141

CH. 6: FINANCING DECISION: LEVERAGE ANALYSIS

the risk
(ombinedleveragemayalso be ascertained to measures can be usedto analyse usedto
The conccept of leverage FL and CL can be
.4changein EPSfor a %change in the Sales and may The OL,
level of the firm, financial the firm.
the
business, and total risk of
defincdas: heasure
be
6 Change in EPS Contribution
(ombinedleverage 0x F
4Change in Sales PBT

GRADED ILLUSTRATIONS

ustration6.1 llustration 6.2 7,00,000and

10,00,000, variable cost of
of 10% rate of
zulatethedegree
of operating leverage (DOL), degree of Atirm has sales2,00,000 and debt of ? 5,00,000 at cormbined
operating, financial and
Cak
(DFL;)andthe degree of combined leverage fixed costs of
vialleverage
tinan
following firms and interpret the results. interest. What are the wants to double its earnings
before
for he
? If the firm sales would be
leverages in
N)
(EBIT), how much of a rise
Firm A Firm B Firm C interest and tax
percentage basis ?
LOutput(Units)
60,000 15,000 1,00,000 needed on a
7,000 14,000 1.500
:Fivedcosts() Solution : EXISTING PROFIT
) 0.20 1.50 0.02 STATEMENT OF
cost per unit 10,00,000
:V'ariable borrowed funds 4,000 8,000
Interest on () 0.60 5.00 0.10 7,00,000
priceper unit Sales
< Selling -Variable Cost 3,00,000
Contribution 2,00,000
-Fixed Cost 1,00,000
Solution:
Firm B Firm C 50,000
Firm A EBIT 5,00,000 50,000
60,000 15,000 1,00,000 -Interest @ 10% on
Output(Units) 5.00 0.10 (PBT)
unit () 0.60 Profit before tax
SelingPrice per 0.20 1.50 0.02
Contribution
3,00,000
=3
unit
Variable Cost per 0.40 3.50 0.08 1,00,000
Contribution per unit ) 752.500 8,000 Operating Leverage: EBIT
7 24,000 1,00,000
Total Contribution 14,000 1,500 EBIT -=2
7,000 6,500
50.000
-Fixed Costs 38.500 Financial Leverage PBT
17,000
EBIT 4,000 8,000
X 2=6
- Interest 13,000 30,500 6,500 Combined Leverage =3 THE EBIT
(P.B.T) NEEDED TO DOUBLE
Profit before Tax STATEMENT OF SALES increase in sales
ie, 33/%
Operating leverage is 3 times operating profit or
EBIT.
100% increase in EBIT will
Leverage volume causes a operating profit or
Degree of Operating 52,500
8,000
of 7 13,33,333,
24,000 Thus, at the sales existing one.
2,00,000 ie, double the
Contribution 6,500
17,000 38,000 become
= 1.23
EBIT =1.36
=1.41 Verification ? 13,33,333
9,33,333
Sales
Leverage 6,500 -Variable Cost (709%6) 4,00,000
Degree of Financial 17,000
38,500
EBIT 6,500 Contribution 2,00,000
30,500
13.000 2,00,000
PBT = 1.26 = 1.00 -Fixed Costs
= 1.31
EBIT

Leverage 8,000
Degree of Combined 52,500 Illustration 6.3 same
24,000 6,500 are related to four firms of the
Contribution
13,000
30,500
= 123
Following information
PBT = 1.72 industry: Change in EPS
= 1.85 Change in EBIT
withhigh Change in Sales 30%
operating leveragecombined operating Firm
A 279%
25% 24%
Interpretation:High situation. Low 25%
32% 21%
representsrisky leveragewillconstitute B
23%
36% 2396
financial leverage withlowfinancial has
riskybecauseitcom-
40%
21%
leveragecombined Therefore. firm Cisless
consequently low
D
(iü) Degree of CL for
all firms.
&
anideal
situation. interest and Calculate (i) Degree of OL
cost and no
low fixed
bined leverage.
142 PART II| : FINANCING DECISION

