compounded for a certain number of times per annum for a certain number of yea?

FORMULAE

1. FV =PV[I + r]" [FV = Future Value. PV = Present Value. r = rate of interest. nt

= number of years]
2. FV =PV [1 + rm]xm (m = number of times interest is compounded for]
3. FVA = A (l+n°-1 (FVA = Future Value of Annuity, A = Annuity.]

The Discounting Concept is simply the inverse of compounding concept. We cany

calculate Present Value and Present Value of Annuity as follows :
1. PV = FVI(1 + r"
2. Interest factor or discounting factor = 1/(1 + r)n
3. PVA = A/r [l - 1/(1 + r)] =Air [1 - Interest factor]
The best invest1Lènt proposai calu be selected by discounted cash flow technique
This method filids out Net Present Value (NPV). NPV = Sum of Present Values
of casl. inflows - Summ of Present values of cash
outflows. An investment
proposal giving maximum NPV, is the best.

PROBLEMS
SIMPLE INTEREST
1. Calculate amount of interest and future
simple interest after 5yea? value of 50,000 deposited at 10%% P
Sol. Simple Interest
= Principal amount x rale of
interest x liumber of years
= 50,000 × 0.1( × S
7 25,003
Add : Principal Aaount
Future Value alter 3 yea1s 50,000
75;)00
 INTRODUCTION 5

COMPOUND INTEREST
Calculate amount of interest and future value of
oompound interest payable half-yearly at the end of vear20,000
1. invested at 12% p.a.
Sol. Principal amount
Add : Interest for Ist half-year 20,000
1,200
Add : Interest for 2nd half-year 21,200
Future value after 1 year 1,272
22,472
2 Calculate future value of ?
50,000 invested at interest 10% p.a. compounded
annually after 5 years
Sol. Formula FV= PV (1 + r)p [FV = Future
value, PV =Present value
FV =50,000 (1 + 0.1)5 r = Rate of interest, n = No. of years)
= 50,000 (1.1)5
= 50,000 x 1.61051 = 80,525.
4, What amount is to be iuvested now at
10% compound interest to yield ? 40,000
after 10 years ?
FV
Sol. Formula PV=
(1+r):
PV =
Rs.40,000 Rs. 40,000 Rs. 40,000
(1+0.1)0 (1.1)l0 2.59374 =7 15,422.
5. Find out the waiting period to yield 30,000 at 6% compound interest from
investment of 15,000
Sol. FV = PV(! T )"
or, ? 30,000 = 15,000 (1 + 0.06)n
or, 30,000 = 15,000 (1.06)
or, 1.06n = 30,000/ 15,000 = 2
or, n log 1.06 = log2
or, n = log2/log 1.06 = 12 (approx) years
0. If àperson has io maki a choice between ? 1,00,000 today and 150,000 after
years at 7% interes compwunded annually, what he will take ?
Sol. PV = FV Rs. 1,50,000 1,50,000
= 1,06,948
(1+r (1+G.07) l.075
ee present value of 150.000 at 7% CI after 5 years =? 1,06,948 >? 1,00,000,
the person will take tlie second choice.
7. A person
can rceive 1,00,00 iS per ie following plans:
Plans
Year i C
40,000 * 25,000
Year 2 725,000
Year 3 40,00G 7 25,000
Year 4 20,000
50,000
25,000
Total Investment ? 1,00,U00
50,000
? 1,00,000 7 1,00,000
 FINANCIAL MANAGEMENT
6

