OPERATING AND FINANCIAL RISK – PROBLEM SET
1. What is the degree of financial leverage of an unlevered firm with EBIT of Rs. 50 crores, and tax rate
of 30%?
2. What is the EPS of a company which makes a profit after tax of Rs. 10 crores, and has 1 crore shares
of face value of Rs. 10 each outstanding?
3. What is the degree of operating leverage of a firm which has annual sales of Rs. 150 crores, variable
costs of Rs. 50 crores, and fixed costs of Rs. 50 crores?
4. Consider two firms A and B, both having the same sales and the same positive operating profit
margin (OPM = EBIT/ Sales). 50% of firm A’s total costs are variable and the remaining costs are
fixed. In firm B, 25% of total costs are variable and the remaining costs are fixed. Which firm has a
higher degree of operating leverage?
5. Firm B has sales of Rs. 100 crores, contribution margin of 40%, operating profit margin (OPM =
EBIT/ Sales) of 20%, and suffers tax at 30% of PBT. It has debt of Rs. 100 crores at an interest rate
of 10% per year. It has issued 7 crore equity shares. When sales of this firm increase by 1%, by what
percentage will its EPS change and in which direction?
6. The profit and loss summary of a firm along with certain other details is given below.
Rs Crore
Sales 400.0
Variable Costs 200.0
Fixed Costs 100.0
EBIT 100.0
Interest 25.0
PBT 75.0
Taxes @30% 22.5
PAT 52.5
Number of equity shares (crore) 20
Face value of shares (Rs) 10
Debt 250
The firm is undertaking a new project involving capital expenditure of Rs. 50 crores. It is considering
two options for raising the funds required for the new project:
(i) Issue of equity shares @ Rs. 10 per share
(ii) Raising debt @ 10% p.a.
a. What is the EBIT at which the EPS of the firm would be the same under both options?
b. What does this indifference point signify?
7. Details pertaining to Firm A are given below:
Rs Crore
Sales 40.0
Variable Costs 20.0
Fixed Costs 10.0
EBIT 10.0
Interest 2.5
PBT 7.5
Taxes @20% 1.5
PAT 6.0
Number of equity shares (crore) 2
Face value of shares (Rs) 10
Debt 25
The firm now plans to expand its operations. The expansion requires an investment of Rs. 10 crore
and is expected to result in an increase in annual sales by Rs. 10 crore. Also, the expanded operations
would require additional fixed costs of Rs. 1 crore per year.
For financing the expansion, the firm is considering three alternatives: (1) Issue of Rs. 3 crore of debt;
(2) Issue of Rs. 6 crore of debt; (3) Issue of Rs. 10 crore of debt. In each case, the balance funding
would be by way of equity. The firm expects that the interest rate on new loans up to Rs. 5 crores
would be 10% p.a. while the interest rate on new loans to the extent that they are in excess of Rs. 5
crores would be 12% p.a. Fresh issues of equity shares are expected to be priced at Rs. 20 per share.
Determine the EPS for the firm based on each of the three financing alternatives.
8. The profit and loss summary of a company along with certain other details is given below.
Rs Crore
Sales 600.0
Variable costs 400.0
Fixed costs 100.0
EBIT 100.0
Interest @ 10% p.a 20.0
PBT 80.0
Taxes @30% 24.0
PAT 56.0
Debt 200.0
Number of equity shares (crore) 10
Face value of shares (Rs) 10
The company is in the fast-moving consumer goods (FMCG) business. It now plans an expansion
involving capital expenditure of Rs. 100 crores. After expansion, the company expects an increase in
sales by Rs. 200 crores. Fixed costs would increase by Rs. 20 crores due to the expansion.
The company is considering two options for raising the funds required for the new project:
(i) Issue of equity shares @ Rs. 10 per share.
(ii) Raising debt @ 10% p.a.
a. What would its degree of financial leverage be post-expansion if it chooses Option (i) above?
What would its degree of financial leverage be if it chooses Option (ii) above?
b. What is the EBIT at which the EPS of the firm would be the same under both options?
c. What would the EPS be at the level of EBIT arrived at above? Assume a tax rate of 30%.
d. Which of the two financing options do you recommend? Why?
