Question 4
Leverages, EBIT at lower sales, break-even sales; the indifference point
18.75 marks
- Time to write
- About 38 minutes
From an older CBCS paper
Question
Question 4 · 18.75 marksQ4. A firm's sales are Rs 90,00,000, its variable cost is Rs 50,40,000 and its fixed cost is Rs 7,20,000. It has 9% debt of Rs 54,00,000, and equity of Rs 66,00,000.
What is the firm's operating, financial and combined leverages?
What will the new EBIT be if the firm's sales drop to Rs 60,00,000?
At what level of sales will the firm's EBT be equal to Zero?
Also explain: in EBIT-EPS analysis, what does the point of indifference signify? What happens when a firm's EBIT level is below the point of indifference?
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
- What is the…?What…?Explain…?5 questions in all: answer every one.
What the paper leaves open
No mark is printed for the question; the paper asks for any four of six, equal marks.
Write it in this order
A step that gives the answer away stays hidden: tap it to see it.
- Read the data; note exactly what is asked 2 min
- 1 Operating, financial and combined leverage 6 marks 11 min
- 2 EBIT at sales 3 marks 6 min
- 3 Sales at which EBT is zero 3 marks 5 min
- 4 Indifference point and EBIT below it 6.8 marks 12 min
- Check: arithmetic, units (₹, %), final answer underlined 2 min
Try it first. About 38 minutes for 18.75 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.
Income statement (₹). No tax rate is given, so leverages are computed before tax.
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.
| Particulars | ₹ |
|---|---|
| Sales | 90,00,000 |
| Less: variable cost | 50,40,000 |
| Contribution | 39,60,000 |
| Less: fixed cost | 7,20,000 |
| EBIT | 32,40,000 |
| Less: interest (9% × 54,00,000) | 4,86,000 |
| EBT | 27,54,000 |
- Operating leverage = 39,60,000 ÷ 32,40,000 = 1.22;
- Financial leverage = 32,40,000 ÷ 27,54,000 = 1.18;
- Combined leverage = 39,60,000 ÷ 27,54,000 = 1.2222 × 1.1765 = 1.44.
2. EBIT at sales of ₹60,00,000. Contribution ratio = 39,60,000 ÷ 90,00,000 = 44%. Contribution = 60,00,000 × 44% = 26,40,000; EBIT = 26,40,000 − 7,20,000 = ₹19,20,000.
3. Sales at which EBT is zero. Contribution must cover fixed cost and interest: 7,20,000 + 4,86,000 = 12,06,000. Sales = 12,06,000 ÷ 0.44 = ₹27,40,909.
The indifference point in EBIT-EPS analysis. It is the level of EBIT at which two (or more) financial plans give the same EPS: at that EBIT the firm is indifferent between, say, raising funds by debt or by equity. It is found by equating the EPS formulae of the plans. Above it, the plan with more fixed-charge finance (debt or preference shares) gives the higher EPS, because the return on the funds exceeds their fixed cost (favourable leverage). Below it, the plan with more equity gives the higher EPS: the fixed charges then eat into a smaller EBIT, and the levered plan's EPS falls faster; if EBIT falls below the financial break-even point (interest plus grossed-up preference dividend), EPS becomes negative. So a firm expecting EBIT below the indifference level should prefer equity.
Where the 18.75 marks sit
| # | Component | Marks |
|---|---|---|
| 1 | Operating, financial and combined leverage | 6 |
| 2 | EBIT at sales of ₹60,00,000 | 3 |
| 3 | Sales at which EBT is zero | 3 |
| 4 | Indifference point and EBIT below it | 6.75 |
| Total | 18.75 |
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