5 LEVERAGE
Question 1
Calculate the operating leverage, financial leverage and combined leve levera rage ge from from the the foll follow owin ing g data data unde underr Situ Situat atio ion n I and and II and and Financial Plan A and B: Installed Capacity Actual Production Production and Sales Selling Price Variable Cost Fixed Cost: Under Situation I Under Situation-II
4,000 units 75% of the the Capacity Rs. 30 Per Unit Rs. 15 Per Unit Rs. 15,000 Rs.20,000
Capital Structure: Financial Plan
Equity Debt (Rate of Interest at 20%)
A Rs. 10,000 10,000
B Rs. 15,000 5,000
20,000
20,000
(Final-May 1996) (14 marks) Answer
Operating Leverage:
Sales (s) 3000 units @ Rs. 30/- per unit Less: Variable Cost (VC) @ Rs. 15 per unit
Situation-I Rs. 90,000
Situation-II Rs. 90,000
45,000
45,000
5.2
Financial Management
Contribution (C) Less: Fixed Cost (FC) Operating Profit (OP) (EBIT)
(ii)
45,000 15,000 30,000
Operating Leverage: 45,00 C = Rs. 30,00 OP = 1.5 Financial Leverages:
45,000 20,000 25,000
Rs.
45,00 25,00 1.8
A (Rs.)
B (Rs.)
30,000 2,000 28,000
30,000 1,000 29,000
Situation 1
Operating Profit (EBIT) Less: Interest on debt PBT Financial Leverage =
30,000 OP = Rs. 28,000 PBT
Situation-II Operating Profit (OP) (EBIT) Less: Interest on debt PBT
=
1.07
Rs.
30,000
A (Rs.)
B (Rs.)
25,000
25,000
2,000 23,000
1,000 24,000
25,000 25,000 OP = 1.09 Rs. = 1.04 = Rs. 23,000 24,000 PBT (iii) Combined Leverages : Financial Leverage =
(a)
Situation I
(b)
Situation II
A (Rs.) 1.5 x 1.07 =1.6
1.8 x 1.09 =1.96
1.04
=
24,000
B (Rs.) 1.5 x 1.04 = 1.56 1.8 x 1.04 =1.87
Leverage
5.3
Question 2
A firm has sales of Rs. 75,00,000 75,00,0 00 variable variab le cost of Rs. 42,00,000 42,00,00 0 and f i xe d c os t of Rs. 6,00,000. 6,00,000. It has a debt of Rs. 45,00,000 45,00,000 at 9% and equity of Rs. 55,00,000. (i) What What is the firm’ firm’s s ROI? ROI? (ii) Does it have have favourable favourable financial financial leverage? leverage? (iii) If the firm belongs belongs to an industry whose whose asset turnover is 3, does it have a high or low asset leverage? (iv) What are the operating, operating, financial and combined leverages leverages of the firm? (v) If the sales sales drop to Rs. Rs. 50,00,000, 50,00,000, what what will be the the new EBIT? EBIT? (vi) At what level level the EBT of the firm will be equal equal to zero? (Final-May (Final-May 1997) (11 marks) Answer Workings:
Rs. 75,00,000 42,00,000 33,00,000 6,00,000 27,00,000 4,05,000
Sales Less: Variable cost Contribution Less: Fixed costs EBIT Less: 9% interest on Rs. 45,00,000 EBT EBIT (i) ROI = Investme = 27% nt
22,95,000 EBIT = Debt + Equity
27,00,000 = Rs.1,00,00,0000
(ii) Since the return on investment investment (27%) is higher than the interest interest paya payable ble on debt debt at 9%, 9%, the the firm firm has has a favo favour urab able le fina financi ncial al leverage.