?
If the discount factor is 10%, which plan he will opt
(1+i)" Can you
plan at discount factor 7%. receive
Find out also, the present value of the best be made at present in order to
determine maximum amount of investment that can
cash inflows as per the best plan ?
Sol. B
A Cash Present
Plans Cash Present Value
Discount Cash Present Inflow
Year Value
Value Inflow
Factor Inflow
25,000 22,782
at 10%
0.9091 40,000 36,364 25,000 20,660
1
0.8264 25,000 18,783
2 50,000 37,565
0.7513 40,000 30,052 25,000 17,075
3 50,000 34150
0.6830 20,000 13,660 1,00,000 79,246
4 71.715
1,00,000 80.076 1,00,000
maximum.
that present value of Plan A f 80,076) is
seen
From above workings, it is
So, Plan A should be wanted. Plan A
Cash Inflow Present Value
Year Discount Factor
at 7%
0.9346 40,000 37,384
2 0.8734
0.8163 40,000 32,652
3
0.7629 20,000 15,258
4
1,00,000 85,294
Maximum 85,293 can be invested at present because present value of cash inflows
is 85,294.
8. A person can receive ? 50,000 after 3years or ? 40,000 after 1 year. Find out
the better option when discount rate is (i) 10% or (ii) 15o. Find out also the discount
rate at which he will be indifferent for any option.
Sol.
Option 1 Option 2
Cash Inflow Cash Inflow
7 50,000 40,000
after 3 years after 1 year
() Discount rate = 10%
Present Value 50,000 x 0.7513 40,000 x 0.9091
=37,565 =? 36,364
(ii) Discount rate =15%
Present Value 50,000 x 0.6575 40,000 x 0.8696
=32,875 =34,784
 INTRODUCTION
At discount rate 10%, option 1 is better.
At 15%,
aleulation
99

of discount rate at which any plan will produce equal

Rs. 40,000 Rs. 50,000 present value
or, (1+r)³ Rs. 50,000
(1+r)' (1+ r)³(1+r)' Rs. 40,000
or, (1 + r)² = 125 or, 1 + r= 1.1180
or, r = 0.1180 = 11.80%
Check
7 40,000 x 0.8945 = 35,780
750,000 x 0.7156 = 35,780
0 If vou deposit
5,00,000 in a bank for 3
after every 4 months, 1.e., 3 times a year, what years at 9% interest compounded
should be the maturity value at the
end of 3 years ?
\nx m
Sol. Formula : FV =
Pv1
i. FV= ? 5,00,000 140.09 *3
3
= 5,00,000 (1.03)9
= 5,00,000 x 1.3048
=6,52,400
10. A company can invest ? 25,00,000 for 5 yeaY A
12% interest comnpounded half yearly or 13% financiai institutio.. allows
to choose the better plan. compounded yearly. Advise the company
Sol. 12% compounded 13% compounded
Future alue = half-yuly
25,00,0GG
yearly
? 25,00,000
Sx 2

=
X

?
1 x (1 +0. 13)5
25,00,000 x 1.7908 = 23,00,000 × 1.8424
=?44,77,00C = 46,06,000
Advise : Plan of 13% interest compounded yearly will produce ?
5 years. 1,29,000 more after
So, this plan is better thal1 the
other plan.
d the iuture vaiue of recurring deposit of Rs 2,000/- paid at the
Of each yearOutfor 4 years at btginning
Sol. interest % P.a.
10
Recurring deposit uf atixed suin is like deposit of annuity of afixed sum.
Formula: FVA
 FINANCIAL MANAGEMENT
8

(1+0.10)-1
.". FVA =
2009 0.10

1.14-1 0.4641
0.1
=
200| 0.1

2,000 × 4.641 = R9,282

=
of 75,000 from a commercial bank at 159% compound
12. A person takes a loan annual instalments starting 1 year after date of
equal
interest. He agrees to pay 5 payment and show the break up of each
instalment
instalment
loan. Find out amount of
into principal and interest. equal amount. It is like annuity.
Sol. Each instalment is of
Formula : PVA =
(1+r)
1
.:.775,000 =

.. A = 22,375 instalments
Break-up of annual Amount
Interest Payment
Instalment Amount toward of Principal
of @ 15% outstanding
Principal
instalmnent
22,375 - 11,250 75,000 - l1,125
22,375
15% × 75,000 = 63.875
1
=?11,250 =11,125
22,375 -9,581 63,875 - 12,794
22,375 15% × 63,875 = 51,081
2 = 9,58 1 = 12,794
22,375 -7,662 51,081 - 14,713
22,375 15% × 51,081 = 36,368
3
= 7,662 = 14,713
22,375 - 5,455 36,368 - 16,920
22,375 15% × 36,368 = 19,448
4 = 16,920
=5,455
19,448 NIL
5 22,375 2927 (balance)
36,875 75,000
Total 1,11,875

wants to reate an endowment fund from which money will be

13. A person
year. If the amount is to De
provided to a school for giving prizes of 10,000 each
invested for 10% interest, how much should be invested ?
Annual amount required
Sol. Amount to be invested
Rate of interest p.a.
Rs. 10,000
10% = 1,00,000
 C.U. QUESTIONS &
ANSWERS 9
4 What will be the present
value of 3,00,000 received after completing 6years
from depositing at interest 9% p.a. ?
n

