Financial Decision Unit 4 PDF

SPONSERED BY ASIA CHARITABLE TRUST SCHOOL OF MANAGEMENT iMBA/BBA(Hons.) Semester: 1 Subject: Financial Management Unit: 4 Financial Decision Compiled By: Dr. Vishvas Shah FINANCING DECISIONS - LEVERAGES LEARNING OUTCOM...

SPONSERED BY ASIA CHARITABLE TRUST SCHOOL OF MANAGEMENT iMBA/BBA(Hons.) Semester: 1 Subject: Financial Management Unit: 4 Financial Decision Compiled By: Dr. Vishvas Shah FINANCING DECISIONS - LEVERAGES LEARNING OUTCOMES ❑ Understand the concept of business risk and financial risk. ❑ Discuss and interpret the types of leverages. ❑ Discuss the relationship between operating leverage, Break - even analysis & Margin of Safety. ❑ Discuss positive and negative Leverage. ❑ Discuss Financial leverage as ‘Trading on equity’. ❑ Discuss Financial Leverage as ‘Double Edged Sword’. Analysis of Leverage Types of Leverage Business and Financial Risk (i) Operating Leverage (ii) Financial Leverage (iii) Combined Leverage INTRODUCTION Objective of financial management is to maximize wealth. Here, wealth means market value. Value is directly related to performance of company and inversely related to expectation of investors. In turn, expectation of investor is dependent on risk of the company. Therefore, to maximize value, company should try to manage its risk. This risk may be business risk, financial risk or both as defined below: Business Risk: It refers to the risk associated with the firm's operations. It is the uncertainty about the future operating income (EBIT) i.e., how well can the operating income be predicted? Financial Risk: It refers to the additional risk placed on the firm's shareholders because of use of debt i.e., the additional risk, a shareholder bears when a company uses debt in addition to equity financing. Companies that issue more debt instruments would have higher financial risk than companies financed mostly or entirely by equity. In this chapter we will discuss factors that influence business and financial risks. MEANING AND TYPES OF LEVERAGE Meaning of Leverage The term leverage represents influence or power. In financial analysis, leverage represents the influence of one financial variable over some other related financial variable. These financial variables may be costs, output, sales revenue, Earnings Before Interest and Tax (EBIT), Earning Per Share (EPS) etc. Generally, if we want to calculate the impact of change in variable X on variable Y, it is termed as Leverage of Y with X, and it is calculated as follows: Change in Y÷Y Measurement of Leverage= Change in X ÷X Types of Leverage There are three commonly used measures of leverage in financial analysis. These are: (i) Operating Leverage: It is the relationship between Sales and EBIT and indicates business risk.  Operating Leverage Business risk (ii) Financial Leverage: It is the relationship between EBIT and EPS and indicates financial risk. Financial Leverage Financial risk (iii) Combined Leverage: It is the relationship between Sales and EPS and indicates total risk i.e., both business risk and financial risk. Combined Leverage Total risk Chart Showing Degree of Operating Leverage, Financial Leverage and Combined leverage Profitability Statement Sales xxx Less: Variable Cost (xxx) Contribution xxx Degree of Operating Less: Fixed Cost (xxx) Leverage Operating Profit/ EBIT xxx Less: Interest (xxx) Earnings Before Tax (EBT) xxx Degree of Less: Tax (xxx) Combined Profit After Tax (PAT) xxx Degree of Financial Leverage Less: Pref. Dividend (if any) (xxx) Leverage Net Earnings available to equity xxx shareholders/ PAT No. Equity shares (N) xxx Earnings per Share (EPS) (PAT ÷ N) xxx OPERATING LEVERAGE Operating Leverage (OL) means tendency of operating income (EBIT) to change disproportionately with change in sale volume. This disproportionate change is caused by operating fixed cost, which does not change with change in sales volume. In other words, Operating Leverage maybe defined as the employment of an asset with a fixed cost so that enough revenue can be generated to cover all the fixed and variable costs. The use of assets for which a company pays a fixed cost is called operating leverage. Operating leverage is a function of three factors: (i) Amount of fixed cost, (ii) Variable contribution margin, and (iii) Volume of sales. Degree of Operating Leverage (DOL) When we measure magnitude of disproportionate change, it is termed as degree of leverage. Degree of Operating Leverage (DOL) may be defined as percentage change in EBIT with respect to percentage change in sales quantity. Percentage Change in EBIT Degree of Operating Leverage (DOL) = Percentage Change in Sales Mathematically: ∆EBIT ∆Q DOL = Here, EBIT = Q (S – V) – F Q = Sales quantity S = Selling price per unit V = Variable cost per unit Denotes change   [Q (S-V)-F] / [Q (S-V)-F] DOL = Q / Q Now F is nil because change in fixed cost is nil. Therefore:  Q (S-V) Q  Q (S-V) Q Q (S-V) DOL = = × = Q (S-V)-F  Q Q (S-V)-F Contribution Contribution DOL = = Contribution - Fixed Cost EBIT Break-Even Analysis and Operating Leverage Break-even analysis is a generally used to study the