Solution:
Firm Operating Levernge Comblned Leverage
infer from the degree of operating leverage at
volumes of 2,500 units and 3,000 units and their sales
OL= 4Change in EBIT
4Change in Sales
CL= Change in EPS
%Change in Sales
any?
Solution:
STATEMENT OF 0PERATING LEVERAGE
if erencet
A OL=
25 30
-0,926 CL= =1,||| Partlculars 2500 Units
27 27
Sales @ 14 per unit 35,000 3000 Unlta
B OL=
32
25
=1.280 CL
24
25
=0.960
Variable cost
Contribution
22,500
12,500
42,0 9
21 00
Fixed cost (2000 X(? 14-9) 10,000 1509)
OL=
36
=1,565 CL
21
EBIT
Contribution
2,500 10900
23 =0,913 Operating Leverage 12,500
23 EBIT 2,500 15009)
40
OL==1.905 CL23=1.095
21 At the sales volume of 3000 units, the
operating proft :
5,000 which is double the operating profit of 2,500 (sal
volume of 2,500 units) because of the fact that the operat
llustration 6.4 leverage is 5 times at the sales volume of 2,500 units, Hen
XCorporation has estimated that for a increase of 20% in sales volume, the operating profit hae
new
even point is 2,000 units if the item is sold forproduct its break
14 per unit; the
increased by 100% ie,5 times of 20%. Atthe level of 3000 unite
cost accounting department has currently the operating leverage is 3 times. IF there is change in sala
cost of?9 per unit. Calculate the degree of identified variable from the level of 3,000 units, the %increase in EBIT
would he
for sales volume of 2,500 units and operating leverage three times that of % increase in sales volume.
3,000 units. What do you
Illustration 6.5
The balance sheet of Well
Established Company is as follows:
Liabilities Amount Assets
Equity Share Capital Amount
60,000 Fixed assets
Retained Earnings 20,000 Current Assets
? 1,50,000
10% Long-term Debt 50,000
80,000
Current Liabilities
40,000
2,00,000
2,00,000
The company's Total Assets turnover ratio is 3,
its
operating costs are 1,00,000 and its Variable operatingFixed
cost
Tax at 30%
75,600
ratio is 40%. The income tax rate is 30%. PAT
Calculate for the 176,400
Company the different types of leverages given that the face Number of shares 6,000
value of the share is 10. EPS
29.40
Solution: Degree of Operating Leverage = Contribution/EBIT
Total Assets Turnover Ratio Sales 3,60,000
= -=1.38
Total Assets 2,60,000
Sales Degree of Financial Leverage= EBIT/PBT
3=
2,00,000 2,60,000
Sales =1.03
6,00,000 2,52,000
Variable Operating Cost (40%) 2,40,000 Degree of Combined Leverage= 1.38 X 1.03 = 1,42
Contribution 3,60,000 Note : In this question, the operating leverage, inancal
- Fixed
EBIT
Operating Cost 1,00,000 leverage and the combined leverage are to be calculated for
which the detailed income statement is required.
-Interest (10% of 80,000) 2,60,000 Therefore
the sales level, as afirst step, is calculated with the help
8,000 of Total
PBT Assets Turnover Ratio.
2,52,000
 143
CH 6 FINANCING DECISION:LEVERAGE ANALYSIS
lacs/ 200 lacs
FRrr/Profit hefore Tax 300
Financial Leverage
uetration6.6
(ontribution/Profit hefore tax 0L X FL
followinginformation is available in tespect of two fims, (ombined Leverage
The
PLtd.andQLid
hence
(Figures In Lacs) higher in case of O Ltd. and
The operating leverage is However,
operating or business risk.
P Lid. O Ltd. it has higher degree of same degree of financial leverage.
500 1000 both the companies have same financial risk. The combined
Sales Hence, both the firns have Therefore,on
Ltd. is 3.5 and is higher than P Ltd. cormpared
-VariableCost 200 300
300
leverage of Q lower risk as
the whole P Ltd. seems to be having
Contibution 700
-FdCost 150 400 to Q Ltd.
150 300
EBIT
-Interest 50 100 llustration 6.7
Profit before Tax 100 200 manufactures a full line of lawn
The Karnal Recreation Ltd. finished unit is7 2,500
ane nequired to calculate different leverages for both the furniture. The average selling priceof a Fixed cost for the
Brms and alsocomment on their relative risk position, and variable cost is 1,500 per unit.
company is 50,00,000 per year.
SoBution. company?
() What is break-even point in units for the
ciulation of different leverages (P Ltd.):
Onerating Leverage = Contribution/EBIT =300 lacs/ 150 lacs (i) Find the degree of operating leverage at the follow
ing production and sales levels
4,000 units; 5,000
:
= 2
units; 6,000 units; 8,000 units.
Einancial Leverage = EBIT/Profit before Tax= 150 lacs/ 100 lacs
or
= 15 (ii) Does the degree of operating leverage increase above
decrease as the production and sales levels rise
Combined Leverage = Contribution/Profit before tax = 0LX FL
= 3
the break-even point? What conclusion would you
draw from such increase or decrease?
Calculation of different leverages (Q Ltd.):
Operating Leverage = Contribution/EBIT=700 lacs/ 300 lacs (iv) By what percentage the EBIT will increase if the
= 2.33
company's sales should increase by 10% from the
production and sales level of 8,000 units?
[B.Com. (H), D.U, 2010]

