
Rs.1O lakhs. At the present level of operations, the DOL of the company is 2.5. The company does not
,..
have any preference shares. The number of ordinary shares is I lakh. Applicable corporate income tax
rate is 50% and the rate of interest on debt capital is 16% p.a. What are the EPS (at sales revenue of
,
Rs.20 lakhs) and amount of debt capital of the company if a 25% decline in sales will wipe out EPS? ,..
...
(Note: DOL - Degree of Operating Leverage; EPS - Earnings Per Share)
,.
10. The following data pertain to Exotica Limited. "
, Selling price per unit Rs.loo ,.
Rs.60 '"
Variable cost per unit
"'
Fixed operatiJigcosts RsAO,OOO '"
Sales volume 1,200 units ..
'"
What is the financial leverage of the company if 10% change in sales will bring about 90% change in EPS?
'"
What percentage increase in variable cost will result in a 750% increase in the existing operating leverage? '"
11. The operating and total leverages of Enigma Company are 2 and 5 respectively. Total variable costs at the ""
existing level of operations amount to Rs.6,50,OOO.Interest expense and dividend on preference shares are ...
Rs.75,OOOand Rs.36,OOOrespectively. Corporate income lax rale is 60%. Whal is the sales revenue of Ihe
,.
company? ""
~
"'-
....
154 '"
;
...
....
 leverage
12. Selected financial data for Alacrity Limited are given below:
"".,
'k~
Variable e,!,pensesas;percentof sales';'.."~r~F ,;' 661% , ,
:~,' .. "", ',.., 3

Interest expenses Rs.20 lakhs

Degree of operating-leverage 5

Degree offinancialleverage 3
~.
Income tax rate 50%
--J
, I

The company has not raised funds through issue of preference capital.

" What are the fixed expenses and profit after tax of the company?
1l1e DFL of Ajay Castings is 2. The company pays an annual interest of RS.I ,00,000 and a preference
(J/13. dividend of Rs. !5,000. The tax rate for the company is 50%. By what percentage will there be a fal: in
II

j
the EPS if EBIT drops to Rs.1 ,30,OOQ? ,r
14. The DTL and DFL of a company are 3 aJ;\d 2 respectively. The company pays an annual interest of
Rs.60,000 and preference share dividend of Rs.16,OOO. The total variable costs of the company are
Rs.2,OO,000 and the applicable income tax rate is 60%. What are the amounts of sales revenue and fixed
operating costs? I~~
I
15. The Gudia Enterprises manufactures and sells a typical electronic toy. The selling price and variable cost ""j
"
per lOy are Rs.20 and Rs.IO respectively. Operating fixed costs amount to Rs.5 !akhs. The interest expense
is Rs.2.5 lakhs and DFL is 2. What are its DOL and Sales Volume respectively?
16. Ill'i
The Sigma Company's operating and total leverage are 2 and 3 respectively at the present sales level of
"I~i
10,000 units. The selling price per unit of output is Rs.12 while its variable cost is Rs.6. The company
has no preference share capital. Applicable corporate income tax rate is 50%. The rate of interest on the !1II1
company's debt is 16% p.a. What is the amount of debt in the capital structure of the company? .l
~ id
l

:;1
I
)
Ii'
IIIII!
I I
,, 'it I
,
lII'i
\ !,
, mii

\,
Ih

\, ;~!
!n
\
IIII

,, H
I

'-
,
",

"
...
,. 'i

""
"rJ 155

..
"
"
r,
!"
"1
;
Solutions
,
Section I
1
\. c 2. b 3. b 4. b 5. b 6. e 7. c 8. a 9. c 10. d I \. .1 12. U ,
Section II .I
II
,
1. a. EBIT = Q(P - V) - F
= 25,000 (20 - 12) - 60,000
,
...

