Leverages

Co A Co B
Sales 2500000 3000000
Fixed Costs 750000 1500000
Variable Expenses as a % of
sales 50 25
Particulars Co A Co B
Sales 2500000 3000000
Less: V.C. 1250000 750000
Contribution 1250000 2250000
Less: F.C. 750000 1500000
EBIT 500000 750000
DOL = Cont / EBIT 2.5 3
Problem:
The operating income of a firm is Rs. 1,86,000 and it pays tax
@50% has the following capital structure
14% Debentures Rs. 5,00,000
15% Preference Shares Rs. 1,00,000
Equity Shares
(Rs.100 Each) Rs. 4,00,000
Particulars Amount
EBIT 1,86,000
(-) Interest (0.14 x 500000) 70,000
EBT 1,16,000
(-) Tax @ 50% 58,000
EAT 58,000
(-) Preference Dividend 15,000
Equity Earnings 43,000

EBIT
DFL =
Pref. Div.
EBIT − I −
(1 − Tax)
1,86,00
=
15,000
1,86,000 − 70,000 −
(1 − 0.5)
= 2.1627
The operating data of a firm is:
Sales Rs. 20,00,000
Variable Costs Rs. 14,00,000
Fixed Costs (Including 15%
Interest on Rs. 10,00,000) Rs. 4,00,000

Income statement
Sales 2000000
Less: V.C. 1400000
Contribution 600000
Less: F.C. 250000
EBIT 350000
Less: Interest 150000
EBT 200000
DOL 1.714286
DFL 1.75
DCL 3
 Particulars Company X Company Y
Variable Costs as a % of sales 50 60
Int. Expenses Rs. 20,000 Rs. 6,000
DOL 3 5
DCL 6 15
Income tax rate 30% 30%

Company X

DFL = DCL/DOL = 6/3 = 2

EBIT
DFL = ;
EBIT − I
EBIT
2= ;
EBIT − 20000
2EBIT − 40000 = EBIT;
EBIT = 40000

Contribution Sales − VC
DOL = =
EBIT EBIT

1Sales − 0.5 Sales

3= ;
40000
0.5 Sales = 120000; Sales = 240000
Fixed Costs = Contribution – EBIT
= 1,20,000-40,000 = 80,000
Company Y

DFL = DCL/DOL = 15/5 = 3

EBIT
DFL = ;
EBIT − I
EBIT
3= ;
EBIT − 6000
3EBIT − 18000 = EBIT;
2EBIT = 18000, EBIT = 9000
Contribution Sales − VC
DOL = =
EBIT EBIT

1Sales − 0.6 Sales

5= ;
9000
Fixed Costs = Contribution – EBIT
= 45,000-9,000 = 36,000
Particulars Amount Co X Amount Co Y
Sales 240000 112500
(-) Variable Cost @ 50%,60% 120000 67500
Contribution 120000 45000
(-) Fixed Cost 80000 36000
EBIT 40000 9000
(-) Interest 20000 6000
EBT 20000 3000
(-) Tax @ 30% 6000 900
EAT 14000 2100
1. VST Corporation has a sales of Rs. 50 lakh, variable cost is 60% of sales
and fixed cost of Rs.10,00,000. The firm has raised Rs. 25 lakh funds by
issue of debentures at the rate of 10 percent. Compute the operating,
financial and combined leverages.
2. Explain 'Leverage' and its components. What are the implications of
Leverage?
3. Define Operating Leverage, Financial Leverage and Combined
Leverage.
 4. The capital structure of a company consists of the following securities:

10% Preference Share Capital Rs.1,00,000/-

Equity Share Capital Rs.1,00,000/-

The amount of operating profit is Rs.60,000/-. The company is in 50% tax

bracket. You are required to calculate the financial leverage of the company.
What would be new financial leverage if the operating profit increases to
Rs.90,000/- ?

Particulars Amount
EBIT 60,000 90,000
(-) Interest 0 0
EBT 60,000 90,000
(-) Tax @ 50% 30,000 45,000
EAT 30,000 45,000
Practice Problems
From the following financial date of and company A and company
B:
Prepare their Income statements.
Company A Company B
Rs. Rs.
Variable cost 56,000 60% of sales
Fixed cost 20,000 __
Interest expenses 12,000 9,000
Financial Leverage 5:1 __
Operating Leverage __ 4:1
Income tax rate 30% 30%
Sales __ 1,05,000

Calculate the degree of operating leverage, degree of financial leverage

for following firms and interpret the results:
P Q R
Output (units) 2,50,000 1,25,000 7,50,000
Fixed cost (Rs.) 5,00,000 2,50,000 10,00,000
Unit variable cost (Rs.) 5 2 7.50
Unit selling price (Rs.) 7.50 2 10.0
Interest expense (Rs.) 75,000 25,000 __
EBIT-EPS analysis

Sales
Less: Variable Costs
Contribution
Less: Fixed Costs
EBIT
Less: Interest
EBT
Less: Taxes
EAT
Less: Pref. Dividend
Equity Earnings
EPS = Equity Earnings/ No. of Equity Shares

