18 - 18 - 1 1

18 - 18 - 1 1
Operating, Financial
Operating, Financial
And Combined
And Combined
Leverage
Leverage
18 - 18 - 2 2
18 - 18 - 2 2
OPERATI!, FIACIAL A"
CO#$IE" LE%ERA!E
Operating Leverage
Financial Leverage
Combined Leverage & Total Ri'(
18 - 18 - ) )
18 - 18 - ) )
Leverage re*er' to t+e ,'e o* an a''et or 'o,rce
o* *,nd' -+ic+ involve' *i.ed co't' or *i.ed
ret,rn'/ A' a re',lt, t+e earning' available to
t+e '+are+older'0o-ner' are a**ected a' al'o
t+eir ri'(/ T+ere are t+ree t1pe' o* leverage,
namel1,
12 Operating
22 Financial
)2 Combined
18 - 18 - 3 3
18 - 18 - 3 3
Operating Leverage
Operating Leverage
Leverage a''ociated -it+ a''et ac4,i'ition or inve'tment
activitie' i' re*erred to a' t+e operating leverage/ It re*er' to
t+e *irm5' abilit1 to ,'e *i.ed operating co't' to magni*1 t+e
e**ect o* c+ange' in 'ale' on it' operating pro*it' 6E$IT2 and
re',lt' in more t+an a proportionate c+ange 672 in E$IT -it+
c+ange in t+e 'ale' reven,e/
"egree o* operating leverage 6"OL2 i' comp,ted in t-o
-a1'&
12 Percentage c+ange in E$IT0Percentage c+ange in 'ale'
and
22 68ale' 9 %ariable co't'20E$IT/
18 - 18 - : :
18 - 18 - : :
T+e operating leverage i' *avo,rable -+en increa'e
in 'ale' vol,me +a' a po'itive magni*1ing e**ect on
E$IT/ It i' ,n*avo,rable -+en a decrea'e in 'ale'
vol,me +a' a negative magni*1ing e**ect on E$IT/
T+ere*ore, +ig+ "OL i' good -+en 'ale' reven,e'
are ri'ing and bad -+en t+e1 are *alling/
T+e "OL i' a mea',re o* t+e b,'ine''0operating ri'(
o* t+e *irm/ Operating ri'( i' t+e ri'( o* t+e *irm not
being able to cover it' *i.ed operating co't'/ T+e
larger i' t+e magnit,de o* ',c+ co't', t+e larger i'
t+e vol,me o* 'ale' re4,ired to recover t+em/ T+,',
t+e "OL depend' on *i.ed operating co't'/
18 - 18 - ; ;
18 - 18 - ; ;
E.ample 1
A *irm 'ell' prod,ct' *or R' 1<< per ,nit, +a' variable operating co't' o* R' :< per
,nit and *i.ed operating co't' o* R' :<,<<< per 1ear/ 8+o- t+e vario,' level' o* E$IT
t+at -o,ld re',lt *rom 'ale o* 6i2 1,<<< ,nit' 6ii2 2,<<< ,nit' and 6iii2 ),<<< ,nit'/
8ol,tion
I* 'ale' level o* 2,<<< ,nit' are ,'ed a' a ba'e *or compari'on, t+e operating leverage
i' ill,'trated in Table 1
Table 1 E$IT *or %ario,' 8ale' Level'
Ca'e 2
9 :<=
$a'e Ca'e 1
> :<=
1/ 8ale' in ,nit' 1,<<< 2,<<< ),<<<
2/ 8ale' reven,e R' 1,<<,<<< R' 2,<<,<<< R' ),<<,<<<
)/ Le''& %ariable operating co't :<,<<< 1,<<,<<< 1,:<,<<<
3/ Contrib,tion :<,<<< 1,<<,<<< 1,:<,<<<
:/ Le''& Fi.ed operating co't :<,<<< :<,<<< :<,<<<
;/ E$IT ?ero :<,<<< 1,<<,<<<
91<<= >1<<=
18 - 18 - @ @
18 - 18 - @ @
From t+e re',lt' contained in Table 1, certain generali'ation'
*ollo-&
12 Ca'e 1& A :< per cent increa'e in 'ale' 6*rom 2,<<< to ),<<<
,nit'2 re',lt' in a 1<< per cent increa'e in E$IT 6*rom R' :<,<<<
to R' 1,<<,<<<2/
22 Ca'e 2& A :< per cent decrea'e in 'ale' 6*rom 2,<<< to 1,<<<
,nit'2 re',lt' in a 1<< per cent decrea'e in E$IT 6*rom R'
:<,<<< to Aero2/
18 - 18 - 8 8
18 - 18 - 8 8
E.ample 2
A *irm 'ell' it' prod,ct' *or R' :< per ,nit, +a' variable operating co't' o*
R' )< per ,nit and *i.ed operating co't' o* R' :,<<< per 1ear/ It' c,rrent
level o* 'ale' i' )<< ,nit'/ "etermine t+e degree o* operationg leverage/
B+at -ill +appen to E$IT i* 'ale' c+ange& 6a2 ri'e to ):< ,nit', and 6b2
decrea'e to 2:< ,nit'C
8ol,tion& T+e E$IT *or vario,' 'ale' level' i' comp,ted in Table 2/
Table 2& E$IT at %ario,' 8ale' Level'
Ca'e 2
91;/@=
$a'e Ca'e 1
>1;/@=
1/ 8ale' in ,nit' 2:< )<< ):<
2/ 8ale' reven,e R' 12,:<< R' 1:,<<< R' 1@,:<<
)/ Le''& %ariable co't @,:<< D,<<< 1<,:<<
3/ Contrib,tion :,<<< ;,<<< @,<<<
:/ Le''& Fi.ed operating
co't
:,<<< :,<<< :,<<<
;/ E$IT ?ero 1,<<< 2,<<<
9 1<<= > 1<<=
18 - 18 - D D
18 - 18 - D D
Interpretation
In ca'e 2, 1;/@ per cent decrea'e in 'ale' vol,me 6*rom )<< ,nit' to 2:< ,nit'2
lead' to 1<< per cent decline in t+e E$IT 6*rom R' 1,<<< to Aero2/ On t+e ot+er
+and, a 1;/@ per cent increa'e in t+e 'ale' level in ca'e 1 6*rom )<< ,nit' to ):<
,nit'2 re',lt' in 1<< per cent increa'e in E$IT 6*rom R' 1,<<< to R' 2,<<<2/
T+e t-o ill,'tration' 6Table' 1 and 22 clearl1 '+o- t+at -+en a *irm +a' *i.ed
operating co't', an increa'e in 'ale' vol,me re',lt' in a more t+an
proportionate increa'e in E$IT/ 8imilarl1, a decrea'e in t+e level o* 'ale' +a'
an e.actl1 oppo'ite e**ect/ T+i' i' operating leverageE t+e *ormer being
*avo,rable leverage, -+ile t+e latter i' ,n*avo,rable/ Leverage, t+,', -or(' in
bot+ direction'/
18 - 18 - 1< 1<
18 - 18 - 1< 1<
Alternative de*inition o* Operating Leverage
B+en proportionate c+ange in E$IT a' a re',lt o* a given c+ange in 'ale' i'
more t+an t+e proportionate c+ange in 'ale', operating leverage e.i't'/ T+e
greater t+e "OL, t+e +ig+er i' t+e operating leverage/ 81mbolicall1,
2)
level) base (at EBIT
level) base (at on Contributi Total
F V) Q(S
V) Q(S
Q
Q
F - V) - Q(S
V) - Q(S
DOL
costs !i"e# Total F
unit $er cost Variable V
unit $er $rice Sellin% S
units in &uantit' Sales Q
()ere
V) - Q(S EBIT F* V) Q(S EBIT
Q Q
EBIT EBIT
DOL el'* +lternativ
,) ,
sales in c)an%e -ercenta%e
EBIT in c)an%e -ercenta%e
DOL
(
(

>
18 - 18 - 11 11
18 - 18 - 11 11
8ince t+e "OL e.ceed' 1 in bot+ t+e ill,'tration', operating leverage e.i't'/
Fo-ever, t+e degree o* operating leverage i' +ig+er 6) time'2 in t+e ca'e o*
t+e *irm in E.ample 2 a' compared to t+e *irm in E.ample 1, t+e re'pective
4,otient' being ; and 2/ T+e 4,otient' mean t+at *or ever1 1 per cent c+ange
in 'ale', t+ere -ill be ; per cent 6E.ample' 22 and 2 per cent 6E.ample 12
c+ange in E$IT in t+e direction t+e 'ale' c+ange/
2
./*/// 0s
,*//*/// 0s
2) (Case 2
./1
,//1
,)* (Case 2
./1
,//1
DOL
%et* 2e , E"a3$le to 2 an# , E&uations +$$l'in%