Sol. Formula PV =

1
: PV= 3.00,00 (1+0.09) =?3,00,000 × 0.9174
= 3.00,000 x 0.5961 =? 1,78,830.
 7. Market Price of equity shares of X Ltd.
as on 1.1.2001 7 240
and as on 31.12.2005 7 300
1he company paid dividend per share of 14 for first 3 vears, and ? 14.50 for
next 2 years.
equity
3sertain specific cost of Equity share capital from the view point of
shareholders.
 FINANCIAL MANAGEMENT
44

Sol.
Realized yield Approach
Discounted Cash Flow Method
(1st Trial]
DF PV
Year Cash @10%
inflows
14
0.909 12.726
2 14
0.826 11.564
3 14
0.751 10.514
14.50
0.683 9.903
4
5 300 + 14.50 0.621 195.305
240.012
Less PV of cash outflow 240.000
NPV
would be taken as specific cost of
As cut off rate is 10% (found after Ist trial), this
equity capital.
100 lakhs by one of two
8. A company is considering raising of funds of about
alternative methods. viz. 14%. institutional term loan and 13% non-convertible
debentures. The term loan option would attract no major incidental cost. The
debentures would have to be issued at a discount of 2.5% and would involve cost of
issue of?1 lakh.
Advise the company as to the better option based on the effective cost of capital
in eaçh case. Assume a tax rate of 50%.
(C.A. Final Nov. 1991)
Sol. Evaluation of raising 100 lakhs based on effective cost of capital
lakhs)
Particulars Option I Option 2
14% Term loan 13% NCD
Face value of amount 100.00
100.00
Less : Discount
2.50
100.00 97.50
Less :Cost of issue
1.00
Net effective amnount raised
() 100.00 96.50
Interest charges p.a. on face value 13.00
14.00
Less : Savings in ax @ 50% 6.50
7.00
Net interest cost 6.50
(ii) 7.00
Effective cost of capital (ii)/(i) x 100 6.74%
7%
Comment : The company should raise capital by issue of
its effective cost of capital is 6.74%, which is non-convertible debentures becauso
lower than (7%) cost of Term Lou
 COST OF CAPITAL 45

to determine the weighted average cost of capital (K) of the

9.You are required
() book value weights; and (ii) market value weights. The following
K.C. Ltd. usingavailable for your perusal. K.C. Ltd.'s present book value capital
information is
structure is :
()
Debentures ? 100 per debentures) 8,00,000
Preference shares (? 100 per share) 2,00,000
Equity shares (? 10 per share) 10,00,000
20,00,000
prices are debentures @
All these securities are traded in the capital markets. Recent
22. Anticipated external
7 110, preference shares @? 120 and equity shares @?
financing opportunities are :
rate, 4%
(i) 100 per debenture redeemable at par : 20-year maturity, 8% coupon
flotation costs, sale price ? 100.
maturity, 109% dividend rate,
(iü)) 100 preference share redeemable at par : 15-year
5% floatation costs, sale price 100.
price 22.
(iii) Equity shares? 2 per share flotation costs, sale
the end. of the year ? 2 per
In addition, the dividend expected on the equity share at company has the practice
share; the anticipated growth rate in dividends is 5% and the
dividends. The corporate tax rate is 50%.
of paying all its earning in the form of (C.S. Final Dec., 1996)

Sol. (i) Cost of Equity Capital (K)

K, = D1 +g= 2 + 0.50 =0.15 or 15%
NP 20
(i)Cost of Debentures (Kd)
100 96

K=
8+
20 29) a-o.s0)
100 + 96
(8.20)(0.50)
98
2

= 0.0418 or 4.18%
(ii) Cost of Preference Shares (Kp
100-95
10 + 15 10+0.33 = 0.1059 or 10.59%.
100+95 97.5
2
46 FINANCIAL MANAGEMENT

