FINANCIAL MANAGEMENT Solutions to Numerical Problems

Rajiv Srivastava - Dr. Anil Misra Chapter 17

17-1: Operating Leverage

Beta Limited and Theta Limited operate in the same line of business of manufacture of
rubber components. However their cost structures and financing structures differ
substantially. An analysis of their financial performance has revealed following data:
Rs Lacs Beta Ltd Theta Ltd
Sales 750 1,100
Variable Cost 300 500
Fixed Cost 250 200
Operating Profit, EBIT 200 400
Interest 75 80
Profit Before Tax 125 320

Find out a) Degree of Operating Leverage, b) Degree of Financial Leverage for both.
What is your interpretation of DOL and DFL?

Solution:
a) Degree of Operating Leverage
Operating leverage provides the sensitivity of the EBIT with respect to change in
sales.
Higher the operating leverage greater is the proportion of fixed cost.

Rs Lacs Beta Ltd Theta Ltd

Sales 750 1,100
Variable Cost 300 500
Contribution 450 600
Fixed Cost 250 200
Operating Profit, EBIT 200 400
DOL* 2.25 1.50
*Degree of Operating Leverage, DOL = Contribution/(Contribution - Fixed Cost)
= Contribution/EBIT
The change in EBIT for Beta Ltd would be 2.25% and for Theta Ltd 1.50% for 1%
change in sales.
This is verified below:

Rs Lacs Increase Increase

Beta Ltd 10% Theta Ltd 10%
Sales 750 825 1,100 1,210
Variable Cost 300 330 500 550
Contribution 450 495 600 660
Fixed Cost 250 250 200 200
Operating Profit, EBIT 200 245 400 460
% change in EBIT 22.50% 15.00%
DOL 2.25 1.50
% change as computed from DOL 22.50% 15.00%

With greater proportion of fixed cost the change in EBIT would be larger.
Beta Ltd. is more sensitive to changing level of sales and is therefore more risky.
In good times it would outperform Theta Ltd. but in bad times it would be worse.

Page 1 of 9
FINANCIAL MANAGEMENT Solutions to Numerical Problems
Rajiv Srivastava - Dr. Anil Misra Chapter 17

b) Degree of Financial Leverage (DFL)

Rs Lacs Beta Ltd Theta Ltd

EBIT 200 400
Interest 75 80
Profit Before Tax 125 320
DFL** 1.60 1.25

**Degree of Financial Leverage, DFL = EBIT/(EBIT - Interest)

Financial leverage provides the sensitivity of the EBT with respect to change in EBIT.

Higher the financial leverage greater is the proportion of fixed interest cost.
With greater proportion of interest the change in EBT would be larger.
Beta Ltd. is more sensitive to changing level of EBIT and is therefore more risky.
In good times it would outperform Theta Ltd. but in bad times it would be worse.

17-2: Applying Leverages

Following information is extracted from the financial statements of Rana Auto Components
Ltd.
Rs Lacs
Fixed Cost 500
EBIT 1,000
Profit Before Tax, PBT 800

Find out the change in PBT for 3% change in sales.

Solution:
The change in earnings before tax can be computed from the degree of operating
leverage and degree of financial leverage.

EBIT = Contribution - Fixed cost,

Contribution = EBIT + Fixed cost = 1000 + 500
= Rs 1,500 lacs
Therefore DOL = Contribution/EBIT = 1500/1000
= 1.50
DFL = EBIT/PBT = 1000/800
= 1.25

Degree of Total Leverage = DOL x DFL = 1.5 x 1.25

= 1.875

% change in sales = 3.00%

% change in the PBT for a given change in sales = DTL x % change in sales
= 1.875 x 3.00%
= 5.625%

Page 2 of 9
FINANCIAL MANAGEMENT Solutions to Numerical Problems
Rajiv Srivastava - Dr. Anil Misra Chapter 17

17-3: Choosing Alternative Technologies and Operating Leverage

Sheetal Auto Components is considering to manufacture sheet metal components with a
capacity of 1200 lac units. The project cost is estimated to be Rs 100 crore.
There are three technologies A, B and C available to them from three different plant
manufacturers that offer similar quality but with different degrees of automation. While the
overall cost of manufacture remains same for all the technologies the composition of cost is
different and is as follows:
Technology A B C
Variable Cost (Rs/pc) 10 9 8
Fixed Cost (Rs lacs) 1,000 2,000 3,000

The selling price estimated by the management is Rs 15 per pc while projecting a sales of 10
crore pcs annually.
Being a new project the management also believes that the sales may face a decline by as
much as 50%. Do you think that selection of technology would have a role to play in
mitigating the risk of losing sales? What would you do in the circumstances?

