Ch.

14: Financial and Operating Leverage

CHAPTER 14

FINANCIAL AND OPERATING LEVERAGE

Problem 1

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Expansion: Plan I Plan II Plan III

Investment (Rs) 500,000 500,000 500,000
No. of shares 50,000
Price (Rs) 10
New equity (Rs) 500,000
Debt (Rs) 500,000
Interest at 14% 70,000
Pref. capital (Rs) 500,000
Dividend at 14% 70,000

Analysis of alternative financing plan:

(Rs)
Plan I Plan II Plan III
Expected:
PBIT 375,000 375,000 375,000
PBIT(1-T) 243,750 243,750 243,750
Assets 1,500,000 1,500,000 ######
ROI: [PBIT(1-T)/Assets] 0.1625 0.1625 0.1625
16.25% 16.25% 16.25%

PBIT 375,000 375,000 375,000

Less : Interest at 14% 0 70,000 0
PBT 375,000 305,000 375,000
Less : Tax @ 35% 131,250 106,750 131,250
PAT (before pref. div.) 243,750 198,250 243,750
Less : Pref. dividend 0 0 70,000
PAT available to equity 243,750 198,250 173,750
shareholders
No. of equity shares (N) 150,000 100,000 100,000
Equity capital (E) 1,500,000 1,000,000 ######
EPS:[ PAT (after pref. div.)/N] 1.625 1.983 1.738
ROE: [PAT (after pref. div.)/E]0.1625 0.1983 0.1738
16.30% 19.80% 17.40%
The second plan (14% Rs 500,000 debt) plan has
maximum shareholder's return (EPS/ROE). Hence, other
things remaining the same, it is better than other two plans.

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I. M. Pandey, Financial Management, 9th Edition, New Delhi: Vikas.

Problem 2

Funds needed (Rs) 200,000

Tax rate 35%

Plan I Equity
No. of shares 20,000
Price (Rs) 10
Equity capital (Rs) 200,000
(Rs)
PBIT 5,000 12,000 25,000
Less : Interest 0 0 0
PBT 5,000 12,000 25,000
Less : Tax 1,750 4,200 8,750
PAT 3,250 7,800 16,250
EPS (T = 0.35) 0.16 0.39 0.81
EPS (T = 0) 0.25 0.60 1.25

Plan II Equity Debent

No. 10,000 1,000
Price 10 100
Total (Rs) 100,000 100,000
Interest rate 14%
Interest 14000
(Rs)
PBIT 5,000 12,000 25,000
Interest 14,000 14,000 14,000
PBT -9,000 -2,000 11,000
Tax 0 0 3,850
PAT -9,000 -2,000 7,150
EPS (T=0.35) -0.90 -0.20 0.72
EPS (T=0) -0.90 -0.20 1.10

Plan III Equity Debent

No. 5,000 1,500
Price 10 100
Total (Rs) 50,000 150,000
Interest rate 14%
Interest 21,000
(Rs)
PBIT 5,000 12,000 25,000
Less : Interest 21,000 21,000 21,000
PBT -16,000 -9,000 4,000
Less : Tax 0 0 1,400
PAT -16,000 -9,000 2,600
EPS (T = 0.35) -3.20 -1.80 0.52
EPS (T = 0) -3.20 -1.80 0.80

Problem 3

Preference dividend 11%

Debenture interest 15%
Tax 35%
Funds needed (Rs lakh) 400
Share price (Rs) 25

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Ch. 14: Financial and Operating Leverage

Plan I Equity Pref. Debent

Proportion 100% - -
Amount (Rs lakh) 400 - -
No of shares 16 - -
Interest (Rs) - - -
Pref. dividend (Rs) - - -

(Rs lakh)
EBIT 10 20 30 40 50 60 70 80
Interest 0 0 0 0 0 0 0 0
PBT 10 20 30 40 50 60 70 80
PAT 6.5 13 19.5 26 32.5 39 45.5 52
Pref. div. 0 0 0 0 0 0 0 0
Equity earnings 6.5 13 19.5 26 32.5 39 45.5 52
EPS 0.41 0.81 1.22 1.63 2.03 2.44 2.84 3.25

Plan II Equity Pref. Debent

Proportion 75% - 25%
Amount (Rs lakh) 300 - 100
No of shares 12 - -
Interest (Rs lakh) - - 15
Pref. dividend (Rs lakh) - - -