II
= 25,000 x 8 - 60,000 't
= Rs.1,40,000 <II
...
b. EB IT = Q(P - V) - F I
1"1
= 40,000 (70 - 40) - 3,00,000 'I
I
= Rs.900,000 it
"f

2. . a. DOL = Q(P- V) II
Q(P -V) - F ..
Q = 100, '(P - V) = 400 F = 80,000
.-j
100x 400 '1
DOL = =-1
100 x 400 - 80,000 "
b. if Q = 300 then
,
II
...
DOL = 300 (400) = 1,20,000
300 x 400 - 80,000 1,20,000 - 80,000 .II
..
= 1,20,000 = 3 ti
40,000 ...
3. (P - V) = Rs.1O
...
EBIT "!I
= Q(P - V) - F
60,000 = 10.000 (10) - F ...

F = Rs.JOO.OOO
- 60.000 = Rs.40,000
...
"'I
4. As the variation is from 10% below and 20% above
Ai
:. if Q is more than forecast by 20% then
L1EBIT = 3.5 x 0.2 = 0.7 = 70% .I
"i
and if Q is less Ihan forecast by 10% then
.AI
~BIT = 3.5 (0.10) = -0.35 "'I
== -35%
...
EBIT '1
5. DFL =
"""
EBIT - I - t,p
I-t
J
- Q (P - V) - F

lQ(P-V)-F)J-I-
.'
t,p
I-t
J
Q = 40,000; P = Rs.400; V = 240; F = !!O,OOO
J = 30,000; T = 0.6; t,p = ! 5,000 .
"1
,..
..,
156 ,.,.
--
,..
"'-
.s
L..
 "
-I"
--
-I
"""
Leverago
-Ir 'I!

40.(X)O (400 - 240) - XO,OOO

-.I DFL ..:
I ') O()()
it

~(),O()() (400 - 24()) - XO,(X)()- 10,000 -~- II

. . 1-0,6
...... h:
40,000 ( 160) - XO,(X)O
.....
~O,O(X) ( 160) - I 1O,(X)O - 37,500

M,OO,OOO - XO,OOO
.....,
M,O(),<X)O - 1,47.500
..... 63,20,!X)O
=
62,52,500 11\
-.I i
DFL = l,t1l0.

6.
Given X

I. Q 80,000
2. S.P.lUnit , 20'

3. Variable CostlUnit 10
-*
4. Fixed Cost 60,000
5. Interest 20,000
6. Dp 10,000
-.;
7. No. of shares 15,000 . '- 10,000
--
8. Tax Rate .50% ,"""'.' ',50% '~
- Required 1\ III,

......
I. EBIT = Q(P - V) - F 7,40,000 -9;10,000 I

-- 2.73
!II!
2. ,9.33 "
II
-- E.P.S = (EBIT - I) ~ - 1) - Dp Iii

--i 3. Operating BE.P (Units) 6,000 15,000

-- Q = F/(P - V)
4. Financial B.E.P (Rs.) 40,000 15,000 \\

--- EBIT = I + -
Dp
]-T
111

'""
...-J 5. Overall B.E.P (Units) 10,000 2,250

"'I
..- F+I+~
I-T
- ."".,
[ P-V
]
""\
-"" 6. DOL = Q (P- V)
Q(P- V)-F
1.081 1.309

- 7. DFL = Q(P- V) - F 1.057 1.015

-- Q(P-V)-F-I- ~I-T
- 8. DTL = Q (P - V)
1.142 1.047

Q(P- V) - F - I - ~I-T
-
r::
r:

r: /57

r:
r:
 "

Financial Managemont

E[3(T
7. DFL , (1)
D
EBIT- I-~
I-T
Ell IT = Q(P, V)- F
= 10,000 (50 - 30) - 1,00,000
Rs. I,00,000
Substituting the value of EBIT and values of I, T, and Dp in (I)
we gel
= 1,00,000
DFL
1,00,000 - 50,000- 20,000

= 1,00,000 0.5
10,000
= 10

8. i.

,,'}'~~iP~;~:::d1~9*~~;~g~~!

2,ool#?'"
'c97~5{)(f 60,000
".,
: 1,02;500 1,40,000
61,500 84,000
41,000 56,000
, ," ' "

" 13, 13,000 -

(1,00,000 x 100)
:\'~S'y;~rs~:Pref~rencedividend .

