MUonde Vew loo2

Financial and Operating Leverage 337

4. f the use of financial leverage magnifies the earnings per share under favourable economic conditions, why
do companies not employ very large amount of debt in their capilal structures?

5. What is an EBIT-EPS analysis? lllustrate your answer

6. What is an indifforence point in the EBIT-EPS analysis? How would you compute it?
7. Explain the merits and demerits of the various measures of financial leverago.
8. Define operating and financial leverage. How can you measure the degree of operating and financial leverago?
llustrate with an example.
9. What is the degree of combined leverago? What do you think is the appropriate combination of operating and
financial leverage?

QUIZ EXERCISES
1. A firm has to choose between two capital structures: oither ordinary share capital R10 crore (R100 pershare)or
15% debentures of crore and ordinary share capital of 5 crore. Assume that the corporate tax rate is 40 por
cent. Calculate EBIT at which the plans give same EPS.
2. Firm Qwants to choose between two financing plans. Plan I: ordinary share capital T8 crore (i00 per share)
and 15% debentures of T2 crore. Plan I1: ordinaryshare capital of 5 crote(100 per share) and 15% debenturos
of 2 crore. Assume that the corporate tax rate is 30 per cent. Calculate EBIT at which plans give same EPS.
3. Firm 1has sales of Ts6o crore, variable cost of T90 crore and fixed cost of 180 crore. Firm Phas sales off300
crore, variable cost of F150 crore and fixed cost of 775 crore. Calculate (a) profit to sales ratio,
the positions of the
(6 break-even point, and (d the degree of operating leverage for both firms. Comment on
firms. If sales increase by 20 per cent what shall be the impact on the profitability of the two firms?

Firm Zhas EBIT of1200 lakh, PBT of T480 lakh and fixed costs of T600 lakh. What is the percentage change
in
4.
EPS if sales increase by 5 per cent?
5. A firm has EBIT of T300 lakh, contribution margin of T600 lakh and interest of T100 lakh. Calculate the percentage

change in EPS if sales decline by 5 per cent.

deviation of 730 crore. Firm Uis non-
6. The expected earnings of firms Uand Z are 7120 crore with a standard
levered. Firm Lis levered and has to pay annual interest charges of R30 crore. Which firm is more risky? Why?

PROBLEMS
1,000,000 financed company may issue 10,000 shares
share, (i) The
1.A company has assets of share and 1,000 debentures of 710o
at 10 per
wholly by equity share capital.
There 100,000are denomination bearing a 14 per cent rate of
shares outstanding with a book value of F10
per
interest. ( ) The company may issue 5,000 shares
share. Last year's profit before taxes was 250,000. at 10 per share and 1,500 debentures of F1000
is
The tax rate is 35 per cent. The company denominations bearing a 14 per cent rate of
thinking of an expansion programme that will cost interest.
the
R500,000. The financial manager considers
three financing plans: () selling 50,000 shares at If the company's profits before interest are
R10 per share, () borrowing R500,000 at an (a) T5,000, (6) R12,000, () R25,000, what are the
respective earnings per share, rate of
return on
interest rate of 14 per cent, or (i) selling 7500,000
total capital and rates of return on total equity
of preference shares with a dividend rate of
14
Which
per cent. The profit
before interest and tax are capital, for each of the three alternatives? lf
estimated to be 375,000 after expansion. alternative would you recommend and why?
what are
the corporate tax rate is 35 per cent,
You are required to calculate: () the after-tax rate
to the above questions? How do you
of return on assets, (D) the earnings per share, your answers
and (d the rate of return on shareholders' equity explain the difference in your answers?
for each of the three financing alternatives. Also, 3. The Apex Limited is a newly incorporated
wants to plan an appropriate capital
suggest which alternative should be accepted by company and
structure. It can issue 15 per cent debt and 11 per
the firm. 35 per cent tax
and has a
A company is considering to raise 7200,000 to cent preference capital
2. for funds is
finance modernization of its plant. The following rate. The firm's initial requirement
shares be sold for a
400 million and equity
can
three financing alternatives are feasible: () The
net price of R25 per
share. The possible capital
company may issue 20,000 shares al 1 0 per
structures are:
338 Financial Management
You are required to ()
calculate the earnings per
Altermatives Equit Preference ebentures share () compute the indilference points, and
100% (i) determine the financial risk, for each of the
three alternatives. Assume a tax rate of 35 per cent.
75% 25%
75% 25% 7. For Ltd the following data is available:
50% 20% 30% 200
EBIT
50% 50% Contribution 400
30% 20% 50% Interest 100