(1) WACC(Ko) (based on Book Values)

Source of capital Cost of capital
Book Value
(<)
Weight
(%) Weicostght(%)ed
Equity capital 0.50 15.00
10,00,000 7.50
10.59
Preference capital 2,00,000 0.10 1.06
Debentures 8,00,000 0.40 4.18 1.67
20,00,000 1.00 WACC=10.239
(2) WACC(K)(based on Market Values)
Source of capital Market Proportion Cost of Weighted
value capital COst
(<) (%) (%)
Equity share capital 22,00,000 .6626 15.00 9.94
Preference share capital 2,40,000 .723 10.59 0.77
Debentures 8,80,000 .2651 4.18 1.11
33,20,000 1.00 WACC = 11.82%
10. XYZ Ltd. has the following book value capital structure:

Equity capital crores)

(in shares of ? 10 each, ful!ly paid-up at par) 15
11% Preference capital
(in shares of 100 each, fully paid-up at par) 1
Retained earnings 20
13.5% Debentures (of 100 each)
15% Term loans 10
12.5
The next expected dividend on equity shares per share is
per share is expected to grow at the rate of 7%. The 3.60 and the dividend
market price per share is 4%
Preference stock, redeemable after ten years, is currently selling at 75
Debentures, redeemable after six years, are selling per share
at 80 per debenture.
The Income-tax rate for the
(i) Required to caleulate the company
is 40 %.
(a) book value weighted average co_t of capital using :
proportions
(b) market value proportions.
(ii) Define the weighted marginal cost of
raises 10 crores next year, given the capital schedule for the company,
(a) the amouni will be raised by equityfollowing information :
(b) the company expects to relain 1.5 and debt in equal proportions.
(c) the additional issue of equity shares willcorres earnings next year.
fixed at? 32.
result in the net price per share belms
 COST OF CAPITAL 8 47
term loans will cost 15% for the first
the debt capital raised by way of 2.5
(d) 2.5 crores.
and 16% for the next
crores 2000)
(C.A. Final Nov.,
Sol.
Cost of Equity Capital (K) and Cost of Retained Earnings (K,)
(1)
3.60 + 0.07= 0.16 or 16%
K,= + g=
40
Po
Capital (K)
(2) Cost of Preference Share
100-75
11+ 10 11+2.5
= 0.1543 or 15.43%
87.5
Kp 100+75
2
(3) Cost of Debentures (K)
100 80
13.5+ )a-o.40) (13.5 +3.33)(0.60)
K¡ 100 + 80 90
2
= 0.1122 or 11.22%
(4) Cost of Term Loans (K,)
Or 9%
K, = I(1- t) =0.15(1 0.40) = 0.09
(5) Cost of Fresh Equity Shares (Ke)
3.60 =0.1825 or 18.25%
K, = D
Po
+g = 32
+ 0.07

(6) Cost of Term Loans (K)

K, = I(1 - t)
On first? 2.5 crores term loan= 0.15 (1 0.40)
= 0.09 or 9%
On next 2.5 crores term loans = 0.16 (1 0.40)
= 0.096 or 9.6%

) (a) Calculation of WACC (using book value proportions)

Source of finance Post-tax Weighted
Book value Weight COst
Cost
crores)
0.04096
Equity capital 15.0 0.256 0. 1600
0.00262
11% Preference capital 1.0 0.017 0.1543
0.05472
Retained earnings
13.5% Debentures
20.0 0.342 0.1600
0.1122
0.01919
10.0 0.171
0.01926
15% Term loan 12.5 0.214 0.0900
. WACC= 13.67% WACC =0.13675
3.5 G00
 48 FINANCIAL MANAGEMENT

proportions)
(b) Calculation of WACC (using market value
Source of finance Market value Weight Post-tax
COst
Weighted
COSt
(R crores)
Equity capital 0.739 0.1600 0.11824
(1,50,00,000 x 40) 60.00
11% Preference capital 0.009 0.1543 0.00139
(1,00,000 x 75) 0.75
13.5% Debentures 0.1122 0.01099
8.00 0.098
(10,00,000 × 80) 0.0900 0.01386
12.50 0.154
15% Term loan
WACC = 0.14448
.:. WACC= 14.45% 81.25
calculation of WACCsince it does not
Note :Retained earnings is not considered for
of equity shares reflects the
have any market value separately. The market value
value of retained earnings also.
(ii) Calculation of WACC of XYZ Ltd. if it raises 10 crores next year
Source of finance Amount Weight Cost of Weighted cost
( crores) capital of capital %
1.5 0.5 0.160 0.080
Retained earnings
Debt 1.5 0.5 0.090 0.045
0.125 or 12.5%