+
+

4
,*/// 0s
4*/// 0s
2) (Case 4
,451 -
,//1 -
,)* (Case 4
,451
,//1
DOL
2* E"a3$le in Si3ilarl'*


+
+

18 - 18 - 12 12
18 - 18 - 12 12
Operating leverage e.i't' onl1 -+en t+ere are *i.ed operating co't'/ I* t+ere are no
*i.ed operating co't', t+ere -ill be no operating leverage/ Con'ider E.ample )/
E.ample )
Partic,lar' $a'e Level e- Level
1/ Gnit' 'old 1,<<< 1,1<<
2/ 8ale' price per ,nit R' 1< R' 1<
)/ %ariable co't per ,nit ; ;
3/ Fi.ed operating co't il il
8ol,tion T+e relevant comp,tation' are given in Table )/
TA$LE ) E$IT *or %ario,' 8ale' %ol,me
Partic,lar' $a'e Level e- Level
1/ 8ale' reven,e' R' 1<,<<< R' 11,<<<
2/ Le''& %ariable co't' ;,<<< ;,;<<
)/ Le''& Fi.ed co't' H H
3/ E$IT 3,<<< 3,3<<
Appl1ing E4,ation 1, "OL I 1/ 8ince t+e 4,otient i' 1, t+ere i' no operating
leverage/
18 - 18 - 1) 1)
18 - 18 - 1) 1)
Financial Leverage
Financial Leverage
Financial leverage i' related to t+e *inancing
activitie' o* a *irm/ It re',lt' *rom t+e pre'ence o*
*i.ed *inancial c+arge' 6',c+ a' intere't on debt and
dividend on pre*erence '+are'2/ 8ince ',c+ *inancial
e.pen'e' do not var1 -it+ t+e operating pro*it',
*inancial leverage i' concerned -it+ t+e e**ect o*
c+ange' in E$IT on t+e earning' available to e4,it1-
+older'/ It i' de*ined a' t+e abilit1 o* a *irm to ,'e
*i.ed *inancial c+arge' to magni*1 t+e e**ect o*
c+ange' in E$IT on t+e earning' per '+are 6EP82/
18 - 18 - 13 13
18 - 18 - 13 13
E.ample 3
T+e *inancial manager o* t+e F1pot+etical Ltd e.pect' t+at it' earning' be*ore
intere't and ta.e' 6E$IT2 in t+e c,rrent 1ear -o,ld amo,nt to R' 1<,<<</ T+e *irm
+a' : per cent bond' aggregating R' 3<,<<<, -+ile t+e 1< per cent pre*erence
'+are' amo,nt to R' 2<,<<</ B+at -o,ld be t+e earning' per '+are 6EP82C
A'',ming t+e E$IT being 6i2 R' ;,<<<, and 6ii2 R' 13,<<<, +o- -o,ld t+e EP8 be
a**ectedC T+e *irm can be a'',med to be in t+e ): per cent ta. brac(et/ T+e n,mber
o* o,t'tanding ordinar1 '+are' i' 1,<<</
8ol,tion
TA$LE 3 EP8 *or %ario,' E$IT Level'
Ca'e 2 $a'e Ca'e 1
93<= >3<=
E$IT
Le''& Intere't on bond'
Earning' be*ore ta.e' 6E$T2
Le''& Ta.e' 6):=2
Earning a*ter ta.e' 6EAT2
Le''& Pre*erence dividend
Earning' available *or ordinar1
'+are+older'
Earning' per '+are 6EP82
R' ;,<<<
2,<<<
3,<<<
1,3<<
2,;<<
2,<<<
;<<
</;
R' 1<,<<<
2,<<<
8,<<<
2,8<<
:,2<<
2,<<<
),2<<
)/2
R' 13,<<<
2,<<<
12,<<<
3,2<<
@,8<<
2,<<<
:,8<<
:/8
9 81/2:= >81/2:=
18 - 18 - 1: 1:
18 - 18 - 1: 1:
T+e interpretation o* Table 3 i' a' *ollo-'&
Ca'e 1&
A 3< per cent increa'e in E$IT 6*rom R' 1<,<<< to R' 13,<<<2
re',lt' in 81/2: per cent increa'e in EP8 6*rom R' )/2 to R'
:/82/
Ca'e 2&
A 3< per cent decrea'e in E$IT 6*rom R' 1<,<<< to R' ;,<<<2
lead' to 81/2: per cent decrea'e in EP8 6*rom R' )/2 to Re
</;2/
18 - 18 - 1; 1;
18 - 18 - 1; 1;
E.ample :
A compan1 +a' R' 1,<<,<<<, 1<= debent,re' and :,<<< e4,it1 '+are'
o,t'tanding/ It i' in t+e ): per cent ta.-brac(et/ A'',ming t+ree level' o* E$IT
6i2 R' :<,<<<, 6ii2 R' )<,<<<, and 6iii2 R' @<,<<<, calc,late t+e c+ange in EP8
6ba'e level o* E$IT I R' :<,<<<2/
8ol,tion
TA$LE : EP8 at %ario,' E$IT Level'
Ca'e 2 $a'e Ca'e 1
93<= >3<=
E$IT
Le''& intere't
Earning' be*ore ta.e'
Le''& Ta.e'
Earning a*ter ta.e'
Earning' per '+are 6EP82
R' )<,<<<
1<,<<<
2<,<<<
@,<<<
1),<<<
2/;
R' :<,<<<
1<,<<<
3<,<<<
13,<<<
2;,<<<
:/2
R' @<,<<<
1<,<<<
;<,<<<
21,<<<
)D,<<<
@/8
9 :<= >:<=
T+,', a 3< per cent increa'e in E$IT in ca'e 2 *rom t+e ba'e level o* E$IT +a' led to
:< per cent increa'e in EP8/ And a decrea'e o* 3< per cent in E$IT +a' decrea'ed
t+e EP8 b1 :< per cent/
18 - 18 - 1@ 1@
18 - 18 - 1@ 1@
Alternative "e*inition o* Financial Leverage
T+e proced,re o,tlined above i' merel1 indicative o* t+e pre'ence or
ab'ence o* *inancial leverage/ Financial leverage can be more preci'el1
e.pre''ed in term' o* t+e degree o* *inancial leverage 6"FL2/ T+e "FL can
be calc,lated b1 E4/ 6)2
( ) ( ) [ ]
( ) [ ]( )
( ) [ ] ( )
( ) [ ] ( )
( ) [ ] ( )
( )
( ) [ ]
( ) [ ] ( )
( ) [ ]
( ) [ ] ( )
( )
( )
( )
( ) [ ] ( ) ( )
) 4 (
t , 6 D I EBIT
EBIT
t , 6 D I F V S Q
F V S Q
V S Q
F V S Q
t , 6 D I F V S Q
V S Q
DFL
t , 6 D I F V S Q
V S Q
t , b' r #eno3inato an# nu3erator Divi#in%
D t , I F V S Q
t , V S Q
E-S
E-S
67 t , V S Q E-S
ts* areconstan D an# I F* Since*
7
D t , I F V S Q
7
D t , I EBIT
E-S
EBIT EBIT
E-S E-S
DFL el'* +lternativ
(8) ,
EBIT in c)an%e -ercenta%e
E-S in c)an%e -ercenta%e
DFL
$ -
-
$
-
$
-
$

