MODULE - 2

Financial Decision

LEVERAGES

Meaning: The term leverage refers to the firm’s ability to use fixed cost funds to magnify the
return to the shareholders. In other words leverage is the employment of fixed assets or funds
for which a firm has to meet fixed costs like interest obligation irrespective of the level of
operating.

MASTER TABLE FOR LEVERAGES:

Particulars Rs
Sales Xxx
Less: variable cost Xxx
Contribution Xxx
Less: Fixed cost Xxx
Earnings before interest and tax (EBIT)/ GP/Operating Profit Xxx
Less: Interest Xxx
Earnings before tax (EBT) Xxx
Less: Tax Xxx
Earnings after tax (EAT) Xxx
Less : Preference Dividend Xxx
Less : Preference Dividend tax Xxx
Earnings Available to Equity shareholders (EAESH) Xxx
Divided by Number of Equity shares Xxx
= Earnings Per share (EPS) Xxx
X Price earnings Ratio (P/E Ratio) Xxx
= Market Price Per Share (MPS) Xxx

𝑴𝑷𝑺
𝑷/𝑬 𝑹𝒂𝒕𝒊𝒐 =
𝑬𝑷𝑺
𝑴𝑷𝑺 = 𝑬𝑷𝑺 ∗ 𝑷/𝑬 𝑹𝒂𝒕𝒊𝒐

𝑬𝑨𝑬𝑺𝑯
𝑬𝑷𝑺 =
𝑵𝒐. 𝒐𝒇 𝑬𝒒𝒖𝒊𝒕𝒚 𝑺𝒉𝒂𝒓𝒆𝒔

1
TYPES OF LEVERAGES

𝑪𝒐𝒏𝒕𝒓𝒊𝒃𝒖𝒕𝒊𝒐𝒏
𝑶𝒑𝒆𝒓𝒂𝒕𝒊𝒏𝒈 𝒍𝒆𝒗𝒆𝒓𝒂𝒈𝒆 =
𝑬𝑩𝑰𝑻

𝑬𝑩𝑰𝑻
𝑭𝒊𝒏𝒂𝒏𝒄𝒊𝒂𝒍 𝒍𝒆𝒗𝒆𝒓𝒂𝒈𝒆 =
𝑬𝑩𝑻

𝑪𝒐𝒏𝒕𝒓𝒊𝒃𝒖𝒕𝒊𝒐𝒏
𝑪𝒐𝒎𝒃𝒊𝒏𝒆𝒅 𝒍𝒆𝒗𝒆𝒓𝒂𝒈𝒆 =
𝑬𝑩𝑻

%𝒄𝒉𝒂𝒏𝒈𝒆 𝒊𝒏 𝑬𝑩𝑰𝑻
𝑫𝒆𝒈𝒓𝒆𝒆 𝒐𝒇 𝒐𝒑𝒆𝒓𝒂𝒕𝒊𝒏𝒈 𝒍𝒆𝒗𝒆𝒓𝒂𝒈𝒆 =
%𝒄𝒉𝒂𝒏𝒈𝒆 𝒊𝒏 𝑺𝒂𝒍𝒆𝒔

%𝒄𝒉𝒂𝒏𝒈𝒆 𝒊𝒏 𝑬𝑷𝑺
𝑫𝒆𝒈𝒓𝒆𝒆 𝒐𝒇 𝒇𝒊𝒏𝒂𝒏𝒄𝒊𝒂𝒍 𝒍𝒆𝒗𝒆𝒓𝒂𝒈𝒆 =
%𝒄𝒉𝒂𝒏𝒈𝒆 𝒊𝒏 𝑬𝑩𝑰𝑻

%𝒄𝒉𝒂𝒏𝒈𝒆 𝒊𝒏 𝑬𝑷𝑺
𝑫𝒆𝒈𝒓𝒆𝒆 𝒐𝒇 𝒄𝒐𝒎𝒃𝒊𝒏𝒆𝒅 𝒍𝒆𝒗𝒆𝒓𝒂𝒈𝒆 =
%𝒄𝒉𝒂𝒏𝒈𝒆 𝒊𝒏 𝑺𝒂𝒍𝒆𝒔

INDIFFERENCE CURVE OR INDIFFERENCE POINT:

It is at that level of EBIT, EPS of two different alternatives be same.
Alternative “A” EPS = Alternative “B” EPS

𝑬𝑨𝑬𝑺𝑯
𝑬𝑷𝑺 =
𝑵𝒐. 𝒐𝒇 𝑬𝒒𝒖𝒊𝒕𝒚 𝒔𝒉𝒂𝒓𝒆𝒔

(𝑬𝑩𝑰𝑻 − 𝑰)(𝟏 − 𝒕) − 𝑷𝑫 (𝑬𝑩𝑰𝑻 − 𝑰)(𝟏 − 𝒕) − 𝑷𝑫

𝑬𝑷𝑺 = = 𝑬𝑷𝑺 =
𝑵𝒐. 𝒐𝒇 𝑬𝒒𝒖𝒊𝒕𝒚 𝒔𝒉𝒂𝒓𝒆𝒔 𝑵𝒐. 𝒐𝒇 𝑬𝒒𝒖𝒊𝒕𝒚 𝒔𝒉𝒂𝒓𝒆𝒔

Where:
t = Tax rate
PD = Preference dividend
ES = Equity shares

(𝑬𝑩𝑰𝑻 − 𝑰)(𝟏 − 𝒕) − 𝑷𝑫 − 𝑷𝑫𝒕 (𝑬𝑩𝑰𝑻 − 𝑰)(𝟏 − 𝒕) − 𝑷𝑫 − 𝑷𝑫𝒕

𝑬𝑷𝑺 = = 𝑬𝑷𝑺 =
𝑵𝒐. 𝒐𝒇 𝑬𝒒𝒖𝒊𝒕𝒚 𝒔𝒉𝒂𝒓𝒆𝒔 𝑵𝒐. 𝒐𝒇 𝑬𝒒𝒖𝒊𝒕𝒚 𝒔𝒉𝒂𝒓𝒆𝒔

PDt = Preference dividend tax

2
Financing Decisions Problems
1. Calculate the operating leverage of the firm from the following data :-
Sales – 15000 units at Rs. 1.20 each
Variable Cost – 40 paise per unit
Fixed Cost – Rs. 3600

Answer:

Calculation of Operating Leverage

Particulars Rs
Sales = (15000 * 1.20) 18000
Less: Variable cost = (15000 * 0.40) 6000
Contribution 12000
Less: Fixed Cost 3600
EBIT 8400
Operating Leverage = (Contribution / EBIT) 1.43 times

2. A firm has sales of Rs.10,00,000 and variable cost of Rs.7,00,000. The fixed cost is
Rs.2,00,000. Debt of Rs.5,00,000 at the rate of 10% interest per annum. Find out the
operating leverage, financial leverage and the combined leverage.