.. "
28;000
i~.':hf:;~~fit to equity shareholderS:
, " ", " " " " ' ,", '
"56,000
Ifk.~::'.?ROE :',frofit avaHable,'toequity
',--" .~.
28,000: , 56,000' .

,\'/shareholdets/equity 'xl 00 3,00,000 x 100 6,00,000 x 100

= 9.33% = 9.33%
4 2.5
'15. ' , DOL = [Q(S -V)] ,
"

'. ,'" 'EBIT

- Preference dividend 2,00,000 2,00,000

II l~;:.~':~,riFr. =PBtr , PBT
-
(1,02,500 32,500) 1.40,000
. ,',' -;. [ I-T ]
= 2.86 = 1.43
17. DTL ::;; DOL x DFL = 4 x 2.86 = 2.5 x 1.43
= 11.44 = 3.575

158
 {;-

L-

Financial Management
'-
7. OFL
EI3IT Co
. ,"'" (1)
E13IT- 1- J2L
1-1' '-
EBiT = Q(p. V)'- F
C-
10,000 (50 - 30) - 1,00,000
RS.I,OO,OOO r'-
Substituting the value of EBIT and values of I, 1', and 01' in (I)
we get c..
= 1,00,000
OFL
1,00,000 - 50.000 - 20,000 c...
1,00,000 0.5 c.
10,000
= 10
c..
8. i, c..
.,)~f;iK;;i,?!:M~9*~~~S§; c.
c..
,-
"'-
.-
.....

"-

.-
10.

~,~,~it7rf~~(,<t~~'j'l
, ,'='~~}.
='25,
.-
'-
....
' ' '" ',',
1 O() OOO ' "',' , 2', 00 , 000 "
, ~'. "cq
"97;500.' ,60,000 c..

. 1,02;500 1,40,000
....
61:500 84,000
41,000 56,000 ...
13, 13,000 -
(I,OQ,OOOx 100) ..
I, ,liji;,;:'gF;fitt~equity shareholders. 28,000 .' 56,000
Ii
, "',' ,', ',,", '
...
Ii 14j,~::<:iROE=.P['ofit availabk{'toequity 28.600' , 56,000' ,
;','/shareholders/equityxl00
" '
3,00,000 x 100 6.00,000 x 100 ...
= 9.33% = 9.33%
4 2.5 ...
II
15. . ' DOL =,[Q(S - V)]
.. , " EBIT
..
- Preference dividend
'

2,00,000 2,00,000
"Ii ~~; :.§<~riFr.= ~BIT PBT
,:.';
'
,
,"

[ I-T ] -
(1,02,500 32,5(0) 1.40,000
..
= 2.86 = 1.43
~
17, DTI. ==DOL x DFL = 4 x 2.86 = 2.5 x 1.43 ~
= 11.44 = 3.575
"

\
158
.
,
~
 ,
'\
..,
~ Levorage

~, F , ,< ",
Broadv''1Y'Co. ,.' .
.': '.i:~~1\-¥i~~~y..Co.;
;' .'<:~>6:~~>';' ::'Rs.
w tJ,':.,
'
. '~f;:>l Je:~\~ '';.~~' ':
18. Operating Break Even Point QF/(P-V) .t...\"
'':
"
i "
75,000
:';,:~{~~~~:
, ,
" ..~ .'C'",.'~,'~1,'"
, ,

w 19. Financial Break-even point

-;<
=
Level of PBrf at which ,0 :=-CO.6){(X'--~97,50(}).
- 13,000 ,; (I ~:O:6)'XX ...r-60;OOO).
!-It ROE is equal to zero ,,::,. 300
'''. . " 000 6,OO,O()O'
.,.'.
w ='0 =0
= Rs.I,30,OOO ~'Rs.60,OOO
...
20. Overall Break-even point = 7;30:ooo~:c "";:,~~B!60,OOO
Operating Fixed Cost + 'Rs;8C' . .' 'HRs.50
... ~
'~~,:,
Interest + ~1 - t / Contribution per unit ~
w '''''''' '

9,125'units.,: : \
~
=7i200:'units I
J
Working Notes:
w 4,.:l';',:..\..:.,::,::J{Broadwa y ' Co '.-'f',", < . '. \c; Midwa Co. '. ,
,',:;;,:",::.::.;)~~~,. : " c.'" " .' "'-, ' , ",' y

H ,/,,,~Rs.
,.
1. Profit before interest
w Total contribution 5;00,000

Less: Fixed operating 'cost" ' . 3,90.000

W
i2;00,000
b 2. Interes t .. ~
~ Broadway Company
1625.