>
18 - 18 - 18 18
18 - 18 - 18 18
A' a r,le, -+en a percentage c+ange in EP8 re',lting *rom a given percentage
c+ange in E$IT i' greater t+an t+e percentage c+ange in E$IT, *inancial leverage
e.i't'/ In ot+er -ord', *inancial leverage occ,r' -+en t+e 4,otient in E4,ation )
i' more t+an one/
In bot+ t+e e.ample', t+e relevant 4,otient i' larger t+an one/ T+ere*ore, *inancial
leverage e.i't'/ $,t t+e degree o* *inancial leverage i' +ig+er in E.ample 3 62/<)2
t+an in E.ample : 61/2:2/ T+e +ig+er t+e 4,otient o* percentage c+ange in EP8
d,e to percentage c+ange in E$IT, t+e greater i' t+e degree o* *inancial leverage/
T+e 4,otient o* 2/<) implie' t+at 1 per cent c+ange in E$IT -ill ca,'e 2/<) per
cent c+ange in EP8 in t+e 'ame direction 67 increa'e0decrea'e2 in -+ic+ t+e E$IT
c+ange'/ Bit+ 1/2: 4,otient t+e proportionate c+ange in EP8 a' a re',lt o* 1 per
cent c+ange in E$IT -ill be comparativel1 le'', t+at i', 1/2: per cent in eit+er
direction/
( ) [ ]
,2.
,/*/// 0s ./*/// 0s
./*/// 0s
,2.
9/1
./1
2 Case ,2.*
9/1
./1
, Case : . e (ii)E"a3$l
2/8
/8. , 2*///6 0s 0s2*/// ,/*/// 0s
,/*/// 0s
2/8
9/1 -
;,2.
2 Case 2/8*
9/1
;,2.1
, Case : 9 E"a3$le (i)For
.* an# 9 E"a3$les in 2 Case an# , Case to 8 E&uations +$$l'in%

+
+

+
+

18 - 18 - 1D 1D
18 - 18 - 1D 1D
"egree o* *inancial leverage 6"FL2& Appl1ing E4/ 6)2
6i2 Ca'e 1 I 6>3<= 0 > 3<=2 I 1
6ii2 Ca'e 2 I 6-3<= 0 -3<=2 I 1
T+,', t+e 4,otient i' 1/ It' implication i' t+at 1 per cent c+ange in E$IT -ill re',lt in 1
per cent c+ange in EP8, t+at i', proportionate/ T+ere i', t+ere*ore, no magni*ication in
t+e EP8/
T+ere -ill be, +o-ever, no *inancial leverage, i* t+ere i' no *i.ed-c+arged *inancing/
6Table ;2/
TA$LE ; EP8 at %ario,' E$IT Level'
Ca'e 2 $a'e Ca'e 1
9 3<= >3<=
E$IT R' )<,<<< R' :<,<<< R' @<,<<<
Le''& Ta.e' 6</):2 1<,:<< 1@,:<< 23,:<<
Earning' available *or e4,it1-
+older'
1D,:<< )2,:<< 3:,:<<
,mber o* '+are' 1<,<<< 1<,<<< 1<,<<<
EP8 1/D: )/2: 3/::
9 3<= >3<=
18 - 18 - 2< 2<
18 - 18 - 2< 2<
Financial leverage involve' t+e ,'e o* *,nd' obtained at a
*i.ed co't in t+e +ope o* increa'ing t+e ret,rn to t+e e4,it1-
+older'/ B+en a *irm earn' more on t+e a''et' p,rc+a'ed
-it+ t+e *,nd' t+an t+e *i.ed co't o* t+eir ,'e, t+e *inancial
leverage i' *avo,rable/ Gn*avo,rable leverage occ,r' -+en
t+e *irm doe' not earn a' m,c+ a' t+e *,nd' co't/
Fig+ *i.ed *inancial co't' increa'e t+e *inancial leverage
and, t+,', *inancial ri'(/ T+e *inancial ri'( re*er' to t+e ri'(
o* t+e *irm not being able to cover it' *i.ed *inancial co't'/
In ca'e o* de*a,lt, t+e *irm can be tec+nicall1 *orced into
li4,idation/ T+e larger i' t+e amo,nt o* *i.ed *inancial co't',
t+e larger i' E$IT re4,ired to recover t+em/ T+,', t+e "FL
depend' on *i.ed *inancial co't'/
18 - 18 - 21 21
18 - 18 - 21 21
E$IT-EP8 Anal1'i'
To devi'e an appropriate capital 'tr,ct,re, t+e amo,nt o* E$IT ,nder
vario,' *inancing plan' '+o,ld be related to EP8/ T+e E$IT-EP8 anal1'i' i'
a -idel1-,'ed met+od o* e.amining t+e e**ect o* *inancial leverage0,'e o*
debt/ A *inancial alternative t+at en',re' t+e large't EP8 i' pre*erred, given
t+e level o* E$IT/
E.ample ;
8,ppo'e a *irm +a' a capital 'tr,ct,re e.cl,'ivel1 compri'ing o* ordinar1 '+are'
amo,nting to R' 1<,<<,<<</ T+e *irm no- -i'+e' to rai'e additional R' 1<,<<,<<< *or
e.pan'ion/ T+e *irm +a' *o,r alternative *inancial plan'&
6A2 It can rai'e t+e entire amo,nt in t+e *orm o* e4,it1 capital/
6$2 It can rai'e :< per cent a' e4,it1 capital and :< per cent a' := debent,re'/
6C2 It can rai'e t+e entire amo,nt a' ;= debent,re'/
6"2 It can rai'e :< per cent a' e4,it1 capital and :< per cent a' := pre*erence
capital/
F,rt+er a'',me t+at t+e e.i'ting E$IT are R' 1,2<,<<<, t+e ta. rate i' ): per cent,
o,t'tanding ordinar1 '+are' 1<,<<< and t+e mar(et price per '+are i' R' 1<< ,nder all
t+e *o,r alternative'/
B+ic+ *inancing plan '+o,ld t+e *irm 'electC
18 - 18 - 22 22
18 - 18 - 22 22
8ol,tion
TA$LE @ EP8 Gnder %ario,' Financial Plan'
Partic,lar' Financing plan'
A $ C "
E$IT
Le''& Intere't
Earning' be*ore ta.e'
Ta.e'
Earning' a*ter ta.e'
Le''& Pre*erence dividend
Earning' available to
ordinar1 '+are+older'
,mber o* '+are'
Earning' per '+are 6EP82
R' 1,2<,<<<
H
1,2<,<<<
32,<<<
@8,<<<
H
@8,<<<
2<,<<<
)/D
R' 1,2<,<<<
2:,<<<
D:,<<<
)),2:<
;1,@:<
H
;1,@:<
1:,<<<
3/1
R' 1,2<,<<<
;<,<<<
;<,<<<
21,<<<
)D,<<<
H
)D,<<<
1<,<<<
)/D
R' 1,2<,<<<
H
1,2<,<<<
32,<<<
@8,<<<
2:,<<<
:),<<<
1:,<<<
)/:
T+e calc,lation' in Table @ reveal t+at given a level o* E$IT o* R' 1,2<,<<<, t+e *inancing
alternative $, -+ic+ involve' :< per cent ordinar1 '+are' and :< per cent debt, i' t+e
mo't *avo,rable -it+ re'pect to EP8/ Anot+er di'clo',re o* t+e table i' t+at alt+o,g+ t+e
proportion o* ordinar1 '+are' in t+e total capitali'ation ,nder t+e *inancing plan " i' al'o
:< per cent, t+at i', e4,al to plan $, EP8 i' con'iderabl1 di**erent 6lo-e't2/ T+e di**erence
in t+e plan' $ and " i' d,e to t+e *act t+at intere't on debt i' ta.-ded,ctible -+ile t+e
dividend on pre*erence '+are' i' not/ Bit+ ): per cent income ta., t+e e.plicit co't o*
pre*erence '+are' -o,ld be +ig+er t+an t+e co't o* debt/
18 - 18 - 2) 2)
18 - 18 - 2) 2)
Financial $rea(-even Point 6$EP2
Financial brea(-even point 6$EP2 repre'ent' a point at -+ic+ be*ore-ta.
earning' are e4,al to t+e *irm5' *i.ed *inancial obligation'/ 81mbolicall1, it i'
comp,ted a' *ollo-'&
JI > D
p
2061 9 t2K 6:2
In ot+er -ord', at *inancial $EP, EP8 i' Aero/
E4,ation : give' be*ore-ta. earning' nece''ar1 to cover t+e *irm5' *i.ed
*inancial obligation'/
A' *i.ed *inancial c+arge' are added, t+e brea(-even point *or Aero EP8 i'
increa'ed b1 t+e amo,nt o* t+e additional *i.ed co't/ $e1ond t+e *inancial
brea(-even point, increa'e in EP8 i' more t+an t+e proportionate increa'e in
E$IT/ T+i' i' ill,'trated in Table 8, -+ic+ pre'ent' t+e E$IT-EP8 relation'+ip
*or t+e data in E.ample ; ,nder t+e vario,' E$IT a'',mption' given in t+e
bo.&
12 R' 8<,<<< 63 per cent ret,rn on total a''et'2
22 1,<<,<<< 6: per cent ret,rn on total a''et'2
)2 1,)<,<<< 6;/: per cent ret,rn on total a''et'2
32 1,;<,<<< 68 per cent ret,rn on total a''et'2
:2 2,<<,<<< 61< per cent ret,rn on total a''et'2
18 - 18 - 23 23
18 - 18 - 23 23
TA$LE 8 E$IT-EP8 Anal1'i' ,nder %ario,' E$IT A'',mption' *or t+e Fo,r Financing Plan' o*
E.ample ;
6i2 E$IT I R' 8<,<<< 63 per cent ret,rn on inve'tment'2
Partic,lar' Financing Plan'
A $ C "
E$IT
Le''& Intere't
E$T
Le''& Ta.e'
EAT
Le''& Pre*erence dividend
EAT *or e4,it1-+older'
EP8
8<,<<< 8<,<<< 8<,<<< 8<,<<<
H 2:,<<< ;<,<<< H
8<,<<< ::,<<< 2<,<<< 8<,<<<
28,<<< 1D,2:< @,<<< 28,<<<
:2,<<< ):,@:< 1),<<< :2,<<<
H H H 2:,<<<
:2,<<< ):,@:< 1),<<< 2@,<<<
2/; 2/)8 1/) 1/8
6ii2 E$IT I R' 1,<<,<<< 6: per cent ret,rn2
E$IT 1,<<,<<< 1,<<,<<< 1,<<,<<< 1,<<,<<<
Le''& Intere't H 2:,<<< ;<,<<< H
E$T 1,<<,<<< @:,<<< 3<,<<< 1,<<,<<<
Le''& Ta.e' ):,<<< 2;,2:< 13,<<< ):,<<<
EAT ;:,<<< 38,@:< 2;,<<< ;:,<<<
Le''& Pre*erence dividend H H H 2:,<<<
EAT *or e4,it1-+older' ;:,<<< 38,@:< 2;,<<< 3<,<<<
EP8 )/2: )/2: 2/; 2/;@
18 - 18 - 2: 2:
18 - 18 - 2: 2:
6iii2 E$IT I R' 1,)<,<<< 6;/: per cent ret,rn2
E$IT 1,)<,<<< 1,)<,<<< 1,)<,<<< 1,)<,<<<
Le''& Intere't H 2:,<<< ;<,<<< H
E$T 1,)<,<<< 1,<:,<<< @<,<<< 1,)<,<<<
Le''& Ta.e' 3:,:<< );,@:< 23,:<< 3:,:<<
EAT 83,:<< ;8,2:< 3:,:<< 83,:<<
Le''& Pre*erence dividend H H H 2:,<<<
EAT *or e4,it1-+older' 83,:<< ;8,2:< 3:,:<< :D,:<<
EP8 3/22 3/:: 3/:: )/D@
6iv2 E$IT I R' 1,;<,<<< 68 per cent ret,rn2
E$IT 1,;<,<<< 1,;<,<<< 1,;<,<<< 1,;<,<<<
Le''& Intere't H 2:,<<< ;<,<<< H
E$T 1,;<,<<< 1,):,<<< 1,<<,<<< 1,;<,<<<
Le''& Ta.e' :;,<<< 3@,2:< ):,<<< :;,<<<
EAT 1,<3,<<< 8@,@:< ;:,<<< 1,<3,<<<
Le''& Pre*erence dividend H H H 2:,<<<
EAT *or e4,it1-+older' 1,<3,<<< 8@,@:< ;:,<<< @D,<<<
EP8 :/2 :/8 ;/: :/)
Contd.
18 - 18 - 2; 2;
18 - 18 - 2; 2;
6v2 E$IT I R' 2,<<,<<< 61< per cent ret,rn2
E$IT 2,<<,<<< 2,<<,<<< 2,<<,<<< 2,<<,<<<
Le''& Intere't H 2:,<<< ;<,<<< H
E$T 2,<<,<<< 1,@:,<<< 1,3<,<<< 2,<<,<<<
Le''& Ta.e' @<,<<< ;1,2:< 3D,<<< @<,<<<
EAT 1,)<,<<< 1,1),@:< D1,<<< 1,)<,<<<
Le''& Pre*erence dividend H H H 2:,<<<
EAT *or e4,it1-+older' 1,)<,<<< 1,1),@:< D1,<<< 1,<:,<<<
EP8 ;/: @/; D/1 @
It can be 'een *rom Table 8 t+at -+en t+e E$IT level e.ceed' t+e *inancial brea(-even
level 6R' 2:,<<<, R' ;<,<<< and R' )8,3;2 *or *inancing alternative', B, C and D
re'pectivel12 EP8 increa'e'/ T+e percentage increa'e in EP8 i' t+e greate't -+en E$IT i'
neare't t+e brea(-even point/ T+,', in Plan C, an increa'e o* 2: per cent in E$IT 6*rom R'
8<,<<< to R' 1,<<,<<<2 re',lt' in a 1<< per cent increa'e in EP8 6*rom Re 1/) to R' 2/;2,
-+erea' t+e percentage increa'e in EP8 i' onl1 3< per cent 6*rom R' ;/: to R' D/12 a' a
re',lt o* t+e c+ange in E$IT at +ig+er level' *rom R' 1,;<,<<< to R' 2,<<,<<< 6i/e/ 2: per
cent increa'e2/
Contd.
18 - 18 - 2@ 2@
18 - 18 - 2@ 2@
Indi**erence point E$IT level be1ond -+ic+ bene*it' o* *inancial leverage
accr,e -it+ re'pect to EP8/
T+e indi**erence point bet-een t-o met+od' o* *inancing can be obtained
mat+ematicall1 6algebraic approac+2 a' -ell a' grap+icall1/
Algebraic Approac+
#at+ematicall1, t+e indi**erence point can be obtained b1 ,'ing t+e *ollo-ing
'1mbol'&
L I earning' be*ore intere't and ta.e' 6E$IT2 at t+e indi**erence point