Answer:

Calculation of Operating, Financial & Combined Leverages

Particulars Rs
Sales 10,00,000
Less: Variable cost 7,00,000
Contribution 3,00,000
Less: Fixed Cost 2,00,000
EBIT 1,00,000
Less: interest = (5,00,000 * 10%) 50,000
EBT 50,000
Operating Leverage = (Contribution / EBIT) 3 times
Financial Leverage = (EBIT / EBT) 2 times
Combined leverage = (Contribution / EBT) 6 times

3
3. Calculate the operating leverage, financial leverage and the combined leverage from the
following data:
Sales - Rs. 2,00,000 (Rs.2/ unit)
Variable Cost – 70 paise per unit
Fixed Cost – Rs.65,000
Interest Charges – Rs.15,000

Answer:

𝑺𝒂𝒍𝒆𝒔 2,00,000
𝑵𝒐. 𝒐𝒇 𝑼𝒏𝒊𝒕𝒔 = = = 100000 𝑢𝑛𝑖𝑡𝑠
𝑺𝒆𝒍𝒍𝒊𝒏𝒈 𝑷𝒓𝒊𝒄𝒆 𝑷𝒆𝒓 𝑼𝒏𝒊𝒕 2

Calculation of Operating, Financial & Combined Leverages

Particulars Situation- A
Sales 2,00,000
Less: Variable cost = (1,00,000 * 0.70) 70,000
Contribution 1,30,000
Less: Fixed Cost 65,000
EBIT 65,000
Less: interest 15,000
EBT 50,000
Operating Leverage = (Contribution / EBIT) 2 times
Financial Leverage = (EBIT / EBT) 1.3 times
Combined leverage = (Contribution / EBT) 2.6 times

4. Calculate the degree of operating leverage from the following data:-

Particulars 1988 1989

EBIT 30,000 35,000
Sales 1,50,000 units 1,80,000 units
Selling price per unit Rs 14.80 Rs 14.80

Answer:

1988 Sales = (1,50,000 * 14.80) = Rs 2220000

1989 Sales = (1,80,000 * 14.80) = Rs 2664000

2664000 − 2220000
% 𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑆𝑎𝑙𝑒𝑠 = ∗ 100 = 20%
2220000
35000 − 30000
% 𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝐸𝐵𝐼𝑇 = ∗ 100 = 16.67%
30000

% 𝐂𝐡𝐚𝐧𝐠𝐞 𝐢𝐧 𝐄𝐁𝐈𝐓 16.67

𝐃𝐞𝐠𝐫𝐞𝐞 𝐨𝐟 𝐎𝐩𝐞𝐫𝐚𝐭𝐢𝐧𝐠 𝐥𝐞𝐯𝐞𝐫𝐚𝐠𝐞 = = = 0.83 𝑡𝑖𝑚𝑒𝑠
% 𝐂𝐡𝐚𝐧𝐠𝐞 𝐢𝐧 𝐒𝐚𝐥𝐞𝐬 20

4
5. Calculate the operating and financial leverage under situations
(a) and (b) and financial plan (1) and (2) respectively from the following information
relating to the operation and capital structure of ABC ltd.
Installed Capacity – 1000 units
Selling price per unit – Rs.20
Actual production and sales - 800 units
Variable cost per unit – Rs.15
Fixed Cost for (a) is Rs.800 and for (b) is Rs. 1,500
The particular of the capital structure of the firm is given below: -

Particulars Financial Plan (1) Financial Plan (2)

Equity Share Rs. 3,000 Rs. 7,000
Capital
Debt Rs. 5,000 Rs. 2,000
Rate of interest 10% 10%

Answer:

Calculation of Operating & Financial Leverages of ABC ltd

Situation- A Situation- B
Particulars
Fin Plan -1 Fin Plan -2 Fin Plan -1 Fin Plan -2
Sales = (800 * 20) 16000 16000 16000 16000
Less: Variable cost = (800 * 15) 12000 12000 12000 12000
Contribution 4000 4000 4000 4000
Less: Fixed Cost 800 800 1500 1500
EBIT 3200 3200 2500 2500
Less: interest
Plan 1: (5000 * 10%)
Plan 2: (2000 * 10%) 500 200 500 200
EBT 2700 3000 2000 2300
Operating Leverage
1.25 times 1.25 times 1.6 times 1.6 times
= (Contribution / EBIT)
Financial Leverage
= (EBIT / EBT) 1.19 times 1.07 times 1.25 times 1.09 times
Combined leverage
1.48 times 1.33 times 2.00 times 1.74 times
= (Contribution / EBT)

5
6. The installed capacity of a factory is 700 units. The actual exploited capacity is 500 units.
The selling price per unit is Rs. 10 and the variable cost is Rs. 6 per unit. Calculate the
operating leverage, financial leverage and the combined leverage when the fixed cost is:-
(a) 500 (b) 1,100 (c) 1,500.
The company has taken a debt of Rs. 5,000 at 5% per month simple interest.

Answer:

Calculation of Operating, Financial & Combined Leverages

Particulars Situation- A Situation- B Situation- C

Sales = (500 * 10) 5000 5000 5000
Less: Variable cost = (500 * 6) 3000 3000 3000
Contribution 2000 2000 2000
Less: Fixed Cost 500 1100 1500
EBIT 1500 900 500
Less: Interest = (5000 * 5%) 250 250 250
EBT 1250 650 250
Operating Leverage
1.33 times 2.22 times 4 times
= (Contribution / EBIT)
Financial Leverage
= (EBIT / EBT) 1.20 times 1.38 times 2.00 times
Combined leverage
1.60 times 3.08 times 8.00 times
= (Contribution / EBT)

7. The combined leverage of a firm is 6. Its financial leverage is 3. What is the

relationship between the contribution and the operating leverage profit of the firm?