Cost Volume Profit analysis. It is concerned with computing the break-even point. At break-even point (BEP) of production level and sales, there will be no profit and loss i.e. total cost is equal to total sales revenue. Break-even point in units = Contribution per unit Let us understand through the following example: Example - 1: Particulars Product X Product Y (`) (`) Selling Price p.u. 40 20 Variable Cost p.u. 20 12 Contribution p.u. 20 8 Total Contribution of 1,000 units 20,000 8,000 Fixed Cost 15,000 5,000 Profit (EBIT) 5,000 3,000 Break- even point (Fixed Cost / 15,000 5,000 = 750 units = 625 units Contribution 20 8  Operating Leverage 20,000 8,000 =4 = 2.67 Contribution 5,000 3,000 EBIT There is a relationship between leverage and Break-even point. Both are used for profit planning. In brief, the relationship between leverage, break-even point and fixed cost is as under: Leverage Break-even point 1. Firm with high leverage 1. Higher Break-even point 2. Firm with low leverage 2. Lower Break-even point Fixed cost Operating leverage 1. High fixed cost 1. High degree of operating leverage 2. Lower fixed cost 2. Lower degree of operating leverage Situation 1: No Fixed Cost Particulars 20,000 units 30,000 units (`) (`) Sales @ ` 10 2,00,000 3,00,000 Variable cost @ ` 5 1,00,000 1,50,000 EBIT 1,00,000 1,50,000 Percentage change in EBIT 50% Degree of Operative leverage (DOL) = = =1 Percentage change in Sales 50% Situation 2: Positive Leverage Particulars 20,000 units 30,000 units (`) (`) Sales @ ` 10 2,00,000 3,00,000 Variable Cost @ ` 5 1,00,000 1,50,000 Contribution 1,00,000 1,50,000 Fixed Cost 50,000 50,000 EBIT 50,000 1,00,000  Percentage change in EBIT 100% Degree of Operative leverage (DOL) = = =2 Percentage change in sales 50% Situation 3: When EBIT is Nil (Contribution = Fixed cost) Contribution Degree of Operating Leverage (DOL) = = Undefined 0 Analysis and Interpretation of operating leverage S. No. Situation Result 1 No Fixed Cost No operating leverage 2. Higher Fixed cost Higher Break-even point 3. Higher than Break-even level Positive operating leverage 4. Lower than Break-even level Negative operating leverage Operating Leverage and EBIT Infinite/ Negative Undefined Possitive Operating at Lower Operating at break- Operating at a Higher Level than break-even point even point than break-even point EBIT= -Ve EBIT = 0 EBIT = +Ve  Positive and Negative Operating Leverage Note: DOL can never be between zero and one. It can be zero or less or it can be one or more. When Sales is much higher than BEP sales, DOL will be slightly more than one. With decrease in sales, DOL will increase. At BEP, DOL will be infinite. When sales is slightly less than BEP, DOL will be negative infinite. With further reduction in sale, DOL will move towards zero. At zero sales, DOL will also be zero. 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? SOLUTION (a) Statement of Profitability ` Sales Revenue (10,000 × 500) 50,00,000 Less: Variable Cost (10,000 × 200) 20,00,000 Contribution 30,00,000 Less: Fixed Cost 25,00,000 EBIT 5,00,000  Operating Leverage = Contribution ` 30 lakhs = = 6 times EBIT ` 5 lakhs % Changein EBIT (b) Operating Leverage (OL) = % ChangeinSales X / 5,00,000 6 = X = ` 3,00,000 EBIT = ` 3,00,000/` 5,00,000 = 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 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. SOLUTION Firms A (`) B (`) C (`) D (`) Sales (units) 5,000 5,000 5,000 5,000 Sales revenue 1,00,000 1,60,000 2,50,000 3,50,000 (Units × sale price per unit) Less: Variable cost (30,000) (80,000) (1,00,000) (2,50,000) (Units × variable cost per unit) Less: Fixed operating costs (60,000) (40,000) (1,00,000) Nil EBIT 10,000 40,000 50,000 1,00,000 Current sales (S) - Variable costs (VC) DOL = Current EBIT ` 1,00,000 ` 30,000 DOL(A =7 ) ` 10,000 DOL = `1,60,000 ` 80,000 =2 (B) ` 40,000 `2,50,000 ` 1,00,000 DOL(C) = =3 ` 50,000 DOL(D) = `3,50,000 ` 2,50,000 =1 ` 1,00,000 The operating leverage exists only when there are fixed costs. In the case of firm D, there is no magnified effect on the EBIT due to change in sales. A 20 per cent increase in sales has resulted in a 20 per cent increase in EBIT. In the case of other firms, operating leverage exists. It is maximum in firm A, followed by firm C and minimum in firm B. The interception of DOL of 7 is that 1 per cent change in sales results in 7 per cent change in EBIT level in the direction of the change of sales level of firm A. FINANCIAL LEVERAGE Financial leverage (FL) maybe defined as ‘the use of funds with a fixed cost in order to increase earnings per share’. In other words, it is the use of company funds on which it pays a limited return. Financial leverage involves the use of funds obtained at a fixed cost in the hope of increasing the return to common stockholders. Earnings before interest and tax(EBIT) Financial Leverage (FL) = Earnings before tax(EBT) Where, EBIT = Sales - (Variable cost + Fixed cost) EBT = EBIT - Interest Degree of Financial Leverage (DFL) Degree of financial leverage is the ratio of the percentage increase in Earnings Per Share (EPS) to the percentage increase in Earnings Before Interest and Taxes (EBIT). Financial Leverage (FL) is also defined as “the ability of a firm to use fixed financial charges to magnify the effect of changes in EBIT on EPS Degree of Financial Leverage (DFL) Percentage change in earnings per share (EPS) = Percentage change in earnigs before interest and tax (EBIT) ∆EPS ∆EBIT DFL = / EPS EBIT ΔEPS means change in EPS and ΔEBIT means change in EBIT Now, EPS = [(EBIT - I)(1- t)] - D/No. of Shares Here, T = Tax Rate D = Dividend on Preference Shares (inclusive of dividend tax if any) On simplifying the above we get, EBIT(1-t) DFL = (EBIT-Int.)