(Rs lakh)
EBIT 10 20 30 40 50 60 70 80
Interest 15 15 15 15 15 15 15 15
PBT -5 5 15 25 35 45 55 65
PAT -5 3.25 9.75 16.25 22.75 29.25 35.75 42.25
Pref. div. 0 0 0 0 0 0 0 0
Equity earnings -5 3.25 9.75 16.25 22.75 29.25 35.75 42.25
EPS (Rs) -0.42 0.27 0.81 1.35 1.90 2.44 2.98 3.52

Plan III Equity Pref. Debent

Proportion 75% 25% 0%
Amount (Rs lakh) 300 100 -
No of shares 12 - -
Interest (Rs lakh) - - -
Pref. dividend (Rs lakh) - 11 -

(Rs lakh)
EBIT 10 20 30 40 50 60 70 80
Interest 0 0 0 0 0 0 0 0
PBT 10 20 30 40 50 60 70 80
PAT 6.5 13 19.5 26 32.5 39 45.5 52
Pref. div. 11 11 11 11 11 11 11 11
Equity earnings -4.5 2 8.5 15 21.5 28 34.5 41
EPS (Rs) -0.38 0.17 0.71 1.25 1.79 2.33 2.88 3.42

Plan IV Equity Pref. Debent

Proportion 50% 20% 30%
Amount (Rs lakh) 200 80 120
No of shares 8 - -
Interest (Rs lakh) - - 18
Pref. dividend (Rs lakh) - 8.8 -

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I. M. Pandey, Financial Management, 9th Edition, New Delhi: Vikas.

(Rs lakh)
EBIT 10 20 30 40 50 60 70 80
Interest 18 18 18 18 18 18 18 18
PBT -8 2 12 22 32 42 52 62
PAT -8 1.3 7.8 14.3 20.8 27.3 33.8 40.3
Pref. div. 8.8 8.8 8.8 8.8 8.8 8.8 8.8 8.8
Equity earnings -8 0 0 5.5 12 18.5 25 31.5
EPS (Rs) -1.00 0.00 0.00 0.69 1.50 2.31 3.13 3.94
* It is assumed that PAT, if positive, will be used to first pay dividend to preference shareholders.

Plan V Equity Pref. Debent

Proportion 50% 0% 50%
Amount (Rs lakh) 200 - 200
No of shares 8 - -
Interest (Rs lakh) - - 30
Pref. dividend (Rs lakh) - - -

(Rs
EBIT 10 20 30 40 50 60 70 80
Interest 30 30 30 30 30 30 30 30
PBT -20 -10 0 10 20 30 40 50
PAT -20 -10 0 6.5 13 19.5 26 32.5
Pref. div. 0 0 0 0 0 0 0 0
Equity earnings -20 -10 0 6.5 13 19.5 26 32.5
EPS (Rs) -2.50 -1.25 0.00 0.81 1.63 2.44 3.25 4.06

Plan VI Equity Pref. Debent

Proportion 30% 20% 50%
Amount (Rs lakh) 120 80 200
No of shares 4.8 - -
Interest (Rs lakh) - - 30
Pref. dividend (Rs lakh) - 8.8

(Rs lakh)
EBIT 10 20 30 40 50 60 70 80
Interest 30 30 30 30 30 30 30 30
PBT -20 -10 0 10 20 30 40 50
PAT -20 -10 0 6.5 13 19.5 26 32.5
Pref. dividend 8.8 8.8 8.8 8.8 8.8 8.8 8.8 8.8
Equity earnings -20 -10 0 0 4.2 10.7 17.2 23.7
EPS -4.17 -2.08 0.00 0.00 0.88 2.23 3.58 4.94
* It is assumed that PAT, if positive, will be used to first pay dividend to preference shareholders.

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Ch. 14: Financial and Operating Leverage

EBIT-EPS Chart

6.00

4.00

2.00

0.00
EPS (Rs)

0 10 20 30 40 50 60 70 80
-2.00 Plan I: EPS
Plan II: EPS
-4.00 Plan III: EPS
Plan IV: EPS
-6.00 Plan V: EPS
Plan VI: EPS
-8.00
EBIT (Rs lakh)

Problem 4

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(Rs ‘000)
Plan I Plan II
EBIT 150 150
Interest 35 80
PBT 115 70
Tax 40.25 24.5
PAT 74.75 45.5
Number of shares 15 12.5
EPS 4.98 3.64

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I. M. Pandey, Financial Management, 9th Edition, New Delhi: Vikas.