Answer:

𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛
𝐶𝑜𝑚𝑏𝑖𝑛𝑒𝑑 𝑙𝑒𝑣𝑒𝑟𝑎𝑔𝑒 = =6
𝐸𝐵𝑇

𝐸𝐵𝐼𝑇
𝐹𝑖𝑛𝑎𝑛𝑐𝑖𝑎𝑙 𝑙𝑒𝑣𝑒𝑟𝑎𝑔𝑒 = =3
𝐸𝐵𝑇

𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛
𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑙𝑒𝑣𝑒𝑟𝑎𝑔𝑒 =
𝐸𝐵𝐼𝑇

𝐶𝑜𝑚𝑏𝑖𝑛𝑒𝑑 𝑙𝑒𝑣𝑒𝑟𝑎𝑔𝑒 = 𝑂𝐿 ∗ 𝐹𝐿

𝐶𝑜𝑚𝑏𝑖𝑛𝑒𝑑 𝑙𝑒𝑣𝑒𝑟𝑎𝑔𝑒 6
𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑙𝑒𝑣𝑒𝑟𝑎𝑔𝑒 = = =2
𝐹𝑖𝑛𝑎𝑛𝑐𝑖𝑎𝑙 𝑙𝑒𝑣𝑒𝑟𝑎𝑔𝑒 3

6
8. The operating leverage of a firm is 2.5. The ratio between its contribution and its EBT
is 10. What is the ratio between its operating profit and EBT?

Answer:

𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛
𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑙𝑒𝑣𝑒𝑟𝑎𝑔𝑒 = = 2.5
𝐸𝐵𝐼𝑇
𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛
𝐶𝑜𝑚𝑏𝑖𝑛𝑒𝑑 𝑙𝑒𝑣𝑒𝑟𝑎𝑔𝑒 = = 10
𝐸𝐵𝑇
𝐸𝐵𝐼𝑇
𝐹𝑖𝑛𝑎𝑛𝑐𝑖𝑎𝑙 𝑙𝑒𝑣𝑒𝑟𝑎𝑔𝑒 =
𝐸𝐵𝑇

𝐶𝑜𝑚𝑏𝑖𝑛𝑒𝑑 𝑙𝑒𝑣𝑒𝑟𝑎𝑔𝑒 = 𝑂𝐿 ∗ 𝐹𝐿

𝐶𝑜𝑚𝑏𝑖𝑛𝑒𝑑 𝑙𝑒𝑣𝑒𝑟𝑎𝑔𝑒 10
𝐹𝑖𝑛𝑎𝑛𝑐𝑖𝑎𝑙 𝑙𝑒𝑣𝑒𝑟𝑎𝑔𝑒 = = =4
𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑙𝑒𝑣𝑒𝑟𝑎𝑔𝑒 2.5

9. Determine the EPS of a company which has operating profit of Rs. 1,60,000. It’s
capital structure consists of the following securities :-
10% Debentures of Rs. 5,00,000
12% Preference Shares of Rs. 1,00,000
Equity Share of Rs. 100 each for Rs. 4,00,000
The company is in the 55% tax bracket.
Determine the EPS and the percentage change in EPS with 30% increase and decrease
in O.P (EBIT).
Also determine the degree of financial leverage in the two cases.

Answer:

Calculation of EPS & DFL

Normal 30% 30%

Particulars
EBIT increase Decrease
Earnings before interest and tax (EBIT) 1,60,000 2,08,000 1,12,000
Less: Interest = (5,00,000 * 10%) 50,000 50,000 50,000
Earnings before tax (EBT) 1,10,000 1,58,000 62,000
Less: Tax @ 55% 60,500 86,900 34,100
Earnings after tax (EAT) 49,500 71,100 27,900
Less: Preference Dividend = (1,00,000 * 12%) 12,000 12,000 12,000
Earnings Available to Equity shareholders
37,500 59,100 15,900
(EAESH)
Divided by Number of Equity shares 4000 4000 4000
EPS = (EAESH / No. of ES) 9.38 14.78 3.98

7
 Normal 30% 30%
Particulars
EBIT increase Decrease
% Change in EPS
= [(14.78-9.38)/9.38] *100
= [(3.98-9.38)/9.38] *100 57.60 -57.60
% Change in EBIT
= [(158000-110000)/110000] *100
= [(62000-110000)/110000] *100 30.00 -30.00
Degree of Financial leverage 1.92 1.92
= (% change in EPS / % Change in EBIT)

No. of ES = (Equity Capital / Per share Price)

10. The capital structure of a Progressive Corporate Ltd., consists of an equity share capital of
Rs. 10,00,000 (share value of Rs. 10 each) and Rs. 10,00,000 of 20% debentures. The sales
increased by 25% from 2,00,000 units to 2,50,000. The selling price is Rs. 10 per unit.
Variable cost is Rs. 6 per unit and the fixed expenditure amounted to Rs. 2,50,000. The
income tax rate was 50%. Calculate the following :-
(a) % change in EPS
(b) Operating and financial leverage @ 2,00,000 and 2,50,000 units
(c) Degrees of operating leverage and financial leverage

Answer:

Calculation of EPS

200000 250000
Particulars
Units Units
Sales = (Units * 10) 2000000 2500000
Less: Variable cost = (Units * 6) 1200000 1500000
Contribution 8,00,000 10,00,000
Less: Fixed cost 2,50,000 2,50,000
Earnings before interest and tax (EBIT) 5,50,000 7,50,000
Less: interest = (10,00,000 * 20%) 2,00,000 2,00,000
Earnings before tax (EBT) 3,50,000 5,50,000
Less: Tax @ 50% 1,75,000 2,75,000
Earnings after tax (EAT) 1,75,000 2,75,000
Less: Preference Dividend 0 0
Earnings Available to Equity shareholders (EAESH) 1,75,000 2,75,000
Divided by Number of Equity shares 100000 100000
EPS = (EAESH / No. of ES) Rs 1.75 Rs 2.75
Operating Leverage = (Contribution / EBIT) 1.45 times 1.33 times
Financial Leverage = (EBIT / EBT) 1.57 times 1.36 times

No. of ES = (Equity Capital / Per share Price)

8
 250000 − 200000
% 𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑆𝑎𝑙𝑒𝑠 = ∗ 100 = 25
200000

750000 − 550000
% 𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝐸𝐵𝐼𝑇 = ∗ 100 = 36.36
550000

2.75 − 1.75
% 𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝐸𝑃𝑆 = ∗ 100 = 57.14
1.75