(1-t) - DP  EBIT DFL= (EBIT-Int.)- DP 1-t If the company has not issued preference shares, then: EBIT EBIT DFL = = EBIT- PBT Int. When DFL is more than one (1), financial leverage exists. More is DFL, higher is financial leverage. A positive DFL/ FL means firm is operating at a level higher than break-even point and EBIT and EPS moves in the same direction. Negative DFL/ FL indicates the firm is operating at lower than break-even point and EPS is negative. Let us understand through the following analysis: Situation 1: No Fixed Interest charges Particulars X Y (`) (`) EBIT 1,00,000 1,50,000 Tax @ 50% 50,000 75,000 PAT 50,000 75,000 No. of shares 10,000 10,000 EPS 5 7.5 Change in EP 50% Degree of Finance Leverage (DFL) = = =1 Change in EBIT 50% Situation 2: Positive Financial Leverage Particulars X Y (`) (`) EBIT 1,00,000 1,50,000 Interest 20,000 20,000 EBT 80,000 1,30,000 Tax @ 50% 40,000 65,000 PAT 40,000 65,000 No of Shares 10,000 10,000 EPS 4 6.5  Change in EPS 62.5%* Degree of Finance Leverage (DFL)= = =1.25 Change in EBIT 50% 2.5 ×100 4 *Change in EPS = = 62.5% 50% Situation 3. When EBT is nil (EBIT = Fixed Interest) EBIT Degree of Finance Leverage (DFL) = = Undefined Nil Financial Leverage Positive Infinite/ Undefined Negative EBIT level is more EBIT level is less than Operating at Financial than Fixed Financia l Fixed Financial break even point Charge Charge EPS: will change in the same direction as No Profit no Loss EPS : Negative EBIT Sl. Situation Positive and Negative Financial Leverage Result No. Analysis and Interpretation of Financial leverage 1 No Fixed Financial Cost No Financial leverage 2. Higher Fixed Financial cost Higher Financial Leverage 3. When EBIT is higher than Financial Break-even point Positive Financial leverage 4. When EBIT is levy then Finance Break-even point Negating Financial leverage Financial Leverage as ‘Trading on Equity’ Financial leverage indicates the use of funds with fixed cost like long term debts and preference share capital alongwith equity share capital which is known as trading on equity. The basic aim of financial leverage is to increase the earnings available to equity shareholders using fixed cost fund. A firm is known to have a positive/favourable leverage when its earnings are more than the cost of debt. If earnings are equal to or less than cost of debt, it will be an negative/unfavourable leverage. When the quantity of fixed cost fund is relatively high in comparison to equity capital it is said that the firm is ‘’trading on equity”. 6.1.1 Financial Leverage as a ‘Double edged Sword’ When the cost of ‘fixed cost fund’ is less than the return on investment, financial leverage will help to increase return on equity and EPS. The firm will also benefit from the saving of tax on interest on debts etc. However, when cost of debt will be more than the return it will affect return of equity and EPS unfavourably and as a result firm can be under financial distress. Therefore, financial leverage is also known as “double edged sword”. Effect on EPS and ROE: When, ROI > Interest – Favourable – Advantage When, ROI < Interest – Unfavourable – Disadvantage When, ROI = Interest – Neutral – Neither advantage nor disadvantage. Note: DFL can never be between zero and one. It can be zero or less or it can be one or more. *Financial BEP is the level of EBIT at which earning per share is zero. If a company has not issued preference shares, then Financial BEP is simply equal to amount of Interest. When EBIT is much higher than Financial BEP, DFL will be slightly more than one. With decrease in EBIT, DFL will increase. At Financial BEP, DFL will be infinite. When EBIT is slightly less than Financial BEP, DFL will be negative infinite. With further reduction in EBIT, DFL will move towards zero. At zero EBIT, DFL will also be zero. COMBINED LEVERAGE Combined leverage maybe defined as the potential use of fixed costs, both operating and financial, which magnifies the effect of sales volume change on the earning per share of the firm. Combined Leverage (CL) = Operating Leverage (OL) × Financial Leverage (FL) C EBIT = × EBIT EBT C = EBT Degree of Combined Leverage (DCL) Degree of combined leverage (DCL) is the ratio of percentage change in earning per share to the percentage change in sales. It indicates the effect the changes in sales will have on EPS. DCL = DOL × DFL % Changein EBIT % Change in EPS = × % Changein Sales % Change in EBIT % Changein EPS = % Changein Sales Like operating leverage and financial leverage, combined leverage can also be positive and negative combined leverage. Analysis of combined leverage Combine leverage measures total risk. It depends on combination of operating and financial risk. DOL DFL Comments Low Low Lower total risk. Cannot take advantage of trading on equity. High High Higher total risk. Very risky combination. High Low Moderate total risk. Not a good combination.  