1
I n,mber o* e4,it1 '+are' o,t'tanding i* onl1 e4,it1 '+are' are i'',ed

2
I n,mber o* e4,it1 '+are' o,t'tanding i* bot+ debent,re' and e4,it1
'+are' are i'',ed

)
I n,mber o* e4,it1 '+are' o,t'tanding i* bot+ pre*erence and e4,it1
'+are' are i'',ed

3
I n,mber o* e4,it1 '+are' o,t'tanding i* bot+ pre*erence '+are' and
debent,re' are i'',ed
I I t+e amo,nt o* intere't on debent,re'
"
P
I t+e amo,nt o* dividend on pre*erence '+are'
t I corporate income ta. rate
"
t
I ta. on pre*erence dividend
18 - 18 - 28 28
18 - 18 - 28 28
For a e- Compan1
T+e indi**erence point can be determined b1 ,'ing t+e *ollo-ing e4,ation'&
( ) ( ) ( )
( )
( )
( )
( ) ( )
( )
( ) ( )
(;)
7
D t , I <
7
t , <
: Debentures an# s)ares -re!erence versus s)ares ' (iii)E&uit
(5+)
7
Dt , D t , <
7
t , <
: #ivi#en# -re!erence on ta" 2it) s)ares -re!erence versus s)ares E&uit' (ii)(b)
(5)
7
D t , <
7
t , <
: s)ares -re!erence versus s)ares E&uit' (ii)(a)
(4)
7
t , I <
7
t , <
: Debentures versus s)ares (i)E&uit'
9
$
,
8
$
,
8
$
,
2 ,

For an E.i'ting Compan1

I* t+e debent,re' are alread1 o,t'tanding, let ,' a'',me I
1
I intere't paid on
e.i'ting debt, and I
2
I intere't pa1able on additional debt, t+en t+e
indi**erence point -o,ld be determined b1 E4,ation D/
( ) ( ) ( ) ( )
) 9 (
N
t 1 I I X
N
t 1 I X
2
2 1
1
1