% 𝐜𝐡𝐚𝐧𝐠𝐞 𝐢𝐧 𝐄𝐁𝐈𝐓 36.36

𝐃𝐞𝐠𝐫𝐞𝐞 𝐨𝐟 𝐎𝐩𝐞𝐫𝐚𝐭𝐢𝐧𝐠 𝐥𝐞𝐯𝐞𝐫𝐚𝐠𝐞 = = = 1.45 𝑡𝑖𝑚𝑒𝑠
% 𝐂𝐡𝐚𝐧𝐠𝐞 𝐢𝐧 𝐒𝐚𝐥𝐞𝐬 25

% 𝐜𝐡𝐚𝐧𝐠𝐞 𝐢𝐧 𝐄𝐏𝐒 57.14

𝐃𝐞𝐠𝐫𝐞𝐞 𝐨𝐟 𝐅𝐢𝐧𝐚𝐧𝐜𝐢𝐚𝐥 𝐥𝐞𝐯𝐞𝐫𝐚𝐠𝐞 = = = 1.57 𝑡𝑖𝑚𝑒𝑠
% 𝐂𝐡𝐚𝐧𝐠𝐞 𝐢𝐧 𝐄𝐁𝐈𝐓 36.36

11. It is proposed to start a business requiring a capital of Rs. 10,00,000 and an assured
return of 15% on investment is forecasted. Calculate the EPS in the following three
cases :-
(a) The entire capital is raised through equity shares of Rs. 100 each.
(b) If 50% is raised from equity shares and 50% is raised through 10% debentures.
(c) If 50% is raised through 10% debentures and 20% through 9% preference shares
and the balance through equity shares.
The tax rate is at 40%.

Answer:

EBIT or Gross profit = 10,00,000 * 15% = Rs 150000

Case – A
Equity = Rs 10 lakhs

No. of ES = (1000000/100) = 10000

Case – B
Equity = Rs 5 lakhs
Debentures = Rs 5 lakhs @ 10%@ 10% interest

No. of ES = (500000/100) = 5000

Case – C
Debentures = Rs 5 lakhs @ 10% @ 10% interest
Preference = Rs 2 lakhs @ 9%
Equity = Rs 3 lakhs

No. of ES = (300000/100) = 3000

9
Calculation of EPS

Particulars Case - A Case - B Case - C

Earnings before interest and tax (EBIT)
= (10,00,000 * 15%) 1,50,000 1,50,000 1,50,000
Less: interest
Case B & Case C= (5,00,000 * 10%) 0 50,000 50,000
Earnings before tax (EBT) 1,50,000 1,00,000 1,00,000
Less: Tax @ 40% 60,000 40,000 40,000
Earnings after tax (EAT) 90,000 60,000 60,000
Less: Preference Dividend
Case C = (2,00,000 * 9%) 0 0 18,000
Earnings Available to Equity shareholders
90,000 60,000 42,000
(EAESH)
Divided by Number of Equity shares 10000 5000 3000
EPS = (EAESH / No. of ES) 9.00 12.00 14.00

Interpretation: Case-C is preferred based on EPS.

12. A Ltd., company has a share capital of 1,00,000 divided into shares of Rs.10 each. It has a
major expansion programme requiring an investment of another Rs. 50,000. The
management is considering the following alternatives for raising this amount.
(a) Issue of 5,000 equity shares of Rs. 10 each
(b) Issue of 5,000 12% preference shares of Rs. 10 each.
(c) Issue of 10% Debentures of Rs. 50,000.

You are required to calculate the effect of each modes of financing on the EPS
assuming the following cases:-
(a) EBIT continues to be the same even after expansion.
(b) EBIT increases by Rs. 10,000.
Assume the tax liability to be at 50%. The operating profit is Rs. 15,000 before expansion.

Answer:

When the EBIT is Rs. 15,000ion of EPS (if EBIT Continues to be same after expansion)

Alternative Alternative Alternative

Particulars
-A -B –C
Earnings before interest and tax (EBIT) 15,000 15,000 15,000
Less: interest
Alternative C= (50,000 * 10%) 0 0 5,000
Earnings before tax (EBT) 15,000 15,000 10,000
Less: Tax @ 50% 7,500 7,500 5,000

10
 Alternative Alternative Alternative
Particulars
-A -B –C
Earnings after tax (EAT) 7,500 7,500 5,000
Less: Preference Dividend
Alternative B = (50,000 * 12%) 0 6,000 0
Earnings Available to Equity shareholders
7,500 1,500 5,000
(EAESH)
Divided by Number of Equity shares 15000 10000 10000
Alternative A = (10000 + 5000) shares shares shares shares
EPS = (EAESH / No. of ES) 0.50 0.15 0.50

Interpretation: Alternative -A or C is preferred based on EPS. Since both are at indifference point.

Calculation of EPS (if EBIT increases by Rs 10000)

When the EBIT is Rs. 25,000
Alternative Alternative Alternative
Particulars
-A -B –C
Earnings before interest and tax (EBIT) 25,000 25,000 25,000
Less: interest
Alternative C= (50,000 * 10%) 0 0 5,000
Earnings before tax (EBT) 25,000 25,000 20,000
Less: Tax @ 50% 12,500 12,500 10,000
Earnings after tax (EAT) 12,500 12,500 10,000
Less: Preference Dividend
Alternative B = (50,000 * 12%) 0 6,000 0
Earnings Available to Equity
12,500 6,500 10,000
shareholders (EAESH)
Divided by Number of Equity shares
15000 10000 10000
Alternative A = (10000 + 5000) shares
EPS = (EAESH / No. of ES) 0.83 0.65 1.00

Interpretation: Alternative -C is preferred based on EPS.

11
13. The balance sheet of X Ltd., As on 31/3/1998 is as follows: -

Liabilities Amount Assets Amount

Equity capital of (Rs) Net fixed
60,000 (Rs)
1,50,000
10% Debentures 80,000 Current Assets 50,000
Retained Earnings 20,000
Current Liability 40,000
2,00,000 2,00,000

*Net fixed assets = Fixed Assets – Depreciation

The company’s total asset turnover ratio is 3:1. Its fixed operating cost is Rs. 1,00,000 and the
variable cost ratio is 40%. The income tax rate is at 50%. Calculate all the three types of leverage
and determine the likely level of EBIT if the EPS is Rs. 5. Also find out the current earnings per
share of the company.

