CHAPTER 4: LEVERAGE

MEANING OF LEVERAGE
✓ The term leverage is derived from the word lever. It means influence of one force over another.
✓ It refers to increased means of accomplishing a task. It can be understood as disproportionate change
in one financial variable due to change in other financial variable.
✓ In financial analysis, it represents the influence of one financial variable over some other related
financial variable.
✓ It is a tool to measure the efficiency and effective utilization of fixed cost in generating the return. It
measures the risk associated with operating fixed cost and financial fixed cost.
✓ It means sensitiveness of one financial variable to change in another. The measure of this
sensitiveness is expressed as a ratio and is called degree of leverage.
✓ Algebraically it can be defined as:

% change in one variable (Dependent Variable)

Leverage =
% change in some other variable (Independent Variable)

✓ To understand the concept of leverage, it is imperative to understand the three measures of leverage
which are as follows:
a) Operating Leverage (OL)
b) Financial Leverage (FL)
c) Combined Leverage (CL)

OPERATING LEVERAGE
✓ It is a tool of measuring Business Risk/Operating risk. [Business Risk: - It refers to the risk associated
with the firm’s operations. It can be defined as the variability of EBIT. Its degree does not differ with
the use of different forms of financing.]
✓ It is defined as the “firm’s ability to use fixed operating costs to magnify effects of changes in sales on
its earnings before interest and taxes (EBIT).”
✓ The effect of change in sales on the level of EBIT is measured by operating leverage. Operating
leverage occurs when a firm has fixed costs which must be met regardless of volume of sales.
Therefore, operating leverage exists if firm has operating fixed costs.
✓ When the firm has fixed costs, the percentage change in operating profits is greater than the
percentage change in sales.
✓ Measurement :

% change in EBIT Contribution

OL/DOL = Or, OL/DOL =
% change in Sales EBIT

✓ The significance of operating leverage may be interpreted as follows:

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 a) If sales changes, operating profit will be changed but % change in operating profit will be more
than the % change in sales.
b) If operating leverage is 1.5 times, it means that 1% change in sales would result in 1.5% change in
EBIT.
c) When there is no fixed cost, the operating leverage will be equal to 1.
d) When fixed cost increases, the operating leverage also goes up, i.e. risk goes up and in this case,
the change in contribution will result into high change in EBIT.
Example:

Particulars Situation 1 Situation 2 Situation 3 Situation 4 Situation 5

Sales 50000 50000 50000 50000 50000
Variable cost 40000 40000 40000 40000 40000
Contribution 10000 10000 10000 10000 10000
Fixed cost 5000 6000 7000 8000 9000
EBIT 5000 4000 3000 2000 1000
Op. Leverage 2 times 2.5 times 3.33 times 5 times 10 times

FINANCIAL LEVERAGE
✓ It is a tool of measuring financial Risk. [Financial Risk: It refers to the additional risk (over and above
the firms basic business risk) placed on equity shareholders as a result of using debt and preference
share capital in capital structure. It can be defined as the variability of EBT. Its degree differs with the
use of different forms of financing.
✓ The financial leverage occurs when a firm’s capital structure contains obligation of fixed financial
charges e.g. interest on debentures, dividend on preference shares etc. along with owner’s equity to
enhance earnings of equity shareholders. The fixed financial charges do not vary with the operating
profits or EBIT. They are fixed and are to be paid irrespective of level of operating profits or EBIT.
✓ It is the relationship between operating profit (EBIT) and profit after fixed financial costs.
✓ The effect of change in EBIT on the level of EBT is measured by financial leverage. Financial leverage
occurs when a firm has fixed financial costs which must be met irrespective of amount of EBIT
available to pay them. Therefore, financial leverage exists if firm has financial fixed costs.
✓ When the firm has fixed financial costs, the percentage change in earnings per share is greater than
the percentage change in EBIT.
✓ Measurement :

% change in EPS EBIT

FL/DFL = Or , FL/DFL =
% change in EBIT EBT

✓ When preference share capital is used in capital structure, the firm has to pay fixed amount of
preference dividend but it is paid out of post-tax profits. Hence, while calculating financial leverage,
the fixed preference dividend is required to be converted into equivalent pretax amount. [Earnings
before tax (EBT) applicable for preference dividends are excluded while calculating financial leverage
because financial leverage is used to measure the sensitivity of returns to equity shareholders.].