Equity shares 1.0 0.5 0.183 0.091

Debt 1.0 0.5 0.090 0.045
0.136 or 13.6%
Equity shares 2.5 0.5 0.183 0.091
Debt 2.5 0.5 0.096 0.048
0.139 or 13.9%

11. A company is considering raising 100 lakh by one of the two alternative
methods viz, 14% institutional term loan and 13% non-convertible debentures. The
term loaa portion would attract no major incidental cost. The debentures would have
to be issued at adiscount of 2.5% and would involve 1lakh as cost of issue.
Advise the company as to the better option ivased on the effective cost of capitl
in each case. Assume a tax rate of 35%. (I.C.W.A. Final June, 2003)
Ans. (a) Cost of Institutional Term Loan
14
K, = I(1 - t) = J00(-0.35) = 0.091 or 9.1%
(b) Cost of Non-convertible Debentures
13
K =I(1 - ) =oE S(l -0.35) = 0.0876 or 8.76%
 COST OF CAPITAL
% 49
Suggestion The effective cost of capital is lower in
case of 13%.
debentures, hence the issue of debentures can be considered. Non-convertible
I Tt£. has the following book-value capital
structure
as on March 31, 200s
)
Equity share capital (2,00,000 shares) 40,00,000
11.5% Preference shares
10,00,000
10% Debentures
30,00,000
80,00,000
The equity share of the company sells for ? 20. It is expected that the company will
pay next year a dividend of * 2 per equity share, which is expected to grow at 5% p.a.
forever. Assume a 35%% corporate tax rate.
Required :
() Compute weighted average cost of capital (WACC) of the company based on the
existing capital structure.
(i) Compute the new WACC, if the company raises an additional 20 lakhs debt by
issuing 12% debentures. This would result in increasing the expected equity dividend to
2.40 and leave the growth rate unchanged, but the price of equity share will fall to ?
16 per share. (C.A. PE-II May, 2003)
Sol. (i) WACC based Existing Capital Structure
(a) Cost of Equity Capital

K= +g= + 0.05 = 0.15 or 15%.

Po
(b) Cost of Preferelnce Shares

K= NP 100
= 0.115 or 11.5%

(c) Cost of Debentures

K¡ = I(1 - t) = 10%(1 0.35) = 6.5%
WACC (based on book values)
Source of capita! Book va'ues Weight Post-tax Weighted
cost% cost%

Equity share saplii 40,00,00C 0.500 15.0 7.50

11.5% Preference shares 10,00,000 0.125 11.5 1.44
10% Debentures 6.5 2.44
30,00,000 0.375
WACC = 11.38%
89,00,000 1.000
FM-4
 50 FINANCIAL MANAGEMENT

(ii) WACC (based on revised capital structure)