Answer:

𝑺𝒂𝒍𝒆𝒔 3 𝑆𝑎𝑙𝑒𝑠
𝑻𝒐𝒕𝒂𝒍 𝒂𝒔𝒔𝒆𝒕 𝒕𝒖𝒓𝒏𝒐𝒗𝒆𝒓 𝒓𝒂𝒕𝒊𝒐 = = 3: 1 = =
𝑻𝒐𝒕𝒂𝒍 𝒂𝒔𝒔𝒆𝒕𝒔 1 200000
3
𝑆𝑎𝑙𝑒𝑠 = 200000 ∗ = 𝑅𝑠 600000
1

Calculation of Operating, Financial & Combined LeveragesEPS

Particulars Rs
Sales 600000
Less: Variable cost @ 40% x 6,00,000 240000
Contribution 360000
Less: Fixed Cost 100000
EBIT 260000
Less: interest = (80000 * 10%) 8000
EBT 252000
Less: Tax @ 50% 126000
EAT 126000
Less: Preference Dividend 0
EAESH 126000
Divide by: No. of Equity Shares 6000 shares
EPS = (EAESH / No. of ES) 21

Operating Leverage = (Contribution / EBIT)) 1.38 times

Financial Leverage = (EBIT / EBT) 1.03 times
Combined leverage = (Contribution / EBT) 1.43 times

12
Calculation of EBIT if EPS is Rs 5
Calculation of EBIT when EPS is Rs. 5,
Particulars Rs
EBIT 68000
Less: interest = (80000 * 10%) 8000
EBT 60000
Less: Tax @ 50% 30000
EAT 30000
Less: Preference Dividend 0
EAESH 30000
Divide by: No. of Equity Shares 6000
EPS = (EAESH / No. of ES) 5

14. Consider the following data of XYZ ltd. The selling price is Rs. 90 per unit and the variable
cost is Rs. 40 per unit. The fixed cost is Rs. 3,00,000. The interest burden is Rs. 1,00,000
per annum. Tax rate is at 40%. Preference dividend is Rs. 50,000.
(a) Calculate the three types of leverages if the units sold are 10,000 units.
(b) Calculate the EPS if the company has a paid up capital of Rs. 5,00,000
shares of Rs. 100 each. Also calculate the EBIT if the EPS is zero.

Answer:

Calculation of Leverages

Particulars Rs
Sales = (10000 *90) 900000
Less Variable cost = (10000 * 40) 400000
Contribution 500000
Less: Fixed cost 300000
EBIT 200000
Less: interest 100000
EBT 100000
Less: tax@ 40% 40000
EAT 60000
Less: Preference Dividend 50000
EAESH 10000

Divide by: No. of Equity shares 5000

13
 EPS 2

OL = (Contribution / EBIT) 2.5

FL = (EBIT/EBT) 2
FL = (Contribution / EBT) 5

No. of ES = Equity capital / Per share price

Calculation of EBIT if EPS is Zero.

Particulars Rs
EBIT 183333
Less: interest 100000
EBT 83333
Less: tax@ 40% 33333
EAT 50000
Less: Preference Dividend 50000
EAESH 0
Divide by: No. of Equity shares 5000
EPS 0

15. Z ltd. produces a special kind of cement which is packed and sold in bags of 20 kgs.
During the year the cost of the revenue patterns were as under: -
(a) Selling price per bag is Rs. 30
(b) Variable cost per bag is Rs. 15
(c) Fixed cost is Rs. 10,000.
Quantity produced and sold is 3,000 bags assuming a 10% increase in production volume.
Calculate the percentage change in profits and also calculate the price the company should charge
per bag and per kg of cement if the variable cost increases by Rs. 1 per bag and the fixed cost
becomes Rs. 16,000 in order to maintain the same level of operating profit, production volume
remains unchanged.

ANS

Sales volume = 3000 bags

10% ease in S volume = 3000 * 10% = 300

Total New sales = 3300

Calculation of Profit

Particulars 3000 BAGS 10 % INCREASE

Sales Quantity (bags) 3000 3300
Sales = (No. of bags * 30) 90000 99000
Less: Variable cost = (No. of bags * 15) 45000 49500
Contribution 45,000 49,500

14
 Less: Fixed cost 10,000 10,000
Earnings before interest and tax (EBIT) 35,000 39,500

39500 − 35000
% 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑝𝑟𝑜𝑓𝑖𝑡 = 100 = 12.86
35000

Calculation of Selling Price

Particulars Rs
Sales Quantity (bags) 3000
Sales = (No. of bags * Selling Price per bag) 99,000
Less: Variable cost = (No. of bags * 16) 48000
Contribution 51,000
Less: Fixed cost 16,000
Earnings before interest and tax (EBIT) 35,000

𝑆𝑎𝑙𝑒𝑠 99000
𝑆𝑒𝑙𝑙𝑖𝑛𝑔 𝑃𝑟𝑖𝑐𝑒 𝑝𝑒𝑟 𝑏𝑎𝑔 = = = 33
𝑁𝑜. 𝑜𝑓 𝑏𝑎𝑔𝑠 30000

𝑆𝑒𝑙𝑙𝑖𝑛𝑔 𝑃𝑟𝑖𝑐𝑒 𝑝𝑒𝑟 𝑏𝑎𝑔 33

𝑆𝑒𝑙𝑙𝑖𝑛𝑔 𝑃𝑟𝑖𝑐𝑒 𝑝𝑒𝑟 𝑘𝑔 = = = 1.65
𝑁𝑜. 𝑜𝑓 𝐾𝑔 𝑝𝑒𝑟 𝑏𝑎𝑔 20

16. From the following calculate the amount of variable cost:-

Sales – Rs. 1,50,000 Profit – Rs. 40,000 Fixed Cost – Rs. 30,000

ANSWER:

Calculation of Variable Cost

Particulars Rs
Sales 1,50,000
Less: Variable cost 80000
Contribution 70000
Less: Fixed cost 30,000
Earnings before interest and tax (EBIT) 40,000

15
17. GD ltd has equity share capital of Rs. 5,00,000 divided into shares of Rs. 100 each. It
wishes to raise further Rs. 3,00,000 for modernization plans. The company plans the
following financial schemes :-
(a) All equity shares
(b) Rs. 1,00,000 through equity shares and Rs. 2,00,000 in debt at the rate of
10% per annum.
(c) All debt at 10% per annum
(d) Rs. 1,00,000 in equity shares, Rs. 2,00,000 in 8% preference shares.
The company estimated EBIT at Rs. 1,50,000. The tax rate is 50%. Calculate EPS in
each case and give a comment as to which capital structure is suitable.

Answer:

Working note: Calculation of Total no. of Equity shares

Plan -A Plan -B Plan -C Plan-D

OLD Equity shares 500000 500000 500000 500000
New Equity shares 300000 100000 100000
Debt @10% 200000 300000
8% preference shares 200000
Total Capital 800000 800000 800000 800000

Total Equity capital 800000 600000 500000 600000

No of ES 8000 6000 5000 6000

Calculation of EPS

Particulars Plan -A Plan -B Plan -C Plan-D

EBIT 150000 150000 150000 150000
Less: interest 0 20000 30000 0
EBT 150000 130000 120000 150000
Less Tax@ 50% 75000 65000 60000 75000
EAT 75000 65000 60000 75000
Less Preference Dividend 16000
EAESH 75000 65000 60000 59000
Divide by No. of ES (Refer
8000 6000 5000 6000
working Note)
EPS 9.38 10.83 12.00 9.83
Rank 4 2 1 3

Interpretation: Plan C is preferrable over other plans. Since the EPS is highest.

