Question 4 (b)
Operating, financial and combined leverage; sales rise to double EBIT
10 marks
- Time to write
- About 20 minutes
From an older CBCS paper
Question
Question 4 (b) · 10 marksYou are given the information below about CDE Ltd.
| Sales | Rs. 12,00,000 |
| Variable cost | Rs. 8,40,000 |
| Fixed cost | Rs. 2,40,000. |
| Capital structure: | |
| Equity shares of Rs.10 each | Rs.12,00,000 |
| 7% Debt | Rs.6,00,000. |
| 9% Preference shares | Rs.2,40,000 |
| Tax rate | 25% |
Calculate the operating, the financial and the combined leverages.
If the firm wishes to double its earnings before interest and tax (EBIT), by what percent should its sales increase? (5,10)
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
- Calculate…What…?Two asks in one question: answer both.
- CalculateFormula first, then the working, then the answer with its unit (₹, %, units).
What the paper leaves open
The preference dividend is grossed up for tax in the financial leverage (C5).
Write it in this order
- Read the data; note exactly what is asked 1 min
- 1 Income statement to EBT 2 marks 4 min
- 2 Operating leverage 2 marks 4 min
- 3 Financial leverage with the preference dividend grossed up 2 marks 3 min
- 4 Combined leverage 1 mark 2 min
- 5 Sales rise to double EBIT, with check 3 marks 5 min
- Check: arithmetic, units (₹, %), final answer underlined 1 min
Try it first. About 20 minutes for 10 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.
| Particulars | ₹ |
|---|---|
| Sales | 12,00,000 |
| Less: variable cost | 8,40,000 |
| Contribution | 3,60,000 |
| Less: fixed cost | 2,40,000 |
| EBIT | 1,20,000 |
| Less: interest on 7% debt (6,00,000) | 42,000 |
| EBT | 78,000 |
Preference dividend = 9% × 2,40,000 = ₹21,600, paid out of profit after tax, so grossed up: 21,600 ÷ (1 − 0.25) = ₹28,800 (paper note).
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.
- Operating leverage = contribution ÷ EBIT = 3,60,000 ÷ 1,20,000 = 3.00.
- Financial leverage = EBIT ÷ [EBT − PD ÷ (1 − t)] = 1,20,000 ÷ (78,000 − 28,800) = 1,20,000 ÷ 49,200 = 2.44.
- Combined leverage = 3.00 × 2.439 = 7.32.
Sales rise needed to double EBIT. DOL is the % change in EBIT from a 1% change in sales. Doubling EBIT is a 100% rise, so sales must rise by 100% ÷ 3 = 33.33%.
Check. Sales of ₹16,00,000 (33.33% more) give contribution ₹4,80,000 (30%), less fixed cost ₹2,40,000 = EBIT ₹2,40,000, double the present ₹1,20,000.
Where the 10 marks sit
| # | Component | Marks |
|---|---|---|
| 1 | Income statement to EBT | 2 |
| 2 | Operating leverage | 2 |
| 3 | Financial leverage with the preference dividend grossed up | 2 |
| 4 | Combined leverage | 1 |
| 5 | Sales rise to double EBIT, with check | 3 |
| Total | 10 |
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