Lower EBIT due to higher DOL and lower advantage of trading on equity due to low DFL. Low High Moderate total risk. Best combination. Higher financial risk is balanced by lower total business risk. 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). Consider tax @ 50 %. 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? SOLUTION (`) Sales 24,00,000 Less: Variable cost 12,00,000 Contribution 12,00,000 Less: Fixed cost 10,00,000 EBIT 2,00,000 Less: Interest 1,00,000 EBT 1,00,000 Less: Tax (50%) 50,000  EAT 50,000 No. of equity shares 10,000 EPS 5 12,00,000 (a) Operating Leverage 6 times 2,00,000 2,00,000 (b) Financial Leverage 2 times 1,00,000 (c) Combined Leverage = OL × FL = 6 × 2 = 12 times. 50,000 (d) RO 100 5% I 10,00,000 EAT-Pref.Dividend Here ROI is calculated as ROE i.e. Equity shareholders'fund (e) Operating Leverage = 6 Δ EBIT 6= 0.25 6 1 Δ EBIT 1.5 4 Increase in EBIT = ` 2,00,000 × 1.5 = ` 3,00,000 New EBIT = ` 5,00,000 ILLUSTRATION 4 The following information is related to Yizi Company Ltd. for the year ended 31st March, 2021: Equity share capital (of ` 10 each) ` 50 lakhs 12% Bonds of ` 1,000 each ` 37 lakhs Sales ` 84 lakhs Fixed cost (excluding interest) ` 6.96 lakhs Financial leverage 1.49 Profit-volume Ratio 27.55% Income Tax Applicable 40% You are required to CALCULATE: (i) Operating Leverage; (ii) Combined leverage; and (iii) Earnings per share. Show calculations up-to two decimal points. SOLUTION Computation of Profits after Tax (PAT) Particulars Amount (`) Sales 84,00,000 Contribution (Sales × P/V ratio) 23,14,200 Less: Fixed cost (excluding Interest) (6,96,000) EBIT (Earnings before interest and tax) 16,18,200 Less: Interest on debentures (12% `37 lakhs) (4,44,000) Less: Other fixed Interest (balancing figure) (88,160)* EBT (Earnings before tax) 10,86,040 Less: Tax @ 40% 4,34,416 PAT (Profit after tax) 6,51,624 (i) Operating Leverage: Contribution `23,14,200 = = = 1.43 EBIT `16,18,200 (ii) Combined Leverage: = Operating Leverage × Financial Leverage = 1.43 1.49 = 2.13 Or, Contribution EBIT Combined Leverage = × EBIT EBT = Contribution ` 23,14,200 Combined Leverage = = 2.13 EBT ` 10,86,040  * EBIT ` 16,18, 200 Financial Leverage = = = 1.49 EBT EBT ` 16,18, 200 So, EBT = = `10,86,040 1.49 Accordingly, other fixed interest = ` 16,18,200 - ` 10,86,040 - ` 4,44,000 = ` 88,160 (iii) Earnings per share (EPS): PAT ` 6,51,624 = = = ` 1.30 No.of shares outstanding 5,00,000 equity shares ILLUSTRATION 5 Following are the selected financial information of A Ltd. and B Ltd. for the year ended March 31st, 2021: A Ltd. B Ltd. Variable Cost Ratio 60% 50% Interest ` 20,000 ` 1,00,000 Operating Leverage 5 2 Financial Leverage 3 2 Tax Rate 30% 30% You are required to FIND out: (i) EBIT (ii) Sales (iii) Fixed Cost (iv) Identify the company which is better placed with reasons based on leverages. SOLUTION Company A EBIT (i) Financial Leverage = EBT i.e EBIT — Interest EBIT So, 3 = EBIT - 20,000  Or, 3 (EBIT – 20,000) = EBIT Or, 2 EBIT = 60,000 Or, EBIT = 30,000 Contribution Contribution (ii) Operating Leverage = Or, 5= EBIT ` 30,000 Or, Contribution = ` 1, 50,000 Contribution ` 1,50,000 Sales = = = ` 3,75,000 P/V Ratio (1 - variable cost ratio) 40% (iii) Fixed Cost = Contribution – EBIT = ` 1, 50,000 – 30,000 Or, Fixed cost = ` 1,20,000 Company B EBIT (i) Financial Leverage = EBT i.e EBIT — Interest EBIT So, 2 = EBIT - 1,00,000 Or, 2 (EBIT – 1,00,000) = EBIT Or, 2 EBIT -2,00,000 = EBIT Or, EBIT = ` 2,00,000 Contribution (ii) Operating Leverage = EBIT Contribution Or, 2 = ` 2,00,000 Or, Contribution = ` 4,00,000 Contribution ` 4,00,000 Sales = = = ` 8,00,000 P/V Ratio (1 - variable cost ratio) 50% (iii) Fixed Cost = Contribution – EBIT = ` 4, 00,000 – ` 2,00,000 Or, Fixed cost = ` 2,00,000  Income Statements of Company A and Company B Company A (`) Company B (`) Sales 3,75,000 8,00,000 Less: Variable cost 2,25,000 4,00,000 Contribution 1,50,000 4,00,000 Less: Fixed Cost 1,20,000 2,00,000 Earnings before interest and tax 30,000 2,00,000 (EBIT) Less: Interest 20,000 1,00,000 Earnings before tax (EBT) 10,000 1,00,000 Less: Tax @ 30% 3,000 30,000 Earnings after tax (EAT) 7,000 70,000 Comment based on Leverage Comment based on leverage – Company B is better than company A of the following reasons: Capacity of Company B to meet interest liability is better than that of companies A (from EBIT/Interest ratio) 30,000 2,00,000 = 2] [A = = 1.5, B = 20,000 1,00,000 Company B has the least financial risk as the total risk (business and financial) of company B is lower (combined leverage of Company A – 15 and Company B- 4) SUMMARY DOL DFL DCL Shows level of business Shows level of financial Shows level of total or risk. risk. combined risk. It is dependent upon It is dependent upon interest It is dependent upon fixed fixed cost. and preference dividend cost, interest & preference dividend.  