Question 3 OR (b)
Operating, financial and combined leverage of two companies
7 marks
- Time to write
- About 14 minutes
From an older CBCS paper
Question
Question 3 OR (b) · 7 marksParticulars of Rekha Ltd. and Meena Ltd are given below:
| Particulars | Rekha Ltd. (₹) | Meena Ltd. (₹) |
|---|---|---|
| Output and Sales (Units) | 96,000 | 1,20,000 |
| Selling Price per unit (₹) | 20 | 16 |
| Variable costs per unit (₹) | 8 | 6 |
| Fixed cost (₹) | 5,76,000 | 6,00,000 |
| Interest Burden on Debt (₹) | 2,88,000 | 1,20,000 |
Compute, from the data above: 7
Operating leverage,
Financial leverage and
(iii)Combined leverage.
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 Contribution, EBIT and EBT of both companies 3 marks 5 min
- 2 Operating leverage 1 mark 2 min
- 3 Financial leverage 1½ marks 3 min
- 4 Combined leverage and comment 1½ marks 2 min
- Check: arithmetic, units (₹, %), final answer underlined 1 min
Try it first. About 14 minutes for 7 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. Operating leverage (DOL) = contribution ÷ EBIT; financial leverage (DFL) = EBIT ÷ EBT (profit before tax); combined leverage (DCL) = contribution ÷ EBT, which equals DOL × DFL.
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.
| Particulars | Rekha Ltd. | Meena Ltd. |
|---|---|---|
| Sales (96,000 × 20; 1,20,000 × 16) | 19,20,000 | 19,20,000 |
| Less: variable costs (96,000 × 8; 1,20,000 × 6) | 7,68,000 | 7,20,000 |
| Contribution | 11,52,000 | 12,00,000 |
| Less: fixed cost | 5,76,000 | 6,00,000 |
| EBIT | 5,76,000 | 6,00,000 |
| Less: interest on debt | 2,88,000 | 1,20,000 |
| EBT | 2,88,000 | 4,80,000 |
| Leverage | Rekha Ltd. | Meena Ltd. |
|---|---|---|
| (i) Operating leverage = contribution ÷ EBIT | 11,52,000 ÷ 5,76,000 = 2 | 12,00,000 ÷ 6,00,000 = 2 |
| (ii) Financial leverage = EBIT ÷ EBT | 5,76,000 ÷ 2,88,000 = 2 | 6,00,000 ÷ 4,80,000 = 1.25 |
| (iii) Combined leverage = DOL × DFL | 2 × 2 = 4 | 2 × 1.25 = 2.5 |
Comment. Both companies have the same operating leverage, so the same business risk: a 1% change in sales changes EBIT by 2%. Rekha Ltd.'s heavier interest burden doubles its financial leverage, so its EPS moves by 4% for each 1% change in sales, against 2.5% for Meena Ltd. DOL measures business risk, DFL financial risk and DCL the total risk.
Where the 7 marks sit
| # | Component | Marks |
|---|---|---|
| 1 | Contribution, EBIT and EBT of both companies | 3 |
| 2 | Operating leverage | 1 |
| 3 | Financial leverage | 1.5 |
| 4 | Combined leverage and comment | 1.5 |
| Total | 7 |
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