(a) Cost of Equity Capital
K, = 2.40
16
+ 0.05 = 0.20 Or 20%

(b) Cost of Preference Shares

Kp Dp_ 11.5 = 0.115 or 11.5%

NP 100
(c) Cost of 10% Debentures
KË = 1(1 - t) =10% (1 - 0.35) = 6.5%
(d) Cost of 12% Debentures
K¡ = I(1 - t) = 12% (1 -0.35) = 7.8%
WACC (based on book values, after raising additional finance by issue of 12%
debentures)
Source of finance Book values Weight Post-tax Weighted
cost% Cost%
Equity share capital 40,00,000 0.4 20.0 8.00
11.5% Preference shares 10,00,000 0.1 11.5 1.1
10% Debentures 30,00,000 0.3 6.5 1.95
12% Debentures 20,00,000 0.2 7.8 1.56
1,00,00,000 1.0 WACC= 12.66%
 LEVERAGE
% 63
Comments :
Contribution to Sales ratio is more in case of B. Ltd.
" Operating leverage for B. Ltd. is more than that of A. Ltd. indicating a larger
proportion of fixed costs in the former. The ratio of Fixed cost to Sales is 37.5% for B.
26.67% for A. Ltd.
Ltd. "against
Financial leverage for B. Ltd. is 3 against 2 for A. Ltd. This indicates a higher
percentage of debt in the capital structure of B. Ltd. although in absolute terms the interest
pel less. Interest accounts for 8.33% of sales realisation in B. Ltd. as against 6.67%
only for A. Ltd.
eAlthough Contribution to Sales is more for B. Ltd., both Operating leverage and
Einancial leverage are higher for the company. As a result profitability (EAT/Sales) is
only 2.5% as against 4% for A. Ltd.
3The Balance Sheet of Alpha Numeric Company is given below :
Liabilities 7 Assets
Equity capital (? 10 per shares) 90,000 Net fixed assets 2,25,000
10% Long-term debt 1,20,000 Current assets 75,000
Retained earnings 30,000
Current liabilities 60,000
3,00,000 3,00.000
The company's total assets turnover ratio is 3, its fixed operating cost is 1,50,000
and its variable operating cost ratio is 50%. The income-tax rate is 50%.
You are required to (i) Calculate the different types of leverages for the company (ii)
Determine the likely level of EBIT if EPS is : (a) Re. 1(b) 2c) Re. 0. (C.s.
final Dec. 2000)
Solution:
Sales
Total assets = Sales Turnover Ratio

Sales
3,00,000 =3
:. Sales = 3x 3,00,000
(i) Calculation of =9,00,000
Income statement Leverages
for the ycar ended ()
Sales 9,00,000
Less : Variable cost (50% 4,50,000
of sales)
Contribution
Less : ixed
4,50,000

EBIT operating cOSt 1,50,000

3,00,000
Less : Interest (
1.20.000 × 10/100) 12,000
64 FINANCIAL MANAGEMENT

EBT 2,88,000
Less : Tax (@ 50%) 1,44,00
EAT 1,44,000
Contribution 4,50,000 = 1.50
(a) Operating Leverage EBIT 3,00,000
EBIT 3,00,000
(b) Financial Leverage = EBT 2,88,000 1.04
Combined Leverage = Operating leverage x Financial leverage = l.50 x 1.04.
(C)
1.56
different levels of EPS
(ii) Calculation of likely levels of EBIT at
(EBIT - I)(1-t)
EPS
N

(a) Level of EBIT, if EPS is Re. 1

(EBIT - 12,000)(1 -0.50)
1 =
9,000
or, 9,000 = (EBIT - 12,000) (0.50)
Or, 9,000 = 0.50 EBIT - 6,000
or, 0.50 EBIT = 9,000 + 6,000
.". EBIT =15,000/0.50 =? 30,000
(b) Level of EBIT, if EPS is 2

2 = (EBIT -12,000)(1-0.50)
9,000
or, 9,000 × 2 = (EBIT 12,000) (0.50)
or, 18,000 = 0.50 EBIT - 6,000
or, 0.50 EBIT = 18,000 + 6.000
. EBIT = 24,000/0.50 =? 48,000
(c) Level of EBIT, if EPS is Re. 0

0= (EBIT-12,000)(1 -0.50)
9,000
or, 9,000 x 0 = (EBIT - 12,000) (0.50)
or, 0.50 EBIT - 6,000 = 0
or, 0.50 EBIT = 6,000
.. EBIT=6,000/0.50 =? 12,000
 LEVERAGE
65
4. You are a finance manager in Big Pen Ltd. The degree of operating leverage
company is 5.0. The degree of financial leverage of yóur company is 3.0.
of yourManaging Director has found that the degree of operating leverage and the
Your financial leverage of your nearest competitor Small Pen Ltd. are 6.0 and
degree of
respectively. In his opinion, the financial position of Small pen Ltd. is better than
4.0 Pen Ltd. because of higher degree of leverages. Do you agree with the
that of Big ? Give reasons.
opinion of your Managing Director
Solution :
Particulars
Big Pen Ltd. Small Pen Ltd.

