Question 3 OR (b)
Leverages and the sales rise needed to double EBIT
7 marks
- Time to write
- About 14 minutes
From an older CBCS paper
Question
Question 3 OR (b) · 7 marks- A firm's sales are ₹8,40,000, its variable costs ₹5,88,000 and its fixed costs ₹96,000. Its outstanding debt is ₹6,00,000, at a 10% rate of interest. Calculate the operating, the financial and the combined leverages. Also, how large a percentage increase in sales would be needed if the firm wishes its earnings to rise to two times that of its EBIT?
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
- Calculate…How…?Two asks in one question: answer both.
- CalculateFormula 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 Income statement 1½ marks 3 min
- 2 Operating, financial and combined leverage 3 marks 5 min
- 3 Sales increase needed, with the other reading 2½ marks 4 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.
| Particulars | ₹ |
|---|---|
| Sales | 8,40,000 |
| Less: variable cost | 5,88,000 |
| Contribution | 2,52,000 |
| Less: fixed cost | 96,000 |
| EBIT | 1,56,000 |
| Less: interest (10% × 6,00,000) | 60,000 |
| EBT | 96,000 |
Using DOL = contribution ÷ EBIT, DFL = EBIT ÷ EBT and DCL = 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.
- Operating leverage = 2,52,000 ÷ 1,56,000 = 1.6154
- Financial leverage = 1,56,000 ÷ 96,000 = 1.6250
- Combined leverage = 1.6154 × 1.6250 = 2.6250 (= 2,52,000 ÷ 96,000)
Sales increase needed for earnings to double. The question asks for "earnings" to rise to two times the EBIT; it is read as the EBIT doubling, a 100% rise. Operating leverage is the % change in EBIT ÷ % change in sales, so the sales increase needed = 100% ÷ 1.6154 = 61.90%.
Check: sales ₹13,60,000 (+61.90%) give contribution 4,08,000 and EBIT 3,12,000, twice ₹1,56,000.
The other reading. If "earnings" means profit before tax (and so EPS), the rise needed is 100% ÷ 2.625 = 38.10%.
Where the 7 marks sit
| # | Component | Marks |
|---|---|---|
| 1 | Income statement | 1.5 |
| 2 | Operating, financial and combined leverage | 3 |
| 3 | Sales increase needed, with the other reading | 2.5 |
| Total | 7 |
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