Corporate Finance

1. The capital structure of ABC Pvt. Ltd is as follows:

Equity share capital (each share of Rs. 10) = Rs. 10,00,000

Debentures with a coupon rate of 9.5% = Rs. 8,00,000
Reserves and surplus = Rs. 7, 00,000

Revenue from the business activities for the company is Rs. 1.50 crores. Its variable cost
is 8% of the revenue, fixed operating cost is Rs. 48 lakhs and the company pays income
tax at a rate of 25%.

a. Calculate financial leverage, operating leverage and combined leverage for the
company.

b. Determine the likely level of EBIT for EPS of (i) Rs. 20, (ii) Rs. 30, and (iii) Rs. 45

Introduction

In the analysis of financial information, leverages depict the impact of one variable of income
statement of an entity over the other. Leverage is a broad term can be associated with
calculating impact for borrowing decisions or for other financial decisions. As far as financial
leverage is concerned, the impact of interest payment charge on earnings of an entity can be
seen whereas from operating leverage, the impact of directly attributable costs over revenue
can be observed. When both financial and operating leverage are taken together, it becomes
combined leverage.

Concept
In simplest terms, leverage from a financial point of view refers to using such sources of
finance/earning income where a fixed cost in form of interest or depreciation other charges is
incurred to lift the profits up. Leverages are calculated as a part of financial ratios to assess
the cost-benefit relationship. 
As said by James Carter Van Home, one of acclaimed American economists, leverage is the
employment of assets or funds for which the firm pays a fixed cost of fixed return. To
understand the concept of leverage, one must take insight into a conventional statement of
income. The income statement can be illustrated as:

Particulars Amount

Revenue (Sales) XXX

(-)Variable Costs XXX

 Contribution XXX

(-)Fixed Costs XXX

Operating Profit /Earnings XXX

before Interest
And Taxes(EBIT)

(-)Interest on Debt XXX

Earnings before Tax(EBT) XXX

(-)Tax XXX

Earnings after Tax/Net XXX

Income/Income attributable
to shareholders

÷ Number of Equity Shares XXX

Earnings Per Share(EPS) XXX

Operating Leverage:  When the term 'operating' is used, an inference can be drawn that only
elements of regular nature are under consideration, in the same way operating leverage also
calculates the degree of impact of routine nature fixed expenses on income such as
depreciation, rental and other production, and administrative overheads.

It can be calculated by dividing contribution with EBIT. Three pillars as to the calculation of
operating leverage are the amount of fixed cost, contribution margin, and sales volume.

Financial Leverage: As opposed to operating leverage, financial leverage is an indicator of

impact on earning as to the use of contractually fixed interest-bearing sources of funds such
as loans or debentures. 

It can be calculated by dividing EBIT with EBT. This formula shows that by how many times
EBIT is more than EBT, i.e., the extent of decrease made in EBIT due to interest obligations
with the supposition that the funds invested in business out of these borrowings will, in turn,
increase the EPS.

Combined Leverage: It is a function of both operating and financial leverage, which depicts
the entity's overall risk by incurring all kinds of fixed costs. 

It can be calculated by multiplying operating leverage with financial leverage. As operating

leverage is computed by dividing contribution with EBIT and financial leverage is calculated
by dividing EBIT with EBT so when we multiply above two leverages, EBIT gets knocked
off and what remains is Contribution/EBT, so it can be said that it focuses on the impact of
contribution posed on shareholders wealth.

Firstly an Income Statement must be drawn to jot down the facts.

 Particulars Amount in Rs.

Revenue (Sales) 1,50,00,000

(-)Variable Costs (8%) 12,00,000

Contribution 1,38,00,000

(-)Fixed Costs 48,00,000

Operating Profit /Earnings 90,00,000

before Interest
And Taxes(EBIT)

(-)Interest on Debt(9.5% of 76,000

800,000)

Earnings before Tax(EBT) 89,24,000

(-)Tax (25%) 22,31,000

Earnings after Tax/Net 66,93,000

Income/Income attributable
to shareholders

÷ Number of Equity Shares 1,00,000

(Rs.10,00,000/100,000)