18 - 18 - 2D 2D
18 - 18 - 2D 2D
E.ample @
T+e *inancial manager o* a compan1 +a' *orm,lated vario,' *inancial plan'
to *inance R' )<,<<,<<< re4,ired to implement vario,' capital b,dgeting
proMect'&
12 Eit+er e4,it1 capital o* R' )<,<<,<<< or R' 1:,<<,<<< 1<= debent,re'
and R' 1:,<<,<<< e4,it1E
22 Eit+er e4,it1 capital o* R' )<,<<,<<< or 1)= pre*erence '+are' o* R'
1<,<<,<<< and R' 2<,<<,<<< e4,it1E
)2 Eit+er e4,it1 capital o* R' )<,<<,<<< or 1)= pre*erence capital o* R'
1<,<<,<<<, 6',bMect to dividend ta. o* 1< per cent2, R' 1<,<<,<<< 1<=
debent,re' and R' 1<,<<,<<< e4,it1E and
32 Eit+er e4,it1 '+are capital o* R' 2<,<<,<<< and 1<= debent,re' o* R'
1<,<<,<<< or 1)= pre*erence capital o* R' 1<,<<,<<<, 1<= debent,re' o*
R' 8,<<,<<< and R' 12,<<,<<< e4,it1/
No, are re4,ired to determine t+e indi**erence point *or eac+ *inancial plan,
a'',ming ): per cent corporate ta. rate and t+e *ace val,e o* e4,it1 '+are'
a' R' 1<</
18 - 18 - )< )<
18 - 18 - )< )<
8ol,tion
Con*irmation Table
Partic,lar' E4,it1 *inancing E4,it1 > debt *inancing
E$IT R' ),<<,<<< R' ),<<,<<<
Le''& Intere't H 1,:<,<<<
Earning be*ore ta.e' ),<<,<<< 1,:<,<<<
Le''& Ta.e' 1,<:,<<< :2,:<<
Earning' *or e4,it1-+older' 1,D:,<<< D@,:<<
,mber o* e4,it1 '+are' )<,<<< 1:,<<<
EP8 ;/: ;/:
( ) ( ) ( )
( ) ( ) ( )
8*//*/// 0s 6/4. ,*=.*/// 0s <
,*=.*/// 0s - /4.< - Or
,*=.*/// 0s - ,8< /4.< Or
,.*///
=5*.// 0s /4.<
8/*///
/4.<
Or
,.*///
/8. , ,*./*/// 0s <
8/*///
/8. , <
Or
7
t , I <
7
t , <
(i)
2 ,

18 - 18 - )1 )1
18 - 18 - )1 )1
Con*irmation Table
Partic,lar' E4,it1 *inancing E4,it1 > Pre*erence *inancing
E$IT R' ;,<<,<<< R' ;,<<,<<<
Le''& Ta.e' 2,1<,<<< 2,1<,<<<
Earning a*ter ta.e' ),D<,<<< ),D<,<<<
Le''& "ividend' on pre*erence
'+are'
H 1,)<,<<<
Earning' *or e4,it1-+older' ),D<,<<< 2,;<,<<<
,mber o* e4,it1 '+are' )<,<<< 2<,<<<
EP8 1) 1)
( )
( )
( ) ( )
4*//*/// 0s <
2/*///
,*8/*/// 0s /4.<
8/*///
/4.<
Or
2/*///
,*8/*/// 0s /8. ,
8/*///
/8. , <
Or
8
7
$
D I <
,
7
t , <
(ii)

18 - 18 - )2 )2
18 - 18 - )2 )2
Con*irmation Table
Partic,lar' E4,it1
*inancing
E4,it1 > Pre*erence >
"ebent,re' *inancing
E$IT R' 3,8<,<<< R' 3,8<,<<<
Le''& Intere't H 1,<<,<<<
Earning' a*ter intere't 3,8<,<<< ),8<,<<<
Le''& Ta.e' 1,;8,<<< 1,)),<<<
Earning a*ter ta.e' ),12,<<< 2,3@,<<<
Le''& "ividend' incl,ding dividend ta.
on pre*erence '+are' H 1,3),<<<
Earning' available *or e4,it1 +older' ),12,<<< 1,<3,<<<
,mber o* e4,it1 '+are' )<,<<< 1<,<<<
EP8 18/3 18/3
( )
( ) ( )
( ) ( ) ( ) ( )
000 , 80 , 4 Rs X
000 , 10
000 , 43 , 1 Rs 000 , 65 Rs X 65 . 0
000 , 30
X 65 . 0
Or
000 , 10
1 . 0 1 1,30,000 Rs 35 . 0 1 000 , 00 , 1 Rs X
000 , 30
35 . 0 1 X
Or
N
Dt 1 D I X
N
t 1 X
) iii (
4
p
1

18 - 18 - )) ))
18 - 18 - )) ))
Con*irmation Table
Partic,lar' E4,it1
*inancing
E4,it1 > "ebt >
Pre*erence *inancing
E$IT R' :,:<,<<< R' :,:<,<<<
Le''& Intere't 1,<<,<<< 8<,<<<
Earning' be*ore ta.e' 3,:<,<<< 3,@<,<<<
Le''& Ta.e' 1,:@,:<< 1,;3,:<<
Earning a*ter ta.e' 2,D2,:<< ),<:,:<<
Le''& "ividend' on pre*erence
'+are'
H 1,)<,<<<
Earning' *or e4,it1-+older' 2,D2,:<< 1,@:,:<<
,mber o* e4,it1 '+are' 2<,<<< 12,<<<
EP8 13/;2: 13/;2:
( ) ( )
( ) ( )
( ) ( ) ( ) ( )
000 , 50 , 5 Rs X
000 , 12
000 , 30 , 1 35 . 0 1 000 , 80 X
000 , 20
35 . 0 1 000 , 00 , 1 Rs X
Or
N
D t 1 I X
N
t 1 1 X
) iv (
4
p
2

18 - 18 - )3 )3
18 - 18 - )3 )3
!rap+ic Approac+
!rap+ic Approac+
T+e indi**erence point can al'o be determined
grap+icall1/ In order to grap+ t+e *inancial plan, t-o
'et' o* E$IT-EP8 coordinate' are re4,ired *or eac+
*inancial plan/ T+e point at -+ic+ t+e t-o line'
inter'ect i' t+e IP/
18 - 18 - ): ):
18 - 18 - ): ):
In order to grap+ t+e *inancial plan, t-o 'et' o* E$IT-EP8 coordinate' are
re4,ired/ T+e EP8 val,e' a''ociated -it+ E$IT val,e' o* R' 2,<<,<<< and R'
;,<<,<<< are calc,lated and plotted on t+e grap+ paper ,nder eac+ *inancial
plan in ca'e o* Fig,re 1/ It ma1 noted t+at 1<< per cent e4,it1 *inancing plan
'tart' *rom origin 6O2 beca,'e EP8 -o,ld be Aero i* E$IT i' Aero/
Fo-ever, E$IT re4,ired to +ave t+e val,e o* t+e EP8 a' Aero i' R' 1,:<,<<<,
t+at i', t+e intere't c+arge' pa1able on 1<= debent,re' o* R' 1:,<<,<<</
T+ere*ore, t+e 'tarting point o* :< per cent e4,it1 *inancing plan i' a-a1 *rom
t+e point o* t+e origin 6i/e/ it 'tart' *rom R' 1/: la(+2/ T+e point at -+ic+ t+e
t-o line' inter'ect i' t+e indi**erence point 6IP2/ B+en -e dra- a
perpendic,lar to t+e L-a.i' *rom t+e point o* inter'ection, -e +ave E$IT
re4,ired *or t+e IP/ A line dra-n *rom t+e point o* inter'ection and Moined
-it+ t+e N-a.i' determine' t+e EP8 at t+e indi**erence point o* E$IT/
An important point to be remembered in relation to t+e dra-ing o* )) per cent
pre*erence '+are *inancial plan 6Fig/ 22, i' t+at EP8 -o,ld not be Aero i* t+e
*irm5' E$IT i' R' 1,)<,<<<, beca,'e dividend pa1able on pre*erence '+are i'
not ta.-ded,ctible/ T+e *irm m,'t earn 'o m,c+ more t+an R' 1,)<,<<< t+at it
i' le*t -it+ R' 1,)<,<<< a*ter pa1ing ta.e'/ T+i' amo,nt can be calc,lated
dividing R' 1,)<,<<< b1 61 9 t2/ T+e re4,ired amo,nt i' R' 2,<<,<<< JR'
1,)<,<<<2 O 61 9 </):2K/ T+,', t+e 'tarting point o* pre*erence '+are *inancial
plan -o,ld be R' 2 la(+/
18 - 18 - ); );
18 - 18 - ); );
< 1 2 ) 3 : ; @
;/:
1)
1D/:
E$IT 6R' in la(+'2
Fig,re 1& E$IT-EP8 Anal1'i'
"ebt Advantage
"ebt > E4,it1
Alternative
E4,it1 Alternative
Indi**erence Point
E4,it1
Advantage
E
P
8

