Leverage
QUESTION FOR PRACTICE

Q.1. A firm has sales of Rs.10,00,000, variable cost of Rs.7,00,000 and fixed cost of Rs.2,00,000 and debt of Rs.5,00,000 at 10% rage of interest. What are the operating, financial and combined leverages ? if the firm wants to double it earnings before interest and tax (EBIT) , how much of a rise in sales would be needed on a percentage basis ?

Ans. 3,2 and 6; 33.33%

Q.2. X corporation has estimated that for a new product its break even point is 2,000 units if the item is sold for Rs.14 per unit; the cost accounting department has currently identified variable cost of Rs.9 per unit. Calculate the degree of operating leverage for sale volume of 2500 units and 3000 units.

Ans. 5 and 3

Q.3. Coke (India), sells 5,00,000 bottles of soft drinks a year. Each bottle produced has a variable cost of Rs.2.50 and sells for Rs.4.50. Fixed operating costs are 5,00,000. The company has current interest charges of Rs.60,000 and preferred dividends of Rs.24,000. The corporate tax rate is 40%.
(a) Calculate DOL , DFL and combined leverages.
(b) Do part (a) at the 7,50,000 bottle sales level.
(c) What generalization can you make comparing (a) to (b) after first finding the overall break even point ?

Ans. 2, 1.25, 2.5

Q.4. You are a Finance manager in Big pen Ltd. The degree of operating leverage of your company is 5.0. The degree of financial leverage of your company is 3.0. Your managing Director has found that the degree of operating leverage and the degree of financial leverage of you competitor small pen ltd. Are 6.0 and 4.0 respectively. In his opinion, the small pen ltd. Is better than that of Big pen ltd. Because of higher value of degree of leverages . Do ou agree with the opinion of you managing Director ? Give Reason.

Q.5. The share capital of a company is Rs. 10,00,000 with shares of face value of Rs. 10. The company has debt capital of Rs. 6,00,000 at 10% rate of interest. The sales of the firm are 3,00,000 units per annum at a selling price of Rs. 5 per unit and the variable cost is Rs. 3 per unit. The fixed cost amounts to Rs. 2,00,000. The company pays tax at 35%. If the sales increase by 10%,
You are calculate to:
(i) Percentage increase in EPS ;
(ii) Degree of operating leverage at the two levels ; and
(iv) Degree of financial leverage at the two levels.

Q.6. A firm sales of Rs. 20,00,000, Variable costs of Rs. 14,00,000 and Fixed costs of Rs. 4,00,000 inclusive of interest of Rs. 1,00,000.
(i) Calculate its operation, financial and Combined leverages.
(ii) If the firm decided to double its EBIT, how much of a rise in sales would be needed on a percentage basis?

Ans. Operating leverage is 2. So, 50% increase in sales is required for 100% increase in EBIT

Q.7. XYZ Ltd. has an average selling price of Rs. 10 per unit. Its variable unit costs are Rs. 7, and fixed costs amount to Rs. 1,70,000. It finances all its assets by equity funds. It pays 50% tax on its income. ABC Ltd. is identical to XYZ Ltd. except in respect of the pattern of financing. The latter finances its assts 505 by equity and 50% by debt, the interest on which amounts to Rs. 20,000. Determine the degree of operating, financial and combined leverages at Rs, 7,00,000 sales for both the firms, and interpret the results.

Ans. Combined leverage of the two firms are 5.25 and 10.5

Q.8. The Karnal Recreation Ltd. manufactures a full line of lawn furniture. The average  selling price of a finished unit is Rs. 2,500 and variable cost is Rs. 1,500 per unit. Fixed cost for the company is Rs. 50,00,000 per year.
(i) What is the break-even point in units for the company?
(ii) Find the degree of operating leverage at the following production and sales levels: 4,000 units; 5,000 units; 6,000 units; 8,000 units,
(iii) Does the degree of operating leverage increase or decrease as the production and sales levels rise above the break-even point? What conclusion would you draw from such increase or decrease?
(iv) By what percentage the EBIT will increase if the company's sales should increase by 10% from the production and sales level of 8,000 units?

Q.9. The capital structure of Radhika Ltd. consists of Equity share capital of Rs. 10,00,000 (The par value of one equity share is Rs. 100) and Rs. 10,00,000 of 10% debentures. The unit sales increased by 20 percent from 1,00,000 units to 1,20,000 units, the selling price is Rs. 10 per unit, variable costs amount to Rs. 6 per unit and fixed expenses amount to Rs. 2,00,000. The income tax rate is 35 per cent.

(1) You are required to calculate:
(i) The percentage increase in EPS.
(ii) The degree of financial leverage at 1,00,000 and 1,20,000 units.
(iii) The degree of operating leverage at 1,00,000 and 1,20,000 units.

(2) Comment on the behaviour of operating and financial leverage in relation to increase in production from 1,00,000 to 1,20,000 units.

Q.10. The following data is available for XYZ Ltd.:

 Rs. Sales 2,00,000 Variable cost @ 30% 60,000 Contribution 1,40,000 Fixed cost 1,00,000 EBIT 40,000 Interest 5,000 Profit before tax 35,000

Find out:
(1) Using the concept of financial leverage by what percentage will the taxable income increase if EBIT increases by 6%.
(2) Using the concept of operating leverage by what percentage will EBIT increase if there is 10% increase in sales, and
(3) Using the concept of leverage by what percentage will the taxable income increase if the sales increase by 8%.
Also verify the results in view of the above figures.