Problem 5

(Rs)
Plan I Plan II Plan III
Equity 300,000 180,000 120,000
Debt 0 120,000 180,000
Total capital 300,000 300,000 300,000
Share issue price 20 20 20
Number of shares 15,000 9,000 6,000
Tax rate 35% 35% 35%

EBIT 45,000 45,000 45,000

Interest 0 18,000 28,200
PBT 45,000 27,000 16,800
Tax 15,750 9,450 5,880
PAT 29,250 17,550 10,920
Number of shares 15,000 9,000 6,000
EPS 1.95 1.95 1.82

Interest calculation:
Plan I Plan II
Interest (%) Debt Interest Debt Interest amt.
14% 60,000 8400 60,000 8,400
16% 60,000 9600 90,000 14,400
18% 0 0 30,000 5,400
120,000 18,000 180,000 28,200

Problem 6

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Ch. 14: Financial and Operating Leverage

Problem 7

EBIT 200
Contribution 400
Interest (INT) 100
Decline in sales -5%

Fixed cost (FC): 200

contribution minus EBIT
PBT: EBIT - interest 100
Degree of combined 4
leverage:
Percentage change in
EPS: % change in sales × -20%

INT + FC 100 + 200

DCL = 1 + = 1+
PBT 100
The formula for DCL can also be written as follows:
% ∆ in EPS
DCL =
% ∆ in sales
% ∆ in EPS
= =4
- 5%
% ∆ in EPS = -5% × 4 = -20%

Problem 8

A B
Expected EBIT 120,000 120,000
Standard deviation of 30,000 30,000
expected EBIT
Coefficient of variation 25% 25%
of expected EBIT
Interest 0 30,000
Expected PBT 120,000 90,000
Standard deviation of 30,000 30,000
expected PBT
Coefficient of variation 25% 33%
of expected PBT
B, with fixed interest charges, is more risky.
Since interest will remain constant irrespective of what happens to EBIT, the standard deviation of expected PBT will
be Rs 30,000. The business risk of the two firms is same. However, firm B has higher financial risk due to interest
charges.

Problem 9

(Rs)
Funds needed 1,000,000
Tax 35%
Existing shares 100,000
Plan I:
Debt 15% 1,000,000
Plan II: No. (Rs)
Equity 100,000 1,000,000
Total shares 200,000

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I. M. Pandey, Financial Management, 9th Edition, New Delhi: Vikas.

Probabilit [{EBIT i -
EBIT i y (p i ) EBITp i E(EBIT)} 2 ]p i
100,000 0.05 5,000 845,000,000
150,000 0.10 15,000 640,000,000
200,000 0.30 60,000 270,000,000
250,000 0.40 100,000 160,000,000
300,000 0.10 30,000 490,000,000
400,000 0.05 20,000 1,445,000,000
Variance 230,000 3,850,000,000
Standard dev. 62,048
Coeff. Variation 27%

Plan I
E(EPS)} 2
EBIT i Interest PAT EPS i EPS i p i ]p i
100,000 150,000 -32,500 -0.33 -0.0163 0.0357
150,000 150,000 0 0.00 0.0000 0.0270
200,000 150,000 32,500 0.33 0.0975 0.0114
250,000 150,000 65,000 0.65 0.2600 0.0068
300,000 150,000 97,500 0.98 0.0975 0.0207
400,000 150,000 162,500 1.63 0.0813 0.0611
Variance 0.5200 0.1627
Standard dev. 0.4033
Coeff. Variation 77.56%

Plan II
{[EPS -
E(EPS)} 2
EBIT i Interest PAT EPS i EPS i p i ]p i
100,000 0 65,000 0.33 0.0163 0.0089
150,000 0 97,500 0.49 0.0488 0.0068
200,000 0 130,000 0.65 0.1950 0.0029
250,000 0 162,500 0.81 0.3250 0.0017
300,000 0 195,000 0.98 0.0975 0.0052
400,000 0 260,000 1.30 0.0650 0.0153
Variance 0.7475 0.0407
Standard dev. 0.2017
Coeff. Variation 27%
Plan I is more risky as it has higher standard deviation.

