Unit 6

LEVERAGE
Question 1
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 Rs. 30 Per Unit
Variable Cost Rs. 15 Per Unit
Fixed Cost:
Under Situation I Rs. 15,000
Under Situation-II Rs.20,000
Capital Structure:
Financial Plan
A B
Rs. Rs.
Equity 10,000 15,000
Debt (Rate of Interest at 20%) 10,000 5,000
20,000 20,000

Solution:
Operating Leverage: Situation-I Situation-II
Rs. Rs.
Sales (s) 90,000 90,000
3000 units @ Rs. 30/- per unit
Less: Variable Cost (VC) @ Rs. 15 per unit 45,000 45,000
Contribution (C) 45,000 45,000
Less: Fixed Cost (FC) 15,000 20,000
Operating Profit (OP) 30,000 25,000
(EBIT)

(i) Operating Leverage:

= Rs. Rs.

=1.5 1.8

(ii) Financial Leverages:

Situation-I
 A B
(Rs.) (Rs.)

Operating Profit (EBIT) 30,000 30,000

Less: Interest on debt 2,000 1,000
PBT 28,000 29,000

Financial Leverage = =

A B
(Rs.) (Rs.)
Situation-II
Operating Profit (OP) 25,000 25,000
(EBIT)
Less: Interest on debt 2,000 1,000
PBT 23,000 24,000

Financial Leverage = =

(iii) Combined Leverages:

A B
(Rs.) (Rs.)
(a) Situation I 1.5 x 1.07 =1.6 1.5 x 1.03 = 1.55
(b) Situation II 1.8 x 1.09 =1.96 1.8 x 1.04 =1.87

Question 2
A firm has sales of Rs. 75,00,000 variable cost of Rs. 42,00,000 and fixed cost of
Rs. 6,00,000. It has a debt of Rs. 45,00,000 at 9% and equity of Rs. 55,00,000.
(i) What is the firm’s ROI?
(ii) Does it have favourable financial leverage?
(iii) If the firm belongs to an industry whose asset turnover is 3, does it have a high or low
asset leverage?
(iv) What are the operating, financial and combined leverages of the firm?
(v) If the sales drop to Rs. 50,00,000, what will be the new EBIT?
(vi) At what level the EBT of the firm will be equal to zero?

Solution:
Workings:
Rs.
 Sales 75,00,000
Less: Variable cost 42,00,000
Contribution 33,00,000
Less: Fixed costs 6,00,000
EBIT 27,00,000
Less: 9% interest on Rs. 45,00,000 4,05,000
EBT 22,95,000
EBIT EBIT 27,00,000
(i) ROI = Investment = Debt + Equity = Rs. 1,00,00,000 = 27%

(ii) Since the return on investment (27%) is higher than the interest payable on debt at 9%,
the firm has a favourable financial leverage.

Net Sales
(iii) Asset Turnover = Total assets = Total Investment

75,00,000
Firm’s Asset Turnover is = 1,00,00,000 = 0.75

The industry average is 3. Hence the firm has low asset leverage.

Contribution 33,00,000
(iv) Operating leverage = EBIT = 27,00,000 = 1.2222

EBIT 27,00,000
Financial leverage = EBT = 22,95,000 = 1.1764

Contribution 33,00,000
Combined leverage = EBT = 22,95,000 = 1.438

(OR)
Combined leverage = Operating leverage x Financial leverage
= 1.2222 x 1.1764 =1.438
(v) If the sales drop to Rs. 50,00,000 from Rs. 75,00,000,
Decrease in Sales % = (Decrease in Sales/ Sales before Decrease) x 100
Decrease in Sales % = (25 Lakh / 75 Lakh) x 100= 33.3333 %
DOL = % Change in EBIT / % change in sales
1.22 = % change in EBIT / 33.33 %
% Change(Decrease) in EBIT = 40.74 %
Hence the new EBIT will be Rs. 27,00,000 – 40.74% of 27,00,000
= Rs. 16,00,020