- 6,00,000 x 100 ,= Rs.9?500

" "
" " "
'
'"
tf

~ Midway Company' -4;00;000 x'~1t~[]{s:~~~~<;.,

11. Though ROE is the same for both the companies, Broadway Company is exposed to greater risk
" than Midway Company. The DOL, DFL and DTL are much higher for Broadway Company than
III
Midway Cornpany. This is also reflected in the Break-even points calculated. Midway Company
is therefore better managed.
~
9. = Q (P - V)
Degree of Operating Leverage
~ Q (P - V) - F
!.I,
2.5 = 10
" lO-F
".. 25 - 2.5 F 10
F =
.
..
l1.=6
2.5
:. Fixed Cost =
. =
~.6.00,OOO
~
Contribution when sales decline by 25% 10 ~--q5 =7.5
,..
:. EBIT = 7.5 - 6 1.5 lakhs=
Let the debt capital be 'x' lakhs
~
. Interest on deht capital = O.16x
~
~
If EPS will he wiped out at a decline of 25% in sales revenue, PAT =0
PAT = (1.5 -0.16x)0.5 =0
~.

-
,
159

,.
 '!I
" '-
~
'-I

Rnanclal Management
j
0.75 - 0.08x
0.75
= 0; x = 0.08
= 9.375
J
At sales revenue of Rs.20 lakhs,
Rs.9,37,500
J
10.
EPS = [10 - 6 - 0.16 (9.375)] 0.5
.
Degree of operating leverage =
= Rs.1.25
Q (SP- VC)
J
Q (SP - VC) - FC
~~
Where Q is the sales volume
SP = Selling price per unit
J
VC = Variable cost per unil J
FC

DOL
=
=
Fixed cost
1200 (100 - 60) J
=
1200 ( 100 - 60) - 40,000
6
~
Degree of lOlal leverage = % change in EPS
% change in sales
J
= 90
10
~
= 9 ~
DTL = DFL x DOL
9 = DFL x 6 ~
DFL = 1.5 (1 ) 'I
DOL = 6 ~'
750% increase in DOL = 6 + 750% of6
= 51
.,
6'

:. DOL = Q (S - VC) '1

III'
Q (S - VC) - FC ""'t

51 = 1200 (100 - x) 11"\

1200 (100 - x)-40000 '-1
.....
= 120000- 1200x
51 ~
8()(){}J
- 1200x I
.....
51 (80,000 - 1200x) = 1,20,000 - 1200x ~
= '"
40,80,000 - 61200x 1,20,000 - 1200x
'-1
60,OOOx = 39.60,000 ....
x = 66 'I
Variable cost per unit = Rs.66 .....

Less: previous variable cost

= J
per unit Rs.60
-
Increase = -Rs.06 J
% increase = 6
60 x 100 J
= 10% (2)
j

~
160 ~

~
~
:),

~ Leverage

~ 11. DOL = Q (P - V). or Sales- VariableCosts.

Q (P - V) - F Sales- Vari;]blcCosts - Fixed Cost
~ We know that DOL =2 and V = Rs.6,50.000
2 = S - 6,50,000
(I)
~ S - 6,50,000- F ""''''

s-v
D1'L=-
III
II
S-V-F-l- ::l.
1-1' .
~ We know thai D1'L = 5, V = 6,50,000, I = 75,000, Dr = 36,00<' Ulld T = 60%
5 = S - 6150,000
-!I (2)
S - 6.50,000 - F- 75000- 36,000
, 1-0.6
.. From (1) 2S - 13,00,000 - 2F = S - 6.50,000
or 5 - 2F = 6,50,000 (3)
..
From (2) 5 = S - 6,50.000
5 - F - 8,15,000
~ or 55 - SF- 40,75.000 = S - 6,50,000
or 4S - SF 34,25,000 = ""'''''' (4)
.. Multiplying (3) by 4 and subtracting it from (4) we get
4S - SF = 34,25,000
II!I - 4S -I-8F = (-) 26,00,000
3F = 8,25,000
~
, 8,25,000
,. F = = RS.2,75,OOO
3 I
=
~

