2. Leverage

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CA. Nagendra Sah Page 2.1

CH A

PTER

Leverage

Coverage of Leverage in Past Examinations:

Year Nov-2011

May-2011

Nov-2010

May-2010

Nov-2009

June-2009

Nov-2008

May-2008

IPCC 8 5 4 --- 8 NA NA NA

PCC Same Same Same --- Same --- 3 2

Leverage The term leverage in general refers to a relationship between two interrelated variables. In financialanalysis it represents the influence of one financial variable over some other related financial variable. ThisFinancial Variable may be EBIT, EBT, EAT, EPS etc.

There are three commonly used measures of leverage in financial analysis. These are:(i) Operating Leverage(ii) Financial Leverage(iii) Combined Leverage

In simple, the leverage indicates involvement of risk in the business due to fixed cost elements.

Fixed Finance Cost (eg. Interest, Preference div.)

Analysis of Financial risk

Financial Leverage.

Fixed operating cost (eg. Rent, Depreciation, Wages)

Analysis of business risk

Operating Leverage

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Financial Management

Email: [email protected] Page 2.2

To remember these above formulas, consider following cost sheet.

Sale *****

Less: Variable cost *****

Contribution *****

Less: Fixed cost ***** op. leverage = contribution ÷ EBITEBIT *****

Less: Interest *****

EBT ***** Fin. Leverage = EBIT ÷ EBT

Less: Tax ***** Or

EAT *****

Less Preference Div ***** Fin. Leverage = EBIT/ EAT for equity

EAT for Equity *****

Pre tax post tax

Hence, (When there are Preference share)

Fin. Leverage = EBIT (1-tax) ÷ EAT for Equity

Post tax post tax

Degree of Combined Leverage (DCL) = (i) DOL DFL; or

(ii)

or, (iii)

Degree of Op. leverage (DOL) =

(i) OR,

(ii)

(DOL should be Calculated in No.of times)

When No Preference sharein capital Structure

Leverage

Operating Leverage Financial Leverage

When Preference sharein Capital Structure

Degree of Fin Leverage(DFL) =

OR

(DFL Leverage should becalculated in No. of times)

Degree of Fin Leverage(DFL) =

OR

(DFL Leverage should becalculated in No. of times)

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Leverage


Analysis:High Fixed cost means high Leverage.High leverage means High risk High risk means high change in profit (EBIT, EBT, EAT or EAT for equity as the case may be) even for small change in Sale.

Relationship between different variables (sale and profit): Operating leverage 5 times (Assumed) , means 1% change in sale or contribution will result 5% changein EBIT

Financial leverage 4 times (assumed) , means:o 1% change in EBIT will result 4% change in EBT or EAT or EPS (when there is no preference

share) or, o 1% change in EBIT will result 4% change in EAT for equity or EPS (when there is preference

share) Combined leverage 20 times (Assumed) , means:

o 1% change in sale or contribution will result 20% change in EBT or EAT or EPS (when there is

no preference share) or, o 1% change in Sale or Contribution will result 20% change in EAT for equity or EPS (when

there is preference share)

Note: “%” change in sale or contribution is always same, as only variable cost comes between thesevariables.

“%” change in EBT or EAT or EAT for Equity or EPS is same, when only variable cost comes betweenthese variables. (i.e. no preference fixed dividend). When there is fixed preference dividend then % changein EAT and EAT for equity is different.

Question No. 1 [Study Mat.]A Company produces and sells 10,000 shirts. The selling price per shirt is 500. Variable cost is 200 pershirt and fixed operating cost is 25,00,000.(a) Calculate operating leverage.(b) If sales are up by 10%, then what is the impact on EBIT?

Ans: (a) Operating leverage = 6times; (b) EBIT will increase by 60%

Question No. 2 [Study Mat.]Calculate the operating leverage for each of the four firms A, B, C and D from the following price and cost data.

A( )

B( )

C( )

D( )

Sale price per Unit 20 32 50 70Variable Cost per Unit 6 16 20 50Fixed operating cost 80,000 40,000 2,00,000 Nil

What calculations can you draw with respect to levels of fixed cost and the degree of operating leverageresults?Explain. Assume number of units sold is 5,000.

Ans : DOL(A) = 7; DOL(B) = 2; DOL(C) = 3; DOL(D) = 1

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Question No. 3 [Study Mat.]A firm’s details are as under:

Sales (@100 per unit) 24,00,000Variable 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) 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?

