Question 3 (b)
EPS, operating and financial leverage after a 10% rise in sales
7 marks
- Time to write
- About 14 minutes
From an older CBCS paper
Question
Question 3 (b) · 7 marksA company's share capital is Rs. 12,00,000, in shares with a face value of Rs. 10. Its debt capital is Rs. 7,20,000, at a 10% rate of interest. The firm sells 3,60,000 units per annum, at a selling price of Rs.5 per unit, with a variable cost of Rs. 3 per unit. Its fixed cost amounts to Rs. 2,40,000. The company pays tax act 35%. If sales rise by 10%, calculate:
Percentage increase in EPS;
The Degree of operating leverage at both levels; and
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
Read from the question
- calculateFormula first, then the working, then the answer with its unit (₹, %, units).
What the paper leaves open
"Pays tax act 35%" is read as tax at 35%.
Write it in this order
- Read the data; note exactly what is asked 1 min
- 1 Income statements and EPS at both levels 3 marks 5 min
- 2 Percentage increase in EPS 1 mark 2 min
- 3 DOL at both levels 1½ marks 3 min
- 4 DFL at both levels 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.
Shares = 12,00,000 ÷ 10 = 1,20,000; interest = 10% × 7,20,000 = ₹72,000; tax 35%.
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 (₹) | Present | Sales up 10% |
|---|---|---|
| Units | 3,60,000 | 3,96,000 |
| Sales @ ₹5 | 18,00,000 | 19,80,000 |
| Less: variable cost @ ₹3 | 10,80,000 | 11,88,000 |
| Contribution | 7,20,000 | 7,92,000 |
| Less: fixed cost | 2,40,000 | 2,40,000 |
| EBIT | 4,80,000 | 5,52,000 |
| Less: interest | 72,000 | 72,000 |
| EBT | 4,08,000 | 4,80,000 |
| Less: tax @ 35% | 1,42,800 | 1,68,000 |
| PAT | 2,65,200 | 3,12,000 |
| EPS (PAT ÷ 1,20,000) | 2.21 | 2.60 |
(i) Percentage increase in EPS = (2.60 − 2.21) ÷ 2.21 = 46,800 ÷ 2,65,200 = 17.65%.
(ii) Degree of operating leverage = contribution ÷ EBIT:
- present: 7,20,000 ÷ 4,80,000 = 1.50; after the rise: 7,92,000 ÷ 5,52,000 = 1.43.
(iii) Degree of financial leverage = EBIT ÷ EBT:
- present: 4,80,000 ÷ 4,08,000 = 1.18; after the rise: 5,52,000 ÷ 4,80,000 = 1.15.
Check. Combined leverage at present = 1.50 × 1.1765 = 1.765; a 10% rise in sales gives 17.65% more EPS, as computed. Both leverages fall as sales rise further above the break-even level.
Where the 7 marks sit
| # | Component | Marks |
|---|---|---|
| 1 | Income statements and EPS at both levels | 3 |
| 2 | Percentage increase in EPS | 1 |
| 3 | DOL at both levels | 1.5 |
| 4 | DFL at both levels | 1.5 |
| Total | 7 |
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