(vi) (As Tax % is not given instead of EPS, EBT is considered Zero here)
EBT to become zero means 100% reduction in EBT.
DCL = % Change in EBT / % Change in Sales
Since combined leverage is 1.438 & % Change in EBT =100% Decrease
 1.438 = 100/ % Change(Decrease) in Sales
% Change(Decrease) in Sales = 69.54%.
Hence the new sales will be Rs. 75,00,000 –(69.54% of 75,00,000)
= Rs. 22,84,500

Question 3
From the following, prepare Income Statement of Company A, B and C. Briefly comment on
each company’s performance:
Company A B C
Financial leverage 3:1 4:1 2:1
Interest Rs. 200 Rs. 300 Rs. 1,000
Operating leverage 4:1 5:1 3:1
Variable Cost as a Percentage to
Sales 75% 50%

Income tax Rate 45% 45% 45%

Solution:
Working Notes:
Company A

EBIT 3
Financial leverage = =
EBT = 1 or EBIT = 3 x EBT ……. (1)

Again EBIT – Interest = EBT

Or EBIT-200 = EBT ……..(2)
Taking (1) and (2) we get 3EBT-200 = EBT
or 2 EBT = 200 or EBT = Rs. 100
Hence EBIT = 3EBT = Rs. 300

Contribution 4
Again we have operating leverage = =
EBIT 1

EBIT = Rs. 300, hence we get

Contribution = 4 x EBIT =Rs. 1,200

Now variable cost = on sales

Contribution = 100- i.e. on sales

Hence sales = = Rs. 3,600

Same way EBIT, EBT, contribution and sales for company B and C can be worked out.

Company B

Financial leverage = = or EBIT = 4 EBT …….(3)

Again EBIT – Interest = EBT or EBIT – 300 =EBT …….(4)

Taking (3) and (4) we get, 4EBT-300=EBT
or 3EBT = 300 or EBT=100
Hence EBIT = 4 x EBT=400
Contribution 5
Again we have operating leverage = EBT = 1

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 = = = or EBIT = 2EBT ……….. (5)

Again EBIT- Interest = EBT or EBIT– 1000=EBT ……….. (6)

Taking (5) and (6) we get, 2EBT-1000 =EBT or EBT =1,000

Hence EBIT = 2 x EBT = 2 x 1,000= 2,000

Again we have operating leverage =

EBIT=2,000, Hence we get contribution = 3 x EBIT =6,000

Now variable cost = 50% on sales
Contribution = 100-50=50% on sales

Hence sales = = Rs. 12,000

Income Statement
A B C
Rs. Rs. Rs.
Sales 3,600 8,000 12,000
Less: Variable cost 2,400 6,000 6,000
Contribution 1,200 2,000 6,000
Less: Fixed cost 900 1,600 4,000
EBIT 300 400 2,000
Less: Interest 200 300 1,000
EBT 100 100 1,000
Less: Tax 45% 45 45 450
EAT 55 55 550

Comments on Company’s Performance:

The financial position of company C can be regarded better than that of other Companies A &
B because of the following reasons:
(i) Financial leverage is the measure of financial risk. Company C has the least financial
risk as it has minimum degree of financial leverage. No doubt it is true that there will be a
more 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 of combined leverage is maximum in company B - 20, for Company A - 12 and
for Company C – 6. Clearly, the total risk (business and financial) complexion of
Company C is the lowest, while that of the other firms are very high.
(iii) The ability of Company C to meet interest liability is better than that of Companies A and
B.
EBIT/Interest ratio for three companies:

C=

B=

A=

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.

Solution:
Working Notes:

(i) Operating leverage =

= (Rs. 1,120 + Rs. 700 lakhs)

Rs. 1,120 lakhs

= 1.625
 (ii) Financial leverage =

= 3.5

(iii) Combined Leverage= OL X FL = 1.625 X 3.5 = 5.6875

Computation of percentage of change in earnings per share, if sales increased by

5%

Degree of Combined leverage =

or 5.687 =

or % change in EPS = 5.687 x 5

= 28.4375%

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%.
(i) Calculate the Return-on-equity for the company
(ii) Calculate the Operating Leverage of the Company given that combined leverage is 3.