Solution :
Calculation of Operating Leverages:
Production (No. of Units) 4,000 5,000 6,000 8,000 8,800
Selling Price () 2,500 2,500 2,500 2,500 2,500
Sales (3) 100,00,000 125,00,000 150,00,000 200,00,000 220,00,000
-Variable Cost @ 1,500 60,00,000 75,00,000 90,00,000 120,00,000 132,00,000
Contribution 40,00,000 50,00,000 60,00,000 80,00,000 88,00,000
- Fixed Cost 50,00,000 50,00,000 50,00,000 50,00,000 50,00,000
EBIT -10,00,000 10,00,000 30,00,000 38,00,000
OL (Contribution FC) 6.000 2.667 2.316
Break-even level (Units) = FC/(SP - VC) llustration 6.8
50,00,000/(2500 1500)
=
The capital structure of Radhika Ltd. consists of
= 5,000 share capital of 10,00,000 (shares of 100 each) ordinary
and
When the sales level rises above the break-even level, the OL 10,00,000 of 10% debentures. The
variable costs amount to 6persellingprice
decreases. This means that when the sales increases beyond is 10 per unit;
the break-even level, the increase in operating profits (EBIT) unit and fixed expenses
is lesser and amount to 2,00,000.The income tax rate is
lesser. 30%. The sales level is expected to assumed to be
In case the sales increases by 10% from 8000 level, the EBIT
to1,20,000 units. increase from 1,00,000 units
Would increase by10X2.667=26.67%. This can be verified in
the table. TheEB0T increases by 8,00,000 from 30,00,000 (a) You are required to
738,00,000 ie., 26.679%. to calculate:
() The
percentage increase in earnings per share;
(i) The degree of
1,20,000 units. financial leverage at 1,00,000 units and
 l44 PART FINANCINO DECISION

() The degne nf Drating leveage at 1,00.000 nits Parttentar I.00,000 antts

and 1.20 o00 units
( (Comment onthc hehaviou ofOpeating and Financial Profit after ta 70000
levernges in relation to incense in rvduction from () EPS(10,000 «harea) 79,000
L.00.000 units to l20,000 units 10000
/BCom. (H), DU, 2011) 709
%increase in EPS
Solution (i) Degree of Financial Leverage 2,00,000
(a) Comparattve Statement of EPs, Fnanclal & Operating I.00000
Leverages
(ih Degree of Operating Leverage 4,00,000
Partleutar 1,00,000 units 1,20,000 unlts
2,00,000
Satex at I0 per unft R 10.00,.000 12,00,000
Variabie osts at per unit 6,00,000 7,20,000 (h As a result of 171
increase in sales
1,20,000 units (20% increase), bothfrom
Contribution 4.00000 4,80,000
1,00,000 units ,
-Fxed Expenses 2,00,000 2,00,000
the financial leverv
EBIT and operating leverage
the business risk and have decreased. This signify ih
2,00,000 2,80,000
-Interest on Debentures 1,00,000 1,00,000
Profit before tax 1,00,000 1,80,000 reduced.
financial risk of the business a

llustration 6.9
The data relating to two companies are as given below:

Capital CompanyA Company B

12% Debentures 6,00,000
Output (units) per annum 4,00,000 73,50,000
Selling price/unit 60,000
76,50,000
15,000
Fixed Costs per annum 30 250
Variable Cost per unit 77,00,000 ?14,00,00
R75
Youare required to calculate the Operating
leverage, Financial leverage and Combined leverage of two
Solution: Companies.
COMPUTATION OF OPERATING LEVERAGE, FINANCIAL LEVERAGE AND
COMBINED LEVERAGE
Output (units per annum) Company A Company B
Selling price per unit 60,000 15,000
Sales revenue 30 250
Less:Variable costs @10 and 75 R18,00,000 ?37,50,000
Contribution 6,00,000 11,25,000
Less:Fixed costs 12,00,000 26,25,000
EBIT 7,00,000 14,00,000
Less: Interest (@ 12% on 5,00,000 12,25,000
Debentures 48,000
PBT 78,000
4,52,000 11,47,000
DOL = Cont.
EBIT
(12,00,000/ 5,00,000) 26,25,000/ 12,25,000)
2.4
DFL = EBIT 2,14
PBT
R5,00,000/4,52,000) 12,25,000/ 11,47,000)
DCL= DOLXDFL 1.11 1.07
(2.4 X 1.11) = 2.66 (2.14 X 1.07) = 2.29
 CH. 6:
FINANGING DEGISION:LEVERAGE
llustration 6.10 ANALYSIS 145

The following information is available for ABC &Co. Caleulatlon of Plnanclal Leverage :
EBIT Plan | Plan I Plan II
Protit beorr Tay RIL,20,000 Situntton A
EBIT
Fixed costs 3,20,000 3,000 ?3.000 ?3,000
-Interest (@ 12%
Cakulate
7,00,000 Profit before Tax
600 300 900
ehange in EPSifthe sales are 2,400 2,700
expected toinerease Financial Leverage 1.25
2,100
143
Solution : (EBIT/Profit
Situatlon B
before Tax)
Inonderto find out the
change EPS as aresult of %
in EBIT
2,000 ? 2,000 2,000
sales, the combined leverage should be change -Interest (@ 12% 600
lows: as calculated fol Profit before Tax
1,400
300
1,700
900
1,100
Operating Leverage = Contribution/EBIT Financial Leverage 1.43 1.18 1.82
=|1,20,000 + 7,00,000/11,20,000 (EBIT/Profit before Tax)
Situatlon C
= 1.625 EBIT
71,000 ?1,000
Financial Leverage = EBIT/Profit before Tax -Interest @12%
?1,000
600 300 900
=11,20,000/3,20,000
= 3.5
Profit before Tax
Financial Leverage
400
2.5
700 100
1.43 10.0
Combined Leverage = (EBIT/Profit before Tax)
Contribution/Profit before Tax = 0LX FL
= 1.625 X 3.5 = 5.69.
The combined leverage of 5.69 Calculation of Combined Leverage: The combined leverage
implies that for 1% change in
sales level, the %change in EPS would may be calculated by multiplying the operating
be leverage and
are expected to increase by 5%, then the5.69%. So, if the sales
%increase in EPS
financial leverage for different combination of Situation A, B
& Cand the Financial Plans I, II & IIas
would be 5X 5.69= 28,454%. follows:
Situation A Situation BSituation C
llustration 6.11 Plan I 1.66 2.86 10
Plan II
XYZ &Co. has three financial plans 1.47 2.36 5.72
and before it, Plan I, Plan I Plan II 1.90
Plan IIL Calculate operating and 3.64 40
firm on the basis of the following financial leverage for the
The calculation of combined leverage shows the
Dut the highest and lowest value of information and also find extent of the
combined leverage: total risk and is helpful to understand the variability of EPS as
Production a consequence of change in sales levels. In this case,
800 Units the
Selling Price per unit highest combined leverages is there when Financial Plan II is
15
Variable cost per unit 10
implemented in situation C; and lowest value of combined
Fixed cost: Situation A leverage is attained when Financial Plan II is implemented in
1,000 situation A.
SituationB 2,000
SituationC 3,000 Illustration 6.12
Capital Structure Plan I Plan II Plan III The share capital of a company is 10,00,000 with shares of
Equity Capital 5,000 77,500 ? 2,500 face value of 10. The company has debt capital of
12% Debt 6,00,000 at 10% rate of interest. The sales of the firm are
5,000 2,500 7,500
3,00,000 unitsper annum at a selling price of 5 per unit and
olution : the variable cost is 3 per unit. The fixed cost amounts to
alculation of Operating Leverage: ?2,00,000. The company pays tax at 35%. If the sales increase
by 10%, calculate:
Situation ASituation B Situation C () Percentage Increase in EPS;
Number of unit sold 800 800 800
Bales @ 15 12,000 12,000 12,000
(i) Degree of Operating Leverage at the two levels ; and
Wariable cost @ 10 8,000 8,000 8,000 (ii) Degree of Financial Leverage at the two levels.
Dontribution 4,000 4,000 4,000 Solution:
Pixed cost 1,000 2,000 3,000
BBIT
3,000 2,000 1,000
Dperating Leverage Existing Expected
1.33 2.00 4.00 Sales (in units) 3,00,000 3,30,000
Contribution/EBIT) Sales @5/ 7 15,00,000 16,50,000
Variable Cost at 3/ 9,00,000 9,90,000
Contribution 6,00,000 6,60,000
Fixed cost 2,00,000 2,00,000
 146
DECISION
PART IM FINANCING
So, Contribution 40,500
Erlsttng Espected Fixed Cost t 40,500- 27,000 =? 13,500
Operating
Less Profiont (FBT) 4,00,000 4,60,000 PV Ratio 40%, and Contribution =
Interest
Profft Beore Tax
debt at 10 60,000
3,40,000
60,000 So, Sales Contribution + PV Ratio
40,500 + 40 =1,01250
40500
Less Tax 354 4,(00,000
1,19,000 1,40,000 Variable Cost 1,01,250 X.60 = 60.750
Net Profi after tax
2,21,000 2,60,000 EPS of the Company can be calculated as followe.
Incrense in EPS
Sales
-Variable Cost
Existing EPS =Net Profit 221,000 2.21| Contribution
No. of Shares 1,10,000 Fixed Cost

