Chapter 8 : Leverage and CVP Analysis

2001 Dec 2b: The present output details of manufacturing department of Simple Ltd are as follows: Average output per week 48,000 units Saleable value of output : Rs. 60,000 ; Contribution made from sale : Rs. 24,000 The management plans to introduce more mechanization in the department at a capital cost of Rs. 16,000. As an effect of this the number of employees will be reduced from the existing strength of 160 nos to 120 nos, but the output of the individual will increase by 60%. As an incentive to achieve the extra output, the management proposes to offer an one per cent increase in the existing piece work price of Re. 0.10 per article for every 2% increase in the individual output achieved. In order to sell the increased output, it will be necessary to reduce the sale price by 4%. You are required to calculate extra weekly contribution resulting from the proposed changes, as above, and give your recommendation. Solution : Tutorial notes: 1. At present 160 workers are producing 48,000 units per week. It means present rate of production is 300 units per worker per week. 2. With more mechanization, workers will be 120 producing 480 (60% above current level of 300 units) per worker per week. Production will go up to 120 x 480 = 57,600 units. 3. The incentive is given as 1% for every 2% increase in individual output. The individual output increases by 60% as given, hence incentive will be 30% of the present rate of Re. 0.10. The revised rate will be Re.0.13 per piece. 4. The variable cost will also change with production. Presently the variable cost is Rs. 36,000 which includes Rs. 4,800 (48,000 x 0.10) as labour. Variable cost without labour is Rs. 31,200 which is 0.65 per unit (31,200 / 48,000). 5. Present selling price per unit is Rs. 1.25 (60,000 / 48,000). The proposed selling price is 4% less than the current selling price i.e. 0.96 x 1.25 = Rs. 1.20 per unit. 6. Solve the question on the above lines and compare your solution with the one given below. Comparative statement of present and proposed position Present Proposed Production in units 48,000 57,600 Selling price Rs. per unit 1.25 1.20 Sales revenue 60,000 69,120 Variable cost per unit Labour 0.10 0.13 Other 0.65 0.65 Total variable cost per unit 0.75 0.78 Total variable cost 36,000 44,928 Contribution 24,000 24,192 Extra contribution in proposed scheme : Rs. 192 per week. Present capital outlay : Rs. 16,000. Break even will be 16,000 / 192 = 83.3 weeks. If the present scheme is implemented, the scheme will start giving profit of Rs. 192 per week after a period of 83.3 weeks. 2001 Dec 4b: The following figures are available for Success and Company: Net Sales : Rs. 15 crores; EBIT as % of sales : 12% Income tax applicable : 40% Capital employed : (a) Equity Rs. 5 crores (b) Debt at 15% Rs. 3 crores (c) Preference shares of Rs. 1 crore at 13% rate of dividend. You are required to calculate : (i) the Return on equity of the company and (ii) the operating leverage of the company given that combined leverage is 3 Solution: It is very easy. Solve it on your own. Net sales 1500 (figures in Rs. lacs)

EBIT @ 12% of net sales 180 Less : Interest on debt (15% of Rs. 300 lacs) 45 EBT 135 Tax @ 40% 54 Earning after tax 81 Less : Preference dividend at 13% on Rs. 100 lacs 13 Earning for equity shareholder Or Return on equity Or ROE 68 ROE as % (68 /500) = 13.6%. (ii) Second part is formula based : Financial leverage = EBIT / [ EBT { Pref.Div./ (1 T)}] Financial leverage = 180 / [135 ( 13 ) / (1 0.40)] = 1.6 We have Combined leverage = Financial Leverage x Operating leverage CL is given as 3. So operating leverage = 3 / 1.6 = 1.9 2005 June 3b: During the year 2000 01, Gulf Oil India made a sales of lubricants and greases worth Rs. 257 crores, which was down by 7.4% compared to previous year's sales. While the company could reduce its overheads, its variable input (base oil and additives) cost went up significantly. As a result, variable cost-to-sales ratio in 2000 - 01 stood at 55.8% as opposed to 48.5% in the previous year. The financial highlights of the company for the year 2000-01 are as under: Sales (Rs. crores) 257.0 (figures in Rs. crores) Overheads (excluding depreciation and interests) 103.5 Depreciation 2.7 Interest 6.5 Earnings before tax (excluding other income) 0.7 (i) Calculate the operating leverage. The company is expecting a decline in sales by 1% in the next year. If the cost structure remains the same, what will be the expected EBIT? Show necessary calculations. (ii) Calculate financial leverage. What would be the impact of financial leverage if company's sales decline by 1 per cent in the next year? Assume that financial structure remains the same. Solution : Tutorial notes: 1. Some additional data have been given which are superfluous (extra). (i) OL is Contribution / EBIT. Variable cost is given as 55.8% of sales, hence contribution will be 44.2% of sales of Rs. 257 crores. Contribution is 0.442 x 257 = Rs. 113.6 crores. EBIT is EBT plus interest. EBT is given as 0.7 crore and interest is Rs. 6.5 crore. EBIT is Rs. 7.2 crores. EBIT and contribution both are known, compute the OL. You must find it to be 15.78. OL of 15.78 means if sale increases or decreases by 1%, the EBIT will increase or decrease by 15.78%. As the present EBIT is Rs. 7.2 crores, it will decline by 15.78% (i.e. to Rs. 6.06 crores) if sale declines by 1%. (ii) FL is EBIT / [EBT (pref.div) /(1 T)]. As the pref. dividend is nil here the FL is simply the ratio of EBIT with EBT. Both are given with the question. Find FL. FL is 7.20 / 0.7 = 10.3. The EPS will decline by OL x FL i.e. by 10.3 x 15.78 = 162.31%. In other words the EPS will be negative.
2006 June 2b: The following key information pertains to Excel Ltd. for the year 2005-06.(Rs. In lacs) Sales 82.50 Variable cost 46.20 9% Debentures 50.00 Eq. shares Rs.100 each 60.00 Fixed cost 6.60 Corporate tax 35% You are required to work out : What is the company's ROI ? (i) Does it have favourable financial leverage ? (ii) (iii) If the company belongs to an industry whose asset Turnover is 3, does it have a high or low asset leverage