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 Therefore, when the firm uses preference share capital in its capital structure, the formula for
financial leverage will be calculated as under:

EBIT EBIT EBIT

FL/DFL = Or, FL/DFL = Or, FL/DFL =
EBT (For Equity) Pref. Div. EAT (For Equity)
EBT –
(1-Tax rate) (1-Tax rate)

✓ The significance of financial leverage may be interpreted as follows:

a) When there is no financial fixed cost (No interest and Preference dividend), financial leverage is
equal to 1. That means a firm is completely financed from equity (called all equity firm/Unlevered
firm).
b) If EBIT changes, EPS will also change but % change in EPS (or Equity share holders return) will be
more than the % change in EBIT.
c) If financial leverage is 2.5 times, it means that 1% change in EBIT would result 2.5% change in
EPS.
d) When fixed financial cost increases, the financial leverage also goes up, i.e. risk goes up and in
this case, the change in EBIT will result into high change in EBT (for equity).
e) If financial leverage is high, it means that fixed financial costs are high. It implies that financial
risks are higher. In such a case, the firm is justified in using fixed cost funds, only when it is able to
earn at a rate higher than what it pays towards debt and preference share capital.

COMBINED LEVERAGE
✓ It is a tool of measuring total risk. (Business risk + financial risk).
✓ It is defined as “the ability of a firm to use overall fixed costs to magnify the effects of changes in
sales, on the firm’s earnings per share”.
✓ It is the relationship between sales and EPS
✓ It is the product of Operating Leverage and Financial Leverage.
✓ Measurement:

% change in EPS Contribution

CL/DCL = Or, CL/DCL = Or, CL/DCL = OL x FL
% change in Sales EBT (for equity)

✓ The significance of operating leverage may be interpreted as follows:

a) Higher the combined leverage, higher the overall risk to the firm.
b) It measures the impact of change in sales on EPS. If combined leverage is 3 times, it implies that
1% change in sales will lead to 3% change in EPS. Hence, if sales increases by 30%, EPS increases
by 30% x 3 = 90%. On the other side, if sales decreases by 15%, EPS falls by 15% x 3 = 45%.

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FINANCIAL LEVERAGE AS ‘TRADING ON EQUITY’
✓ Trading on equity means maximizing return of equity shareholders by using debt and preference
share capital raised at a rate lower than the rate of return on investment.
✓ That is, fixed costs funds are raised mainly on the basis of equity capital. Those who provide fixed cost
funds, have a limited share in the firm‘s earning and hence want to be protected in terms of earnings
and values represented by equity capital. Since fixed charges do not vary with firms earnings before
interest and tax, a magnified effect is produced on earning per share.
✓ The basic aim of financial leverage is to increase the earnings available to equity shareholders using
fixed cost fund. A firm is known to have a favourable financial leverage when its earnings are more
than the cost of debt and preference share capital.
✓ If ROI (after tax) is more than after tax cost of debt( Kd ) and cost of preference share capital (Kp),
financial leverage is said to be favourable.
✓ The proportionate benefit to equity shareholders due to use of fixed cost fund can be explained as:
ROE = ROI + Proportionate saving due to use of debt + Proportionate saving due to use of PSC
Or,
Debt PSC
ROE = ROI (1-t) + [ROI (1-t) - ( Kd ,net of tax)] x + [ROI (1-t) - ( KP )] x
Equity Equity

Proportionate saving due to use of debt Proportionate saving due to use of PSC
Where,
ROI = Return on Investment = EBIT/ Capital employed
ROE = Return on Equity = Earnings available to Equity share holders/Equity shareholders fund
Kd = cost of debt [ Interest rate (1-tax rate)
KP = cost of preference share = preference dividend / preference share capital

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PROBLEMS:
Question No-1:
A company produces and sells 10,000 shirts. The selling price per shirt is Rs 500. Variable cost is Rs 200
per shirt and fixed operating cost is Rs 25 lakhs.
(a) Calculate operating leverage
(b) If sales up by 10%, then what is the impact on EBIT?
Solution:
Income Statement
Particulars Amount (Rs)
Sales (10,000x500) 50,00,000
Less: Variable cost (50,000 x200) 20,00,000
Contribution 30,00,000
Less: Operating fixed Cost 25,00,000
Operating Profit (EBIT) 500,000

a) Operating Leverage (OL) = Contribution / EBIT = 30, 00,000/500,000 = 6 times.