16
18. A firm has sales of Rs. 10,00,000. The variable cost is Rs. 7,00,000.
The fixed cost is Rs. 2,00,000
and Debt of Rs. 5,00,000 is at 10% rate of interest per annum.
(a) What are the three leverages?
(b) If the firm wants to double its EBIT, how much of increase in sales would
be needed on a percentage basis; also find out the new sales value.

Answer:

Calculation of Operating & Financial Leverages of ABC ltd

Particulars Rs
Sales 10,00,000
Less: Variable cost 7,00,000
Contribution 3,00,000
Less: Fixed Cost 2,00,000
EBIT 1,00,000
Less: interest = (5,00,000 * 10%) 50000
EBT 50000
Operating Leverage = (Contribution / EBIT) 3 times
Financial Leverage = (EBIT / EBT) 2 times
Combined leverage = (Contribution / EBT) 6 times

Contribution ratio = Contribution / Sales *100 = 30%

Sales = Contribution/Contribution ratio

% increase in sales
= (1333333-1000000)/1000000*100 = 33.33

17
19. From the following financial data prepare the statement of profitability: -

Particulars Company A Company B Company C

Variable Cost as a percentage of sales 66 2/3% 75% 50%
Interest Expenses Rs. 200 Rs. 300 Rs. 100
Degree of operating leverage 5:1 6:1 2:1
Degree of financial leverage 3:1 4:1 2:1
Income tax rate 50% 50% 50%

Answer:

Income statement (in Rs)

Particulars Company Company Company

A B C
Sales 4500 9600 800
Less: VC 3000 7200 400
Contribution 1500 2400 400
Less: FC 1200 2000 200
EBIT 300 400 200
Less: Interest 200 300 100
EBT 100 100 100
Less: Tax @50% 50 50 50
EAT 50 50 50

Working Note-1: (Calculation of EBIT)

Company A Company B Company C

𝐸𝐵𝐼𝑇 3 𝐸𝐵𝐼𝑇 4 𝐸𝐵𝐼𝑇 2
𝐷𝐹𝐿 = = 3: 1 = 𝐷𝐹𝐿 = = 4: 1 = 𝐷𝐹𝐿 = = 2: 1 =
𝐸𝐵𝑇 1 𝐸𝐵𝑇 1 𝐸𝐵𝑇 1
𝐸𝐵𝐼𝑇 3 𝐸𝐵𝐼𝑇 4 𝐸𝐵𝐼𝑇 2
= = =
𝐸𝐵𝑇 1 𝐸𝐵𝑇 1 𝐸𝐵𝑇 1

Let EBIT=x and EBIT – Interest = EBT EBIT – Interest = EBT

EBT be x-200 4 – Interest = 1 2 – Interest = 1
3 𝑥 Interest = 3 = Rs 300 Interest = 1 = Rs 100
=
1 𝑥 − 200
EBIT = 300 *4/3 = 400 EBIT = 100 *2/1 = 200
𝑥 = 3𝑥 − 600 EBT = 300 * 1/3 = 100 EBT = 100 * 1/1 = 100
3𝑥 − 𝑥 = 600
2𝑥 = 600
𝑥 = 300

EBIT = =300
EBT = 300-200 = 100

18
Working Note-2: (Calculation of Contribution)

Company A Company B Company C

𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛 5 𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛 6 𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛 2
𝐷𝑂𝐿 = = 5: 1 = 𝐷𝑂𝐿 = = 6: 1 = 𝐷𝑂𝐿 = = 2: 1 =
𝐸𝐵𝐼𝑇 1 𝐸𝐵𝐼𝑇 1 𝐸𝐵𝐼𝑇 1
𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛 5 𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛 6 𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛 2
= = =
300 1 400 1 200 1

𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛 = 𝐸𝐵𝐼𝑇 ∗ 𝐷𝑂𝐿 𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛 = 𝐸𝐵𝐼𝑇 ∗ 𝐷𝑂𝐿 𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛 = 𝐸𝐵𝐼𝑇 ∗ 𝐷𝑂𝐿

5 6 2
𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛 = 300 ∗ = 1500 𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛 = 400 ∗ = 2400 𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛 = 200 ∗ = 400
1 1 1

Working Note-3: (Calculation of Sales)

Company A Company B Company C

VC % on sales is 66.66 VC % on sales 75 VC % on sales 50

Sales – VC = Contribution Sales – VC = Contribution Sales – VC = Contribution

100% - 66.66% = 33.34% 100% - 75% = 25% 100% - 50% = 50%

Contribution = Rs 1500 = Contribution = Rs 2400 = 25% Contribution = Rs 400 = 50%

33.34%
100 100
100 𝑆𝑎𝑙𝑒𝑠 = 2400 ∗ 𝑆𝑎𝑙𝑒𝑠 = 400 ∗
𝑆𝑎𝑙𝑒𝑠 = 1500 ∗ 25 50
33.34
= 9600 = 800
= 4499 = 4500

Approx. = 4500

19
20. A company’s capital structure consists of the following :-

Equity shares of Rs.100 each Rs. 10,00,000

Retained Earnings Rs. 5,00,000
9% Preference Shares Rs. 6,00,000
7% Debentures Rs. 4,00,000
Total Rs. 25,00,000

The company earns 12% on its capital. The income tax rate is 50%. The company requires a
sum of Rs. 12,50,000 to finance its expansion program for which the following alternatives
are available:-
(a) Issue of 10,000 equity shares at a premium of Rs. 25 per share
(b) Issue of 10,000 10% preference shares
(c) Issue of 10,000, 8% Debentures
It is estimated that the price earning ratios for equity, preference and debenture financing
would be 21.4, 17, 15.7 respectively. Which of the three financing alternatives would you
recommend and why?