Contribution 5 6
1.Operating Leverage = EBIT
EBIT 3 4
2. Financial Leverage = EBT
Contribution 15 24
3. Combined Leverage = EBT
Small Pen Ltd. is 6. It means
The operating leverage of Big Pen Ltd. is 5 and of of Small Pen Ltd. than that
EBIT
change in the level of sales will have more impact on
be higher in case of Small Pen Ltd. than
of Big Pen Ltd. The volume of fixed cost may
is also more as compared to
that of Big Pen Ltd. The business risk of Small Pen Ltd.
Big Pen Ltd.
financial leverage of Big Pen Ltd. is 3, and of Small Pen Ltd. is 4. It means
The
interest burden of Small Pen Ltd. is higher than Big Pen Ltd. Financial risk of Small
the
Pen Ltd. is higher as compared to Big Pen Ltd.
degree of combined leverage of Big Pen Ltd. is 15 and that of Small Pen Lid.
" The more impact on EPS in case of Small Pen
It means any change in sales will show
1S 24.
Ltd.
view of the above, the Managing Directors' opinion about Small Pen Ltd. is wrong.
In and financial risk as compared to Small
Inerefore, Big Pen Ltd. carries less business risk
Pen Ltd.

company is 10,00,000 with shares of face value of

eshare capital of a 6,00,000 at 10% rate of interest. The sales of
capital of ?
the ecompany has debt annum at a selling price of 5 per unit and the
per
Variok are S,00,000 units fixed cost amounts to ? 2,00,000. The company
COSt Is ?3 per unit. The
Dave
pays tax at 35 %. If the sales increase by 10 %, calculate :
(4) Percentage increase in EPS.
(ii) Degree of operating leverage at the two levels, and
(1) Degree of financial leverage at the two levels. (C.S. Final Dec. 2003)

FM-5
66 FINANCIAL MANAGEMENT

Solution :

Particulars
Existing level Revised level
Sales (units)
3,00,000
3,30,00)
Sales (@? 5)
15,00,000
16,50,00,
Less : Variable cost (@? 3)
9,00,000 9,90,00%
Contribution
6,00,000 6,60,00
Less: Fixed cost
2,00,000 2,00,000
EBIT
4,00,000 4,60,00
60,000 60,000
Less : Interest 3,40,000 4,00,000
1,19,000 1,40,000
Less: Tax @35% 2,21,000 2,60,000
EAT

EAT
(i) EPS = No. of shares
Rs. 2,21,000 =? 2.21
Existing 1,00,000 shares
Rs. 2,60, 000 = 2.60
Revised
1,00,000 shares
0.39
Percentage increase in EPS = x 100 = 17.65%
2.21
Contribution
(ii) Degree of Operating Leverage EBIT
6,00,000 = 1.5 Revised = 6,60,000 = 1.43
Existing 4,00,000 4,60,000
EBIT
(ii) Degree of Financial Leverage = EBT
4,00,000 4,60,000
Existing = 3,40,000 =1.176 Revised = 4,00,000 = 1.150

below .
6. Tlhe data relatiLz to to companies Gre as given
Particulars Company A Company B
Equity Capital 7 6,00,000 3,50,000
12% Debentures ? 4,00,000 ?6,50,000
Output (units) p.a. 60,000 15,000
Selling price unit ?30 7 250
Fixed costs p.a. ? i,00,000 ? 14,00,000
Variable cost p.u. ?75
 LEVERAGE 8 67

required to calculate the operating leverage, financial leverage and combined

You are companies.
leverage two
of
(C.A. PE-II Nov. 2002)
Solution :
<)
Particulars Company A Company B
Output (units) 60,000 15,000
30 250
Selling price p.u.
p.u. 10 75
Less : Variable cost
20 175
Contribution p.u.
Total contribution 12,00,000 26,25,000
7,00,000 14,00,000
Less : Fixed costs
5,00,000 12,25,000
EBIT
Interest 48,000 78,000
Less
4,52,000 li,47,000
EBT