Earnings Per Share(EPS) 67

1(a). Calculation of Leverages for ABC Pvt. Ltd

Financial Leverage = EBIT/EBT

= Rs. 90, 00,000/89, 24,000
= 1.01x
Operating Leverage = Contribution/EBIT
= Rs. 1, 38, 00,000/90, 00,000
= 1.53x
Combined Leverage = Financial Leverage X Operating Leverage
= 1.01 x 1.53
= 1.55x

1(b). Calculation of Levels of EBIT for ABC Pvt. Ltd

S. No. Particulars At EPS of Rs. At EPS of Rs. At EPS of Rs.

20/- 30/- 45/-
A EPS 20 30 45
B Number of Equity 100,000 100,000 100,000
Shares
C Earnings after Tax 20,00,000 30,00,000 45,00,000
D Tax{(C/75%)*25%} 6,66,667 10,00,000 15,00,000
E Earnings before 26,66,667 40,00,000 60,00,000
Tax(EBT){C+D}
F (-)Interest on 76,000 76,000 76,000
Debt(9.5% of
800,000)
G Earnings before 27,42,667 40,76,000 60.76,000
Interest
And Taxes(EBIT)
{E+F}

To calculate EBIT based on EPS, calculations need to be done backward.

When EPS is Rs. 20 per share and the number of shares are constant (as nothings are
mentioned in the question), i.e., 100,000 shares, Earnings After-tax would be Rs. 20, 00,000
[100,000*20] and
EBIT as per the above calculation would be Rs. 27, 42,667, in the same manner when EPS is
Rs. 30 per share Earnings After-tax would be Rs. 30, 00,000 [100,000*30] and EBIT as per
above calculation would be Rs. 40, 76,000, and when EPS is Rs. 45 per share, Earnings
After-tax would be Rs. 45, 00,000 [100,000*45] and EBIT as per the above calculation would
be Rs. 60, 76,000.

2. The equity shares of a publicly traded company are priced at Rs. 450 with P/E (Price
to Earnings) ratio of 15. The announces a dividend of Rs. 9 per shares. The
shareholders of the company expect the dividend to grow at a rate of 6% every year,
and the cost of equity for the company is 15%. According to the dividend relevance
approach suggested by Walter and Gordon, what would be the impact of dividend
announcement on the market price of the shares of the company if required rate of
return for investors is (i) 12%, (ii) 15% and (iii) 18%. (10 Marks)

Introduction

Valuation of shares of a company can is an activity through true value of a company can be
assessed. Several methods suggested by scholars by which valuation is done, each method
has its own set of significant rules and assumptions and pros and cons. The value determined
through different methods could be different. Out of those, there are these two valuation
techniques, one of which is given by Professor James E. Walter, known as Walter’s Model,
and the other one is developed by Myron Gordon, also known as Gordon’s Model.

Concept

Models of equity share valuation can be broadly classified into three categories as follows:
1. Dividend Based Models
2. Earnings Based Models
3. Cash Flows Based Models
The technique of valuation, as suggested by the above two scholars, falls in the category of
Dividend Based Models where dividend rate, rate of return earned by the company, rate of
return expected by investors, and growth rate are some of the key tools to be used in the
calculation.
While making calculations, two factors, i.e., Time Value of Money and Perpetual Life
Of company are the basic assumptions to be made. The two models can be understood as:
Walter’s Model: Under this model fair price of equity share as of today is calculated as by the
below-mentioned formula

Po= DPS/Ke + r*(EPS-DPS)/Ke^2

Where, 
Po= Fair Price of share as of today
EPS= Earnings per Share
DPS= Dividend per Share
Ke= Rate of Return Expected by Investors
r= Rate of Return on Investments Earned by Company

In this model, EPS, DPS, Ke, and r are assumed to be constant, i.e., the factor of growth is
completely ignored. This model highly focuses on the interconnectivity between the rate of
return earned by the company(r), rate of return expected by investors (ke). According to this
model, the optimum dividend payout ratio shall be determined depending upon r and ke, and
at that point price of share will be the highest.