Net Sales Asset Turnover = Total assets assets = Total Investment Investment 75,00,00 Firm’s Asset Turnover is =0 = 0. 7 5 1,00,00, 000
(iii)
5.4
Financial Management
The industry indu stry average is 3. Hence the firm has low asset leverage. Contributi = (iv) Operating leverageon EBIT EBIT Financial leverage = EBT Contributi Combined leverage = on EBT (OR) Combine Combined d levera leverage ge
33,00,000 = 27,00,000
= 1.2222
27,00,000 = 22,95,000
= 1.1764
33,00,000 = 22,95,000
= 1.438
= Operatin Operating g leverag leverage e x Financia Financiall leverag leverage e
= 1.2222 x 1.1764 =1.438 (v) If the sales drop to Rs. 50,00,000 from Rs. 75,00,000, the fall is by 33.33% Hence EBIT will drop by 40.73%
(%Fall in sales x operating leverage) Hence the new EBIT will wil l be Rs. 27,00,000 x (1- 40.73%) = Rs. 16,00,290 or rounded upto Rs. 16,00,000 (vi)
EBT to become zero means 100% reduction in EBT. Since the combined leverage is 1.438, sales have to drop by 100/1.438 i.e. 69.54%. Hence the new sales will be Rs. 75,00,000 x (1- 69.54%) = Rs. 22,84,500 (approx.)
Question 3
From the following, prepare Income Statement of Company A, B and C. Briefly comment on each company’s performance: Company Financial leverage Interest Operating leverage Variable Cost as a Percentage to Sales Income tax Rate Answer
A 3:1 Rs. 200 4:1
B 4:1 Rs. 300 5:1
C 2:1 Rs. 1,000 3:1
2 66 % 3
75%
50%
45%
45% 45% (Final-Nov. 1997) (12 marks)
Leverage
5.5
Working Notes: Company A
EBIT Financial leverage EBT = (1)
3 = 1
=
Again EBIT – Interest
=
EBT
Or EBIT-200
=
EBT
Taking (1) and (2) we get 3EBT-200
or EBIT = 3 x EBT …….
……..(2) =
or 2 EBT = 200 or EBT
=
Rs. 100
Hence EBIT = 3EBT
=
Rs. 300
EBT
Contribution Again we have operating leverage = EBIT EBIT
4 = 1
= Rs. 300, hence we get
Contribution Contribut ion
=
4 x EBIT =Rs. 1,200
Now variable cost =
2 66 % on sales 3
Contribution Contribut ion
2 1 = 100- 66 % i.e. 33 % on sales 3 3
Hence sales
1200 1 = = Rs. 3,600 33 % 3
Same way EBIT, EBT, contribution and sales for company B and C can be worked out. Company B
Financial leverage =
EBIT 4 = or EBIT = 4 EBT EBIT 1
…….(3) Again EBIT – Interest = EBT or EBIT – 300 =EBT …….(4) Taking (3) and (4) we get, 4EBT-300=EBT 4EBT-300=EBT or 3EBT = 300 or EBT=100
5.6
Financial Management
Hence EBIT = 4 x EBT=400 5 1 =
Contribution Again we have operating leverage EBT =
EBIT= 400 ; Hence we get contribution = 5 x EBIT =2000 Now variable cost =75% on sales Contribution = 100- 75% i.e. 25% on sales 2,000 Hence Sales =25%
= Rs. 8,000
Company C
Final leverage =
EBIT 2 = = or EBIT = 2EBT EBIT 1
……….. (5) Again EBIT- Interest = EBT or EBIT– 1000=EBT ……….. (6) Taking (5) and (6) we get, 2EBT-1000 =EBT or EBT EBT =1,000 Hence EBIT = 2 x EBT = 2 x 1,000= 2,000
Again we have operating leverage =
Contributi on 3 = EBIT 1
EBIT=2,000, Hence we get contribution = 3 x EBIT =6,000 Now variable cost =
50% on sales
Cont Contri ribu buti tion on
=
100100-50 50=5 =50% 0% on sale sales s
Hence sales
=
6,00 = Rs. 12,000 50% Income Statement
Sales Less: Variable cost
A Rs. 3,600 2,400
B Rs. 8,000 6,000
C Rs. 12,000 6,000
Leverage
Contribution Less: Fixed cost EBIT Less: Interest EBT Less: Tax 45% EAT
1,200 900 300 200 100 45 55
2,000 1,600 400 300 100 45 55
5.7
6,000 4,000 2,000 1,000 1,000 450 550
Comments on Company’s Performance:
The financial finan cial position positi on of company compan y C can be regarded regarde d better bette r than that of other Companies A & B b ecause of the following reasons: (i)
Financia Financiall leverage leverage is the meas measure ure of financ financial ial risk. risk. Company Company C has the least financial risk as it has minimum degree of financial leverage. leverage. No doubt it is true that there will be a more magnified magnified impact on earnings per share on A and B companies than that of C due to change in EBIT but their EBIT level due to low sales is very low suggesting that such an advantage is not great.