ISV Ltd. Needs Rs. 5,00,000 for its expansion programme. The company can issue 50,000 equity shares of Rs.
10 per share or can issue 25,000 shares of Rs. 10 per share and 2500 debentures of Rs. 100 per debenture
carrying a coupon rate of 10% or can issue 25,000 shares of Rs. 10 per share and 2500 preference shares of
Rs. 100 per preference share carrying a dividend rate of 10%. What would be the EPS in each of the
alternatives when EBIT is Rs. 1,50,000 and the tax rate is 50%
 Plan 1: 50,000 Equity Shares of Rs. 10 each
Particulars 1 2 3 4 5
EBIT 10000 20000 40000 60000 100000
(-) Interest 0 0 0 0 0
EBT 10000 20000 40000 60000 100000
(-) Tax @ 50% 5000 10000 20000 30000 50000
EAT 5000 10000 20000 30000 50000
(-) Pref. Dividend 0 0 0 0 0
EE/EESH 5000 10000 20000 30000 50000
EPS = EE ÷ N
EPS 0.1 0.2 0.4 0.6 1.0
Plan 2: 25,000 Equity Shares of Rs. 10 each and 2500 Debentures
(8%) of Rs.100 each
Particulars 1 2 3 4 5
EBIT 10000 20000 40000 60000 100000
(-) Interest 20000 20000 20000 20000 20000
EBT -10000 0 20000 40000 80000
(-) Tax @ 50% 0 0 10000 20000 40000
EAT -10000 0 10000 20000 40000
(-) Pref. Dividend 0 0 0 0 0
EE/EESH -10000 0 10000 20000 40000
EPS = EE ÷ N
EPS -0.4 0 0.4 0.8 1.6
Plan 3: 25,000 Equity Shares of Rs. 10 each and 2500 Preference
Shares (8%) of Rs.100 each
Particulars 1 2 3 4 5
EBIT 10000 20000 40000 60000 100000
(-) Interest 0 0 0 0 0
EBT 10000 20000 40000 60000 100000
(-) Tax @ 50% 5000 10000 20000 30000 50000
EAT 5000 10000 20000 30000 50000
(-) Pref. Dividend 20000 20000 20000 20000 20000
EE/EESH -15000 -10000 0 10000 30000
EPS = EE ÷ N
EPS -0.6 -0.4 0 0.4 1.2
Particulars Alternative Alternative Alternative Alternative
1 2 3 4
EBIT 200000 200000 200000 200000
(-) Interest 0 20000 30000 0
EBT 200000 180000 170000 200000
(-) Tax @ 50% 100000 90000 85000 100000
EAT 100000 90000 85000 100000
(-) Pref. 0 0 0 16000
Dividend
EE/EESH 100000 90000 85000 84000
EPS = EE ÷ N
N 5000+3000 5000+1000 5000+0 5000+1000
EPS 12.5 15 17 14
 EBIT - EPS Indifference Point

EPS1 = EPS2

(EBIT ∗ − I1 )(1 − t) − DP1 (EBIT ∗ − I2 )(1 − t) − DP2

=
N1 N2
 Problem 1
A new project under consideration requires a capital
outlay of Rs 600 lakhs for which the funds can either be
raised by the issue of equity shares of Rs 100 each or
by the issue of equity shares of the value of Rs 400 lacs
and by the issue of 15% loan of Rs 200 lacs. Find out the
indifference level of EBIT given the tax rate at 50%.

EPS1 = EPS2
(EBIT ∗ − I1 )(1 − t) − DP1 (EBIT ∗ − I2 )(1 − t) − DP2
=
N1 N2
(EBIT ∗ − 0)(1 − 0.5) − 0
600000
(EBIT ∗ − 3000000)(1 − 0.5) − 0
=
400000
(EBIT ∗ − 0)(0.5) (EBIT ∗ − 3000000)(0.5)
=
6 4
(EBIT ∗ ) (EBIT ∗ − 3000000)
=
3 2
3EBIT* - 9000000 = 2EBIT*
EBIT ∗ = 9000000
 Problem 2
A company has the choice for raising an additional sum
of Rs 20,00,000 either by raising a 10% debt or by issue
of additional equity shares of Rs 100 each at par. The
present capital structure of the company consists of
2,00,000 equity shares of Rs 100 each and no debt. At
what level of earnings before interest and tax (EBIT)
after the new funds are raised, would earnings per
share (EPS) be the same whether new funds are raised
either by raising debt or issue of equity? (Tax rate is
50%)
EPS1 = EPS2
(EBIT ∗ − I1 )(1 − t) − DP1 (EBIT ∗ − I2 )(1 − t) − DP2
=
N1 N2
(EBIT ∗ − 200000)(1 − 0.5) − 0
200000
(EBIT ∗ − 0)(1 − 0.5) − 0
=
220000
(EBIT ∗ − 200000) (EBIT ∗ )
=
10 11
EBIT* = 2200000
 Problem 2 Contd…
Also determine the level of EBIT at which uncommitted
earnings per share (UEPS) would be the same, if sinking
fund obligations amount to Rs. 2,00,000 per year.
Assume a 50% tax rate.

UEPS1 = UEPS2

(EBIT ∗ − I1 )(1 − t) − DP1 − SF1

N1
(EBIT ∗ − I2 )(1 − t) − DP2 − SF2
=
N2

(EBIT ∗ − 200000)(1 − 0.5) − 0 − 200000

200000
(EBIT ∗ − 0)(1 − 0.5) − 0 − 200000
=
220000
EBIT*= 2600000
 Problem on Financial Break-even Point
Particulars Amount(Rs.) Amount(Rs.)
EBIT 9214286
(-) Interest 2500000
EBT 6714286
(-) Tax @30% 2014286
EAT 4700000
(-) Preference Dividend 700000
EE 4000000
(-) Min. Returns for ESH 4000000
Residual Income 0

Financial Break-even Point:

DP − Eq. Benefit
0 = (EBIT − I) −
(1 − t)
700000 − 4000000
0 = (EBIT − 2500000) −
(1 − 0.3)