Question 1 (c)
Income statement from the degrees of leverage
9 marks
- Time to write
- About 18 minutes
Question
Question 1 (c) · 9 marksThe following information is available for Saffron Hill Ltd.:
| Degree of Operating Leverage | 3:1 |
| Degree of Financial Leverage | 3:1 |
| Degree of Combined Leverage | 9:1 |
| Interest | ₹4,80,000 |
| Contribution Margin | 40% |
| Tax rate | 40% |
| 10% preference share capital | ₹12,00,000 |
Prepare the income statement of the company.
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
- Prepare the income statementDraw the format first (heading, columns, dates), then fill in the figures from your working.
Write it in this order
- Read the data; tick every adjustment as you plan it 1 min
- 1 Grossing up the preference dividend; fixed financial charges 2 marks 4 min
- 2 EBIT from DFL 2 marks 4 min
- 3 Contribution, fixed cost and sales from DOL and the contribution margin 2 marks 3 min
- 4 Income statement down to earnings for equity 3 marks 5 min
- Check: every adjustment used, both sides agree, dates in 1 min
Try it first. About 18 minutes for 9 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.
Formulas used. DOL = contribution ÷ EBIT. The preference dividend is payable only out of profit after tax, so before tax it is a fixed charge of preference dividend ÷ (1 − t). Hence, with preference shares, DFL = EBIT ÷ [EBIT − interest − preference dividend ÷ (1 − t)]. DCL = DOL × DFL = 3 × 3 = 9, which agrees with the combined leverage given.
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.
Working 1: fixed financial charges before tax
| ₹ | |
|---|---|
| Interest | 4,80,000 |
| Preference dividend grossed up: (10% × 12,00,000) ÷ (1 − 0.40) = 1,20,000 ÷ 0.60 | 2,00,000 |
| Fixed financial charges | 6,80,000 |
Working 2: EBIT. DFL = EBIT ÷ (EBIT − 6,80,000) = 3, so 3 EBIT − 20,40,000 = EBIT, and EBIT = ₹10,20,000.
Working 3: building up to sales
| ₹ | |
|---|---|
| EBT (10,20,000 − 4,80,000) | 5,40,000 |
| Add: interest | 4,80,000 |
| EBIT | 10,20,000 |
| Add: fixed cost (contribution − EBIT) | 20,40,000 |
| Contribution (DOL × EBIT = 3 × 10,20,000) | 30,60,000 |
| Add: variable cost (60% of sales) | 45,90,000 |
| Sales (contribution ÷ 40%) | 76,50,000 |
Income statement of Saffron Hill Ltd.
| Particulars | ₹ |
|---|---|
| Sales | 76,50,000 |
| Less: variable cost | 45,90,000 |
| Contribution | 30,60,000 |
| Less: fixed cost | 20,40,000 |
| EBIT | 10,20,000 |
| Less: interest | 4,80,000 |
| EBT | 5,40,000 |
| Less: tax @ 40% | 2,16,000 |
| EAT | 3,24,000 |
| Less: preference dividend @ 10% | 1,20,000 |
| Earnings available to equity shareholders | 2,04,000 |
Check. DOL = 30,60,000 ÷ 10,20,000 = 3; DFL = 10,20,000 ÷ (5,40,000 − 2,00,000) = 3; DCL = 9.
Where the 9 marks sit
| # | Component | Marks |
|---|---|---|
| 1 | Grossing up the preference dividend; fixed financial charges | 2 |
| 2 | EBIT from DFL | 2 |
| 3 | Contribution, fixed cost and sales from DOL and the contribution margin | 2 |
| 4 | Income statement down to earnings for equity | 3 |
| Total | 9 |
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