Solution:
Cost of Project Rs 10,000 lacs
Capacity (Nos. of pcs/annum) 1,200 lacs
Production & sales (Nos./annum) 1,000 lacs

Technology A B C
Variable Cost (Rs/pc) 10 9 8
Fixed Cost (Rs lacs) 1,000 2,000 3,000
Nos. lacs Rs/pc A B C
Sales 1,000 15 15,000 15,000 15,000
Variable Cost 1,000 10,000 9,000 8,000
Contribution 5,000 6,000 7,000
Fixed Cost 1,000 2,000 3,000
Operating Profit 4,000 4,000 4,000
Degree of Operating Leverage 1.25 1.50 1.75
=Contribution/(Contribution - Fixed Cost)
% change in Operating Profit with 50%
decline -62.50% -75.00% -87.50%

Selection of technology is dependent upon the ability of management to assume

the amount of risk.
For the same level of profit the management must consider the technology that
has least variability of operating profit with changing level of sales. It must opt for
Technology A since it has least degree of operating leverage. A 50% decline in
sales would result in 62.5% decline in profit. The revised levels of operating profit for
the three technologies are worked out below:

Nos. lacs Rs/pc A B C

Sales 500 15 7,500 7,500 7,500
Variable Cost 500 5,000 4,500 4,000
Contribution 2,500 3,000 3,500
Fixed Cost 1,000 2,000 3,000
Operating Profit 1,500 1,000 500
% change in Operating Profit -62.50% -75.00% -87.50%

Page 3 of 9
FINANCIAL MANAGEMENT Solutions to Numerical Problems
Rajiv Srivastava - Dr. Anil Misra Chapter 17

17-4: Capital Structure and DFL

With the EBIT level of Rs 40 crore Sheetal Auto components has a choice of three alternative
capital structure. The project cost of Rs 100 crore can be funded by debts of 25%, 40% and
60% at cost of 10%, 11% and 12%.

Financing Plan I II III

Debt, Rs crore 2,500 4,000 6,000
Interest Rate, % 12% 14% 16%

Find out degree of financial leverage for the three alternative capital structures.

Solution:
Financing Plan I II III
EBIT 4,000 4,000 4,000
Interest 300 560 960
EBT 3,700 3,440 3,040
DFL 1.08 1.16 1.32

DFL implies that with 1% change in EBIT level the profit would change by 1.08%,
1.16% and 1.32% respectively for the 25%, 40% and 60% debt.

Page 4 of 9
FINANCIAL MANAGEMENT Solutions to Numerical Problems
Rajiv Srivastava - Dr. Anil Misra Chapter 17

17-5: EBIT-EPS Analysis and maximisation of Stock Price

Rotomac Corporation is an all equity firm with current EPS of Rs 3.25. It share is trading at Rs 42
with 50 lacs shares outstanding. The firm has an expansion plan of Rs 12 crore that would
provide an additional EBIT of Rs 1.80 crore.
For the first time it is contemplating funding the expansion through debt with the amount of
debt being the debatable issue. The bankers have offered following schedule of interest to
the firm:
Up to Rs 100 lacs 8.00%
Between Rs 100 lacs and Rs 500 lacs 10.00%
Between Rs 500 lacs and Rs 1000 lacs 12.00%
Based on the above the firm is considering availing debt at levels of Rs 1, 3, 5 and 7 crore
with balance to be mobilised by issue of shares. Depending upon the debt level the price at
which it can place equity in the market would vary. An estimate of the likely price with
different levels of debt is as under:
Level of debt (Rs Lacs) 100 300 500 700
Price of new shares (Rs) 42 42 38 36
The level of debt affects the stock valuation and it is expected that for four different levels of
debt the PE multiple would be 14 up to debt of Rs 3 crore and would decline to 13 and 12
respectively for debts of 5Rs 5 crore and 7 crore.,
Consistent with the objective of maximising the price of the share which of the financing
option would you prefer?

