Question 3 (b)
Income statements from leverage data; risk position
11 marks
- Time to write
- About 22 minutes
From an older CBCS paper
Question
Question 3 (b) · 11 marksSelected financial information of two companies, X Ltd. and Y Ltd., for the year ended 31st March, 2016 is as below:
| Particulars | X Ltd. | Y Ltd. |
|---|---|---|
| Variable cost as a Percentage of Sales | 66.67 | 75 |
| Interest Expense (₹) | 240 | 360 |
| Degree of Operating Leverage | 5 | 6 |
| Financial leverage (degree) | 3 | 4 |
| Income tax rate | 35% | 35% |
Prepare the Income Statement of both companies, and comment on their risk position. 11
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
- and comment onThe comment carries marks too: say what the figures show, in two or three lines.
- Prepare the Income StatementDraw the format first (heading, columns, dates), then fill in the figures from your working.
What the paper leaves open
Sales and fixed costs are derived from the leverages and interest given.
Write it in this order
- Read the data; tick every adjustment as you plan it 1 min
- 1 EBIT, contribution and sales derived from the leverages 4 marks 7 min
- 2 Income statements of both companies 4 marks 7 min
- 3 Combined leverage and comment on risk 3 marks 6 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.
Working back from the leverages. DFL = EBIT ÷ (EBIT − interest), so EBIT = interest × DFL ÷ (DFL − 1); DOL = contribution ÷ EBIT, so contribution = EBIT × DOL; sales = contribution ÷ (1 − variable-cost ratio) (66.67% read as two-thirds; paper note: sales and fixed costs are derived from the leverages and interest).
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.
- X Ltd.: EBIT = 240 × 3 ÷ 2 = 360; contribution = 360 × 5 = 1,800; sales = 1,800 ÷ (1/3) = 5,400.
- Y Ltd.: EBIT = 360 × 4 ÷ 3 = 480; contribution = 480 × 6 = 2,880; sales = 2,880 ÷ 0.25 = 11,520.
| Particulars | X Ltd. | Y Ltd. |
|---|---|---|
| Sales | 5,400 | 11,520 |
| Less: variable cost (66.67% / 75%) | 3,600 | 8,640 |
| Contribution | 1,800 | 2,880 |
| Less: fixed cost (balancing) | 1,440 | 2,400 |
| EBIT | 360 | 480 |
| Less: interest | 240 | 360 |
| EBT | 120 | 120 |
| Less: tax @ 35% | 42 | 42 |
| EAT | 78 | 78 |
Risk position. Combined leverage = DOL × DFL: X Ltd. 5 × 3 = 15; Y Ltd. 6 × 4 = 24. DOL shows business risk (it depends on fixed costs) and DFL financial risk (it depends on interest); their product shows total risk, the % change in EPS from a 1% change in sales.
Y Ltd. carries more risk on both counts: higher operating leverage (6 against 5) and higher financial leverage (4 against 3). A 1% fall in sales cuts Y's EPS by 24%, against 15% for X, although both earn the same ₹78 after tax at present.
Where the 11 marks sit
| # | Component | Marks |
|---|---|---|
| 1 | EBIT, contribution and sales derived from the leverages | 4 |
| 2 | Income statements of both companies | 4 |
| 3 | Combined leverage and comment on risk | 3 |
| Total | 11 |
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