(ii) Degree Degree of combined combined leverage leverage is maximum maximum in company company B - 20, 20, for Company A - 12 and for Company C – 6. Clearly, the total risk (business (business and financial) financial) complexion of Company C is the lowest, lowest, while that of the other firms are very high. (iii) The ability of Company Company C to meet interest interest liability is better than than that of Companies A and B.
EBIT/Interest ratio for three companies:
C= B= A=
2,000 =2 1,000 400
= 1.3
300
300 = 1. 200
Question 4
Consider the following information for Strong Ltd: EBIT 1,120 Rs. in lakh PBT 320 Rs. in lakh Fixed Cost 700 Rs. in lakh Calculate the percentage of change in earnings per share, if sales increased by 5 per cent.
5.8
Financial Management
(Final-Nov. 2001) (6 marks) Answer
Computation Computation of percentage of change in earnings per share, if sales increased by 5%
Degree of Combined leverage =
%change inEarning pershare (EPS %change insales
or Degree of operating leverage x Degree of financial leverage = %change inEarning pershare (EPS) %change insales
or 1.625 x 3.5 (Refer to working notes (i) and (ii) = %change inEarning pershare (EPS 5 %change inEarning pershare (EPS or 5.687 = 5 or % change in EPS = 5.687 x 5 = 28.4375% Working Notes:
(i) Degree Degree of oper operati ating ng lever leverage age (DOC) (DOC) = =
Contribut on EBIT
( Rs.1,120+ Rs.700lakhs ) Rs.1,120lakhs
= 1.625 (ii) Degree of of fi financial le leverage (D (DOF) =
=
EBIT PBT
Rs.1,12 Rs.320
= 3.5 Question 5
The net sales of A Ltd. is Rs. 30 crores. Earnings before interest and tax of the company as a percentage of net sales is 12%. The capital employed comprises Rs. 10 crores of equity, Rs. 2 crores of 13% Cumulative Preference Share Capital and 15% Debentures of Rs. 6 crores. Income-tax rate is 40%.
Leverage
5.9
(i) Calcula Calculate te the Return Return-on-on-equ equity ity for the the company company and indica indicate te its segments due to the presence of Preference Share Capital and Borrowing (Debentures). (ii) (ii) Calcu Calculat late e the the Oper Operat ating ing Leve Levera rage ge of the Co Comp mpan any y given given that that combined leverage is 3. (Final-May 2002) (6 marks) Answer (i)
Net Sales : Rs. 30 crores EBIT Rs. 3.6 crores @ 12% on sales EBIT 3.6 = × 100= 20% ROI = Capital Employed10+ 2+ 6 Rs. in EBIT Interest on Debt EBT Less : Tax @ 40% EAT Less : Preference dividend Earnings available for Equity Shareholders Return on equity = 1.36/10x 100=13.6%
3.6 0.9 2.7 1.08 1.62 0.26 1.36
Segm Segmen ents ts due due to the the pres presen ence ce of Pref Prefer eren ence ce Shar Share e capital and Borrowing (Debentures)
Segment of ROE due to preference capital : [.20(1-.4)-.13] x .2 =-.002 Segment of ROE due to Debentures: [.20 (1-.4) - .15 (1-.4)] x .6 =-.018 or -.2% + 1.8% =1.6%
5.10
Financial Management
The weighted average cost of capital is as follows