Measures % change in EBIT Measures % change in EPS Measures % change in EPS which results from a 1% which results from a 1% which results from a 1% change in Sales. change in EBIT. change in Sales. For example, if DOL is 3 and For example, if DFL is 2 and For example, if DCL is 6 and there is 8% increase in there is 5% increase in EBIT there is a 8% increase in output then EBIT will then EPS will increase by sales then EPS will increase increase by 24% & if there 10% and if there is a 5% by 48% and if there is a 8% is a 8% decrease in output decrease in EBIT then EPS decrease in sales then EPS then EBIT will decrease by will decrease by 10%. will decrease by 48%. 24%. There is a unique DOL for There is a unique DFL for There is a unique DCL for each level of output. each level of EBIT. each level of sales. It is undefined at It is undefined at It is undefined at Operating B.E.P. Financial B.E.P. Financial B.E.P. TEST YOUR KNOWLEDGE MCQs based Questions 1. Given Operating fixed costs ` 20,000 Sales ` 1,00,000 P/ V ratio 40% The operating leverage is: (a) 2.00 (b) 2.50 (c) 2.67 (d) 2.47 2. If EBIT is ` 15,00,000, interest is ` 2,50,000, corporate tax is 40%, degree of financial leverage is; (a) 1:11 (b) 1.20  (c) 1.31 (d) 1.41 3. If DOL is 1.24 and DFL is 1.99, DCL would be: (a) 2.14 (b) 2.18 (c) 2.31 (d) 2.47 4. Operating Leverage is calculated as: (a) Contribution ÷ EBIT (b) EBIT ÷ PBT (c) EBIT ÷ Interest (d) EBIT ÷ Tax 5. Financial Leverage is calculated as: (a) EBIT ÷ Contribution (b) EBIT ÷ PBT (c) EBIT ÷ Sales (d) EBIT ÷ Variables Cost 6. Which of the following is correct? (a) CL = OL + FL (b) CL = OL – FL (c) OL = OL × FL (d) OL = OL ÷ FL 7. Which of the following indicates business risk? (a) Operating leverage (b) Financial leverage (c) Combined leverage (d) Total leverage 8. Degree of combined leverage is the fraction of: (a) Percentage change in EBIT on Percentage change in Sales. (b) Percentage change in EPS on Percentage change in Sales. (c) Percentage change in Sales on Percentage change in EPS. (d) Percentage change in EPS on Percentage change in EBIT. 9. From the following information, calculate combined leverage: Sales ` 20,00,000 Variable Cost 40% Fixed Cost ` 10,00,000 Borrowings ` 10,00,000 @ 8% p.a. (a) 10 times (b) 6 times (c) 1.667 times (d) 0.10 times 10. Operating leverage is a function of which of the following factors? (a) Amount of variable cost. (b) Variable contribution margin. (c) Volume of purchases. (d) Amount of semi-variable cost. 11. Financial leverage may be defined as: (a) Use of funds with a product cost in order to increase earnings per share. (b) Use of funds with a contribution cost in order to increase earnings before interest and taxes. (c) Use of funds with a fixed cost in order to increase earnings per share. (d) Use of funds with a fixed cost in order to increase earnings before interest and taxes. 12. If Margin of Safety is 0.25 and there is 8% increase in output, then EBIT will be: (a) Decrease by 2% (b) Increase by 32% (c) Increase by 2% (d) Decrease by 32% 13. If degree of financial leverage is 3 and there is 15% increase in Earning per share (EPS), then EBIT will be: (a) Decrease by 15% (b) Increase by 45% (c) Decrease by 45% (d) Increase by 5% 14. When EBIT is much higher than Financial break-even point, then degree of financial leverage will be slightly: (a) Less than 1 (b) Equals to 1 (c) More than 1 (d) Equals to 0 15. Firm with high operating leverage will have: (a) Higher breakeven point (b) Lower business risk (c) Higher margin of safety (d) All of above 16. When sales is at breakeven point, the degree of operating leverage will be: (a) Zero (b) Infinite (c) One (d) None of above 17. If degree of combined leverage is 3 and margin of safety is 0.50, then degree of financial leverage is: (a) 6.00 (b) 3.00 (c) 0.50 (d) 1.50 Theoretical based Questions 1. DIFFERENTIATE between Business risk and Financial risk. 2. “Operating risk is associated with cost structure, whereas financial risk is associated with capital structure of a business concern.” Critically EXAMINE this statement. 3. EXPLAIN the concept of “Double edged sword” in Financial leverage analysis? Practical Problems 1. From the following information extracted from the books of accounts of Imax Ltd., CALCULATE percentage change in earnings per share, if sales increase by 10% and Fixed Operating cost is ` 1,57,500. Particulars Amount in (`) EBIT (Earnings before Interest and Tax) 31,50,000 Earnings before Tax (EBT) 14,00,000 2. Consider the following information for Mega Ltd.: Production level 2,500 units Contribution per unit ` 150 Operating leverage 6 Combined leverage 24 Tax rate 30% Required: COMPUTE its earnings after tax. 3. Betatronics Ltd. has the following balance sheet and income statement information: Balance Sheet as on March 31st 2021 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 2021 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: Taxes 56,000 Net Earnings (EAT) 1,04,000 (a) DETERMINE the degree of operating, financial and combined leverages at the current sales level, if all operating expenses, other than depreciation, are variable costs. (b) If total assets remain at the same level, but sales (i) increase by 20 percent and (ii) decrease by 20 percent, COMPUTE the earnings per share at the new sales level? 