S - 2 (2,75,000) 6,50,000
f or 5 = 12,00,000. I~

f EBIT
12. DFL = ii;

, 3 =
EBIT - Interest
EBIT
'Ii
"'
I
I
EBI1'- 20 :BI.

:. EBIT = Rs.30 lakhs

'1,!
1

- Interest 20 I' 1

PBT ii'
10
Tax @ 50% 5 111
PAT = Rs.5 lakhs I
I
I
II 1

DOL = Q (P - V)
Q (P - V) - F 11'11

Since Q (P - V) - F = EBIT = Rs.30 lakhs II!:

II

III:
5 = Q (P - V)
30 Jil
5 x 30 = Q(P - V) = ISO .1 l

Q( P - V) - F= EBIT = 30
Subtracting (2) from (I) we get
Fixed Expenses
.. = Rs. 120 lakhs

161

:1

I.
 :,-

Financial Managoment

EI3I1'
13. DFL = '1
EI3IT - I - ~1-1'
[131'1'
2
EI3IT - I 00000-
,.
15,000
(I -0.5)
i
EI3IT = (EI3IT - 1.30.(00)2 EBIT ::: 2,60,000
1
If E13IT drops to 1.30,000 i.e. a fall of 50%,
EPS will fall hy 2 x 50% = 100%
~
... ,.
- -.
~-14. DTL 3
A

DFL 2 ..
Therefore, DOL = 3/2 = 1.5
Given DFL = 2 ~
.

EBIT
EBIT

- I - J2.L
= 2 .
,.
1-1'
EBIT = 2
EBIT - 60 000 - 16,000
, 0.4
EBIT
2
EBIT - 1,00.000
EBiT ::: 2EBIT - 2,00,000
EBIT 2.00,000
Given DOL 1.5
Contribution ::: 1.5
EBIT
Contribution ::: 1.5 EBIT
Q (P - V) ::: 3,00.000
QP - QV ::: 3,00.000
QP - 2,00,000 ::: 3.00,000
QP ::: 5.00,000
or sales revenue ::: 5.00,000
Fixed Operating Costs ::: Contribution - EBIT
:::
Q(P - V) - {Q(P - V) - F}
::: 3.00,000 - 2,00,000
RS.I,OO,ooo

EBIT
15. DFL :::
EBIT - I
Let the sales volume of the toys be x.
x (20-10)-5
2 :::
[x (20 - 10) - 5)1- 2.5
IOx-5
2 :::
lOx - 7.5
20x - 15 ::: lOx - 5
lOx ::: 10
x ::: I lakh units
Q (P - V)
DOC :::
Q (P - V) - F

:::
1,00,000 x 10
::: 10,00.000::: 2.
(1,00,000 x 10) - 5.nO,OOo 5,00,000

162

....
 I
I
;
I
I
,.=-- I
Ii
Leverage
IJ
16. Q (P - V)
Degree of operating leverage = I»
Q (P - V) - F 4
r-
Where Q is the quantity sold.
IIli

P is the selling price

V is the variable cost II

F is the fixed cost. ,. . I

I
Substituting the data, we get I
i

2 = 10,000(12 - 6) 1

10,000 (12 - 6) - F
:. F = 30,000
!

Degree of total leverage = Q (P - V)

Q (P - V) - F - I - ~
I-T

'\ 3 = 10,000 (12 - 6)

10,000 (12 - 6) - 30,000 -I :. Interest = 10,000

The interest on debt is 16%. The debt component == 1~:~ = Rs.62,500

Hi-

III

II:

illI
1~fl

"II
III.
i
;:~
il
i~I
I
ii
II
II
II.
I

163