6
R
'
2
18 - 18 - )@ )@
18 - 18 - )@ )@
T+e indi**erence point' o* Fig'/ 1 and 2 corre'pond to -+at -e +ave determined
t+ro,g+ t+e algebraic approac+/ $,t t+e ,tilit1 o* t+e E$IT-EP8 c+art lie' in it'
being more in*ormative regarding t+e E$IT-EP8 relation'+ip/ It give' a bird5' e1e
vie- o* EP8 at vario,' level' o* E$IT/ T+e EP8 val,e at t+e e'timated level o*
E$IT can be promptl1 a'certained/ #oreover, it more ea'il1 e.plain' -+1 an
e4,it1 *inancing plan i' better t+an ot+er plan' re4,iring debent,re and0or
pre*erence '+are' *or t+e E$IT level belo- t+e IP/
For in'tance, Fig/ 2 indicate' t+at *or all E$IT level' belo- R' ; la(+, t+e EP8
,nder e4,it1 alternative i' greater t+an )) per cent pre*erence '+are *inancing
plan and *or all E$IT level' above R' ; la(+, t+e EP8 i' greater ,nder )) per cent
*inancing plan t+an 1<< per cent e4,it1 *inancing/ T+e IP can be compared -it+
t+e mo't li(el1 level o* E$IT/ I* t+e li(el1 level o* E$IT i' more t+an t+e IP, t+e ,'e
o* *i.ed co't *inancing plan ma1 be recommended, ot+er-i'e e4,it1 plan -o,ld
be more ',itable/
To ',m ,p, t+e greater t+e li(el1 level o* E$IT t+an t+e indi**erence point, t+e
'tronger i' t+e ca'e *or ,'ing levered *inancial plan' to ma.imi'e t+e EP8/
Conver'el1, t+e lo-er t+e li(el1 level o* E$IT in relation to t+e indi**erence point,
t+e more ,'e*,l t+e ,nlevered *inancial plan -o,ld be *rom t+e vie- point o* EP8/
In ot+er -ord', *inancial leverage -ill be *avo,rable and '+are+older' -ill get
+ig+er EP8 i* t+e ret,rn on total inve'tment i' more t+an t+e *i.ed co't 6intere't
and pre*erence dividend2/ I* t+e ret,rn i' le'' t+an t+e *i.ed *inancial c+arge, t+e
EP8 -ill decline -it+ t+e ,'e o* debt and t+e leverage -ill be ,n*avo,rable/ T+e
*inancial leverage -ill +ave no e**ect on EP8 in ca'e t+e ret,rn on inve'tment i'
e.actl1 e4,al to t+e *i.ed *inancial co't'/
18 - 18 - )8 )8
18 - 18 - )8 )8
< 1
;/:
1)
1D/:
E$IT 6R' in la(+'2
Fig,re 2& E$IT-EP8 Anal1'i'
E4,it1 > Pre*erence
Advantage
E4,it1 > Pre*erence
Alternative
E4,it1 Alternative
Indi**erence Point
E4,it1
Advantage
E
P
8

6
R
'
2
2 ) 3 : ; @ 8 D 1< 11 12 1)
2;
)2/:
18 - 18 - )D )D
18 - 18 - )D )D
T+e indi**erence point ma1 be comp,ted in anot+er -a1 ,'ing mar(et val,e a'
t+e ba'i'/ 8ince t+e operational obMective o* *inancial management i' t+e
ma.imi'ation o* '+are price', t+e mar(et price o* '+are' o* a *irm -it+ t-o
di**erent *inancial plan' '+o,ld be identical/ T+,', on t+e ba'i' o* level o* E$IT
-+ic+ en',re' identical mar(et price *or alternative *inancial plan', t+e
indi**erence point can be '1mbolicall1 comp,ted b1 E4,ation 1</
where PE
1
= P/E ratio of unlevered plan and P/E
2
= P/E ratio of levered plan.
( )
( ) ( )
) 10 (
N
D t 1 I X
E / P
N
t 1 X
E / P
2
p
2
1
1 1
]
1

1
]
1

E.ample 8
"etermine t+e indi**erence point at -+ic+ mar(et price o* e4,it1 '+are' o* a
corporate *irm -ill be t+e 'ame *rom t+e *ollo-ing data&
1/ F,nd' re4,ired, R' :<,<<</
2/ E.i'ting n,mber o* e4,it1 '+are' o,t'tanding, :,<<< P R' 1< per '+are/
)/ E.i'ting 1<= debt, R' 2<,<<<
3/ F,nd' re4,ired can be rai'ed eit+er b1 6a2 i'',e o* 2,<<< e4,it1 '+are',
netting R' 2: per '+are or 6b2 ne- 1: per cent debt/
:/ T+e P0E ratio -ill be @ time' in e4,it1 alternative and ; time' in debt
alternative/
;/ Corporate ta. rate, ): per cent/
18 - 18 - 3< 3<
18 - 18 - 3< 3<
Con*irmation Table
Partic,lar' 1:= "ebt i'',e E4,it1 i'',e
E$IT R' 3@,<<< R' 3@,<<<
Le''& Intere't D,:<< 2,<<<
Earning be*ore ta.e' )@,:<< 3:,<<<
Le''& Ta.e' 1),12: 1:,@:<
Earning a*ter ta.e' 23,)@: 2D,2:<
,mber o* e4,it1 '+are' :,<<< @,<<<
Earning' per '+are 3/8@: 3/18
P0E ratio 6time'2 ; @
#ar(et price o* t+e '+are 2D/2: 2D/2:
( ) ( ) ( ) ( )
( ) ( )
95*/// 0s " ie 2*,8*;./* 0s or9.."
85*/./) 0s 5(8=" =*,//) 0s or.(9.."
.*///
4*,5. 0s /4."
5*///
,*8// 0s /4."
.*///
/4. =*.// 0s "
4
5*///
/4. 2*/// 0s "
5 Or
7
t , I I "
-6E
7
t , I "
-6E
2
2 ,
2
,
,
,

1
]
1

1
]
1

1
]
1

1
]
1

18 - 18 - 31 31
18 - 18 - 31 31
#ea',re' o* Financial Leverage'
Financial leverage mea',re' t+e degree o* t+e ,'e o* debt and ot+er *i.ed-co't
'o,rce' o* *,nd to *inance t+e a''et' t+e *irm +a' ac4,ired/ A' '+o-n above, t+e
,'e o* debt +a' a magni*1ing e**ect on t+e earning' per '+are/ It can be 'aid t+at
t+e +ig+er t+e proportion o* debt in t+e capital 'tr,ct,re, t+e +ig+er i' t+e *inancial
leverage and vice-versa. $roadl1 'pea(ing, *inancial leverage can be mea',red in
t-o -a1'& 6i2 'toc( term', and 6ii2 *lo- term'/
12 8toc( Term'
It can be mea',red eit+er b1 6a2 a 'imple ratio o* debt to e4,it1, or 6b2 b1 t+e ratio
o* long-term debt pl,' pre*erence '+are to total capitali'ation/ Eac+ o* t+e'e
mea',re' indicate' t+e relative proportion o* t+e *,nd' to t+e total *,nd' o* t+e *irm
on -+ic+ it i' to pa1 *i.ed *inancial c+arge'/
22 Flo- Term'
T+e *inancial leverage can be mea',red eit+er b1 6a2 t+e ratio o* E$IT to intere't
pa1ment' or 6b2 t+e ratio o* ca'+ *lo-' to intere't pa1ment, pop,larl1 called t+e
debt 'ervice capacit10coverage/ T+e'e coverage ratio' are ,'e*,l to t+e ',pplier'
o* t+e *,nd' a' t+e1 a''e'' t+e degree o* ri'( a''ociated -it+ lending to t+e *irm/
In general, t+e +ig+er t+e Q'toc(5 ratio' and t+e lo-er t+e Q*lo-5 ratio', t+e greater i'
t+e ri'( and vice-versa.
18 - 18 - 32 32
18 - 18 - 32 32
CO#$IE" LE%ERA!E& TOTAL RI8R
Combined leverage i' t+e prod,ct o* operating leverage and *inancial leverage/
Total ri'( i' t+e ri'( a''ociated -it+ combined leverage/
"CL I "OL L "FL 6112
T+,', t+e "CL mea',re' t+e percentage c+ange in EP8 d,e to percentage
c+ange in 'ale'/ I* t+e degree o* operating leverage o* a *irm i' ; and it'
*inancial leverage i' 2/:, t+e combined leverage o* t+i' *irm -o,ld be 1:6; .
2/:2/ T+at i', 1 per cent c+ange in 'ale' -o,ld bring abo,t 1: per cent c+ange
in EP8 in t+e direction o* t+e c+ange in 'ale'/ T+e combined leverage can
-or( in eit+er direction/ It -ill be *avo,rable i* 'ale' increa'e and ,n*avo,rable
-+en 'ale' decrea'e beca,'e c+ange' in 'ale' -ill re',lt in more t+an
proportionate ret,rn' in t+e *orm o* EP8/
) 13 (
I EBI
!" #!"tri$%ti
I EBI
EBI
EIB
!" #!"tri$%ti
D#&
) 12 (
s'()s i" *+'",) -
EP. i" *+'",) -
EBI i" *+'",) -
EP. i" *+'",) -
s'()s i" *+'",) -
EBI i" *+'",) -
D#&

