Question 1 OR (d)
EPS, DFL and EPS after a 30% rise in operating profit
6 marks
- Time to write
- About 12 minutes
Question
Question 1 OR (d) · 6 marksA firm has 12,000 equity shares, an EBIT of ₹3,60,000, an Interest liability of ₹48,000 and a Preference Dividend of ₹24,000; the tax rate is 40%. Compute the Earnings Per Share (EPS) and the Degree of Financial Leverage (DFL). What will the EPS be if operating profit increases by 30%.
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
- ComputeFormula first, then the working, then the answer with its unit (₹, %, units).
Write it in this order
- Read the data; note exactly what is asked 1 min
- 1 EPS 2 marks 3 min
- 2 DFL with the preference dividend grossed up 2 marks 3 min
- 3 EPS after a 30% rise in EBIT 2 marks 3 min
- Check: arithmetic, units (₹, %), final answer underlined 2 min
Try it first. About 12 minutes for 6 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.
| Present ₹ | EBIT up 30% ₹ | |
|---|---|---|
| EBIT | 3,60,000 | 4,68,000 |
| Less: interest | 48,000 | 48,000 |
| EBT | 3,12,000 | 4,20,000 |
| Less: tax @ 40% | 1,24,800 | 1,68,000 |
| EAT | 1,87,200 | 2,52,000 |
| Less: preference dividend | 24,000 | 24,000 |
| Earnings for equity | 1,63,200 | 2,28,000 |
| Number of equity shares | 12,000 | 12,000 |
| EPS (₹) | 13.60 | 19.00 |
(ii) Degree of financial leverage. The preference dividend is paid out of profit after tax, so before tax it is a fixed charge of 24,000 ÷ (1 − 0.40) = ₹40,000. With preference shares:
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.
DFL = EBIT ÷ [EBIT − interest − preference dividend ÷ (1 − t)] = 3,60,000 ÷ (3,60,000 − 48,000 − 40,000) = 3,60,000 ÷ 2,72,000 = 1.32.
(iii) EPS if operating profit rises by 30% = ₹19.00 (second column above). Check: EPS rises by (19.00 − 13.60) ÷ 13.60 = 39.71%, which is DFL × 30% = 1.3235 × 30% = 39.71%.
Where the 6 marks sit
| # | Component | Marks |
|---|---|---|
| 1 | EPS | 2 |
| 2 | DFL with the preference dividend grossed up | 2 |
| 3 | EPS after a 30% rise in EBIT | 2 |
| Total | 6 |
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