ANSWER:

𝑴𝑷𝑺
𝑷𝒓𝒊𝒄𝒆 𝒆𝒂𝒓𝒏𝒊𝒏𝒈 𝒓𝒂𝒕𝒊𝒐 =
𝑬𝑷𝑺

MPS = Price Earnings ratio * EPS

Calculation of EPS

Particulars Plan – A Plan-B Plan-C

EBIT = [(25,00,000+12,50,000)* 12%] 4,50,000 4,50,000 4,50,000
Less: interest
Old = (4,00,000 * 7%)
Plan - C (Additional) = (12,50,000 *8%) 28,000 28,000 1,28,000
EBT 422000 422000 3,22,000
Less: Tax @50% 211000 211000 1,61,000
EAT 211000 211000 1,61,000
Less: Preference Dividend
Old = (6,00,000 * 9%)
Plan-B (Additional) = (12,50,000 *10%) 54,000 1,79,000 54,000
EAESH 1,57,000 32,000 1,07,000
No. of Equity Shares
OLD = 10000 20,000 10,000 10,000
Plan - A (Additional) = 10000 shares shares shares
EPS = (EAESH / No. of ES) 7.85 3.2 10.7
Rank based on EPS 2 3 1

Price Earnings ratio 21.4 17 15.7

MPS 168 54.4 168

20
21. The following is the balance sheet of PQR ltd :-

Liabilities Amount (Rs) Assets Amount (Rs)

Equity Share Capital of Rs.10 each 1,20,000 Net Fixed Assets 3,00,000
10% long term debt 1,60,000 Current Assets 1,00,000
Retained Earnings 40,000
Current Liabilities 80,000
4,00,000 4,00,000

The company’s total asset turnover ratio is 3. Its fixed operating cost is Rs. 2,00,000 and the
variable cost is 40% of the sales. The income tax rate is 35%.
(a) Calculate all the types of leverages and EPS
(b) Determine the likely EBIT if the EPS is one, if the EPS is three and if the EPS is
zero.

ANSWER:

𝑆𝑎𝑙𝑒𝑠
𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠 𝑇𝑢𝑟𝑛𝑜𝑣𝑒𝑟 𝑅𝑎𝑡𝑖𝑜 = =3
𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠

𝑆𝑎𝑙𝑒𝑠
=3
400000

𝑆𝑎𝑙𝑒𝑠 = 12,00,000
Calculation of EPS

Particulars Rs
Sales 1200000
Less: Variable cost @ 40% 4,80,000
Contribution 7,20,000
Less: Fixed cost 2,00,000
Earnings before interest and tax (EBIT) 5,20,000
Less: Interest = (1,60,000 * 10%) 16,000
Earnings before tax (EBT) 5,04,000
Less: Tax @ 35% 1,76,400
Earnings after tax (EAT) 3,27,600
Less : Preference Dividend 0

Earnings Available to Equity shareholders (EAESH)

3,27,600
Divided by Number of Equity shares 12000
EPS = (EAESH / No. of ES) Rs 27.3
Operating Leverage = (Contribution / EBIT) 1.45 times
Financial Leverage = (EBIT / EBT) 1.57 times

21
22. ABC ltd needs Rs. 10,00,000 for expansion. The expansion is expected to yield an annual
EBIT of Rs. 1,60,000. In choosing a financial plan with the objective of maximum EPS,
ABC ltd. is considering the possibility of issuing shares or raising debentures. The debt in
the three financial plans are :-
Scheme (a) :Rs. 1,00,000 debentures, Rs. 9,00,000 equity share capital
Scheme (b): Rs. 4,00,000 debentures, Rs. 6,00,000 equity share capital
Scheme (c) :Rs. 6,00,000 debentures, Rs. 4,00,000 equity share capital
The current market price per share is Rs. 25 and is expected to drop to Rs. 20 if the debts
raised is more than Rs. 5,00,000. Funds can be borrowed at the rates as indicated:
(1) Up to Rs. 1,00,000 @ 8%
(2) Over Rs. 1,00,000 up to Rs. 5,00,000 @ 12%
(3) Above Rs. 5,00,000 @ 18 %
Assume tax rate at 50% and calculate the EPS for three
alternatives if:
(a) The rates of interest is calculated at the flat rate on the sum borrowed @ 8%
(b) The debt rate of interest is calculated at the slab rate with incremental rates as the
debt increases.

ANSWER:

Working Note - 1: Calculation of No. of Equity shares Shares

Scheme (a) Scheme (b) Scheme (C)

Debentures 1,00,000 4,00,000 6,00,000
Equity Capital 9,00,000 6,00,000 4,00,000
Price per share 25 25 20
No. of Equity 36000 shares 24000 shares 20000 shares
shares

Working Note - 2: Calculation of Interest as per the slab rate

Scheme (a)
Interest = 100000 * 8% = Rs 8000

Scheme (b)

Interest = 100000 * 8% = Rs 8000

Interest = 300000 * 12% = Rs 36000
Total interest = Rs 44000

Scheme (C)

Interest = 100000 * 8% = Rs 8000

Interest = 400000 * 12% = Rs 48000
Interest = 100000 * 18% = Rs 18000
Total interest = Rs 74000

22
Calculation of EPS (flat rate interest on the sum borrowed.)

Particulars Scheme (a) Scheme (b) Scheme (C)

EBIT 1,60,000 1,60,000 1,60,000
Less: interest @ 8% 8,000 32,000 48,000
EBT 1,52,000 1,28,000 1,12,000
Less: Tax @50% 76,000 64,000 56,000
EAT 76,000 64,000 56,000
Less: Preference Dividend 0 0 0
EAESH 76,000 64,000 56,000
No. of Equity Shares (Ref W.Note -1) 36000 24000 20000
EPS = (EAESH / No. of ES) 2.11 2.67 2.80
Rank based on EPS 3 2 1

Interpretation: Flat interest rate Capital structure Scheme (C) is preferred based on EPS.

Calculation of EPS (The rates of interest as per slab) rates)

Particulars Scheme (a) Scheme (b) Scheme (C)

EBIT 1,60,000 1,60,000 1,60,000
Less: interest (Ref W.Note 2) 8,000 44,000 74,000
EBT 1,52,000 1,16,000 86,000
Less: Tax @50% 76,000 58,000 43,000
EAT 76,000 58,000 43,000
Less: Preference Dividend 0 0 0
EAESH 76,000 58,000 43,000
24000 20000
36000 shares
No. of Equity Shares (Ref W.Note -1) shares shares
EPS = (EAESH / No. of ES) 2.11 2.42 2.15
Rank based on EPS 3 1 2

Interpretation: if Slab interest rate is considered, Capital structure Scheme (b) is preferred
based on EPS.

23
23. A project under consideration by a company requires a capital investment of Rs.
60,00,000. The interest on term loan is 10% per annum and the tax rate is 50%. Calculate
the point of indifference for the project if the debt equity ratio insisted to be is 2:1.

