Caselet 1

Brightways Ltd. is being formed and is in business of manufacturing cast iron and management of firm is
expecting before tax rate of return of 24% on the estimated Investment of Rs 500000
The firm is considering two alternative financial plans:
(i) either to raise the entire funds by issuing 50,000 ordinary shares at Rs 10 per share, or
(ii) to raise Rs 250,000 by issuing 25,000 ordinary shares at Rs 10 per share and borrow
Rs 250,000 at 15 per cent rate of interest.
The tax rate is 50 per cent.
What are the effects of the alternative plan for shareholders earnings? How does it change if the firm has
to finance 75% through Debt
Brightway Ltd is not very sure about the business performance of future and they have forecasted the
probability of economic condition and performance on each condition

Figures in 000

V Poor Poor Normal Good

Probability 0.05 0.1 0.15 0.35 0.3 0.05
Sales(Rs) 510 660 710 800 880 1160
Costs:
Variable(Rs) 255 330 355 400 440 580
Fixed(Rs) 280 280 280 280 280 280
Total Cost 535 610 635 680 720 860
EBIT -25 50 75 120 160 300

What is the impact of financing on EPS & RoE under various economic conditions?
What is the indifference point between No Debt & 50% Debt Financing?
What is degree of Financial Leverage for the company?
Management has also forecasted the income statement for Normal Condition with expected sales volume
of 100000 units

Units Price Rs
Sales 100000 8 800000
Less VC 100000 4 400000
Contributio
n 400000
Less FC 280000
EBIT 120000

Technical committee has advised for installing automated production which will reduce variable costs to
Rs 2 but fixed cost will go to Rs 480000

What is DoL initially and how it will change after automation?

Calculate Degree of Combined Leverage under all possible options

i) Low Automation with Varied financing option

ii) High Automation with Varied financing Option