4. A company had the following Balance Sheet as on 31stMarch, 2021: Liabilities Amount Assets Amount in crores in crores (`) (`) Equity Share Capital (50 5 Fixed Assets (Net) 12.5 lakhs shares of ` 10 each) Reserves and Surplus 1 Current Assets 7.5 15% Debentures 10 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 5. 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 6. The following particulars relating to Navya Ltd. for the year ended 31st March 2021 is given: Output 1,00,000 units at normal capacity Selling price per unit ₹ 40 Variable cost per unit ₹ 20 Fixed cost ₹ 10,00,000 The capital structure of the company as on 31st March, 2021 is as follows: Particulars ₹ Equity share capital (1,00,000 shares of ₹ 10 each) 10,00,000 Reserves and surplus 5,00,000 7% debentures 10,00,000 Current liabilities 5,00,000 Total 30,00,000 Navya Ltd. has decided to undertake an expansion project to use the market potential, that will involve ₹ 10 lakhs. The company expects an increase in output by 50%. Fixed cost will be increased by ₹ 5,00,000 and variable cost per unit will be decreased by 10%. The additional output can be sold at the existing selling price without any adverse impact on the market. The following alternative schemes for financing the proposed expansion programme are planned: (i) Entirely by equity shares of ₹ 10 each at par. (ii) ₹ 5 lakh by issue of equity shares of ₹ 10 each and the balance by issue of 6% debentures of ₹ 100 each at par. (iii) Entirely by 6% debentures of ₹ 100 each at par. FIND out which of the above-mentioned alternatives would you recommend for Navya Ltd. with reference to the risk and return involved, assuming a corporate tax of 40%.  7. You are given the following information of 5 firms of the same industry: Name of the Change in Change in Change in Firm Revenue Operating Income Earning per share M 28% 26% 32% N 27% 34% 26% P 25% 38% 23% Q 23% 43% 27% R 25% 40% 28% You are required to CALCULATE for all firms: (i) Degree of operating leverage and (ii) Degree of combined leverage. Practice Sums: Q.1 The following figures relate to two companies: ( ₹ in lakhs) P Ltd. Q Ltd. Sales 500 1,000 Less: Variable costs 200 300 Contribution 300 700 Less: Fixed costs 150 400 E.B.I.T. 150 300 Less: Interest 50 100 Profit before tax (PBT) 100 200 You are required to: Calculate the operating, financial and combined leverages for the two companies. Q.2 The financial manager of the HM Ltd. expects that its earnings before interest and taxes (EBIT) in the current year would amount to ₹40,000. The firm has capital of 8 per cent bonds aggregating ₹1,00,000, while the 10 per cent preference shares amount to ₹50,000. What would be the earnings per share (EPS)? Assuming the EBIT being (i) ₹20,000 and (ii) ₹60,000 how would the EPS be affected? The firm can be assumed to be in the 30 per cent tax bracket. The number of outstanding ordinary shares is 1,000. Q.3 The capital structure of AB Ltd. consists of an ordinary share capital of ₹10,00,000 (equity shares of ₹100 each at par value) and ₹10,00,000 (10% debenture of ₹100 each). Sales increased from 1,00,000 units to 1,20,000 units, the selling price is ₹12 per unit, variable cost amounts to 80% of sales and fixed expenses amount to ₹2,00,000. The income tax rate is assumed to be 30%. You are required to calculate the following: (a) The percentage increase in earnings per share: (b) The degree of financial leverage at 1,00,000 units to 1,20,000 units; (c) The degree of operating leverage at 1,00,000 units to 1,20,000 units; Q.4 A firm has sales of ₹75,00,000 variable cost of ₹42,00,000 and fixed costs of ₹6,00,000 It has a debt of ₹45,00,000 at 9% and equity of ₹55,00,000. (i) What is the firm’s R.O.I.? (ii) What are the operating, financial and combined leverage of the firm? (iii) If the sales drop to ₹50,00,000, what will be the new E.B.I.T.? Q.5 Calculate the operating leverage, financial leverage and combined leverage from the following data under Situations 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 Financial Plan A B ₹ ₹ Equity 10,000 15,000 Debt (Rate of Interest at 20%) 10,000 5,000 20,000 20,000 Answers to Practical problems 1. Operating Leverage (OL) Contribution EBIT +Fixed Cost ` 31,50,000 + ` 1,57,500 = = = = 1.05 EBIT EBIT ` 31,50,000 Financial Leverage (FL) ` 31,50,000 = EBIT = = 2.25 EBT ` 14,00,000 Combined Leverage (CL) = 1.05 2.25 = 2.3625 Percentage Change in Earnings per share % change in EPS % change in EPS DCL = = 2.3625 = % change in Sales 10% % change in EPS = 23.625% Hence, if sales increases by 10%, EPS will be increased by 23.625%. 