Answer:

Assuming Per share price is Rs 100

Alternative A = Rs. 60,00,000 Equity

No. of ES = 60000

Alternative B (debt equity ratio insisted to be is 2:1)

𝐷𝑒𝑏𝑡 2
debt equity ratio = = 2: 1 =
𝐸𝑞𝑢𝑖𝑡𝑦 1

Debt = 60,00,000 * 2/3 = Rs 40,00,000

Equity = 60,00,000 * 1/3 = Rs 20,00,000
No. of ES = 20000
Interest = Rs 40,00,000 * 10% = Rs 4,00,000

Calculation of Indifference Point

(𝑬𝑩𝑰𝑻 − 𝑰)(𝟏 − 𝒕) − 𝑷𝑫 (𝑬𝑩𝑰𝑻 − 𝑰)(𝟏 − 𝒕) − 𝑷𝑫

𝑬𝑷𝑺 = = 𝑬𝑷𝑺 =
𝑵𝒐. 𝒐𝒇 𝑬𝒒𝒖𝒊𝒕𝒚 𝒔𝒉𝒂𝒓𝒆𝒔 𝑵𝒐. 𝒐𝒇 𝑬𝒒𝒖𝒊𝒕𝒚 𝒔𝒉𝒂𝒓𝒆𝒔

(𝐸𝐵𝐼𝑇 − 0)(1 − 0.5) − 0 (𝐸𝐵𝐼𝑇 − 400000)(1 − 0.5) − 0

=
60000 20000

(𝐸𝐵𝐼𝑇)(0.5) (𝐸𝐵𝐼𝑇 − 400000)(0.5)

=
60000 20000

0.5 𝐸𝐵𝐼𝑇 0.5 𝐸𝐵𝐼𝑇 − 200000

=
60000 20000
Cross multiply

0.5 𝐸𝐵𝐼𝑇 ∗ 20000 = (0.5 𝐸𝐵𝐼𝑇 − 200000) ∗ 60000

10000 𝐸𝐵𝐼𝑇 = 30000 𝐸𝐵𝐼𝑇 − 12000000000

10000 𝐸𝐵𝐼𝑇 − 30000 𝐸𝐵𝐼𝑇 = −12000000000

−20000 𝐸𝐵𝐼𝑇 = −12000000000
20000 𝐸𝐵𝐼𝑇 = 12000000000

12000000000
𝐸𝐵𝐼𝑇 = = 600000
20000

24
24. A new project under consideration requires a capital outlay of Rs. 600 lakhs for which the
fund 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 lakhs and by the issue of 15% long term debt of Rs.
200 lakhs. Find out the indifference level of EBIT, given the tax rate is at the rate of 50%.

Answer:

Calculation of Indifference Point

(𝑬𝑩𝑰𝑻 − 𝑰)(𝟏 − 𝒕) − 𝑷𝑫 (𝑬𝑩𝑰𝑻 − 𝑰)(𝟏 − 𝒕) − 𝑷𝑫

𝑬𝑷𝑺 = = 𝑬𝑷𝑺 =
𝑵𝒐. 𝒐𝒇 𝑬𝒒𝒖𝒊𝒕𝒚 𝒔𝒉𝒂𝒓𝒆𝒔 𝑵𝒐. 𝒐𝒇 𝑬𝒒𝒖𝒊𝒕𝒚 𝒔𝒉𝒂𝒓𝒆𝒔

(𝐸𝐵𝐼𝑇 − 0)(1 − 0.5) − 0 (𝐸𝐵𝐼𝑇 − 3000000)(1 − 0.5) − 0

=
600000 400000

(𝐸𝐵𝐼𝑇)(0.5) (𝐸𝐵𝐼𝑇 − 3000000)(0.5)

=
600000 400000

0.5 𝐸𝐵𝐼𝑇 0.5 𝐸𝐵𝐼𝑇 − 1500000

=
600000 400000
Cross multiply

0.5 𝐸𝐵𝐼𝑇 ∗ 400000 = (0.5 𝐸𝐵𝐼𝑇 − 1500000) ∗ 600000

200000 𝐸𝐵𝐼𝑇 = 300000 𝐸𝐵𝐼𝑇 − 900000000000

200000 𝐸𝐵𝐼𝑇 − 300000 𝐸𝐵𝐼𝑇 = −900000000000

−100000 𝐸𝐵𝐼𝑇 = −900000000000
100000 𝐸𝐵𝐼𝑇 = 900000000000

900000000000
𝐸𝐵𝐼𝑇 = = 𝑅𝑠 9000000
100000

25
25. Skyline software ltd. has a project requiring an investment of Rs. 30,00,000 for which it
can raise the entire sum through equity shares of Rs. 100 each or through 10%
debentures, 12% preference shares and equity shares, all in equal proportion. If the tax
rate is 40%, calculate the point if indifference for the two capital structures.

Answer:

Calculation of Indifference Point

[(𝑬𝑩𝑰𝑻 − 𝑰)(𝟏 − 𝒕)] − 𝑷𝑫 [(𝑬𝑩𝑰𝑻 − 𝑰)(𝟏 − 𝒕)] − 𝑷𝑫

𝑬𝑷𝑺 = = 𝑬𝑷𝑺 =
𝑵𝒐. 𝒐𝒇 𝑬𝒒𝒖𝒊𝒕𝒚 𝒔𝒉𝒂𝒓𝒆𝒔 𝑵𝒐. 𝒐𝒇 𝑬𝒒𝒖𝒊𝒕𝒚 𝒔𝒉𝒂𝒓𝒆𝒔

[(𝐸𝐵𝐼𝑇 − 0)(1 − 0.4)] − 0 [(𝐸𝐵𝐼𝑇 − 100000)(1 − 0.4)] − 120000

=
30000 10000

(𝐸𝐵𝐼𝑇)(0.6) [(𝐸𝐵𝐼𝑇 − 100000)(0.6)] − 120000

=
30000 10000
0.6 𝐸𝐵𝐼𝑇 0.6 𝐸𝐵𝐼𝑇 − 60000 − 120000
=
30000 10000
0.6 𝐸𝐵𝐼𝑇 0.6 𝐸𝐵𝐼𝑇 − 180000
=
30000 10000

Cross multiply
0.6 𝐸𝐵𝐼𝑇 ∗ 10000 = (0.6 𝐸𝐵𝐼𝑇 − 180000) ∗ 30000

6000 𝐸𝐵𝐼𝑇 = 18000 𝐸𝐵𝐼𝑇 − 5400000000

6000 𝐸𝐵𝐼𝑇 − 18000 𝐸𝐵𝐼𝑇 = −5400000000

−12000 𝐸𝐵𝐼𝑇 = −5400000000
12000 𝐸𝐵𝐼𝑇 = 5400000000

5400000000
𝐸𝐵𝐼𝑇 = = 𝑅𝑠 4,50,000
12000

26