Source
Proportion
Cost (%)
WACC(%)
(i)
Equity
10/18
13.60
7.56
(ii)
Preference shares
2/18
13.00
1.44
(iii)
Debt
6/18
9.00
3.00
Total
12.00
(ii) Degree of Financial Financi al Leverage
=
=
EBIT EBIT- Interest - Preference divide
3.6 = 1.475 3.6– .9– .26
Degree of Combined Leverage 3 = 1.4754 x DOL 3 ∴ DOL = 1.475
= DFL x DOL
Degree of Operating Leverage =2.033 Question 6
The data relating to two Companies are as given below: Company A
Company B
Equity Capital
Rs.6,00,00 0
Rs.3,50,00 0
12% Debentures
Rs.4,00,00 0
Rs.6,50,00 0
60,000
15,000
Rs.30
Rs.250
Rs.7,00,00 0
Rs.14,00,0 00
Rs.10
Rs.75
Output (units) per annum Selling price/ unit Fixed Costs per annum Variable Cost per unit
Leverage
5.11
You You are are requi require red d to calcu calcula late te the Opera Operatin ting g leve levera rage, ge, Finan Financia ciall lev levera erage and Co Comb mbin ine ed lev levera erage of two two Co Comp mpa anies nies.. (PE(PE-II II-N -No ov. 2002) (4 marks)
5.12
Financial Management
Answer Computation of degree of Operating leverage, Financial leverage and Combined leverage of two companies
Output units per annum Selling price / unit Sales revenue
Less: Variable costs
Contribution (C) Less: Fixed costs EBIT Less: Interest @ 12% on debentures PBT DOL =
DFL =
C EBIT EBIT PBT
DCL = DOL DFL
×
C om p a n y A 60,000 Rs. 30 18,00,000 (60,000 units × Rs.30) 6,00,000 (60,000 units × Rs.10) 12,00,000 7,00,000 5,00,000 48,000
Company B 15,000 Rs. 250 37,50,000 (15,000 units × Rs.250) 11,25,000 (15,000 units × Rs.75) 26,25,000 14,00,000 12,25,000 78,000
4,52,000
11,47,000
2.4 (Rs.12,00,000 / Rs.5,00,000) 1.11 (Rs.5,00,000 / Rs.4,52,000) 2.66
2.14 (Rs.26,25,000 / Rs.12,25,000) 1.07 (Rs.12,25,000 / Rs.11,47,000) 2.29
(2.4× 1.11)
(2.14 × 1.07)
Question 7
The follow following ing summar summarises ises the percent percentage age changes changes in opera operating ting inco income me,, perc percen enta tage ge chan change ges s in reve revenu nues es,, and and beta betas s for for four four pharmaceuti pharmac eutical cal firms. f irms. Firm PQR Ltd.
Change in revenue
Change in operating income
Beta
27%
25%
1.00
Leverage
RST Ltd.
25%
32%
1.15
TUV Ltd.
23%
36%
1.30
WXY Ltd. Required:
21%
40%
1.40
5.13
(i) Calcu Calculat late e the the degr degree ee of oper operat ating ing lever leverag age e for for ea each ch of thes these e firms. Comment also. (ii) (ii) Use Use the operat operating ing levera leverage ge to expla explain in why why these these firms firms have have different beta. (PE-II-Nov. 2004) (6 marks) Answer (i) Degree of operating leverage
=
%Change inOperating inco %Change inRevenues
PQ R L t d .
=
2 5 % / 2 7% =
0.9259
RST Ltd.
=
0 . 3 2 / 0. 2 5 =
1.28
TUV Ltd. Ltd .
=
0.36 / 0.23 =
1.5652
WXY Ltd.
=
0.40 / 0.21 =
1.9048
It is level specific. (ii)
High operating leverage leads to high beta. The sources of risk are the cyclic nature revenues, operating risk and financial risk.