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Ch. 14: Financial and Operating Leverage

Problem 10

Company 1 Company 2
10% fall in 10% rise in 10% fall in 10% rise
Current sales sales Current sales sales in sales
Sales 108.65 97.79 119.52 108.65 97.79 119.52
Less : variable cost 43.46 39.12 47.81 35.85 32.27 39.44
Contribution 65.19 58.67 71.71 72.80 65.52 80.08
Less: fixed cost 52.69 52.69 52.69 61.40 61.40 61.40
EBIT 12.50 5.98 19.02 11.40 4.12 18.68
Less : interest 9.27 9.27 9.27 6.95 6.95 6.95
PBT 3.23 -3.29 9.75 4.45 -2.83 11.73
Less : tax at 35% 1.13 -1.15 3.41 1.56 -0.99 4.11
PAT* 2.10 -2.14 6.34 2.89 -1.84 7.62
Total assets 92.70 92.70 92.70 92.70 92.70 92.70
Equity 30.90 30.90 30.90 46.35 46.35 46.35
Debt 61.80 61.80 61.80 46.35 46.35 46.35

Variable cost ratio 40.00% 40.00% 40.00% 33.00% 33.00% 33.00%

Contribution ratio 60.00% 60.00% 60.00% 67.00% 67.00% 67.00%
Before-tax ROI: 13.48% 6.46% 20.52% 12.30% 4.44% 20.15%
After-tax ROI: EBIT(1- 8.76% 4.20% 13.34% 7.99% 2.89% 13.10%
ROE: PAT/Equity 6.79% -6.91% 20.51% 6.24% -3.97% 16.45%
Debt-equity ratio 2.0 2.0 2.0 1.0 1.0 1.0
DOL: %∆EBIT/%∆Sales 5.22 5.22 6.39 6.39
DFL: %∆PAT/%∆EBIT 3.87 3.87 2.56 2.56
DCL: %∆PAT/%∆Sales 20.18 20.18 16.36 16.36
* On loss tax credit is assumed.
Company 2 has a higher degree of operating risk and lower degree of financial risk as compared to company 1.
However, the overall risk of company 2 is higher than company 1. In terms of low risk, the chemical company should
consider acquiring company 1.

Problem 11

(Rs crore)
Existing situation: Expansion:
Sales 137.5 Expansion in capacity 30%
PAT 7.15 Additional fixed assets 30
Tax rate 35% Additional sales 55
PBIT: PAT/(1 - T) 11 New sales 192.5
Fixed assets 100 PBIT/sales ratio 18%
Net worth 135 Additional PBIT 9.9
Number of shares 4 New PBIT 20.9
EPS 1.79 Total cost: sales - PBIT 171.6
Fixed cost/total cost 70%
Fixed cost 120.12
Variable cost 51.48

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I. M. Pandey, Financial Management, 9th Edition, New Delhi: Vikas.

Proposed financing: (Rs crore)

Debt Equity
Debt 30 Equity 30
Interest rate 15% Per share issue price 10
Tax rate 35% Additional shares 3
Number of shares (Nd) 4 Number of shares (Ne) 7

Analysis:
Sales 192.5 192.5
Less: variable cost 51.48 51.48
Contribution 141.02 141.02
Less: fixed cost 120.12 120.12
PBIT 20.9 20.9
Less: interest 4.5 0
PBT 16.4 20.9
Tax 5.74 7.32
PAT 10.66 13.59

Number of shares 4 7
EPS (Rs): PAT/N 2.67 1.94
Break-even PBIT:
[Ne/(Ne - Nd)] x INT 10.5 10.5
Break-even EPS (Rs) 0.98 0.98
Contribution ratio 73.26% 73.26%
Break-even point 163.97 163.97
Margin of safety 17.40% 17.40%
DOL: Contribution/PBIT 6.75 6.75
DFL: PBIT/PBT 1.27 1.00
DCL 8.60 6.75
Debt financing will generate more EPS provided PBIT is higher than Rs 10.5 crore (break-even PBIT). Thus debt
financing will remain attractive even if expected PBIT drops by about 50%. PBIT will drop if sales decline.1% decline
in sales will cause PBIT to drop by 6.75% (operating leverage). About 7.5% drop in sales will cause 50% drop in
PBIT. A 15% drop in sales will entirely wipe out PBIT. Debt adds financial risk, and thus increases EPS variability.

Problem 12

Volga
Net worth 153.31
Borrowing 165.47
EBIT 43.17
Interest (INT) 34.39
Fixed cost (FC) 118.23

1. Debt-equity ratio 1.08

2. Interest coverage 1.26
3. DOL = [1 + FC/EBIT] 3.74
4. DFL = [EBIT/(EBIT - 4.92
5. DCL = DOL x DFL 18.38

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Ch. 14: Financial and Operating Leverage

CASE

Case 14.1: Central Equipment Company

The objective of the case is to analyse the interaction between operating risk and financial risk. It also focuses on the
practical considerations of managers in understanding the operating conditions and risks that have a bearing on a firm's
borrowing decision (capital structure). From the facts of the case, one can argue that a low debt-equity ratio might
prove to be risky for a firm with high operating risk. The instructor can focus on break-even analysis and EPS analysis
to illustrate the concepts of and interaction between operating and financial risks. The instructor can close the case by
pointing out the inadequacy of this analysis, and set the background for the need for analysing the impact of capital
structure on the value of the firm.