Ans: (a) Op Lev. = 6 times; (b) Fin. Lev. = 2 times; (c) Com Lev = 12 times (d) ROI = 5%; (e) New EBIT = 5,00,000

Question No. 4 [May-2008-Old-8 Marks]Delta Ltd. currently has an equity share capital of 10,00,000 consisting of 1,00,000 Equity share of 10each. The company is going through a major expansion plan requiring to raise funds to the tune of 6,00,000. To finance the expansion the management has following plans:

Plan-I : Issue 60,000 Equity shares of 10 each.Plan-II: Issue 40,000 Equity shares of 10 each and the balance through long-term borrowing

at 12% interest p.a.Plan-III : Issue 30,000 Equity shares of 10 each and 3,000 100, 9% Debentures.Plan-IV : Issue 30,000 Equity shares of 10 each and the balance through 6% preference shares.

The EBIT of the company is expected to be 4,00,000 p.a. assume corporate tax rate of 40%.Required:

(i) Calculate EPS in each of the above plans.(ii) Ascertain the degree of financial leverage in each plan.

Ans: (i) EPS : I = 1.50; II = 1.61; III = 1.72; IV = 1.71; (ii) DFL : I = 1; II = 1.06; III = 1.07; IV = 1.00

Question No. 5 [Study Mat.]Betatronics Ltd. has the following balance sheet and income statement information:

Balance sheet as on 31 st MarchLiabilities ( ) Assets ( )Equity capital ( 10 per share) 8,00,000 Net fixed assets 10,00,00010% Debt 6,00,000 Current assets 9,00,000Retained earnings 3,50,000Current liabilities 1,50,000

19,00,000 19,00,000

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Income Statement for the year ending 31 st March ( )

Sales 3,40,000Operating expenses (including 60,000 depreciation) 1,20,000EBIT 2,20,000Less: Interest 60,000

Earnings before tax 1,60,000Less: Taxes 56,000Net Earnings (EAT) 1,04,000

(a) Determine the degree of operating , financial and combined leverages at the current sales level, if alloperating 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 20percent, what will be the earnings per share at the new sales level?

Ans: (a) DOL = 1.27; DFL = 1.37; DCL = 1.75; (b) (i) EPS = 1.75; (ii) EPS = 0.84

Question No. 6 [Study Mat.] [Final-May-1996-14 Marks] [As May-11-5 Marks]Calculate the operating leverage , financial leverage and combined leverage from the following data underSituation I and II and Financial Plan A and B:

Installed Capacity 4,000 unitsActual Production andSales

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 15,000Debt (Rate of Interest at 20%) 10,000 5,000Total 20,000 20,000

Ans: Op Lev : S-I = 1.5; S-II = 1.8; Fin. Lev : Situation-I: Plan A = 1.07, Plan B = 1.04; Situation-II: Plan A = 1.09; Plan B = 1.04Combined Lev : Situation-I: A=1.6, B=1.56; Situation-II A=1.96, B= 1.87

Question No. 7 [Study Mat.-Self Exam]Calculate the Financial Leverage from the following data:

Net woth (Equity) 2500,000Debt/Equity 3:1Interest rate 12%Operating profit 20,00,000

Ans: DFL = 1.82

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Question No. 8 [Study Mat.-Self Exam] [As Nov-2010-IPCC-4 Marks]Calculate the Degree of Operating Leverage , Degree of Financial Leverage and the Degree of CombinedLeverage for the following firms and interpret the results:

P Q ROutput (unit) 3,00,000 75,000 5,00,000Fixed Costs ( ) 3,50,000 7,00,000 5,00,000

Unit Variable costs ( ) 1.00 7.50 0.10Interest expenses ( ) 25,000 40,000 – Unit Selling price ( ) 3.00 25.00 0.50

Question No. 9 [Study Mat.-Self Exam]XYZ Ltd. sells 2000 units @ 10 per unit. The variable cost of production is 7 and Fixed cost is 1,000.The company raised the required funds by issue of 100, 10% debentures @ 100 each and 2000 equityshares @ 10 per share. The sales of XYZ Ltd. are expected to increase by 20%. Assume tax rate of company is 50%. You are required to calculate the impact of increase in sales on earning per share.

Question No.10 [Study Mat] [Final-Nov-2001-6 Marks]Consider the following information for Strong Ltd:

EBIT 1,120 in lakhPBT 320 in lakhFixed Cost 700 in lakh

Calculate the percentage of change in earnings per share, if sales increased by 5 per cent. Ans: Change in EPS = 28.4375%

Question No. 11 [Nov-2007-Old-3 Marks]

Consider the following information for Omega Ltd.:in lakhs

EBIT (Earnings before Interest and Tax) 15,750Earnings before Tax (EBT): 7,000Fixed Operating costs: 1,575

Required:Calculate percentage change in earnings per share, if sales increase by 5%.

