Question 3 OR (b)
Income statement, operating and financial leverage, EPS after a rise in EBIT
11 marks
- Time to write
- About 22 minutes
From an older CBCS paper
Question
Question 3 OR (b) · 11 marksHawkins Ltd's capital structure consists of:
| Equity shares of Rs 10 each | Rs. 48,00,000 |
| 10% Preference shares of Rs 100 each | Rs. 36,00,000 |
| 12% Secured Debentures of Rs 100 each | Rs. 24,00,000 |
The company's net sales were Rs 1.92 Crores. EBIT is estimated at 10% of sales. The Corporate tax rate is 40%. The Fixed cost is estimated at Rs 60,00,000.
Draw up the Income Statement of Hawkins Ltd.
Calculate the operating and financial leverages.
If EBIT rises by 10%, what will be the % change in EPS? What will the new EPS be?
Reworded from the university paper: names and figures differ, the task is the same. The original paper belongs to the University of Delhi. See DU's question bank.
Before you write
Read off the question and its marks
Read from the question
- Draw…Calculate…What…?4 asks, each with its own marks below. Answer all 4.
- Draw up the Income StatementDraw the format first (heading, columns, dates), then fill in the figures from your working.
- estimatedFormula first, then the working, then the answer with its unit (₹, %, units).
What the paper leaves open
"Draw the Income Statement" asks for a statement from sales to EPS. The number of equity shares is the equity capital over Rs 10.
Write it in this order
- Read the data; tick every adjustment as you plan it 1 min
- 1 Income statement from sales to EPS 4 marks 7 min
- 2 Operating leverage 2 marks 4 min
- 3 Financial leverage with the preference dividend grossed up 2 marks 4 min
- 4 % change in EPS and the new EPS, with check 3 marks 5 min
- Check: every adjustment used, both sides agree, dates in 1 min
Try it first. About 22 minutes for 11 marks. Write it out, then open the solution.
Solution
Hover or tap a marked figure, like 72,000, to see how it is made and where else it appears.
Equity shares = 48,00,000 ÷ ₹10 = 4,80,000 (paper note). Preference dividend = 10% × 36,00,000 = ₹3,60,000. Debenture interest = 12% × 24,00,000 = ₹2,88,000. EBIT = 10% of ₹1,92,00,000 = ₹19,20,000; contribution = EBIT + fixed cost.
1The baker signs for the bank's money at a fixed interest.
Financial leverageThe use of fixed-charge funds (debt, preference shares) in the capital structure.
2The ovens run full, the queue is long—the loan earns more than it costs, and the owner's share swells.
FavourableThe fixed-charge funds earn more than they cost, so EPS rises.
3The same counter empty: the interest envelope still goes out, from a thinner cash box.
UnfavourableWhen ROI is below the cost of debt: EPS falls.
(i) Income statement of Hawkins Ltd. (₹)
| Particulars | ₹ |
|---|---|
| Net sales | 1,92,00,000 |
| Less: variable cost (balancing figure) | 1,12,80,000 |
| Contribution (EBIT + fixed cost) | 79,20,000 |
| Less: fixed cost | 60,00,000 |
| EBIT (10% of sales) | 19,20,000 |
| Less: interest on 12% debentures | 2,88,000 |
| EBT | 16,32,000 |
| Less: tax @ 40% | 6,52,800 |
| EAT | 9,79,200 |
| Less: preference dividend | 3,60,000 |
| Earnings for equity shareholders | 6,19,200 |
| EPS (÷ 4,80,000 shares) | 1.29 |
- Operating leverage = Contribution ÷ EBIT = 79,20,000 ÷ 19,20,000 = 4.125.
- Financial leverage. The preference dividend is paid out of profit after tax, so it is grossed up: 3,60,000 ÷ 0.60 = ₹6,00,000. DFL = EBIT ÷ [EBT − PD ÷ (1 − t)] = 19,20,000 ÷ (16,32,000 − 6,00,000) = 19,20,000 ÷ 10,32,000 = 1.86.
(iii) Effect of a 10% rise in EBIT. DFL measures the % change in EPS from a 1% change in EBIT: % change in EPS = 1.8605 × 10% = 18.60%. New EPS = 1.29 × 1.186 = ₹1.53.
Check. EBIT ₹21,12,000 − interest 2,88,000 = EBT 18,24,000; less tax 7,29,600 = EAT 10,94,400; less preference dividend 3,60,000 = 7,34,400; EPS = 7,34,400 ÷ 4,80,000 = ₹1.53, which is 18.60% above ₹1.29.
Where the 11 marks sit
| # | Component | Marks |
|---|---|---|
| 1 | Income statement from sales to EPS | 4 |
| 2 | Operating leverage | 2 |
| 3 | Financial leverage with the preference dividend grossed up | 2 |
| 4 | % change in EPS and the new EPS, with check | 3 |
| Total | 11 |
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