Question 3 OR (b)
Leverages of two firms and their risk
9 marks
- Time to write
- About 18 minutes
Question
Question 3 OR (b) · 9 marksThe following information relates to two firms, Kirti Ltd. and Shruti Ltd.:
| (Figures in Lacs) | Kirti Ltd. | Shruti Ltd. |
|---|---|---|
| Sales | 1200 | 2400 |
| —Variable Cost | 600 | 1200 |
| Contribution | 600 | 1200 |
| —Fixed Cost | 180 | 480 |
| EBIT | 420 | 720 |
| —Interest | 60 | 120 |
| Profit before Tax | 360 | 600 |
Calculate the different leverages of both firms and also comment on their relative risk position.
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…Comment…Two asks in one question: answer both.
- comment onThe comment carries marks too: say what the figures show, in two or three lines.
- 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 DOL of both firms 2 marks 4 min
- 2 DFL of both firms 2 marks 4 min
- 3 DCL of both firms 2 marks 3 min
- 4 Comment on relative risk 3 marks 5 min
- Check: arithmetic, units (₹, %), final answer underlined 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: operating leverage = contribution ÷ EBIT; financial leverage = EBIT ÷ PBT (no preference shares); combined leverage = contribution ÷ PBT = 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.
| (₹ lakhs) | Kirti Ltd. | Shruti Ltd. |
|---|---|---|
| Contribution | 600 | 1,200 |
| EBIT | 420 | 720 |
| Profit before tax | 360 | 600 |
| Degree of operating leverage | 600 ÷ 420 = 1.43 | 1,200 ÷ 720 = 1.67 |
| Degree of financial leverage | 420 ÷ 360 = 1.17 | 720 ÷ 600 = 1.20 |
| Degree of combined leverage | 600 ÷ 360 = 1.67 | 1,200 ÷ 600 = 2.00 |
- Business (operating) risk: Shruti's DOL (1.67) is higher, because its fixed costs are a larger share of contribution (480 of 1,200 against 180 of 600). A 10% change in sales changes Shruti's EBIT by 16.7% and Kirti's by 14.3%.
- Financial risk: Shruti's DFL (1.20) is slightly higher, so a change in EBIT moves its PBT (and EPS) a little more.
- Total risk: Shruti's DCL (2.00) is higher than Kirti's (1.67): a 10% change in sales changes Shruti's PBT by 20% and Kirti's by 16.7%.
Shruti Ltd. carries more risk on all three measures; Kirti Ltd. is the less risky firm.
Where the 9 marks sit
| # | Component | Marks |
|---|---|---|
| 1 | DOL of both firms | 2 |
| 2 | DFL of both firms | 2 |
| 3 | DCL of both firms | 2 |
| 4 | Comment on relative risk | 3 |
| Total | 9 |
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