Ans: Change in EPS = 12.375%

Question No.12 [Study Mat] [Final-May-2002-6 Marks] [CWA-Final-Dec-2001-12 Marks]The net sale of A Ltd. is 30 crores. Earnings before interest and tax of the company as a percentage of net sales is 12%. The capital employed comprises 10 crores of equity, 2 crores of 13% CumulativePreference Share Capital and 15% Debentures of 6 crores. Income-tax rate is 40%.(i) Calculate the Return-on-equity for the company and indicate its segments due to the presence of

Preference Share Capital and Borrowing (Debentures).(ii) Calculate the Operating Leverage of the Company given that combined leverage is 3.

Ans: (i) ROE = 13.6%; Its Segments: ROA = 12%, Debt effect = 1.8%, Pref. effect = -0.2%(ii)Operating Leverage = 1.889

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Question No.13 [Study Mat.] [Nov-2002-Old-4 Marks]The data relating to two Companies are as given below:

Company A Company BEquity Capital 6,00,000 3,50,00012% Debentures 4,00,000 6,50,000Output (units) per annum 60,000 15,000

Selling price/ unit 30 250Fixed Costs per annum 7,00,000 14,00,000Variable Cost per unit 10 75

You are required to calculate the Operating leverage , Financial leverage and Combined leverage of twoCompanies.

Ans: Company A: DOL = 2.4; DFL = 1.11; DCL = 2.66; Company B: DOL = 2.14; DFL = 1.07; DCL = 2.29

Question No. 14 [Nov-2004-6 marks]The following summarises the percentage changes in operating income, percentage changes in revenues,and betas for four pharmaceutical firms.

Firm Change in revenue Change in operating income BetaPQR Ltd. 27% 25% 1.00RST Ltd. 25% 32% 1.15TUV Ltd. 23% 36% 1.30WXY Ltd. 21% 40% 1.40

Required:(i) Calculate the degree of operating leverage for each of these firms. Comment also.(ii) Use the operating leverage to explain why these firms have different beta.

Ans: (i) DOL: PQR=0.9259; RST = 1.28; TUV = 1.5652; WXY = 1.9048; (ii) High operating leverage leads to high beta.

Question No. 15 [Nov-2011-8 Marks] [Nov-2006-8 Marks]A Company had the following Balance Sheet as on March 31, 2006:

Liabilities and Equity (in crores) Assets (in crores)Equity Share Capital(one crore shares of 10each)

10Fixed Assets (Net)Current Assets

2515

Reserves and Surplus 215% Debentures 20

Current Liabilities 8 ___40 40

The additional information given is as under:Fixed Costs per annum (excluding interest) 8 croresVariable operating costs ratio 65%Total Assets turnover ratio 2.5Income-tax rate 40%

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Required:Calculate the following and comment:(i) Earnings per share(ii) Operating Leverage(iii) Financial Leverage(iv) Combined Leverage.

Ans: (i) EPS = 14.40, (ii) OL = 1.296, (iii) FL = 1.125, (iv) CL = 1.458

Question No.16 [Nov-2008-Old-3 Marks] Annual sales of a company is 60,00,000. Sales to variable cost ratio is 150 per cent and Fixed cost otherthan interest is 5,00,000 per annum. Company has 11 per cent debentures of 30,00,000.You are required to calculate the operating , Financial and combined leverage of the company.

Ans: OL = 1.3333; FL = 1.2821; CL = 1.7094

Question No. 17 [Study Mat.-Self Exam]

The following figures relate to two companies:( in lakhs)

P Ltd. Q Ltd.Sales 500 1,000Less : Variable costs 200 300Contribution 300 700Less : Fixed costs 150 400EBIT 150 300Less : Interest 50 100Profit before tax (PBT) 100 200

You are required to:(i) Calculate the operating , financial and combined leverages for the two companies; and(ii) Comment on the relative risk position of them.

Question No.18 [Study Mat.-Self Exam]The capital structure of ABC Ltd. consist of an ordinary share capital of 5,00,000 (equity shares of 100each at par value) and 5,00,000 (10% debenture of 100 each). Sales increased from 50,000 units to60,000 units, the selling price is 12 per unit, variable cost amounts to 8 per unit and fixed expensesamount to 1,00,000. The income tax rate is assumed to be 50%.You are required to calculate the following:(a) The percentage increase in earnings per share ;(b) The degree of financial leverage at 50,000 units and 60,000 units;(c) The degree of operating leverage at 50,000 units and 60,000 units;(d) Comment on the behavior E.P.S., operating and financial leverage in relation to increases in sales from

50,000 units to 60,000 units.

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Question No. 19[Study Mat.-Self Exam] [Final-May-1997-11 Marks] [CWA-Final-June-2006-10 Marks] A firm has sales of 75,00,000, variable cost of 42,00,000 and fixed cost 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) Does it have favorable financial leverage?