b) If sales up by 10%, then EBIT will increase by 10% x 6 times = 60%. Hence New EBIT will be Rs
800,000. (500,000 x(1.6)

Question No-2:
Calculate the operating leverage for each of the four firms A, B, C and D from the following price and cost
data.
Firms
A B C D
Rs Rs Rs Rs
Sale price per unit 20 32 50 70
Variable cost per unit 6 16 20 50
Fixed operating cost 80,000 40,000 200,000 Nil

What conclusions can you draw with respect to levels of fixed cost and the degree of operating leverage
result? Explain. Assume number of units sold is 5000
Solution:
Income Statement and Operating Leverage
A B C D
Particulars Amount(Rs) Amount (Rs) Amount (Rs) Amount (Rs)
Sales 100,000 160,000 250,000 350,000
Less: Variable cost 30,000 80,000 100,000 250,000
(50,000 x200)
Contribution 70,000 80,000 150,000 100,000
Less: Operating fixed Cost 80,000 40,000 200,000 -
Operating Profit (EBIT) (10,000) 40,000 (50,000) 100,000
Operating Leverage= 7 Times 2 Times 3 Times 1 Times
Contribution/EBIT

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Conclusions:
1) Leverage is double edged sword. Hence Operating leverage result in negative term does not affect its
interpretation.
2) If there is no fixed cost, there is no operating leverage. In such a case change in sales will have equal
changes in EBIT

Question No-3:
A firm's details are as under:
Sales @ Rs 100 per unit Rs 24, 00,000
Variable cost 50%
Fixed Cost Rs 10, 00,000

It has borrowed Rs 10,00,000 @ 10% p.a. and its equity share capital is Rs 10,00,000 (Rs 100 each).
Assume tax rate is 50%.
Calculate:
1. Operating, financial and combined leverage.
2. Return on equity
3. If the sales increases by Rs 6, 00,000 what will be the new EBIT?
Solution:
Income Statement
Particulars Amount (Rs)
Sales 24,00,000
Less: Variable cost 12,00,000
Contribution 12,00,000
Less: Operating fixed Cost 10,00,000
Operating Profit (EBIT) 200,000
Less: interest on loan 100,000
EBT 100,000
Less: Tax 50,000
EAT 50,000
Operating Leverage= Contribution/EBIT 6 Times
Financial Leverage= EBIT/EBT 2 Times
Combined Leverage= OL x FL 12 Times
ROE = EAE/ Equity Fund (50,000/10,00,000) 5%
If Sales increases by 600,000, % increase in sales is 600,000/24, 00,000 = 25%.
If Sales increases by 25%, EBIT will increase by 25% x 6 times = 150%.
Hence new EBIT = 200,000 +200,000x1.5=500,000

Question No-4:
Betatronics Ltd. has the following balance sheet and income statement information:
Balance Sheet as on March 31st
Liabilities Rs Assets Rs
Equity Capital (Rs 10 per share) 800,000 Net Fixed Assets 10, 00,000
10% Debt 600,000 Current Assets 900,000

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Retained Earnings 350,000
Current Liabilities 150,000 --
19, 00,000 19, 00,000

Income Statement for the year ending March 31st

Sales RS 340,000
Operating expenses including Rs 60,000 depreciation 120,000
EBIT 220,000
Less: Interest 60,000
EBT 160,000
Less: Taxes 56,000
EAT 104,000
Required:
(a) Determine the degree of operating, financial and combined leverage at the current sales level, if all
operating expenses, other than depreciation, are variable nature.
(b) If total assets remain at the same level, but sales (i) increases by 20% and (ii) decrease by 20%, what
will be the EPS at the new sales level?
Solution:
Income Statement and leverages
Particulars Amount (Rs)
Sales 340,000
Less: Variable cost 60,000
Contribution 280,000
Less: Operating fixed Cost 60,000
Operating Profit (EBIT) 220,000
Less: interest on loan 60,000
EBT 160,000
Less: Tax 56,000
EAT 104,000
Divide by no of shares 80,000
EPS 1.3
Operating Leverage= Contribution/EBIT 1.27 Times
Financial Leverage= EBIT/EBT 1.375 Times
Combined Leverage= OL x FL 1.75 Times
ROE = EAE/ Equity Fund (50,000/10,00,000) 5%
If Sales increases by 20%, EPS will increase by 20% x 1.75 times = 35%.
Hence new EPS = 1.3 +1.3x 0.35 = Rs 1.755 per share
Similarly, If Sales decreases by 20%, EPS will decrease by 20% x 1.75 times = 35%.
Hence new EPS = 1.3 - 1.3x 0.35 = Rs 0.845 per share