Question 8
A Company Compa ny had the followin fol lowing g Balance Balan ce Sheet Sh eet as on March Marc h 31, 2006: Liabilities and Equity Rs. (in crores) Equity Share Capital (one crore shares of Rs. 10 each) Reserves and Surplus 15% Debentures Current Liabilities
Assets Rs. (in crores) 10
Fi xed A ss e t s (Net) Current Assets
25 15
2 20 8
40 The additional information given is as under: Fixe Fixed d Cos Costs ts per per ann annum um (exc (exclu ludi ding ng inte intere rest st)) Variable operating costs ratio
___ 40 Rs. Rs. 8 cro crore res s 65%
5.14
Financial Management
Total Assets turnover ratio Income- tax rate
2. 5 40%
Required: Calculate the following and comment: (i) (i) Earn Earnin ings gs per per sha share re (ii) Operat Operating ing Levera Leverage ge (iii) Financial Financial Levera Leverage ge (iv) Combined Combined Leverage. Leverage. (8 marks)
(PE-II-Nov. 2006)
Leverage
5.15
Answer
Total Assets
= Rs. 40 4 0 crores
Total Asset Turnover T urnover Ratio Hence, Total Sales crores
= 2.5 = 40
× 2.5 2.5 = Rs. Rs. 100 100
Computation of Profits after Tax (PAT) (Rs. in crores)
Sales Less: Variable operating cost @ 65% Contribution Less: Fixed cost (other than Interest) EBIT Less: Interest on debentures (15% × 20) PBT Less: Tax 40% PAT (i) Earn Earnin ings gs per per sha share re
∴ EPS =
Rs. Rs.14.4crores
1croreequityshares
100 65 35 8 27 3 24 9.6 14.4
= Rs. 14.40
(ii) Operating Operating Leverag Leverage e
Contribu ibution ion 35 Operatingleverage= = =1.296 EBIT 27 It indica indicate tes s the the choic choice e of techn technol olog ogy y and and fixed fixed cost cost in cost cost struc structu ture re.. It is lev level el spec specifi ific. c. When When firm firm opera operates tes bey beyon ond d operating operating break-even break-even level, level, then operating operating leverag leverage e is low. It indicates sensitivity of earnings before interest and tax (EBIT) to change in sales at a particular level. (iii (iii))
Fina Finan ncial cial Leve Levera rage ge
EBIT 27 FinancialLeverage= = =1.125 PBT 24 The financial finan cial leverage leverag e is very comfortable comforta ble since the debt service servic e obligation is small vis-à-vis EBIT. (iv) iv)
Combined Le Levera erage
Con Contribu ibution ion EBIT EBIT Com Combined binedLeverage Leverage = × EBIT PBT
5.16
Financial Management
= 1.296
× 1.125
= 1.458 The combined combi ned leverage leverag e studies studi es the choice choic e of fixed cost in cost structure structure and choice of of debt in capital structure. structure. It studies how how sensitive the change in EPS is vis-à-vis change in sales. The leverages leverag es of risk.
− operating, financial and combined are measures
Question 9
Consider the following information for Omega Ltd.: Rs.
in lakhs
EBIT (Earnings before Interest and Tax)
1 5, 7 5 0
Earnings before Tax (EBT):
7,000
Fixed Operating costs: Required:
1,575
Calculate percentage change in earnings per share, if sales increase by 5%. (PE-II-Nov. 2007) (3 marks) Answer Degree of Operating Leverage (DOL)
=
Contributi on EBIT+ Fixed Cos = EBIT EBIT
=
15,750 + 1,575 = 1. 15,750
Degree of Financial Leverage (DFL)
=
EBIT 15,750 = = 2.2 EBT 7,000
Degree of Combined Leverage (DCL)
× DFL = 1.1 × 2.25 = DOL
= 2.475 Percentage Change in Earnings per share
Leverage
DCL=
5.17
%change inEPS %change inSales
= 2.475
%change inEPS 5%
∴ % change in E PS = 12.375%. Question 10
Delta Delta Ltd. Ltd. curren currently tly has an equity equity share share capita capitall of Rs. Rs. 10,00 10,00,00 ,000 0 consisting of 1,00,000 Equity share of Rs. 10 each. The company is going through a major expansion plan requiring to raise funds to the tune of Rs. 6,00,000. To finance the expansion the management has following plans: Pl a n - I :
Issue 60 60,000 Equity sh shares of of Rs Rs. 10 10 each.
Pl a n - I I : Issue 40,000 Equity shares of Rs. 10 each and the bal ance through longterm borrowing at at 12 12% interest p.a. Pl a n - I I I : Issue 30 30,000 Eq Equity sh shares of of Rs Rs.10 ea each an a nd 3,000 Rs.100, 9% Debentures. Pl a n - I V : Issue 30,000 Equity shares of Rs. 10 each and the balance through 6% preference shares. The EBIT of the company is expected to be Rs. 4,00,000 p.a. assume corporate tax rate of 40%. Required: (i) Calcula Calculate te EPS EPS in each each of the the abov above e plans. plans. (ii) (ii) Asce Ascert rtain ain the degr degree ee of finan financia ciall lev lever erag age e iin n eac each h pla plan. n. May 2008) (8 marks)
(PE-I (PE-III-
Answer Computation of EPS and Financial Leverage PLAN I
PLAN II
PLAN I II
PLAN I V
1,00,00 0
1,00,000
1,00,000
1,00,000
60,000
40,000
30,000
30,000
Equi Equity ty shar share e capi capita tall (Rs. (Rs.))