(iii)

What are the operating, financial and combined leverage of the firm ?(iv) If the sales drop to 50,00,000, what will be the new E.B.I.T. ?

Question No. 20 [Study Mat-Self Exam] [Final-Nov-1997-12 Marks] From the following, prepare Income Statement of Company A, B and C.

Company A B CFinancial leverage 3:1 4:1 2:1Interest 200 300 1,000Operating leverage 4:1 5:1 3:1

Variable Cost as a Percentage to sales %3

2 66 75% 50%

Income tax Rate 45% 45% 45%

Ans:Income Statement

A B C

Sales 3,600 8,000 12,000Less: Variable cost 2,400 6,000 6,000Contribution 1,200 2,000 6,000Less: Fixed cost 900 1,600 4,000EBIT 300 400 2,000Less: Interest 200 300 1,000

EBT 100 100 1,000Less: Tax 45% 45 45 450EAT 55 55 550

Question No.21 [May-2003-Old-3 Marks] [May-2004-Old-3 Marks] Discuss the impact of financial leverage on shareholders wealth by using return-on-assets (ROA) andreturn-on-equity (ROE) analytic framework.

Question No.-22 [May-2008-Old-2 Marks]The following data relate to RT Ltd:

Earning before interest and tax (EBIT) 10,00,000Fixed cost 20,00,000Earning Before Tax (EBT) 8,00,000

Required: Calculate combined leverage

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Question No. – 23The following is the income statement of XYZ Ltd. for the year 2003:

The company has 4 lacs equity shares issued to the shareholders. Find out the degree of (i) Operating leverage ,(ii) Financial leverage ,

(iii) Combined leverage.What would be the EPS if the sales level increases by 10% and the EPS if the sales level decreases by 20%?

Ans: (i) 2 times; (ii) 1.5 times; (iii) 3 timesIf sales increases by 10%, EPS = 2.6; if sales decreases by 20%, EPS = 0.8

Question No. -24 [Nov-2009-IPCC-8 Marks]From the following financial data of Company A and Company B: Prepare their Income Statements.

Company A( )

Company B( )

Variable Cost 56,000 60% of sales

Fixed Cost 20,000 -Interest Expenses 12,000 9,000Financial Leverage 5:1 -Operating Leverage - 4:1Income Tax Rate 30% 30%Sales - 1,05,000

Ans:Company A ( ) Company B ( )

Sales 91,000 1,05,000

Less: Variable cost 56,000 63,000

Contribution 35,000 42,000

Less: Fixed Cost 20,000 31,500

Earnings before interest and tax (EBIT) 15,000 10,500

Less: Interest 12,000 9,000

Earnings before tax (EBT) 3,000 1,500

Less: Tax @ 30% 900 450

Earnings after tax (EAT) 2,100 1,050

Sales 50 lacsLess: variable cost 10 lacsLess: Fixed cost 20 lacsEBIT 20 lacs

Less: interest 5 lacsEarning before tax 15 lacsLess: tax at 40% 6 lacsEarning after tax 9 lacsLess: preference dividend 1 lacsEarning for equity shareholder 8 lacs

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Question No.-25 [CWA-Final-June-2005-(6+4) Marks]During the year 2010-11, Gulf oil India made a sales of lubricants and greases worth 257 crores, whichwas down by 7.4% compared to previous year’s sales. While the company could reduce its overheads, itsvariable input (base oil and additives) cost went up significantly. As a result, variable cost to sales ratio in2010-11 stood at 55.8% as opposed to 48.5 % in the previous year. The financial highlights of the companyof the company for the year 2010-11 are as given under:

( crores)

Sales 257.0Overheads(excluding depreciation & interest)

103.5

Depreciation 2.7

Interest 6.5

Earnings before tax(excluding other income)

0.7

(i) Calculate operating leverage. The company is expecting a decline in sales by 1% in the next year. If the cost structure remains the same, What will be the expected EBIT? Show necessary calculations.

(ii) Calculate financial leverage. What would be the impact of financial leverage if company’s salesdecline by 1% in the next yar? Assume that financial structure will remain the same.

Question No.-26 [CWA-Final-June-2008-6 Marks]The financial highlights of Amtek Ltd, for the year 2007-08 are as given under:

EBDIT 830 croreDepreciation 6 croreEffective tax Rate 30%EPS 4Book Value 30 per shareNumber of outstanding shares 33 croreD/E ratio 1.5:1

Required:(i) Calculate Degree of Financial leverage(ii) What is the Financial Break-even Point of Amtek Ltd.(iii) What should be the impact of EPS if the EBIT is increased by 5%.

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7/31/2019 2. Leverage


Leverage


7/31/2019 2. Leverage




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2. Leverage