Question No-5: (CAP-II, june-14, 8 Marks)

Calculate the operating, financial and combined leverage from the following data under situation I and
situation II and financial plan A and B

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Installed Capacity 4000 units
Actual production and sales 75% of the Capacity
Selling Price Rs 30 per unit
Variable cost Rs 15 per unit
Fixed Cost:
Under situation –I Rs 15,000
Under situation –II Rs 20,000

Capital Structure: Financial Plan

A B
Equity 10,000 15,000
Debt (Rate of Interest at 20%) 10,000 5,000
20,000 20,000
Solution:
Income Statement and Operating Leverage
Situation -I Situation -II
Financial Plan Financial Plan
A B A B
Particulars Amount(Rs) Amount (Rs) Amount (Rs) Amount (Rs)
Sales 90,000 90,000 90,000 90,000
Less: Variable cost 45,000 45,000 45,000 45,000
Contribution 45,000 45,000 45,000 45,000
Less: Operating fixed Cost 15,000 15,000 20,000 20,000
Operating Profit (EBIT) 30,000 30,000 25,000 25,000
Less: Interest 2,000 1,000 2,000 1,000
EBT 28,000 29,000 23,000 24,000
Operating Leverage= 1.5 Times 1.5 Times 1.8 Times 1.8 Times
Contribution/EBIT
Financial Leverage= 1.07imes 1.03 Times 1.09imes 1.04imes
EBIT/EBT
Combined Leverage= OL x 1.61 Times 1.55 Times 1.96 Times 1.87 Times
FL

Question No-6:
Consider the following information for strong Ltd:
EBIT Rs 1120 Lakhs
EBT 320 Lakhs
Fixed Cost 700 Lakhs
Calculate the percentage of change in EPS if sales increased by 5%.
Solution:
1) Relationship between sales and EPS is measured by combined leverage.

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 2) Since fixed cost is 700 Lakhs and EBIT is 1120 Lakhs. Contribution can be obtained as EBIT + Fixed
Cost = 700 + 1120 = 1820 Lakhs.
3) Combined Leverage will be Contribution/ EBT = 1820/320 = 5.6875 times.
4) If Sales increases by 5%, then EPS will increase by 5% x 5.6875 = 28.4375%.

Question No-7:
The following data is available for XYZ Ltd:
Sales Rs 200,000
Less Variable Costs@25% 50,000
Contribution 150,000
Less: Fixed Cost 100,000
EBIT 50,000
Less: Interest 10,000
Earnings before Tax (EBT) 40,000
Required:
1. By using OL, by what percentage will EBIT increase if there is 10% increase in sales
2. By using FL, by what percentage will the taxable income increase if EBIT increases by 6% and
3. Using the concept of leverage, by what percentage will the taxable income increase if the sales
increase by 8%? Also verify the results in view of the above figures.
Solution:
Leverages and effects
Operating Leverage= Contribution/EBIT 3 Times
Financial Leverage= EBIT/EBT 1.25 Times
Combined Leverage= OL x FL 3.75 Times
If Sales increases by 10%,EBIT will increase by 10 x 3 times 30%
If EBIT increases by 6%, EBT will increase by 6% x 1.25 times = 7.5%.
If Sales increases by 8%, EBT will increase by 8% x 3.75 times = 30%.