16,0 16,00, 0,0 0 00
14,00,00 0
13,00,00 0
13,00,00 0
No. of Equity shares
1,60,00
1,40,000
1,30,000
1,30,000
Pr esent Eq ui ty S hare s New Issu e
5.18
Financial Management
0 12% Long term loan (Rs.)
−
9% Debentures (Rs.)
−
6% Preference Shares (Rs.)
−
E B I T ( Rs . )
4,00,00 0
Interest on 12% Loan (Rs.)
−
Interest on 9% debentures (Rs.)
−
−
−
−
3,00,000
−
−
−
3,00,000
4,00,000
4,00,000
4,00,000
24,000
−
−
27,000
−
2,00,000
−
E BT (Rs. )
4,00,00 0
3,76,000
3,73,000
4,00,000
Less : Tax@ 40%
1,60,00 0
1,50,400
1,49,200
1,60,000
E AT (Rs. )
2,40,00 0
2,25,600
2,23,800
2,40,000
Less: Preference Dividends (Rs.)
−
−
−
18,000
(a) Earnings for equity shares (Rs.)
2,40,00 0
2,25,600
2,23,800
2,22,000
(b ) No. of eq ui ty share s
1,60,00 0
1,40,000
1,30,000
1,30,000
1.50
1.61
1.72
1.71
1.00
1.06
1.07
1.00
(c) EPS (a
÷ b) Rs.
Degree of Financial leverage-
EBIT or EBIT− I
EBIT EBT
Comments:
Since the EPS and degree of financial leverage both are highest in plan III, the management could accept it Question 11
Leverage
5.19
Annual sales of a company is Rs. 60,00,000. 60,00,000 . Sales to variable variab le cost rati ratio o is 150 150 per per cent cent and and Fixe Fixed d cost cost othe otherr than than inte intere rest st is Rs. Rs. 5,00,000 5,00,000 per annum. annum. Company Company has 11 per cent cent debentures debentures of Rs. 30,00,000. You are required to calculate the operating, Financial and combined leverage of of th the co company pany.. (PE-II -II-No -Nov. 20 2008) (3 (3 ma marks) Answer Calculation of Leverages
Rs. 60,00,000 40,00,000
Sal es Less: Variable Cost
Sales× 100 150
C on t r i b u t i on Less: Fixed Cost EBIT Less: Interest on Debentures EBT
20,00,000 5,00,000 15,00,000 3,30,000 11,70,000
Contributi on Operating Leverage = EBIT
=
Rs.20,00,0 Rs.15,00,0 = 1.3333
EBIT Financial Leverage = EBT
=
Rs.15,00,0 Rs.11,70,0 = 1.2821
Contributi on Combined Leverage = OL× FLor EBT
= 1.3333 × 1.2821 or = 1.7094. Question 12
Rs.20,00,0 Rs.11,70,0
5.20
Financial Management
Discuss the impact of financial leverage on shareholders wealth by using using returnreturn-onon-ass assets ets (ROA) (ROA) and returnreturn-onon-equ equity ity (ROE) (ROE) analyti analytic c framework. (PE-II-May 2003 & May 2004) (3 marks) Answer
The impact impac t of financial financ ial leverage leverag e on ROE is positive, positi ve, if cost of debt (after-tax) is less than ROA. But it is a double-edged sword. ROA =
NOPAT Sales × Sales Capital employ
ROE = ROA +
D (ROA − K d) E
Where NOPAT = EBIT * ( 1 − Tc) Capital employed = Shareholders funds + Loan funds D = Debt Debt amount in capital structure structure E = Equity capital amount in capital structure
− Tc) in case of fresh loans of a company. K d = Yield to maturity *(1 T − Tc) in case of existing loans of a K d = Interest rate * ( 1 company.
