Business Risk, Financial Risk and Leverage

1. The Net Sales of A Ltd are Rs 30 crores. Earnings before interest and tax of the
company as a percentage of net sales are 12%. The capital employed comprises Rs 10
crores of equity, Rs 2 crores of 13% Cumulative Preference Share Capital and 15%
Debentures of Rs 6 crores. Income-tax rate is 40%.
(i) Calculate the Return-on-equity for the company and indicate its segments due
to the presence of Preference Share Capital and Borrowing (Debentures)
(ii) Calculate the Operating Leverage of the Company given that combined
leverage is 3.
(IPCC, May 2002)

Ans: (i) Return on equity 13.6%; (ii) Degree of Operating Leverage 2.033.

2. The data relating to two companies are as given below:

Equity Capital
12% Debentures
Output (units) per annum
Selling price/unit
Fixed Costs per annum
Variable Cost per unit

Company A
Rs 600,000
Rs 4,00,000
60,000
Rs
30
Rs 7,00,000
Rs
10

Company B
Rs 3,50,000
Rs 6,50,000
15,000
Rs
250
Rs 14,00,000
Rs
75

You are required to calculate the Operating leverage, Financial leverage and
Combined leverage of these two companies.
(IPCC, May 2006)
Ans :
Company A Company B
Operating Leverage
2.4
2.14
Financial Leverage
1.11
1.07
Combined Leverage
2.66
2.29

3. You are analyzing the beta for ABC Computers Ltd and have divided the Company
into four broad business groups, with market values and betas for each group.
Business group
Main frames
Personal Computers
Software
Printers

Market value of equity

Rs 100 billion
Rs 100 billion
Rs 50 billion
Rs 150 billion

Unleveraged beta
1.10
1.50
2.00
1.00

ABC Computers Ltd had Rs 50 billion in debt outstanding.

Required:
(i) Estimate the beta for ABC Computers Ltd as a company. Is this beta going to
be equal to the beta estimated by regressing past returns on ABC Computers
stock against a market index. Why or why not?
(ii) If the treasury bonds rate is 7.5%, estimate the cost of equity for ABC
Computers Ltd Estimate the cost of equity for each division. Which cost of
equity would you use to value the printer division? The average market risk
premium is 8.5%.
(IPCC, Nov. 2004)

Ans: (i) Beta = 1.275; Beta calculations will not be the same; (ii) Mainframe
16.85%, Personal Computers 20.25%, Software 24.5%. Printers 16%;

To value printer division 16% rate is recommended.

4. The following summarizes the percentage changes in operating income, revenues,

and betas for four pharmaceutical firms.
Firm
PQR Ltd
RST Ltd
TUV Ltd
WXY Ltd

Change in revenue
27%
25%
23%
21%

Change in operating income

25%
32%
36%
40%

Beta
1.00
1.15
1.30
1.40

Required:
(i) Calculate the degree of operating leverage for each of these firms. Comment
also.
(ii) Use the operating leverage to explain why these firms have different beta.
(IPCC, Nov. 2004)

Ans: (i) RST Ltd 1.28, TUA Ltd 1.5652;

(ii) High operating leverage leads to high beta.

5. A Company had the following Balance Sheet as on 31 March 2006:

Liabilities and Equity
Equity Share Capital
(one crore shares of Rs 10 each)
Reserves and Surplus
15% Debentures
Current Liabilities

Rs
(Crore)
10
2
20
8
40

Assets
Fixed Assets (Net)
Current Assets

Rs
(Crore)
25
15

40

The additional information given is as under:

Fixed Costs per annum (excluding interest)
Variable operating costs ratio
Income-tax rate

:Rs 8 crore
:2.5
:40%

Required:
Calculate the following and comment:
(i) Earnings per share
(ii) Operating Leverage
(iii) Financial Leverage
(iv) Combined Leverage
(IPCC, Nov. 2005)

Hint:
Total Assets = Rs 40 crore.
Assets turnover ratio = 2.5
Hence, Total sales = 40 2.5 = Rs 100 crore.
Ans:

(i) Earnings per share

= Rs 14.40
(ii) Operating leverage
= Rs 1.296
(iii) Financial leverage
= Rs 1.125

(iv) Combined leverage =

Rs 1.458.
6. ABC Limited is has an average cost of debt at 10 per cent and tax rate is 40 per
cent. The financial leverage ratio for the company is 0.60. Calculate Return on Equity
(ROE) if its Return on Investment (ROI) is 20 per cent.
(IPCC, May 2007)

Hint: ROE = [ROI + {(ROI r) D/E}] (1t)

Ans: ROE = 15.60%.

7. The following details of RST Limited for the year ended 31 March 2006 are given
below:
Operating leverage
Combined leverage
Fixed Cost (Excluding interest)
Sales
12% Debentures of Rs 100 each
Equity Share Capital of Rs. 10 each
Income tax rate 30 per cent

Rs
Rs
Rs
Rs

1.4
2.8
2.04 lakh
30.00 lakh
21.25 lakh
17.00 lakh

Required:
(i) Calculate Financial leverage
(ii) Calculate P/V ratio and Earning per share (EPS)
(iii) If the company belongs to an industry, whose assets turnover is 1.5, does it have
a high or low assets leverage?
(iv) At what level of sales the Earning before Tax (EBT) of the company will be
equal to zero?
(IPCC, May 2007)

Hint:
(i) Combined Leverage = Operating Leverage (OL) Financial Leverage (FL).
C
(ii) P/V ratio = S 100.
C
Operating leverage = C - F 100.
Profit after tax
EPS = No. of equity shares
Sales
(iii) Assets turnover = Total Assets
(iv) EBT zero means 100% reduction in EBT. Since combined leverage is 2.8, sales
have to be dropped by 100/2.8 = 35.71%.
Ans:
(i) Financial leverage = 2
(ii) P/V Ratio = 23.8%; EPS = 1.05
(iii) 0.784 < 1.5 means lower than
industry turnover.
(iv) At 19,28,700 level of sales, the
earnings before tax of the company
will be equal to zero.

8. Answer the following:

A firm has sales of Rs 40 lakh; Variable cost of Rs 25 lakh; Fixed cost of Rs 6 lakh;
10% debts of Rs 30 lakh; and Equity Capital of Rs 45 lakh.
Required:
Calculate operating and financial leverage.
(IPCC, Nov. 2007)

Ans: Operating leverage = 1.67, Financial leverage = 1.50

9.
The following data relate to RT Ltd:
Earning before interest and tax (EBIT)
Fixed cost
Earning Before Tax (EBT)

Rs
10,00,000
20,00,000
8,00,000

Required:
Calculate combined leverage
(IPCC, May 2008)

Hint : Contribution EBIT + Fixed Cost.

Combined leverage = Operating leverage Financial leverage.
Ans: Combined leverage = 3.75.

10. Answer the following:

A company operates at a production level of 1,000 units. The contribution is Rs 60 per
unit, operating leverage is 6, combined leverage is 24. If tax rate is 30%, what would be
its earnings after tax?
(IPCC, Nov. 2008)

Ans: Rs 1,750.