Solution:
Rs Lacs Total cost of expansion 1,200
Financing Options I II III IV
Equity 1,100 900 700 500
Debt 100 300 500 700
Cost of debt 8 28 48 72
Stock price (Rs) 42.00 42.00 38.00 36.00
New shares (nos. lacs) 26.19 21.43 18.42 13.89
Existing EPS (Rs) 3.25 3.25 3.25 3.25
Existing shares (nos. lacs) 50.00 50.00 50.00 50.00
Evaluation of financing options Rs Lacs
Additional EBIT 190.00 190.00 190.00 190.00
Interest 8.00 28.00 48.00 72.00
EBT 182.00 162.00 142.00 118.00
Taxes 36% 65.52 58.32 51.12 42.48
Additional Earnings 116.48 103.68 90.88 75.52
Existing Earnings 162.50 162.50 162.50 162.50
Total Earnings 278.98 266.18 253.38 238.02
Total Nos. of shares (lacs) 76.19 71.43 68.42 63.89
New EPS (Rs) 3.66 3.73 3.70 3.73
Leading PE multiple, times 14.00 14.00 13.00 12.00
Expected Price (Rs) 51.26 52.17 48.14 44.71

It is evident from the above data that the stock price would be maximised if debt
level is Rs 3 crore. The firm must finance the project with Rs 3 crore of debt and
mobilise Rs 9 crore by issue of fresh shares at Rs 42.

Page 5 of 9
FINANCIAL MANAGEMENT Solutions to Numerical Problems
Rajiv Srivastava - Dr. Anil Misra Chapter 17

17-6: Indifferent Level of EBIT

ABC Ltd. needs Rs 500 lacs for an expansion plan that is expected to yield 15% return on
assets. Currently its return on asset is 12% and the firm is all equity funded. For expansion it has
alternatives of funding the entire expenditure either through debt or equity. Following
information is available:
Nos. of shares already existing 20 lacs
Price at which the shares can be issued (Rs) Rs 50
Existing interest Rs 30 lacs
Interest rate on debt 10%
Tax rate 40%
Find out the new EPS with equity and debt financing.
Also find at what level of earnings the firm is indifferent to mode of financing.

Solution:
Current value of assets = Current value of equity Rs 1,000 lacs
Return on existing assets 12% Rs 120 lacs
Assets on expansion plan Rs 500 lacs
Expected return on new assets 15% Rs 75 lacs
New level of return on assets Rs 195 lacs

Interest and Nos. of shares under financing plans Lacs

Financing Plan Equity Debt
Nos. of shares to be issued 10
Existing shares 20 20
Total shares 30 20
Rs Lacs
Existing interest 30 30
Additional interest 0 50
Total Interest 30 80

Evaluation of financing plans Rs Lacs

Financing Plan Equity Debt
New level of EBIT 195 195
Interest 30 80
EBT 165 115
Tax 40% 66 46
EAT 99 69
Nos. of shares, lacs 30 20
EPS Rs 3.30 Rs 3.45

The level of EBIT at which the firm is indifferent to financing alternatives is given by

(EBIT * - I1)(1- T) (EBIT * - I 2 )(1- T)

=
N1 N2

(N2 - N1) EBIT* = I1 x N2 - I2 x N1

(30 - 20) EBIT* = 30 x 80 - 20 x 30
or EBIT* = Rs 180 lacs

Page 6 of 9
FINANCIAL MANAGEMENT Solutions to Numerical Problems
Rajiv Srivastava - Dr. Anil Misra Chapter 17

17-7: EBIT-EPS Analysis and Capital Structure

Modi Networks Limited is a major player in the computer hardware components industry.
Select financial data of the firm is presented below:

Capital Structure Rs crore Profit & Loss Rs crore

Sales 200.00
Equity 60.00 Cost 170.00
Reserves 60.00 EBIT 30.00
Debentures 10% 40.00 Interest 4.00
Total 160.00 PBT 26.00
Taxes 30% 7.80
Nos of shares, crore 6.00 PAT 18.20

The stock price of the firm is currently traded at PE ratio of 15.