Question No-8:
The following is the income statement of XYZ Ltd. for the year 2003:
Sales Rs50,00,000
Less Variable Costs@20% 10,00,000
Contribution 40,00,000
Less: Fixed Cost 20,00,000
EBIT 20,00,000
Less: Interest 500,000
Earnings Before Tax (EBT) 15,00,000
Less: Tax @ 40% 600,000
Earnings after Tax 900,000
Less: Preference Dividend 100,000
Earning for equity share holders 800,000

The co. has 4 lakhs equity shares issued to the shareholders. Find out the degree of
1. Operating Leverage
2. Financial Leverage
3. Combined Leverage
What would be the EPS if sales level increases by 10%? And, the EPS if the sales level decreases by 20%?
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Solution:
Leverages and effects
Operating Leverage= Contribution/EBIT 2 Times
Financial Leverage= EBIT/{EBT –PD/(1-t)} 1.5 Times
Combined Leverage= OL x FL 3 Times
If Sales increases by 10%,EPS will increase by 10 x 3 times =30%
If Sales decreases by 20%, EPS will decrease by 20% x 3 times = 60%.

Corporate Dividend Tax (CDT):

✓ It is also known dividend distribution Tax. When a company pay dividend (preference dividend and
equity dividend), it is required to pay certain percentage of dividend as dividend distribution tax to
Government.
✓ For the company, the total committed payment will be dividend plus dividend tax. While calculating
financial leverage, the dividend tax on preference dividend should be added to preference dividend:

Question No-9:
A firm has an EBIT of Rs 200,000. The interest liability is Rs 30,000. It has issued 10% preference shares of
Rs 300,000 and 10,000 equity shares of Rs 100 each. The tax rate to the firm is 40% and corporate
dividend tax is 20%. What would be the EPS if EBIT of the firm increase by 20%?
Solution:
Income Statement
Particulars Amount (Rs)
Operating Profit (EBIT) 200,000
Less: interest 30,000
EBT 170,000
Less: Tax @40% 68,000
EAT 102,000
Less: Preference dividend including CDT (30,000 + 6,000) 36,000
EAE 66,000
Divide by number of equity shares 10,000
EPS 6.6
Financial Leverage EBIT/{EBT –PD including CDT/(1-t)} 1.82 times

The relation between EBIT and EPS is measured by Financial Leverage. Therefore, if EBIT increase by 20%,
EPS will increase by 20% x 1.82 times = 36.4%

Question No-10: (IMP)

The following data relate to two companies A Ltd. and B Ltd.
A Ltd. B Ltd.
Equity Share Capital (in Rs 10 shares) 500,000 250,000
9% Debentures ----- 250,000
EBIT 100,000 100,000
Return on Capital Employed 20% 20%
The equity shareholders of A Ltd. find to their dismay that in spite of same return earned by their
company on the total capital employed, their earnings per share is much less as compared to B Ltd.
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You are required to state for the satisfaction of the shareholders of A Ltd. the reasons for such lower
earnings per share on their capital. Assume the tax rate is 50%.
Solution:
Income Statement and leverages
Particulars A Ltd. (Rs) BLtd. (Rs)
Operating Profit (EBIT) 100,000 100,000
Less: interest on loan - 22,500
EBT 100,000 77,500
Less: Tax 50,000 38,750
EAT 50,000 38,750
Divide by no of shares 50,000 25,000
EPS Rs 1 Rs 1.55
Reasons for lower earnings per share of A Ltd:
1) B Ltd uses debt in its capital structure which is relatively cheaper source of finance as
well as interest on debt saves taxes.
2) Return provided to debt holders is lower than the return generated by B Ltd from using
debt funds.
3) Hence benefit of lower cost debt (i.e. effect of financial leverage) goes to the equity
share holders of B Ltd. Therefore, EPS of B Ltd is higher than A Ltd.

Question No-11:
The details of L& T construction Ltd. for the year ended 31-03-2010 is furnished.
Operating Leverage 3:1
Financial Leverage 2:1
Interest charges per annum Rs 20 Lakhs
Corporate Tax Rate 50%
Variable cost as percentage of sales 60%
Prepare the income statement of the company.
Solution:
Income Statement
Particulars Amount (Rs in lakhs)
Sales (Step-5) = 120/0.4 300
Less: Variable cost (balance) 180
Contribution(Step-4) 120
Less: Operating fixed Cost(Step-3) 80
Operating Profit (EBIT) (Step-2) 40
Less: interest on loan (Step-1) 20
EBT 20
Less: Tax 10
EAT 10
Workings:
1) Financial Leverage= EBIT/EBT =EBIT/ (EBIT – Interest)
Or, 2 = EBIT/ EBIT – 20
Hence EBIT = 40
2) Operating Leverage= Contribution/EBIT =(EBIT + FC)/EBIT
Or, 3 = (40 + FC)/40. Hence, FC = 80