Solution:
(i) Net Sales : Rs. 30 crores

EBIT Rs. 3.6 crores @ 12% on sales

Rs. in crores
EBIT 3.6
Interest on Debt 0.9
EBT 2.7
Less : Tax @ 40% 1.08
EAT 1.62
Less : Preference dividend 0.26
Earnings available for Equity Shareholders 1.36

Return on equity = (Earnings available for Eq. Shareholders / Eq Share Capital) x 100
= 1.36/10x 100
 =13.6%

ROI =

(ii) Financial Leverage =

Combined Leverage = FL x OL

3 = 1.58823 x OL
 OL =

Operating Leverage = 1.88

Question 6
The data relating to two Companies are as given below:

Company A Company B
Equity Capital Rs.6,00,000 Rs.3,50,000
12% Debentures Rs.4,00,000 Rs.6,50,000
Output (units) per annum 60,000 15,000
Selling price/ unit Rs.30 Rs.250
Fixed Costs per annum Rs.7,00,000 Rs.14,00,000
Variable Cost per unit Rs.10 Rs.75
You are required to calculate the Operating leverage, Financial leverage and Combined
leverage of two Companies.
Solution: Computation of Operating leverage, Financial leverage & Combined leverage
Company A Company B
Output units per annum 60,000 15,000
Rs. Rs.
Selling price / unit 30 250
Sales revenue 18,00,000 37,50,000
(60,000 units  Rs.30) (15,000 units  Rs.250)
Less: Variable costs 6,00,000 11,25,000
(60,000 units  Rs.10) (15,000 units  Rs.75)
Contribution (C) 12,00,000 26,25,000
Less: Fixed costs 7,00,000 14,00,000
EBIT 5,00,000 12,25,000
Less: Interest @ 12% on debentures 48,000 78,000
PBT 4,52,000 11,47,000

2.4 2.14
OL =
(Rs.12,00,000 / Rs.5,00,000) (Rs.26,25,000 / Rs.12,25,000)
1.11 1.07
FL =
(Rs.5,00,000 / Rs.4,52,000) (Rs.12,25,000 / Rs.11,47,000)
CL = OL  FL 2.66 2.29
(2.41.11) (2.141.07)

Question 7
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 Beta
PQR Ltd. 27% 25% 1.00
RST Ltd. 25% 32% 1.15
TUV Ltd. 23% 36% 1.30
WXY Ltd. 21% 40% 1.40
Required:
(i) Calculate the degree of operating leverage for each of these firms. Also comment.
(ii) Use the operating leverage to explain why these firms have different beta.

Solution:

(i) Degree of operating leverage =

PQR Ltd . = 0.25 /0. 27 = 0.9259

RST Ltd. = 0.32 / 0.25 = 1.28
TUV Ltd. = 0.36 / 0.23 = 1.5652
WXY Ltd. = 0.40 / 0.21 = 1.9048
(ii) It is level specific. 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 had the following Balance Sheet as on March 31, 2006:
Liabilities and Equity Rs. (in crores) Assets Rs. (in crores)
Equity Share Capital Fixed Assets (Net) 25
(one crore shares of Rs. 10 each) 10 Current Assets 15
Reserves and Surplus 2
15% Debentures 20
Current Liabilities 8 ___
40 40
The additional information given is as under:
 Fixed Costs per annum (excluding interest) Rs. 8 crores
Variable operating costs ratio 65%
Total Assets turnover ratio 2.5
Income-tax rate 40%

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

Solution:
Total Assets = Rs. 40 crores
Total Asset Turnover Ratio = 2.5
Hence, Total Sales = 40  2.5 = Rs. 100 crores

Computation of Profits after Tax (PAT)

(Rs. in Crores)
Sales 100
Less: Variable operating cost @ 65% 65
Contribution 35
Less: Fixed cost (other than Interest) 8
EBIT 27
Less: Interest on debentures (15%  20) 3
PBT 24
Less: Tax 40% 9.6
PAT 14.4

(i) Earnings per share

= Rs. 14.40

(ii) Operating Leverage

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
 The financial leverage is very comfortable since the debt service obligation is small vis-à-
vis EBIT.
(iv) Combined 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 measures of risk.