Construct an EBIT-EPS chart for the six If the company's sales are expected to decline by 5
per cent. determine the percentage change
altermatives over an EBIT range of 710 million in EPS.
to T80 million. 8. The expected earnings of firms A and a r e
uDetermine the indifference points for first and 120,000 with a standard deviation of T30,000.
fourth alternatives and for fourth and sixth Firm A is non-levered. Firm Bis levered and has
alternatives. to pay annual interest charges of F30,000. Which
i I s the maximization of EPS at a specific level firm is more risky? Why?
of EBIT the only function of a firm's capital 9. Rastogi Ltd is considering two plans (a) 15% debt
structure? If not, are the poínts determined or ( issue of 100,000 shares of10 each to finance
ip (i) truly 'indifference' points? a proposed expansion at a cost of T1,000.000. The
4. Ewpire Ltd needs 1.000,000 to build a new company expects EBIT with associated
ctory which will yield EBIT ofR150,000
per year. probabilities as follows:
The company has to choose between two
alternative financing plans: 75 per cent equity and EBIT Probabilities
25 per cent debt or 50 per cent equity and 50 per 100,000 0.05
cent debt. Under the first plan, shares can be sold 150,000 0.10
at 50 per share, and the interest rate on debt 200,000 0.30
will be 14 per cent. Under the second plan, shares 250,000 0.40
sold for R40 per share and the interest rate 300,000 0.10
can e
on debt will be 16 per cent. Determine the EPS 400,000 0.05
or each plan assuming a 35 per cent tax rate.
Howard Company is considering three financing Determine the expected EBIT and coefficiont of
variation of EBIT. Also calculate expected EPS and
plans: all equity; 60 per cent equity and 40 per
its variability under two plans. Comment on your
cent debt: and 40 per cent equity and 60 per cent
results. The company has 100,000 shares
debt. Total funds needed are 300,000. EBIT is
expected to be R45.000. Shares can be sold at the
outstanding, and the corporate tax rate is 35 per
rate of 20 per a share. Funds can be borrowed cent
as fotows up to and including R60.000 at 14 per 10.
arge chemical
two snall
company is considering
cep: 60,000 to R150,000 at 16 per cent and over AAcquiring companies. The following is
the tinancial data about two companies:
50.000 at 18 per cent. Compute the EPS of each
plan. Assume a tax rate of 35 per cent. (millio)
YZLId wishes to raise 1,000,060 to finance the
Company1 Company2
acquisition of new assets. It is considering three Sales 108.65 108.65
alternativee ways of financing assets: () to issue
only equity shares at 20 per share, () to borrow Less: Variable cost 43.46 35.85
500,000 at 14 per cent rate of interest and issue Contribution 65.19 72.80
equity shares at R20 per share for the balance or Less: Fixed cost 52.69 61.40
n to borrow R750,000 at 14 per cent rate of EBIT 12.50 11.40
interest and issue equity shares at R20 per share Less: Interest 9.27 6.995
PBT 3.23 .45
for the balance. The following are the estimates
of the earnings from the assets with their Lass: Tax (35%) 1.13 56
probability distribution: PAT 2.10 .89
Total assets 92.70 .70
30.90 46.35
EBITR Probhabilities Equity 61.80 35
Debt
80,000 0.10
120,000 0.20 What would be the effect on companies'
160,000 0.40 profitability and risk if sales fluctuate by 10 per
200,000 0.20 cent? If the chemical company intends to acquire
320,000 0.10 a less risky firai, which o n e should
it buy? Give
reason.
 Financial and Operating Leverage 339