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Question No-12:
Delta Ltd. currently has an equity share capital of Rs 10 lakhs consisting of 1 lakhs equity share of Rs 10
each. The company is going through a major expansion plan requiring to raise funds to the tune of Rs 6
lakhs. To finance the expansion the management has following plans:
Plan I: issue 60,000 equity shares of Rs 10 each
Plan II: issue 40,000 equity shares of Rs 10 each and the balance through long-term borrowing at 12%
interest p.a.
Plan III: issue 30,000 equity shares of Rs 10 each and 3000 9% debentures of Rs 100 each
Plan IV: issue 30,000 equity shares of Rs 10 each and the balance through 6% preference shares

The EBIT of the company is expected to be Rs 400,000 p.a. Assume corporate tax rate is 40%
(i) Calculate EPS in each of the above plans
(ii) Ascertain the degree of financial leverage in each plan
Solution:
Income Statement and Operating Leverage
Particulars Plan I(Rs) Plan II(Rs) Plan III(Rs) Plan IV(Rs)
No equity shares:
Existing E Shares 100,000 100,000 100,000 100,000
New E. Shares 60,000 40,000 30,000 30,000
Preference Share capital - - - 300,000 (6%)
Loan - 200,000(12%) 300,000 (9%)
Operating Profit (EBIT) 400,000 400,000 400,000 400,000
Less: interest - 24,000 27,000 -
EBT 400,000 376,000 373,000 400,000
Less: tax 160,000 150,400 149,200 160,000
EAT 240,000 225,600 223,800 240,000
Less: Pref. dividend - - - 18,000
EAE 240,000 225,600 223,800 222,000
Divide by No of shares 160,000 140,000 130,000 130,000
EPS Rs 1.5 Rs 1.61 Rs 1.72 Rs 1.7
Financial Leverage= 1 Times 1.064 1.072 1.081
EBIT/EBT for equity Times Times Times

Question No-13: (CAP-II, Dec-10, 2.5+1.5+1=5 Marks)

Weather Coats Paints Ltd. has fixed operating costs of Rs. 36 million a year. Variable operating costs are
180 per half liter of paint produced, and the average selling price is Rs. 200 per half liter.
You are required to answer the following questions with computations to support each one of your
answer
1) What is the annual operating break-even point in half liters (QBE) and in rupees of sales (SBE)?
2) What would be the effect on the operating break-even point (QBE) of a simultaneous decline to Rs.
170 per half liter in the variable operating costs and an increment of 20% in the fixed cost?
3) Compute the degree of operating leverage (DOL) at the current sales level of 2 million half liters.

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Solution:
Income Statement
Particulars Amount
Selling price per half liter Rs 200
Less: Variable cost per half liter Rs 180
Contribution per half liter Rs 20
Operating fixed Cost 36 Million
Operating BEP in half liters (FC/Contribution per half liter) 1.8 Million half liters
BEP in amount (BEP half liters x selling price per half liter) 360 Million
Effect of change:
Selling price per half liter Rs 200
Less: Variable cost per half liter Rs 170
Contribution per half liter Rs 30
Operating fixed Cost 43.2 Million
Operating BEP in half liters (FC/Contribution per half liter) 1.44 Million half liters
BEP in amount (BEP half liters x selling price per half liter) 288 Million
Operating Leverage= Contribution/EBIT = 40M/4M 10 Times
(contribution = 2 x 20 = 40 M and EBIT = 40 -36 = 4M)

Question No-14: (CAP-II, Dec-17, 5 Marks)