Gordon’s Model: This model is often known as the Growth Model or Dividend Discount
Model, where the fair price of equity share as on today is calculated by using growth rate as
mentioned below

Po= DPSo (1+g)/ (Ke-g)

 
All terms remain the same as above except that a new term ‘g’ is also introduced in it, which
refers to the growth rate of dividend of company. 
This model is one of the most widely used models, where the current value of share is
assumed to be the present value of future dividend payments to be received by the
shareholder. Further, it is assumed that the growth rate of dividend, rate of earnings, and
retention ratio will remain the same.

 
Optimum Dividend Payout Plan under Both Models can be illustrated as:

Cases Nature Optimum Payout

r>ke Good 0%
r=ke Normal Indifferent
r<ke Bad 100%

Calculation as per Walter’s Model

The facts given in the question are:

Market Price of Share /Po= Rs. 450
PE Ratio= 15 times
Dividend = Rs 9
Ke= 15% 
From the above detail, EPS can be calculated as follows:
PE Ratio = Market Price of Share
                                 EPS
EPS= Rs. 30

After putting these values in the main formula of Po

 
Po= DPS/Ke + r*(EPS-DPS)/Ke^2
450= 9/15% + r*(30-9)/15%^2

r= 41.79%

Now, impact of dividend announcement on the market price of the shares on market price of
share can be calculated as:
 
(i)At Ke of 12%:
Po= DPS/Ke + r*(EPS-DPS)/Ke^2
     = 9/12% + 41.79*(30-9)/15%^2
      = Rs.684.38
 
(ii)At Ke of 15%:
Po= DPS/Ke + r*(EPS-DPS)/Ke^2
     = 9/15% + 41.79*(30-9)/15%^2
      = Rs.450
 
(iii)At Ke of 18%:
Po= DPS/Ke + r*(EPS-DPS)/Ke^2
     = 9/18% + 41.79*(30-9)/15%^2
      = Rs.320.83
 
Calculation as per Gordon’s Model
The facts given in the question are:
Dividend = Rs 9
Ke= 15% 
g= 6%
After putting these values in the main formula of Po
Po= DPSo (1+g)/ (Ke-g)
     = 9*(1+6%)/ (15%-6%)
     = Rs.106

#Note:  As it is mentioned that company announces dividend of Rs. 9, it has been assumed
that it is the current year dividend and hence considered as Do.
 
Impact of dividend announcement on the market price of the shares can be calculated as:
(i)At Ke of 12%:
Po= DPSo (1+g)/ (Ke-g)
     = 9*(1+6%)/ (12%-6%)
     = Rs.159
(ii)At Ke of 15%:
Po= DPSo (1+g)/ (Ke-g)
     = 9*(1+6%)/ (15%-6%)
     = Rs.106
 
(iii)At Ke of 18%:
Po= DPSo (1+g)/ (Ke-g)
     = 9*(1+6%)/ (18%-6%)
     = Rs.79.5

 As the Optimum Dividend Payout Plan suggests, when r is higher than Ke, the company
shall reinvest the earnings into the business to achieve better results. It is reflected in higher
share prices. In the given question, r is 41.79%, which is higher than Ke for all of the three
cases, so when Ke was at its least, i.e., 12% Po under both the options was highest at this
point, i.e., Rs. 159 under Gordon’s Model and Rs. 684.38 under Walter’s Model, and when
Ke was highest, i.e., 18%, Po was at its lowest, i.e., Rs. 79.5 and Rs. 320.83 respectively
under both models.

3. A manufacturing company forecast that it is likely to sell 6,00,000 units for the year
2021. The processing cost of an order is Rs. 150 and the carrying cost per unit of
inventory is Rs. 12. The lead time of an order is 8 days.

a. What would be the economic order quantity (EOQ) and re-order point assuming 300
days in a year. (5 Marks)

Introduction
Economic Order Quantity and Re-order Point calculations are a part of inventory control
management. Inventory controls regulate the inventory levels within the entity to minimize
inventory holding and purchasing costs and maximize the benefit earned through it. The
Chartered Institute of Management Accountants (CIMA) defines Inventory Control as ‘The
function of ensuring that sufficient goods are retained in stock to meet all requirements
without carrying large stocks.”