11. Indus Engineering Company has gross sales of firm.

R137.5 billion and profit after tax of R7.15 billion
0.22, which is quite low for an engineering its
Indus is a highly capital intensive company;
in the year 2013. The company is considering fixed costs are 70 per cent
It is
of the total costs.
expanding
its
its capacity by adding 30 per cent
fixed assets. Sales
more notable that the performance of engineerin8
economic changes.
to existing are likely to industry is quite susceptible to
increase by 755 billion. For the proposed Should the company borrow? Give your analysis
expansion, PBIT to sales ratio is 18 per cent. The by making appropriate assumptions.
company has never borrowed in the past.
and marketing
Balance Sheet as on 31 December 2013 12. y6lga is a large manufacturing
in the private sector. In 2013, the
(billion) Company
company had a gross
sales of F980.2 million. The
are given
Share capital other financial data for the company
(4 crore shares Fixed assets 100.0 below:
at 10) 40.0 Some Financial Datafor Volga,2013
Reserve 95.0 Current assets:
Net worth 135.0 Debtors 20.0 Items million
30.0 152.31
Current Inventory Net worth
165.47
liabilities 35.5 Borrowing 43.17
Cash 20.5 EBIT
34.39
170.5 170.5 Interest
Fixed costs (excluding interest) 118.23
The finance director has recommended that the
ratio;
company should raise 15 per cent interest bearing You are required to calculate (a) debt-equity
debt for financing the expansion. In his opinion, () debt ratio; () interest coverage, (d) combined
operating8
the leverage and (
given 35 per cent corporate income tax rate, and leverage, (e) financial
and comment on
effective cost of debt will be 9.75 per cent, leverage. Interpret your results
considering the current net worth (see balance the Volga's debt policy.
sheet given below), debt-equity ratio will be only

CASE 14.1:CENTRAL EQUIPMENT COMPANY4

Director Table 14.1.1: Central Equipment Company:

In the beginning ofJanuary 2014, Mr L.C. Tandon, ending on 31 March
Selected Financial Data for the Year
of Finance of Central Equipment Company (CEC),
was

evaluating the pros and cons of debt and equity financing Sales PBIT PAT Diidend EPS
for the purpose of expansion of CEC's existing production FY R
facilities. At a recent meeting of the board of directors,
a
milion) million) million) million) milion)
heated discussion took place on the best method of financing
2005 1804.0 34.3 17.1 9.0 9.50
the expansion. Mr K.C. Soni, Chairman and Managing
2006 1707.8 15.5 7.8 9.0 4.33
Mr Tandon to
Director (CMD), had therefore directed 41.2 20.6 9.0 11.44
members 2007 1894.0
made by the various
critically evaluate the points on behalf 2008 2270.8 52.2 26.1 9.0 14.50
of the board. He also asked him to prepare a report 29.0 10.8 16.1
the board 2009 2520.0 58.0
to be presented at
of the company's management 2010 2775.0 66.6 33.3 10.8 18.50
held in the last week of January 2014.
meeting to be 2011 2949.2 76.8 38.4 14.4 21.33
2012 2433.8 -5.3 -5.3 9.0
66.2 43.5 27.0 24.17
Background of the Company 2013 3042.3
2014$ 3376.9 77.5 50.3 27.0 27.94
CEC was started in the late fifties as a government company
It is one of the important engineering companies in the $-Estimates
public sector in India, manufacturing a wide range of
(divided into 1.8 million shares each) and reserves
of R100
products. CEC's products include industrial machinery and sales have shown a
equipments for chemicals, paper, cement, and fertilizers of 459.6 million. The company's
industries, super heaters, economizers, and solid material trend in spite of a number of difficulties
general increasing
handling and conveying equipments. such as recessionary conditions, high input cost, frequent
of certain
CEC had started with a paid-up capital of 10 million power cuts and unremunerative regulated prices
last decade, CEC's sales have increased
in 1959. As per the estimated balance sheet at the endmillion
of the products. In the
financial year it has a paid-up capital of180 from {1,804 million in the financial year 2005 to R3,042
2014,

and Ramesh Bhat, Cases in Financial Management, New Delhi: Tata McGraw, 2nd edition, 2002.
14. Case adapted from, Pandey, I.M.