The net sales of A Ltd. are Rs 30 Crores. Earnings before interest and tax of the company as a
percentage of net sales are 12%. The capital e employed comprises Rs 10 Crores of equity, Rs 2 Crores
of 13% Cumulative preference share capital and 15% debentures of Rs 6 Crores. Income tax rate is 40%.
Calculate the Return on equity for the company and indicate its segments due to presence of
Preference Share Capital and Borrowing (debentures)
Solution:
Statement showing calculation of Return on Equity [ROE]
Particulars Amount (Rs in crores)
Sales 30
Operating Profit (EBIT) [12% of Sales] 3.6
Less: interest on loan[15% on NRs 6 Crore] 0.9
EBT 2.7
Less: Tax 1.08
EAT 1.62
Less: Preference Dividend 0.26
Earning for Equity Holders 1.36
Return on Equity ( 1.36/10) 13.6%
Capital Employed = Equity Share Capital + Preference Share Capital + Debt = 10+2+6 = Rs.18 Crore
Post Tax Return on Investment = [EBIT× (1-Tax)/Capital Employed] = [3.6× (1-0.4)/18] = 12%
Segment Decomposition of ROE may be analyzed as below:
ROE = Post Tax ROI + [Post Tax ROI- Cost of Preference Share] × [Preference Share/Equity] + [Post Tax
ROI- Post Tax Cost of Debt] × [Debt/Equity]
= 12% + [12%-13%] × [2/10] + [12%-9%] × [6/10] =12% -0.20% + 1.8%% =13.60%
The negative 0.2% and Positive 1.8% is the segment of ROE caused by presence of Preference Share
Capital and Debenture in the Capital Structure.
Post Tax Cost of Debt = Coupon Rate× [1-Tax Rate] = 15%× [1-0.40] =9%

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Question No-15: (CAP-II, june-13, 5 Marks)
Kathmandu Medical Hospital is planning to introduce a new CT scan machine which costs Rs. 16 million.
Expected annual revenue of the machine is projected to be Rs. 18 million. Variable cost is 60% of sales
and fixed costs are Rs. 2 million. The firm is planning to finance the fund requirement by bank loan of Rs.
5 million @ 12%, by issue of debenture of Rs. 5 million @ 8% and remaining by equity shares which will
be issued at Rs. 10 (par) per share. The tax rate to the firm is 25%.
Required:
Calculate operating leverage, financial leverage and combined leverage.

Question No: 16 (CAP-II, June-12, 4 Marks)

The following details of XYZ Ltd. for the year ended on Ashadh end, 2068 are given below:
Fixed cost (excluding interest) : Rs. 204 thousand
Sales : Rs. 3,000 thousand
12% Debentures of Rs. 100 each: Rs. 2,125 thousand
Equity shares capital of Rs. 100 each: Rs. 1,700 thousand
Income-tax rate : 30%
Operating leverage : 1.4
Combined leverage : 2.8
Calculated the P/V ratio and Earning per share (EPS).

Question No: 17 (CAP-II, July-15, 4 Marks)

The annual sales of a company are Rs. 6,000,000. Sales to variable cost ratio are 150 percent and fixed
cost other than interest is Rs. 500,000 per annum. The company has 11% Debentures of Rs. 3,000,000.
Required:
Calculate the operating, financial and combined leverage of the company.

Question No- 18:

PGSS produces and sells a single product. The company has issued share capital of 8,000 equity shares
of NRs. 100 each. For the year ended 16th July 2014, the company sold 60,000 units of product at a
price of NRs. 30 each.
The income statement for the year to 16th July 2014 is as follows:
NRs.’ 000’
Sales 1,800
Variable costs 720
Fixed costs 360
Net profit before interest and tax 720
Interest payable 190
Net profit before tax 530
Tax@ 35% 186
Net profit after Tax 344

The company has decided to introduce a new automated production process, in order to improve
efficiency. The new process will increase annual fixed costs by NRs. 120,000 (including depreciation) but
will reduce variable costs by NRs. 7 per unit.

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There will be no increase in annual sales volume. The new production process will be financed by the
issue of NRs. 2,000,000 debentures @ 12.5%.
Required:
a) Calculate the change in earnings per share if the company introduces the new production process.
b) Assume that the company introduces the new production process immediately on 17th July 2014.
Calculate for the year to 16th July 2015:
(i) The degree of operating gearing
(ii) The degree of financial gearing
(iii) The combined gearing effect
Solution Hint:
a) Existing earnings per share = Rs 43
b) Earnings per share with new production process:
NRs.’ 000
Sales 1,800
Variable costs (60,000 x NRs. 5) 300
Fixed costs (360+120) 480
Net profit before interest and tax 1,020
Interest payable {190+ (12.5% x NRs. 2 440
Million)
Net profit before tax 580
Tax@ 35% 203
Net profit after Tax 377
EPS 47.13

There is increase in EPS by NRs. 4.13

(i) The degree of operating gearing = 1.47 times
(ii) The degree of operating gearing = 1.76 times
(iii) The combined gearing effect = 1.47 x 1.76 = 2.59 times

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