18 - 18 - 3) 3)
18 - 18 - 3) 3)
8OL%E" PRO$LE#
8OL%E" PRO$LE#
18 - 18 - 33 33
18 - 18 - 33 33
A pla'tic man,*act,ring compan1 i' planning to e.pand it' a''et' b1 :< per
cent/ All *inancing *or t+i' e.pan'ion -ill come *rom e.ternal 'o,rce'/ T+e
e.pan'ion -ill generate additional 'ale' o* R' ) la(+ -it+ a ret,rn o* 2: per
cent on 'ale' be*ore intere't and ta.e'/ T+e *inance department o* t+e
compan1 +a' ',bmitted t+e *ollo-ing plan' *or t+e con'ideration o* t+e $oard/
Plan 1& I'',e o* 1<= debent,re'/
Plan 2& I'',e o* 1<= debent,re' *or +al* t+e re4,ired amo,nt and balance in
e4,it1 '+are' to be i'',ed at 2: per cent premi,m/
Plan )& I'',e e4,it1 '+are' at 2: per cent premi,m/
$alance '+eet o* t+e compan1 a' on #arc+ )1
Liabilitie' Amo,nt A''et' Amo,nt
E4,it1 capital 6R' 1< per '+are2 R' 3,<<,<<< Total a''et' R' 12,<<,<<<
8= "ebent,re' ),<<,<<<
Retained earning' 2,<<,<<<
C,rrent liabilitie' ),<<,<<< SSSSSSSS SSSSSSSS
12,<<,<<< 12,<<,<<<
18 - 18 - 3: 3:
18 - 18 - 3: 3:
Income 'tatement *or t+e 1ear ending #arc+ )1
8ale' R' 1D,<<,<<<
Operating co't' 1;,<<,<<<
E$IT ),<<,<<<
Intere't 23,<<<
Earning a*ter intere't' 2,@;,<<<
Ta.e' D;,;<<
EAT 1,@D,3<<
EP8 3/38
6a2 "etermine t+e n,mber o* e4,it1 '+are' t+at -ill be i'',ed i* *inancial plan )
i' adopted/
6b2 "etermine indi**erence point bet-een 6i2 plan' 1 and 2, 6ii2 plan' 1 and ),
and 6iii2 plan' 2 and )/
6c2 A'',me t+at t+e price earning' ratio i' e.pected to remain ,nc+anged at 8 i*
plan ) i' adopted, b,t i' li(el1 to drop to ; i* eit+er plan 1 or 2 i' ,'ed to
*inance t+e e.pan'ion/ "etermine t+e e.pected mar(et price o* t+e '+are' in
eac+ o* t+e 'it,ation'/
18 - 18 - 3; 3;
18 - 18 - 3; 3;
1,34,000 Rs X
88,000
0.65 24,000 Rs X
40,000
0.65 54,000 Rs / X

2
N
t 1
2
I / X
1
N
2
I
1
I / X
(iii)
1,34,000 Rs X
88,000
0.65 24,000 Rs X
40,000
0.65 84,000 Rs / X

2
N
t 1
1
I / X
1
N
t 1
2
I
1
I / X
(ii)
1,34,000 Rs X
64,000
0.65 0,000 3 Rs / 24,000 Rs / X
40,000
0.65 60,000 Rs / 24,000 Rs / X
!r
2
N
t 1
2
I
1
I / X
1
N
t 1
2
I
1
I / X
(i) ($)
12.5 Rs
6,00,000 Rs
48,000 iss%)0 s+'r)s !1 N%2$)r (')
.!(%ti!"