2. Workings: 1. Operating Leverage = Contribution = ` 150 x 2,500 ` 3,75,000 = =6 EBIT EBIT EBIT ‫ ؞‬EBIT = ` 3,75,000 = ` 62,500 6  2. Operating Leverage (OL) Financial Leverage (FL)= Combined Leverage (CL) 6 Financial Leverage = 24 Financial Leverage = 4 Also, Financial Leverage = EBIT = 4 EBT EBIT 62,500 EBT = = = ` 15,625 4 4 Computation of Earnings after tax Earnings after Tax (EAT) = EBT (1 − t) = ` 15,625 (1 − 0.30) = ` 15,625 0.70 Earnings after Tax (EAT) = ` 10,938 3. Income Statement Particulars Company A Company B (`) (`) Sales 80,000 36,000 Less: Variable Cost 60,000 24,000 Contribution 20,000 12,000 Less: Fixed Cost 16,000 9,000 EBIT 4,000 3,000 Less: Interest 3,000 2,000 EBT 1,000 1,000 Tax (45%) 450 450 EAT 550 550 Workings: (i) Company A Financial Leverage = EBIT/(EBIT- Interest) 4 = EBIT/(EBIT- ` 3,000) 4EBIT – ` 12,000 = EBIT 3EBIT = ` 12,000 EBIT = ` 4,000  Company B Financial Leverage = EBIT/(EBIT - Interest) 3 = EBIT/(EBIT – ` 2,000) 3EBIT – ` 6000 = EBIT 2EBIT = ` 6,000 EBIT = ` 3,000 (ii) Company A Operating Leverage = 1/Margin of Safety = 1/0.20 =5 Operating Leverage = Contribution/EBIT 5 = Contribution/` 4,000 Contribution = ` 20,000 Company B Operating Leverage = 1/Margin of Safety = 1/0.25 =4 Operating Leverage = Contribution/EBIT 4 = Contribution/` 3,000 Contribution = ` 12,000 (iii) Company A Profit Volume Ratio = 25%(Given) Profit Volume Ratio = Contribution/Sales 100 25% = ` 20,000/Sales Sales = ` 20,000/25% Sales = ` 80,000 Company B Profit Volume Ratio = 33.33% Therefore, Sales = ` 12,000/33.33% Sales = ` 36,000 4. Income Statement with required calculations Particulars (`) (`) Sales in units 1,20,000 1,00,000 Sales Value 14,40,000 12,00,000 Variable Cost (9,60,000) (8,00,000) Contribution 4,80,000 4,00,000 Fixed expenses (2,00,000) (2,00,000) EBIT 2,80,000 2,00,000 Debenture Interest (1,00,000) (1,00,000) EBT 1,80,000 1,00,000 Tax @ 30% (54,000) (30,000) Profit after tax (PAT) 1,26,000 70,000 No. of shares 10,000 10,000 (i) Financial Leverage ` 2,80,000 ` 2,00,000 = = EBIT `1,80,000 `1,00,000 = EBT = 1.56 =2 (ii) Operating leverage ` 4,80,000 ` 4,00,000 = = Contribution ` 2,80,000 ` 2,00,000 = EBIT = 1.71 =2 (iii) Earnings per share (EPS) ` 1, 26, 000 ` 70, 000 = = PAT 10, 000 10, 000 = No. of shares = ` 12.6 =`7 Decrease in EPS = ` 12.6 – ` 7 = ` 5.6 5.6 % decrease in EPS = 100 12.6 = 44.44% 5. (i) Calculation of Fixed Cost Contribution ` 10,00,000 DOL = or 2.5 = or EBIT= ` 4,00,000 Contribution-Fixed Cost EBIT EBIT = Contribution – Fixed Cost  4,00,000 = 10,00,000 – Fixed Cost Fixed Cost = 10,00,000 - 4,00,000 = ` 6,00,000 (ii) Calculation of Degree of Combined Leverage (DCL) Question says that 25% change in sales will wipe out EPS. Here, wipe out means it will reduce EPS by 100%. Percentage Change in EPS 100% DCL = = =4 Percentage Change in Sales 25% (iii) Calculation of Degree of Financial Leverage (DFL) DCL = DOL DFL 4 = 2.5 DFL So, DFL = 1.6 (iv) Calculation of Interest and amount of Debt EBIT ` 4,00,000 DFL = Or, 1.6 = Or, Int = ` 1,50,000 EBIT- ` 4,00,000 - Int Int Debt Interest rate = Amount of Interest Debt 16% = ` 1,50,000 Debt = ` 9,37,500 (v) Calculation of Earnings per share (EPS) (EBIT-Int)(1-t) (` 4,00,000 - ` 1,50,000)0.5 EPS = = = ` 1.25 N 1,00,000 6. (a) Calculation of Degree of Operating (DOL), Financial (DFL) and Combined leverages (DCL). ` 3, 40,000 - ` 60,000 DOL = = 1.27 ` 2,20,000 ` 2,20,000 = 1.38 DFL = `1,60,000 DCL = DOL DFL = 1.27 1.38 = 1.75  (b) Earnings per share at the new sales level (i) Increase (ii) Decrease by by 20% 20% (`) (`) Sales level 4,08,000 2,72,000 Less: Variable expenses 72,000 48,000 Less: Fixed cost 60,000 60,000 Earnings before interest and taxes 2,76,000 1,64,000 Less: Interest 60,000 60,000 Earnings before taxes 2,16,000 1,04,000 Less: Taxes 75,600 36,400 Earnings after taxes (EAT) 1,40,400 67,600 Number of equity shares 80,000 80,000 EPS 1.76 0.85 Working Notes: (i) Variable Costs = ` 60,000 (total cost depreciation) (ii) Variable Costs at: (a) Sales level of ` 4,08,000 = ` 72,000 (increase by 20%) (b) Sales level of ` 2,72,000 = ` 48,000 (decrease by 20%) 7. Workings: Total Assets = ` 20 crores Total Asset Turnover Ratio = 2.5 Hence, Total Sales = 20 2.5 = ` 50 crores Computation of Profit after Tax (PAT) (`) in crores Sales 50.00 Less: Variable Operating Cost @ 65% 32.50  Contribution 17.50 Less: Fixed Cost (other than Interest) 4.00 EBIT 13.50 Less: Interest on Debentures (15% ` 10 crores) 1.50 PBT 12.00 Less: Tax @ 30% 3.60 PAT 8.40 (i) Earnings per Share ` 8.40 crores ` 8.40 crores EPS = = = ` 16.80 Number of Equity Shares 50, 00, 000 It indicates the amount, the company earns per share. Investors use this as a guide while valuing the share and making investment decisions. It is also an indicator used in comparing firms within an industry or industry segment. (ii) Operating Leverage Contribution ` 17.50 crores Operating Leverage = = = 1.296 EBIT ` 13.50 crores It indicates the choice of technology and fixed cost in cost structure. It is level specific. When firm operates beyond operating break-even level, then operating leverage is low. It indicates sensitivity of earnings before interest and tax (EBIT) to change in sales at a particular level. (iii) Financial Leverage EBIT ` 13.50 crores Financial Leverage = = = 1.125 PBT ` 12.00 crores The financial leverage is very comfortable since the debt service obligation is small vis-à-vis EBIT.  (iv) Combined Leverage Contribution EBIT Combined Leverage = EBIT PBT Or, = Operating Leverage × Financial Leverage = 1.296 1.125 = 1.458 The combined leverage studies the choice of fixed cost in cost structure and choice of debt in capital structure. It studies how sensitive the change in EPS is vis-à-vis change in sales. The leverages, operating, financial and combined are used as measurement of risk. 8. (i) Operating Leverage (OL) Situation-I Situation-II (`) (`) Sales (3000 units @ ` 30 per unit) 90,000 90,000 Less: Variable Cost (@ ` 15 per unit) 45,000 45,000 Contribution (C) 45,000 45,000 Less: Fixed Cost 15,000 20,000 EBIT 30,000 25,000 C ` 45,000 ` 45,000 Operating Leverage (OL) = = = EBIT ` 30,000 ` 25,000 = 1.5 = 1.8 (ii) Financial Leverage (FL) A (`) B (`) Situation I EBIT 30,000 30,000 Less: Interest on debt 2,000 1,000 EBT 28,000 29,000 EBIT ` 30,000 ` 30,000 Financial Leverage (FL) = = = EBT ` 28,000 ` 29,000 = 1.07 = 1.034  A (`) B (`) Situation-II EBIT 25,000 25,000 Less: Interest on debt 2,000 1,000 EBT 23,000 24,000 EBIT ` 25,000 ` 25,000 Financial Leverage (FL) = = = EBT ` 23,000 ` 24,000 = 1.09 = 1.04 (iii) Combined Leverage (CL) A B Situation-I CL = FL x OL 1.5×1.07 = 1.61 1.5 × 1.034 = 1.55 Situation-II CL = FL x OL 1.8 × 1.09 = 1.96 1.8 × 1.04 = 1.872 9. Statement showing Profitability of Alternative Schemes for Financing (₹ in ‘00,000) Particulars Existing Alternative Schemes (i) (ii) (iii) Equity Share capital 10 10 10 10 (existing) New issues - 10 5 - 10 20 15 10 7% debentures 10 10 10 10 6% debentures - - 5 10 20 30 30 30 Debenture interest (7%) 0.7 0.7 0.7 0.7 Debenture interest (6%) - - 0.3 0.6 0.7 0.7 1.0 1.3 Output (units in lakh) 1 1.5 1.5 1.5 Contribution per. unit (₹) 20 22 22 22 (Selling price - Variable Cost) Contribution (₹ lakh) 20 33 33 33 Less: Fixed cost 10 15 15 15 EBIT 10 18 18 18 Less: Interest (as 0.7 0.7 1.0 1.3 calculated above) EBT 9.3 17.3 17 16.7 Less: Tax (40%) 3.72 6.92 6.8 6.68 EAT 5.58 10.38 10.20 10.02 Operating Leverage 2.00 1.83 1.83 1.83 (Contribution /EBIT) Financial Leverage 1.08 1.04 1.06 1.08 (EBIT/EBT) Combined Leverage 2.15 1.91 1.94 1.98 (Contribution/EBT) EPS (EAT/No. of shares) 5.58 5.19 6.80 10.02 (₹) Risk - Lowest Lower Highest than option (3) Return - Lowest Lower Highest than option (3)  From the above figures, we can see that the Operating Leverage is same in all alternatives though Financial Leverage differs. Alternative (iii) uses the maximum amount of debt and result into the highest degree of financial leverage, followed by alternative (ii). Accordingly, risk of the company will be maximum in these options. Corresponding to this scheme, however, maximum EPS (i.e., ` 10.02 per share) will be also in option (iii). So, if Navya Ltd. is ready to take a high degree of risk, then alternative (iii) is strongly recommended. In case of opting for less risk, alternative (ii) is the next best option with a reduced EPS of ` 6.80 per share. In case of alternative (i), EPS is even lower than the existing option, hence not recommended. 10. (i) Financial leverage Combined Leverage = Operating Leverage (OL) Financial Leverage (FL) 2.5 =2 FL Or, FL = 1.25 Financial Leverage = 1.25 (ii) P/V Ratio and Earning per share (EPS) Contribution(C) Operating leverage = Contribution - Fixed Cost (FC) C 2 = C - 3,40,000 Or, C = 2 (C – 3,40,000) Or, C = 2C – 6,80,000 Or, Contribution = ` 6,80,000 Contribution (C) 6,80,000 Now, P/V ratio = × 100 = × 100 = 13.6% Sales (S) 50,00,000 Therefore, P/V Ratio = 13.6% EBT = Sales – Variable Cost – Fixed Cost – Interest = `50,00,000 – `50,00,000 (1-0.136) – `3,40,000 – (8% × `30,25,000) = ` 50,00,000 – ` 43,20,000 – ` 3,40,000 – ` 2,42,000 = ` 98,000 PAT = EBT(1-T)= ` 98,000(1-0.3) = ` 68,600  Profit after tax EPS = No. of equity shares EPS ` 68,600 = = ` 0.202 3,40,000 shares (iii) Assets turnover Sales ` 50,00,000 Assets turnover = = = 0.78 Total Assets * ` 34,00,000 +` 30,25,000 0.78 < 1.5 means lower than industry turnover. *Total Asset = Equity share capital + 8% Debentures (iv) EBT zero means 100% reduction in EBT. Since combined leverage is 2.5, sales have to be dropped by 100/2.5 = 40%. Hence new sales will be ` 50,00,000 (100 – 40) % = ` 30,00,000. Therefore, at ` 30,00,000 level of sales, the Earnings before Tax (EBT) of the company will be zero. Alternatively Fixed Cost + Interest + desired Profit Required sales when EBT is zero = P/V Ratio ` 3,40,000 + ` 2,42,000 + zero = 13.60% ` 5,82,000 = 13.60% = ` 42,79,412 [Note: The question can also be solved by first calculating EBIT with the help of Financial Leverage. Accordingly answer to the requirement (ii) and (iv) will also vary] 11. Calculation of Degree of Operating leverage and Degree of Combined leverage Firm Degree of Operating Degree of Combined Leverage (DOL) Leverage (DCL) % change in Operating Income % change in EPS = = % change in Revenue % change in Revenue 26% 32% M = 0.929 = 1.143 28% 28% 34% 26% N = 1.259 = 0.963 27% 27% 38% 23% P = 1.520 = 0.920 25% 25% 43% 27% Q = 1.870 = 1.174 23% 23% 40% 28% R = 1.60 = 1.120 25% 25%