Question 5 OR
Leverages, indifference point and financial break-even of three plans
18 marks
- Time to write
- About 36 minutes
Question
Question 5 OR · 18 marksKavya Ltd provides the following details:
Installed Capacity: 1,80,000 Units
Actual production and sales: 1,20,000 Units
Selling price: ₹1 per unit
Variable cost per unit: ₹0.50
Fixed cost: ₹45,600
Funds required: ₹1,20,000
| Capital Structure | Financial Plans | ||
|---|---|---|---|
| A | B | C | |
| Equity shares of ₹ 10 each to be issued at 20% premium | 60% | 40% | 35% |
| 15% Debt | 40% | 60% | 50% |
| 12% Preference shares of ₹ 10 each | NIL | NIL | 15% |
Assume an Income Tax rate of 30%
Degree of Operating Leverage, Financial Leverage and Combined Leverage of each plan.
The point of indifference between plan A and B.
The Financial break-even point of each plan.
Suggest which plan has been more financial risk?
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
- Assume an Income Tax rate of…The paper fixes this: use it as given, and say so in your answer.
What the paper leaves open
Parts (i) to (iii) name what is to be found without a verb; they are read as "calculate". The last line is read as asking which plan carries more financial risk.
Write it in this order
- Read the data; note exactly what is asked 2 min
- 1 EBIT and DOL 2 marks 4 min
- 2 Financing under each plan: shares, interest, preference dividend 3 marks 5 min
- 3 EPS and DFL under each plan, with preference dividend grossed up 4 marks 7 min
- 4 DCL under each plan 2 marks 4 min
- 5 (ii) Indifference EBIT between A and B 3 marks 5 min
- 6 (iii) Financial break-even point of each plan 2 marks 4 min
- 7 Plan with the most financial risk, with reasons 2 marks 3 min
- Check: arithmetic, units (₹, %), final answer underlined 2 min
Try it first. About 36 minutes for 18 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.
1. EBIT (the same under every plan)
Sales 1,20,000 units × ₹1 = ₹1,20,000; variable cost 1,20,000 × ₹0.50 = ₹60,000; contribution = ₹60,000; fixed cost ₹45,600; EBIT = ₹14,400. (Installed capacity of 1,80,000 units is not needed: the leverages are measured at the actual level of 1,20,000 units.)
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.
2. Financing of ₹1,20,000 under each plan (equity issued at ₹10 + 20% premium = ₹12 a share; preference at par)
| ₹ | Plan A | Plan B | Plan C |
|---|---|---|---|
| Equity share capital | 72,000 | 48,000 | 42,000 |
| 15% Debt | 48,000 | 72,000 | 60,000 |
| 12% Preference shares | — | — | 18,000 |
| Total funds | 1,20,000 | 1,20,000 | 1,20,000 |
| Number of equity shares (÷ ₹12) | 6,000 | 4,000 | 3,500 |
| Interest @ 15% | 7,200 | 10,800 | 9,000 |
| Preference dividend @ 12% | — | — | 2,160 |
3. (i) Degree of operating, financial and combined leverage
DOL = contribution ÷ EBIT. DFL = EBIT ÷ [EBIT − interest − preference dividend ÷ (1 − t)], because the preference dividend is paid out of profit after tax. DCL = DOL × DFL.
| ₹ | Plan A | Plan B | Plan C |
|---|---|---|---|
| EBIT | 14,400 | 14,400 | 14,400 |
| Less: interest | 7,200 | 10,800 | 9,000 |
| EBT | 7,200 | 3,600 | 5,400 |
| Less: tax @ 30% | 2,160 | 1,080 | 1,620 |
| EAT | 5,040 | 2,520 | 3,780 |
| Less: preference dividend | — | — | 2,160 |
| Earnings for equity | 5,040 | 2,520 | 1,620 |
| EPS (₹) | 0.84 | 0.63 | 0.46 |
| DOL (60,000 ÷ 14,400) | 4.17 | 4.17 | 4.17 |
| DFL | 14,400 ÷ 7,200 = 2.00 | 14,400 ÷ 3,600 = 4.00 | 14,400 ÷ (5,400 − 3,085.71) = 6.22 |
| DCL | 8.33 | 16.67 | 25.93 |
(For Plan C, 2,160 ÷ 0.70 = ₹3,085.71.)
(ii) Indifference point between Plans A and B. At the indifference EBIT (X) both plans give the same EPS:
(X − 7,200)(1 − 0.30) ÷ 6,000 = (X − 10,800)(1 − 0.30) ÷ 4,000
4,000(X − 7,200) = 6,000(X − 10,800), so 2,000X = 3,60,00,000, and X = ₹18,000. At this EBIT, EPS = 10,800 × 0.70 ÷ 6,000 = ₹1.26 under both plans.
(iii) Financial break-even point. This is the EBIT that just covers the fixed financial charges, with the preference dividend grossed up for tax: interest + preference dividend ÷ (1 − t).
| Plan A | Plan B | Plan C | |
|---|---|---|---|
| Financial break-even EBIT (₹) | 7,200 | 10,800 | 9,000 + 3,085.71 = 12,085.71 |
Which plan carries more financial risk. Plan C. It has the highest degree of financial leverage (6.22) and combined leverage (25.93), and the highest financial break-even point (₹12,085.71), which leaves EBIT of ₹14,400 only ₹2,314.29 above break-even. A 1% change in EBIT changes Plan C's EPS by 6.22%, against 4% under Plan B and 2% under Plan A.
Where the 18 marks sit
| # | Component | Marks |
|---|---|---|
| 1 | EBIT and DOL | 2 |
| 2 | Financing under each plan: shares, interest, preference dividend | 3 |
| 3 | EPS and DFL under each plan, with preference dividend grossed up | 4 |
| 4 | DCL under each plan | 2 |
| 5 | (ii) Indifference EBIT between A and B | 3 |
| 6 | (iii) Financial break-even point of each plan | 2 |
| 7 | Plan with the most financial risk, with reasons | 2 |
| Total | 18 |
Report a problemopens an email to admin@getkunji.com with the question ID1403-Q5ORalready filled in.