They are considering expansion plan costing Rs 80 crore with an EBIT of 14%. The decline in
EBIT would be due to reduced sale price of product in order to increase the volume.
They have two financing plans in mind - to raise the required fund by issue of debenture at
12% or by raising equity at about discount of Rs 5 to the current price level.
i) With the expansion the sales would rise to a minimum of Rs 250 crore and can go as high
as Rs 350 crore. Examine the EPS of the firm at sales levels of Rs 250 crore, 300 crore and 350
crore under two alternatives of funding the expansion by debt and equity. Also draw a
graph of EBIT and EPS.
ii) What would be recommended mode of financing if the management believes that sale
of a) Rs 325 crore b) 225 crore can be achieved
iii) What is the level of EBIT where the firm is indifferent to mode of financing?
iv) Find the value of the shares at three different level of sales assuming PE ratio of 12 when
financed through debt and 16 when financed through equity?

Solution:
The current value of the share with the PE ratio of 15 is worked out as below:
Profit after taxes Rs 18.20 crore
Nos. of shares 6.00 crore
EPS Rs 3.03
PE ratio 15.00
Price per share Rs 45.50

Expansion New EBIT level = 14% of sales

Amount to be raised = Rs 80.00 crore

Equity Plan Debt Plan

Price of new Share Rs 40.00 Cost of new debt 12%
Nos. of new shares, crore 2.00 PE ratio revised 15.00
PE ratio 16.00

Page 7 of 9
FINANCIAL MANAGEMENT Solutions to Numerical Problems
Rajiv Srivastava - Dr. Anil Misra Chapter 17

i) EBIT EPS analysis for three levels of operation is as below:

EBIT - EPS Analysis

Rs crore Debt Plan Equity Plan
Sales 250.00 300.00 350.00 250.00 300.00 350.00
EBIT 35.00 42.00 49.00 35.00 42.00 49.00
Interest
Existing Debt 4.00 4.00 4.00 4.00 4.00 4.00
New Debt 9.60 9.60 9.60 0.00 0.00 0.00
Total Interest 13.60 13.60 13.60 4.00 4.00 4.00
EBT 21.40 28.40 35.40 31.00 38.00 45.00
Taxes 30% 6.42 8.52 10.62 9.30 11.40 13.50
PAT 14.98 19.88 24.78 21.70 26.60 31.50
Nos of Shares
Existing 6.00 6.00 6.00 6.00 6.00 6.00
New Shares 2.00 2.00 2.00
Total Shares 6.00 6.00 6.00 8.00 8.00 8.00
EPS, Rs 2.50 3.31 4.13 2.71 3.33 3.94
PE Ratio 15.00 15.00 15.00 16.00 16.00 16.00
Price of share Rs 37.45 Rs 49.70 Rs 61.95 Rs 43.40 Rs 53.20 Rs 63.00

DEBT EQUITY
EBIT - EPS Analysis
4.50

4.00

3.50
EPS Rs.

3.00

2.50

2.00
35.00 42.00 EBIT Rs. crore 49.00

ii) At sales of Rs 325 crore debt financing is preferable as it gives larger EPS while for
sales level of Rs 225 crore equity financing is preferred giving larger EPS.

Page 8 of 9
FINANCIAL MANAGEMENT Solutions to Numerical Problems
Rajiv Srivastava - Dr. Anil Misra Chapter 17

iii) The level of EBIT at which firm is indifferent to mode of financing is worked out as
below:
Nos. of shares, crore Interest, Rs Crore
Debt Plan 6.00 13.60
Equity Plan 8.00 4.00
For the two financing plans 1 and 2 the common level of EBIT* that makes EPS
equal is given by
(EBIT * - I1)(1- T) (EBIT * - I 2 )(1- T)
=
N1 N2
(N2 - N1) EBIT* = I1 x N2 - I2 x N1
(8 - 6) EBIT* = 8 x 13.6 - 6 x 4
or EBIT* = Rs 42.40 crore

iv) Market value of share at three levels and with two modes of financing are:

Rs crore Debt Plan Equity Plan

EBIT 35.00 42.00 49.00 35.00 42.00 49.00
PAT 14.98 19.88 24.78 21.70 26.60 31.50
Nos of Shares, crore
Existing 6.00 6.00 6.00 6.00 6.00 6.00
New Shares 2.00 2.00 2.00
Total Shares 6.00 6.00 6.00 8.00 8.00 8.00
EPS, Rs 2.50 3.31 4.13 2.71 3.33 3.94
PE Ratio 15.00 15.00 15.00 16.00 16.00 16.00
Price of share Rs 37.45 Rs 49.70 Rs 61.95 Rs 43.40 Rs 53.20 Rs 63.00

Page 9 of 9