Concept

Economic Order Quantity is the size of an order towards which the carrying ordering,
carrying, purchasing, and other such costs are least. It can be calculated as:
EOQ= [{2* Annual Requirement (A) *Cost per Order (O)}/Carrying Cost per
unit(C)]1/2

This is a mathematical formula derived in a way that after entering required variables in the
formula, size of a single order that an entity shall place at defined time intervals so that it
incurs least costs and that level of stock is always present so that it has never to forego its
sales opportunities.

Re-order Point is the amount of quantity required for further sales by the entity and is
mentioned on the purchase requisition note as issued by the purchase department. It can be
calculated as:

ROP= Consumption Rate*Lead Time

Consumption Rate is the rate of sales made by each day during a given year. It is calculated
by dividing the Annual Requirement by the number of days during the year; this gives a
rough average of stock required to be sold. 

Lead time refers to the number of days lying between placing order and refilling of stock in
premises of the company, from the point of view of the company it is the period for which it
has to maintain sufficient levels of stocks to sale. 
 
Calculation of EOQ

Details given in the question are as follows:

Annual Requirement Forecast (A) = 600,000 units
Processing Cost per Order (O) = Rs. 150
Carrying Cost per unit(C) = Rs. 12
EOQ = [{2* A *O}/C]1/2
          = [{2* 600,000*150/12]1/2
                = 3873 units
 
Calculation of ROP

Lead Time= 8 days (given in the question)

Days in a Year= 300 (given in the question)
Consumption Rate = Annual Requirement
                                      Days in a Year
 
                                = 600,000  
                                       300
            
                                 = 2000 units
ROP= Consumption Rate*Lead Time
         = 2000 units* 8 days
         = 16,000 units

So, the ROP would be 16,000 units, i.e., the stock requirement of 8 days of lead time not to
lose any potential sales opportunity in these days.
 
 
b. The company implements business process reengineering which results in to
reduction of 20% in cost of an order, 10% in carrying cost per unit of inventory and
25% in lead time of an order. What would be the new EOQ and re-order point. (5
Marks)

Introduction

Business Process Reengineering (BPR) is the process of implementing new business

processes to make larger fundamental changes in the organization to attain business
objectives and goals in a dynamic business environment.

Concept

BPR results from one of the key top management decisions where the prime focus is on
broader business goals and not on profit and revenue enhancement. Top management
undertakes this strategy when after industry analysis, a need for radical change arises for
being more competitive or standing out in the industry and creating a revamped image. 

Michael Martin Hammer, a management author, defines Business Process Reengineering as

“the fundamental rethinking and radical redesign of business processes to achieve dramatic
improvements in contemporary critical measures of performance, such as cost, quality,
service, and speed.” Based on this definition, four important pillars of BPR are,

Ø Fundamental rethinking, which puts a question mark on the business's very basic
understanding that why a stringent pattern of operations is followed.
Ø Radical redesign focuses on being innovative as per the changing environment and
reinventing the existing procedures.
Ø Dramatic improvements focus on making big and impactful changes rather than minor
alterations so that a visible impact on financial figures and ratios can also be seen.
Ø Business processes emphasize that entire processes shall be looked upon and not only the
problem areas.

The said manufacturing company has implemented a business process reengineering strategy
because of which the following reductions have been made:
Processing Cost per Order (O) = 20%
New Processing Cost per Order (O) = Rs. 120
Carrying Cost per unit(C) = 10%
New Carrying Cost per unit(C) = Rs. 10.8
Lead Time= 25%
New Lead Time= 6 days
Annual Requirement Forecast (A) = 600,000 units (same as before)
Consumption Rate= 2000 units (same as before)
 
Calculation of EOQ

EOQ = [{2* A *O}/C]1/2

          = [{2* 600,000*120/10.8]1/2
                = 3651 units
 

Calculation of ROP

ROP= Consumption Rate*Lead Time

         = 2000 units* 6 days
         = 12,000 units

Applying the principles of Mr. Hammer, elements that are cost and speed can be seen to have
been improved for this manufacturing company. Cost of processing and carrying has got
reduced by 20% and 10 %, respectively, and lead time has reduced by two days, which has
ultimately reduced the EOQ by 221 units and the level of ROP by 4,000; attainment of the
above reductions is an outcome of BPR.