Expected EPS = 260,000 EBIT 13 %

1,00,000 =2.60 Interest
PBT

Percentage increase in EPS 0.39

2.21 =17.65%
-Tax (@ 30% 199
Operating Leverage: No. of Equity Shares 13 95
EPS (13,300+ 10,000)
Existing OL-Contribution6,00,000 13
EBIT 4,00,000
=15 llustration 6.14
The following data is available for XYZ Ltd.:
Expected OL,60,00 =1.43
4,60,000 Sales
72,00,0
Financial Leverage: -Variable cost @30%
Contribution 60,00
Existing FL= EBIT 4,00,000
PBT 3,40,000 1.176
Fixed cost 1,40,00
EBIT 1.00,000
ExpectedFL4,60,000 -Interest 40.000
4,00.0001.150 5.000
Profit before tax
Find out: 35,0
lllustration 6.13
() Using the concept of
Folowing information is available in respect of Som Dut centage will the taxable financial leverage, by what per
Bearings Ltd.: creases by 6%. income increase if EBIT i
Profit Volume (PV) Ratio (i) Using the concept of
Operating Leverage 40% operating leverage, by what per
centage will EBIT increase
1.5000 if there is 10%increase in sales
Financial Leverage 1.421
and
Interest Liability (ii) Using the concept of
the taxable income leverage,if bywhat percentage wll
Tax rate T8,000
Also verify the resultsincrease the sales increase by 6.
No. of Equity Shares 30%
10,000 in viewof the above
figures.
Prepare the income statement and find out EPS. Solution:
Solution: () Degree of Financial leverage :
EBIT EBIT FL=EBIT/Profit before Tax =
FL =
PBT
EBIT
= 115 40,000/35,000
EBIT-Interest EBIT - 8000
1.421 = EBIT IF EBIT increases by6%,
the
EBIT - 8000 1.15 X6=6.9% and it may betaxable income will increase D)
So verified as follows:
EBIT = 27,000 EBIT (after 6% increase) 742,400
PBT = 27,000 - 8,000 = 19,000 -Interest 5,000
OL = Contribution Contribution Profit before Tax 37,400
EBIT
? 27,000 Increase in taxable income is 2.400 Le. 6.9% of
1.5 Contribution 35,000.
(i) Degree of Operating
27.000
OL =
leverage :
Contribution/EBIT = 1,40,000/40,000
=3.50
 147
CH. 6: FINANCING DECISION LEVERAGE ANALYSIS
20,00,000
saleincreases by 10%, the EBIT will increase by 3.50 × 10 RBIT 9,00,000
If
=354andiit may be verified as follows: Interest at 12% on 75,00,000
11,00,000
l0% increase) 2,20,000 PBT
sales (after
Expenses (@ 30,
Variable
Contribution
66,000
Financial Leverage
EBIT 20,00,000 1,82
L54,000 PBT |1,00,000
-Fixedcost 1,00,000