Contribution
(a) Operating Leverage EBIT

12,00,000 26,25, 000 = 2.14

Company A = 5,00,000 2.4 Company B = 12,25, 000
EBIT
(b) Financial Leverage =
EBT
5,00,000 12,25,000 = 1.07
Company A = 4,52,000 = 1.11 Company B = 11,47,000
(c) Combined Leverage = Operaging Leverage x Financial Leverage
Company A = 2.4 x 1.11 = 2.66
Company B = 2.14 x 1.07 = 2.29
7. The following summarises the percentage changes in operating income,
percentage changes in revenues, and betas for four pharmaceutical firms.
Firm Change in revenue Change in operating income Beta
POR LId. 27% 25% 1.00
RST LId. 25% 32% .15

TUV Ltd. 23% 36% 1.30

WXY Ltd. 21% 40% 1.40
 68 FINANCIAL MANAGEMENT

Required :
(i) Calculate the degree of operating leverage for each of these firms. Comment also
different beta
(ii) Use the operating leverage to explain why these firms have
(C.A. PE-II November 2004)
Solution :
(i) Calculation of Operating Leverage
%change in Operating Income
Degree of Operating Leverage = ochange in Re venues
PQR Ltd. RST Ltd. TUV Ltd. WXY Ltd.
0.25 0.32 0.36 0.40

0.27 0.25 0.23 0.21

= 0.926 = 1.2 = 1.565 = 1.905

The degree of operating leverage measures the responsiveness of EBIT to change in

levels of output and it indicates the response of profits with alteration of output and sales
levels.
(ii) WXY Ltd's operating leverage is twice of PQR Ltd. as the fixed overheads might
be higher. The higher the operating leverage ratio the situation is more risky. While a
low ratio indicates a large absorption capacity of a firm in times of adversity. A firm
with high operating leverage will have a higher Beta since the business risk level is higher.
8. A company earns a profit of ? 3,00,000 per annum after meeting its interest
liability of 1,20,000 on 12% debentures. The tax rate is 50%. The number of equity
shares of 10 each are 80,000 and retained earnings amount to ? 12,00,000. The
company propOses to take up an expansion scheme for which a sum of 4,00,000 is
required. It is anticipated that after expansion, the company will be able to achieve
the same return on investment as at present. The funds required for expansion can
be raised either through debt at the rate of 12% or by issuing equity shares at par.
Required :
() Compute the earnings per share (EPS), if :
the additional funds were raised as debt
the additional funds were raised by issue of equity shares
(ii) Advise the company as to which source of finance is preferable.
(CAPE-I Nov. 2002)
Solution :
1. Capilal employed before expansion plan ()
Equity Shares 8,00,000
Debentures (? 1,20,000/12) x 100 10,00,000
Retained earnings 12,00,000
Tota1 capital employed 30,00,00G
 LEVERAGE
B 69
Earnings before the paymnent of interest and tax (EBIT) ()
2.
Profit 3,00,000
Interest 1,20,000
EBIT 4,20,000
Investment (ROI)
3. Return on

ROI =
EBIT X 100 = Rs. 4,20,000 X 100 = 14%
Capital employed Rs. 30,00,000
A Earnings before the payment of interest and tax (EBIT) after expansion :
Capital employed after expansion = 34,00,000
Desired EBIT = ? 34,00,000 x 14/100 =4,76,000
() Statement showing EPS under present and anticipated expansion scheme
Particulars Present situation Expansion scheme
Additional funds raised as
Debt Equity
EBIT (i) 4,20,00G 4,76,000 4,76,000
Interest Old debt 1,20,000 1,20,000 1,20,000
- New debt (@ 12%) 48,000
Total interest (ii) 1,20,000 1,68,000 1,20,000
EBT (i) (i) 3,00,000 3,08,000 3,56,000
Less : Tax (@ 50%) 1,50,000 1,54,000 1,78,000
PAT 1,50,000 1,54,000 1,78,000
Number of equity shares 80,000 80,000 1,20,000
EPS 1.875 1.925 1.48
(ii) Suggestion - If the compauy raises additional funds as debt the EPS would be
greater. Hence, it is suggested to raise additional funds in the form of debt.

EXERCISE
1, The
financial daa of ABC Ltd. is giveu below
Variable cost as % on sales 66%.
Interest 7 150
OL 5: 1
FL 3: 1
Tax Rate 55%
Prepaie the incom statement of the compa1y.