Question 2 OR

EPS, operating and financial leverage at two sales levels

15 marks

Time to write
About 30 minutes

From an older CBCS paper

Question

Question 2 OR · 15 marks

A company's share capital is ₹12,00,000, in shares with a face value of ₹10. It has debt capital of ₹7,20,000 at a 10% rate of interest. The firm's sales are 3,60,000 units per annum, sold at a selling price of ₹5 per unit, and its variable cost is ₹3 per unit. Its fixed cost amounts to ₹2,40,000. It pays tax @ 35%. If sales rise by 10%, calculate:

  1. Percentage increase in EPS.

  2. The Degree of Operating Leverage at both levels

  3. The Degree of Financial Leverage at both levels.

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

30 minfor 15 marks

Read from the question

  • calculateFormula first, then the working, then the answer with its unit (₹, %, units).

Write it in this order

  1. Read the data; note exactly what is asked 2 min
  2. 1 Income statement at both sales levels, with EPS 5 marks 9 min
  3. 2 Percentage increase in EPS 3 marks 5 min
  4. 3 DOL at both levels 3 marks 5 min
  5. 4 DFL at both levels 3 marks 5 min
  6. 5 Check through combined leverage 1 mark 2 min
  7. Check: arithmetic, units (₹, %), final answer underlined 2 min

Try it first. About 30 minutes for 15 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.

Number of equity shares = 12,00,000 ÷ 10 = 1,20,000. Interest = 10% of 7,20,000 = ₹72,000. Sales rise by 10%, from 3,60,000 to 3,96,000 units.

Picture itEPS, operating and financial leverage at two sales levels

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.

Income statement (₹)

ParticularsPresent sales (3,60,000 units)Sales 10% higher (3,96,000 units)
Sales @ ₹518,00,00019,80,000
Less: variable cost @ ₹310,80,00011,88,000
Contribution7,20,0007,92,000
Less: fixed cost2,40,0002,40,000
EBIT4,80,0005,52,000
Less: interest72,00072,000
EBT4,08,0004,80,000
Less: tax @ 35%1,42,8001,68,000
EAT2,65,2003,12,000
EPS (EAT ÷ 1,20,000 shares)2.212.60

(i) Percentage increase in EPS = (2.60 − 2.21) ÷ 2.21 × 100 = 17.65%.

(ii) Degree of operating leverage = Contribution ÷ EBIT:

  • present sales: 7,20,000 ÷ 4,80,000 = 1.50;
  • sales 10% higher: 7,92,000 ÷ 5,52,000 = 1.43.

(iii) Degree of financial leverage = EBIT ÷ EBT:

  • present sales: 4,80,000 ÷ 4,08,000 = 1.18;
  • sales 10% higher: 5,52,000 ÷ 4,80,000 = 1.15.

Check. Combined leverage = DOL × DFL = % change in EPS ÷ % change in sales. At present sales, 1.50 × 1.1765 = 1.765, and 1.765 × 10% = 17.65%, the rise in EPS found above. Both leverages fall at the higher sales level, because there is a unique degree of leverage for each level of output and EBIT, and fixed costs and interest weigh less as EBIT grows.

Where the 15 marks sit

#ComponentMarks
1Income statement at both sales levels, with EPS5
2Percentage increase in EPS3
3DOL at both levels3
4DFL at both levels3
5Check through combined leverage1
Total15
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