Leverage and Capital Structure
1. A 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. B Ltd. is identical to A Ltd. except in respect of the
pattern of financing. The latter finances its assets 50% 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.
Answers
Answer:
fixed costs amount to Rs. 1,70,000. It finances all its assets by equity funds. It
pays 50% tax on its income. B Ltd. is identical to A Ltd. except in respect of the
pattern of financing. The latter finances its assets 50% 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.
Explanation:
Firm A Contribution Margin = 10 - 7
= Rs . 3
Units sold = sales / selling price = 7,00,000 / 10 = Rs 70,000
Total contribution margin = 70,000 * 3 = 2,10,000
Fixed cost = 1,70,000 Operating profit = contribution margin
fixed cost = 2,10,000 - 1,70,000 = 40,000 DOL = contribution margin / operating profit = 2,10,000 /
40,000 = 5.25 DFL = Operating profit / operating profit - interest = 40,000 / 40,000 - 0 = 1 DCL = DFL * DOL = 1 * 5.25 = 5.25
AtQ.
Firm B is similar to Firm A
So,
Firm B Contribution Margin = 10 - 7 = Rs.
3 Units sold = sales / selling price = 7,00,000 / 10 = Rs 70,000
Total contribution margin = 70,000 * 3 = 2,10,000
Fixed cost = 1,70,000 D / E Ratio = 1 Hence you can calculate
Operating profit, DOL, DFL , DCL accordingly .. Hope it helps