(iv) (v) (vi)

What are the operating, Financial and Combined Leverage of the Company ? What is the company's EPS ? What will be the expected EPS if the Sales of Excel Ltd.,increases by 10% in the next year and Cost structure as well as financial structure remains the same ?

Solution : (i) ROI = EBIT / Investment. EBIT is Sales Variable cost Fixed cost = Rs. 29.70 lacs. Investment = Share capital + Debentures = Rs. 110 lacs. ROI = 29.70 / 110 = 27% (ii) Yes, The company has favourable Financial leverage as its ROI is higher than the interest on debt. (iii) Asset Turnover = Sales / Total assets or total investment.= 82.50/110 = 0.75. (iv) Calculation of Leverages : Operating leverage = Contribution / EBIT = 36.30/29.70 1.22 Financial leverage = EBIT / EBT = 29.70 / (29.70 4.50) 1.18 Combined leverage = Contribution/EBT or OL x FL = 1.22 x 1.18 1.44 (v) Determination of EPS current with 10% increase Rs. Lacs Rs. Lacs Sales 82.50 90.75 Less Variable cost 46.20 50.82 Contribution 36.30 39.93 Fixed cost 6.60 6.60 EBIT 29.70 33.33 Less Interest (9% of Rs. 50 lacs) 4.50 4.50 EBT 25.20 28.83 Less :Tax @ 35% 8.82 10.09 EAT or Earnings after tax 16.38 18.74 No. of shares in lacs 0.6 Earnings per share Rs. 27.30 31.23 (vi) Expected EPS : % increase in EPS due to increase in sales by 10% = 10 x OL = 10 x 1.44 = 14.40% So Expected EPS = + 14.40% = 1.144 x 27.30 = Rs. 31.23

2008 June 2a The Financial highlights of Amtex Ltd. for the year 2007 08 are given as under: EBDIT Rs.830 crores Effective tax rate 30% EPS : Rs. 4.00 Depreciation Rs. 6 crores Book value : Rs. 30 per share Number of outstanding shares : 33 crores and D/E ratio : 1.5 : 1 Required : (i) Calculate the degree of financial leverage (ii) What is the financial Break even point of Amtek Ltd. (iii) What should be the impact of EPS if the EBIT is increased by 5%? Solution : 1. Degree of FL is given by EBIT / EBT. EBIT is EBDIT less depreciation. EBIT is known. 2. How will you calculate the Interest? EBIT less Interest will give EBT. Think how can you calculate interest with the data given. 3. Financial break even is that point EPS is zero. When EBIT is just equal to Interest, the EBT is zero. 4. The relationship between EPS and EBIT is given by FL. Once FL is known, the answer to part (ii) becomes easy. 5. You should try to solve it on your own before you see below. Computation of EBT : EPS is given as Rs. 4.0 per share and number of shares is 33 crores. Total earning after tax is 4.0 x 33 = Rs. 132 crores. The tax rate is 30%. EAT is EBT taxes. Hence EBT = EAT / 0.70 = 132 / 0.70 = Rs. 188.57 crores. If EBT is Rs. 188.57 crores and EBIT is Rs. 824 crores. Interest must be 824 188.57 = 635.43. As far as computation of FL is concerned, you can compute it without calculating the Interest. FL is ratio of EBIT / EBT = 824 / 188.57 = 4.37. However, it is advised that you should compute the interest and present your data in proper format as given below.

EBIDT (as given) 830.0 (figures in Rs. crores) Less : Depreciation (given) 6.0 EBIT 824.0 Note : Presentation carries marks in the Less : Interest (working note) 635.4 exam. You must present the data in EBT 188.6 proper format. Less Tax at 30% 56.6 EAT (Earning after tax) 132.0 EPS :EAT / Number of share (33 crores) 4.0 Financial Leverage : EBIT / EBT = 824.0 / 188.6 = 4.4. (ii) At Financial Break even is the point at which the company earns just enough to pay the interest on its debts i.e. it is the point at which EBIT is equal to Interest. At Financial Break even : EBIT = Interest = Rs. 635.4 crores. (iii) If EBIT changes by 5%, the EPS will correspondingly change by 5% x FL = 5% x 4.4 = 22%.