,
_

,
_

,
_

,
_

,
_

,
_

,
_

,
_

,
_

,
_

,
_

,
_

,
_

,
_

,
_

,
_

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_

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_

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_

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_

18 - 18 - 3@ 3@
18 - 18 - 3@ 3@
%eri*ication table
Partic,lar' Plan'
1 2 )
E$8 R' 1,)3,<<< R' 1,)3,<<< R' 1,)3,<<<
Le''& Intere't 83,<<< :3,<<< 23,<<<
Earning' be*ore ta.e' :<,<<< 8<,<<< 1,1<,<<<
Le''& Ta.e' 1@,:<< 28,<<< )8,:<<
EAT )2,:<< :2,<<< @1,:<<
,mber o* e4,it1 '+are' 62 3<,<<< ;3,<<< 88,<<<
EP8 </812 </812 </812
18 - 18 - 38 38
18 - 18 - 38 38
6c2 "etermination o* mar(et price per '+are ,nder vario,' alternative *inancial
plan'&
Partic,lar' Plan'
1 2 )
E$IT R' ),@:,<<< R' ),@:,<<< R' ),@:,<<<
Le''& Intere't 83,<<< :3,<<< 23,<<<
Earning' be*ore ta.e' 2,D1,<<< ),21,<<< ),:1,<<<
Le''& Ta.e' 1,<1,8:< 1,12,):< 1,22,8:<
EAT 1,8D,1:< 2,<8,;:< 2,28,1:<
3<,<<< ;3,<<< 88,<<<
EP8 3/@) )/2; 2/:D
P0E ratio ; ; 8
#ar(et price 28/)8 1D/:; 2</@2
18 - 18 - 3D 3D
18 - 18 - 3D 3D
#II CA8E
#II CA8E
18 - 18 - :< :<
18 - 18 - :< :<
! #an,*act,ring compan1 i' an important prod,cer o* la-n *,rnit,re and
decorative obMective' *or t+e patio and garden/ T+e la't 1ear5' income
'tatement and balance '+eet are a' *ollo-'&
Income 'tatement
8ale'
%ariable co't'
Contrib,tion
Fi.ed co't'
Earning' be*ore intere't and ta. 6E$IT2
Intere't
Earning' be*ore ta. 6E$T2
Ta.ation
et Income a*ter ta.
R' @:,<<,<<<
3;,D<,<<<
28,1<,<<<
13,<<,<<<
13,1<,<<<
2,<<,<<<
12,1<,<<<
;,<:,<<<
;,<:,<<<
$alance '+eet
Liabilitie' Amo,nt A''et' Amo,nt
E4,it1 capital
Re'erve' and ',rpl,'
Long-term debt 61<=2
C,rrent liabilitie'
R' 1<,<<,<<<
32,<<,<<<
2<,<<,<<<
:,<<,<<<
@@,<<,<<<
Fi.ed a''et'
Inventor1
Receivable'
Ca'+
R' ;<,<<,<<<
;,<<,<<<
@,<<,<<<
3,<<,<<<
@@,<<,<<<
18 - 18 - :1 :1
18 - 18 - :1 :1
Fig,re' *or ind,'tr1 compari'on&
ormal a''et t,rnover 1/2 & 1/ ormal pro*it margin 2< per cent
For t+e c,rrent 1ear, t+e *oreca'ted 'ale' are R' 8<,<<,<<< and it i' li(el1 t+at
variable co't' -ill remain at appro.imatel1 t+e 'ame percentage o* 'ale' a'
-a' in t+e la't 1ear/ 6Fig,re' co,ld be ro,nded o**2/ Fi.ed co't' -ill ri'e b1 1<
per cent/
! +a' '+ort-li'ted t+e *ollo-ing t-o prod,ct line' to be 'old t+ro,g+ it'
e.i'ting di'trib,tion c+annel'&
612Prod,ction and 'ale o* metal table and c+air ,nit t+at -ill be 'old *or i'',e
aro,nd '-imming pool'/ T+i' -ill re4,ire an inve'tment o* R' 2<,<<,<<<,
-+ic+ -o,ld involve in'tallation o* man,*act,ring and pac(aging
mac+iner1/ 8ale' *oreca't are R' 1:,<<,<<< per ann,m, variable co't'
acco,nt *or 20)rd o* 'ale' val,e, *i.ed co't' are R' 2,<<,<<< and no
additional -or(ing capital i' needed/
622Fard-ood planter -it+ t+ree 'eparate component', -ill be appropriate *or
medi,m 'iAed '+r,b'/ T+i' -ill re4,ire an inve'tment o* R' )<,<<,<<< -it+
*oreca'ted 'ale' per ann,m o* R' 2:,<<,<<<, variable co't' ;3 per cent o*
'ale' val,e and *i.ed co't' o* R' :,<<,<<</
18 - 18 - :2 :2
18 - 18 - :2 :2
T-o *inancial plan' are available&
a2 It co,ld borro- on a 1< 1ear' note at D per cent *or eit+er or bot+ o* t+e
proMect' o* an amo,nt not to e.ceed R' ;<,<<,<<</
b2 C,m,lative pre*erence '+are' -it+ a 1< per cent dividend ,pto an amo,nt
o* R' )<,<<,<<</
Financing t+ro,g+ t+e i'',e o* e4,it1 '+are' -o,ld not be po''ible at t+e
pre'ent time/
Re4,ired
12 Bit+o,t t+e ne- propo'al', -+at -o,ld be t+e compan15' operating,
*i.ed c+arge' and combined leverage' ne.t 1earC Bo,ld t+e compan1
+ave *avo,rable *inancial leverageC
22 Fo- doe' t+e acceptance o* eac+ proMect a**ect t+e di**ering leverage'
incl,ding a''et leverage'C
)2 Bit+ eac+ *inancing alternative', do t+e compan15' *,t,re earning' per
'+are increa'e or decrea'e, -+1C
18 - 18 - :) :)
18 - 18 - :) :)
8ol,tion
612 Income 'tatement at proMected 'ale' o* R' 8< la(+ in c,rrent 1ear
8ale' reven,e R' 8<,<<,<<<
Le''& %ariable co't' 6R' 8< la(+ T ;2/:= %0% ratio2 :<,<<,<<<
Contrib,tion )<,<<,<<<
Le''& Fi.ed co't' 6R' 13 la(+ > 1<=2 1:,3<,<<<
E$IT 13,;<,<<<
Le''& Intere't 2,<<,<<<
Earning' be*ore ta.e' 6E$T2 12,;<,<<<
Le''& Ta.e' 6</:<2 ;,)<,<<<
Earning' a*ter ta.e' ;,)<,<<<
"etermination o* leverage' 6-it+o,t t+e ne- propo'al'2
"OL I Contrib,tion0E$IT 6R' )<,<<,<<<0R' 13,;<,<<<2 2/<:38
"FL I E$IT0E$T 6R' 13,;<,<<<0R' 12,;<,<<<2 1/1:8@
"CL I Contrib,tion0E$T 6R' )<,<<,<<<0R' 12,;<,<<<2 Or 2/<:38 T
1/1:8@
2/)8<D
18 - 18 - :3 :3
18 - 18 - :3 :3
T+e compan1 i' 'aid to +ave *avo,rable *inancial leverage i* it earn' more on t+e
a''et' p,rc+a'ed 6-it+ debt *,nd'2 t+an t+e intere't it pa1' on debt/ For t+e
p,rpo'e, ROR on capital emplo1ed i' comp,ted/ It i' 6R' 13,;<,<<<0R' @2,<<,<<<2 I
2</28 per cent/ T+i' ret,rn i' +ig+er t+an 1< per cent intere't pa1able on long-term
debt/ Evidentl1, t+e *irm i' +aving po'itive *inancial leverage/
622 Income 'tatement '+o-ing earning' o* t-o proMect', "OL and a''et' leverage
Partic,lar' ProMect'
#etal table and
c+air ,nit
Fard-ood planter
8ale' reven,e R' 1:,<<,<<< R' 2:,<<,<<<
Le''& %ariable co't' 1<,<<,<<< 1;,<<,<<<
Contrib,tion :,<<,<<< D,<<,<<<
Le''& Fi.ed co't' 2,<<,<<< :,<<,<<<
E$IT ),<<,<<< 3,<<,<<<
"OL 6Contrib,tion0E$IT2 1/;;@ 2/2:
A''et' leverage 68ale'0Total a''et'2 </@: </8)
To determine ot+er leverage', it -ill be ,'e*,l to e.tend income 'tatement to
incl,de t+e impact o* *inancing co't'/
18 - 18 - :: ::
18 - 18 - :: ::
Income 'tatement '+o-ing ot+er leverage' 6"FL and "CL2 and ot+er ratio'
Partic,lar' ProMect'
#etal table and c+air ,nit
6Inve'tment' R' 2< la(+2
Fard-ood planter
6Inve'tment' R' )<
la(+2
6i2 Financed t+ro,g+ debt plan&
E$IT R' ),<<,<<< R' 3,<<,<<<
Le''& Intere't 1,8<,<<< 2,@<,<<<
Earning' be*ore ta.e' 6E$T2 1,2<,<<< 1,)<,<<<
Le''& Ta.e' 6</:<2 ;<,<<< ;:,<<<
Earning' a*ter ta.e' ;<,<<< ;:,<<<
"FL 6E$IT0E$T2 2/: 2/<
"CL 6"OL T "FL2 3/1;@: 3/:
Rate o* ret,rn on capital emplo1ed 6=2 1: 1)/))
6ii2 Financed t+ro,g+ c,m,lative pre*erence '+are 6R' )< la(+2 >
R' 2< la(+ debt *or t-o combined proMect' E$IT
@,<<,<<<
Le''& Intere't 6R' 2< la(+ T D=2 1,8<,<<<
Earning' be*ore ta.e' :,2<,<<<
Le''& Ta.e' 6</:<2 2,;<,<<<
Earning' a*ter ta.e' 2,;<,<<<
Le''& "ividend' to pre*erence '+are +older' 6R' )< la(+ T 1<=2 ),<<,<<<
EAT 63<,<<<2U
U8ince EAT i' negative, t+i' *inancial plan i' -ort+ reMecting and +ence -arrant' no more
calc,lation' *or ot+er leverage'/
18 - 18 - :; :;
18 - 18 - :; :;
It is apparent that acceptance of the Hardwood Planter project will adversely
affect risk level (reflected in higher !"# $" and %"&. 'hile the acceptance of
(etal )a*le project decreases operating risk (lower !"&# it increases total risk
(as %" is +.1,&. )he asset leverages are also very low.
)hough the -!- on capital e.ployed is higher for *oth the projects than the
interest rate paid# the acceptance of these projects will decrease the fir./s overall
rate of return on capital e.ployed (the e0isting -!- on capital e.ployed is 21#
22 per cent&.
(3& )he i.pact of financing alternatives on co.pany/s future EP45
$inancial plan (a&5 4ince the rate of return on capital e.ployed is higher (for *oth
the projects& than the rate of interest (6 per cent& paya*le on funds *orrowed# the
projects will increase EP4.
$inancing plan (*&5 7nder this plan# funds are to *e raised *y the issue of -s 31
lakh cu.ulative 11 per cent Preference shares# the EP4 will decrease as pay.ent
of 11 per cent preference dividend re8uires 21 per cent pre9ta0 return on -s 31
lakh: the projected pre9ta0 return is 1;.33 per cent (-s ,#21#111/-s 31#11#111&. In
fact# taking two projects in a co.*ined .anner# the fir. has negative returns for
e8uity9holders. <s a result# this financial plan will have depressing effect on the
EP4 and is not desira*le.
In su.# the fir. should go for *oth projects only when de*t financing is possi*le
for *oth such projects.