(1) The break-even analysis indicates the safety zone (vis-à-vis sales variability) for the firm.
It helps to understand the operating risk faced by the firm.

Sales 4,032.3
PBIT 125.0 2.14 -3.88
Total cost 3,907.3
Variable cost 45% 1,758.3
Fixed cost 55% 2,149.0
Variable cost
ratio 43.6%
Contribution
ratio 56.4%
B/E sales 3,810.6 94.5%

(2) EPS Analysis (vis-à-vis changes in sales and EBIT/PBIT)

EPS
Interest 10% 200.00 Debt Equity D/E
2,00
Debt 0 B/E PBIT 380 6.50 6.50 6.50
Tax 35%

Equity option Debt option Debt-Equity Mix

Change in sales -0.05 Expect. 0.05 -0.05 Expect. 0.05 -0.05 Expect. 0.05
Sales 3,830.7 4,032.3 4,233.9 3,830.7 4,032.3 4,233.9 3,830.7 4,032.3 4,233.9
Varible cost 1,670.4 1,758.3 1,846.2 1,670.4 1,758.3 1,846.2 1,670.4 1,758.3 1,846.2
Contribution 2,160.3 2,274.0 2,387.7 2,160.3 2,274.0 2,387.7 2,160.3 2,274.0 2,387.7
Fixed cost 2,149.0 2,149.0 2,149.0 2,149.0 2,149.0 2,149.0 2,149.0 2,149.0 2,149.0
PBIT 11.3 125.0 238.7 11.3 125.0 238.7 11.3 125.0 238.7
Interest 0.0 0.0 0.0 200.0 200.0 200.0 100.0 100.0 100.0
PBT 11.3 125.0 238.7 -188.7 -75.0 38.7 -88.7 25.0 138.7
Tax 4.0 43.8 83.5 -66.0 -26.3 13.5 -31.0 8.8 48.5
PAT 7.3 81.3 155.2 -122.7 -48.8 25.2 -57.7 16.3 90.2
Debt repayment 1.0 1.0 1.0 1.0 1.0 1.0 1.0 1.0 1.0
Uncommited profit 6.3 80.3 154.2 -123.7 -49.8 24.2 -58.7 15.3 89.2
Number of shares 38 38 38 18 18 18 28 28 28
EPS 0.19 2.14 4.08 -6.81 -2.71 1.40 -2.06 0.58 3.22
Uncommited EPS 0.17 2.11 4.06 -6.87 -2.76 1.34 -2.09 0.54 3.18

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I. M. Pandey, Financial Management, 9th Edition, New Delhi: Vikas.

PBIT-EPS Chart

50

40

30

20
EPS

10

0
-140

140

280

420

560

700

840

980

1,120

1,260

1,400

1,540
-10

-20
PBIT

(3) Operating & Financial Leverage Analysis

Break-even sales 3,810.6 94.5%
Change in sales -0.05 0.05 -0.05 0.05
Change in PBIT -0.91 0.91 -0.91 0.91
DOL 18.19 18.19 18.19 18.19 18.19
Change in EPS -0.91 0.91 1.52 -1.52
DFL 1.00 1.00 -1.67 -1.67 -1.67
DCL 18.19 18.19 -30.32 -30.32 -30.32

(4) Balance Sheet & P&L Analysis: Historical Perspective

Balance Sheet
Cash 8% 89.0
Debtors 16% 180.7
Inventory 4% 41.1
OCA 4% 47.1
CA 31% 357.9
G Block 71% 819.9
Acc dep. 2% 23.5
N Block 69% 796.4
TA 100% 1,154.3
Crs. 2% 15.2
Tax prov. 4% 30.3
OCL 15% 121.5
CL 21% 167.0
Paid up 22% 180.0
R&S 57% 459.6
NW 79% 639.6
TL 100% 807

Financial analysis: The company sales have grown at an average rate of 7.5%. But it shows great variability as well.
Twice during last decade sales growth was negative, a drop of 5.7% in 1991 and 17.5% in 1997.Margin has hovered
around 2%. The company has high level of current assets. If the company realises its debtor and uses surplus cash
balance, it can perhaps reduce its dependence on external funds. The firm is very conservatively financed.

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