COMBINED LEVERAGE

DEGREE OF COMBINED LEVERAGE can be calculated by multiplying the two leverages,

that is, DOL and DFL
DCL = DOL x DFL
𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝐸𝐵𝐼𝑇 𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝐸𝑃𝑆
DCL = 𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑠𝑎𝑙𝑒𝑠 𝑣𝑜𝑙𝑢𝑚𝑒 X 𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝐸𝐵𝐼𝑇

𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝐸𝑃𝑆

DCL = 𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑠𝑎𝑙𝑒𝑠 𝑣𝑜𝑙𝑢𝑚𝑒

Alternatively,
DCL = DOL x DFL
𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛 𝐸𝐵𝐼𝑇
DCL = X 𝐷𝑝
𝐸𝐵𝐼𝑇 𝐸𝐵𝐼𝑇−𝐼−[ ]
1−𝑡

𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛
= 𝐷𝑝
𝐸𝐵𝐼𝑇−𝐼−[ ]
1−𝑡

𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛
= 𝐷𝑝
𝐸𝐵𝑇 −[ ]
1−𝑡

Q1. Calculate the Degree of operating Leverage (DOL), Degree of Financial Leverage (DFL)
and the Degree of Combined Leverage (DCL) for the following firms and interpret the results
Firm B Firm Q Firm R
Output (units) 3,00,000 75,000 5,00,000
Fixed Cost (₹) 3,50,000 7,00,000 75,000
Unit Variable Cost 1.00 7.50 0.10
(₹)
Interest expenses 25,000 40,000 Nil
Unit Selling Price 3.00 25.00 0.50
(₹)

Q2. MMC Company currently has an equity share capital of ₹ 40 lakh, consisting of 40,000
equity shares of ₹ 100 each. The management is planning to raise an additional ₹ 30 lakh to
finance a major programme of expansion through one of four possible financing plans. The
options are:
(i) Entirely through equity issues
(ii) ₹ 15 lakh in equity shares of ₹ 100 each and the balance in 8% debentures
(iii) ₹ 10 lakh in equity shares of ₹ 100 each and the balance through long term
borrowings at 9% interest per annum.
(iv) ₹ 15 lakh in equity shares of ₹ 100 each and the balance through preference shares
with 5% dividend
The company’s expected Earnings before Interest and Taxes (EBIT) will be ₹ 15 lakh.
Assuming a corporate tax rate of 50 per cent, you are required to determine the Earnings Per
Share (EPS) and comment on the financial leverage that will be authorised under each of the
above schemes of financing:

INDIFFERENCE POINT
The indifference point for two alternative methods of financing, is that level of EBIT at
which the EPS is the same for both methods of financing irrespective of the debt-equity
combination.
Mathematically, assuming two alternatives, (i) equity vs. (ii) equity and debt, the indifference
point can be calculated using the following equation:
EPS1 = EPS2
𝐸𝐵𝐼𝑇 (1−𝑡) (𝐸𝐵𝐼𝑇−𝐼 )(1−𝑡)
=
𝑁1 𝑁2

Where, E= Earnings before Interest and Taxes

I = Interest
T = taxes
N1 = Number of equity shares under the first alternative financing plan
N2 = Number of equity shares under the second alternative financing plan
If the alternatives are (i) equity vs. (ii) equity, debt and preference the indifference point can
be calculated using the following equation:
𝐸 (1−𝑡) (𝐸−𝐼 )(1−𝑡)−𝐷𝑝
=
𝑁1 𝑁2

DP = Preference dividend.

Q3. The Lannister Corporation has two alternative financing plans to consider, the details of
which are given below:
Alternative Financing Plans
Plan A (Amount ₹) Plan B (Amount ₹)
Equity Share capital 2,00,000 1,00,000
(₹ 100 each)
10% Debt capital NIL 1,00,000
2,00,000 2,00,000

Corporate tax = 50%

You are required to determine the indifference point, that is the EBIT level at which the EPS
will be the same for both the alternative financing plans.
Q4. The following information is available on Stark Co. Ltd:
Installed capacity 2,000 units
Actual Production and sales 50% of installed capacity
Selling Price per unit ₹ 20
Variable cost per unit ₹ 10

Fixed Cost: Situation 1: ₹ 4000; Situation 2: ₹ 5000

Capital structure:
FINANCIAL PLAN
A (₹) B (₹)
Equity 5,000 15,000
Debt (cost of debt 10%) 15,000 5,000
Total capital 20,000 20,000

You are required to:

a) Calculate operating leverage under situations 1 and 2
b) Calculate financial leverage using financial plans A and B
c) What are the combinations of operating and financial leverage which give the highest
and least value?
d) How is the information useful to the financial manager of a company?

Q5. ABC Ltd has sales of ₹ 75, 00,000, variable cost of ₹ 42, 00,000 and fixed cost of
₹6,00,000. The present capital structure of ABC is given below:
Equity ₹ 55,00,000
Debt (12%) ₹ 45,00,000
Total ₹ 100,00,000

(i) What is the ROI of ABC Ltd?

(ii) Does ABC have a favourable financial leverage?
(iii) If the industry average of asset turnover is 3, does it have a high or low asset
turnover ratio?
(iv) What are the leverages of ABC Ltd?
(v) If sales drop to ₹ 50,00,000, what will be the new EBIT?