EBIT 54,000 llustratton 6.16

year ending
Ineasein EBITis 14,000 ie, 35% of 40,000. The following are details of Bankers Ltd, for the
31.03.2015.
o Degree of Combined leverage: 3
CL=Contribution/Profit before Tax - 1,40,000/ Operating Leverage
35,000 4 Financial Leverage
220 Lakhs
Interest charge per annum
Wsales inTrases by 64, the pofit before tax will increase by Corporate Tax Rate 50%
a=244 and it nmav be verified as follows : Variable Cost as percentage of sales 60%
Sales (after 64 increase) R2,12,000 Prepare Income Staternent of the Company.
[B.Com.(H) D.U, 2013]
lariablc Expenses @ 304 63,600
Contribution 1,48,400 Solution:
-Fixed cost 1,00,000 Calculation of EBIT:
EBIT 48,400 2 (Given)
Financial Leverage
-Interest 5,000 7 20,00,000
Interest
Profitbefore Tax 43,400 EBIT EBIT
Now, FL PBT EBIT- Int.
Increase in Profit betore tax is 8,400 ie., 24% of35.000. EBIT
EBIT - 20,00,000
WMustration 6.15 Z40,00,000
EBIT
(D Find out Operating Leverage from the following data: Calculation of Contribution:
750,000 Operating Leverage 3(Given)
Sales Z40,00,000
Variable Costs 60% EBIT
Contribution
Fixed Costs 12,000 OL
EBIT
(D Find out the Financial Leverage from the following data: So, Contribution T120,00,000
= Contribution-EBIT
Net Worth 25,00,000 Now, Fixed cost
R120,00,000-40,00,000
Debt/Equity 3:1
=80,00,000
Interest rate 1296
Calculation of Sales:
Operating Profit 720,00,000 60%
9% Variable Cost
Solution : So, Contribution 40%

50,000 Contribution 120,00,000

() Sales 300,00,000
30,000 So, Sales 1,20,00,000+ 40)
-Variable cost at 60% Now, the Income Statement can be prepared as follows :
Contribution 20,000 Sales 300,00,000
-Fixed Cost 12,000 Less: Variable Cost (60%) 180,00,000

Operating profit T8,000 Contribution 120,00,000

Less : Fixed Cost 80,00,000
Contribution 20,000 = 2.50
Operating Leverage = Operating Profit =
EBIT 40,00,000
8,000 20,00,000
Less: Interest
(i) Net Worth 725,00,000 Profit Before Tax 20,00,000
3:1 10,00,000
Debt/Equity -Tax @ 50%
Hence Debt 75,00,000 Profit After Tax 10,00,000

OBJECTIVE TYPE QUESTIONS

State whether each of the following _tatements is True (T) or (i) Financial leverage depends upon the operating leverage.
False (F). (ii) Dividend on Pref. shares is afactor of operating leverage.
(0 Operating leverage analyses the relationship between
sales level and EPS. (iv) Operating leverage may be defined as Contribution :
EPS.