Problems
1. Money Inc., has no debt outstanding and a total market value of $150,000. Earnings before interest
and taxes [EBIT] are projected to be $14,000 if economic conditions are normal. If there is a strong
expansion in the economy, then EBIT will be 30% higher. If there is a recession, then EBIT will be 60%
lower. Money is considering a $60,000 debt issue with a 5% interest rate. The proceeds will be used to
repurchase shares of stock. There are currently 2,500 shares outstanding. Ignore taxes for this problem.
Calculate earnings per share [EPS] under each of the three economic scenarios before any debt is issued.
Also calculate the % changes in EPS when the economy expands or enters a recession.
2. Calculate the Degree of Operating Leverage (DOL), Degree of Financial leverage (DFL) and the Degree
of Combined Leverage (DCL) for the following firms and interpret the results.
Firm A Firm B Firm C
Output (units) 60,000 15,000 1,00,000
Fixed Costs (Rs) 7,000 14,000 1,500
Variable cost per unit (Rs.) 0.20 1.50 0.02
Interest on borrowed funds 4,000 8,000 -----
Selling price per unit (Rs) 0.60 5.00 0.10
3. The data relating to two companies are as given below:
Company A Company B
Capital Rs.6,00,000 Rs.3,50,000
Debentures Rs. 4,00,000 6,50,000
Output (units) per annum 60,000 15,000
Selling price/unit Rs.30 250
Fixed costs per annum 7,00,000 14,00,000
Variable cost per unit 10 75
You are required to calculate the Operating leverage, Financial leverage and Combined Leverage of two
companies.
4. Copybold Corporation is a start-up firm considering two alternative capital structures--one is
conservative and the other aggressive. The conservative capital structure calls for a D/A ratio = 0.25,
while the aggressive strategy call for D/A = 0.75. Once the firm selects its target capital structure it
envisions two possible scenarios for its operations: Feast or Famine. The Feast scenario has a 60 percent
probability of occurring and forecast EBIT in this state is $60,000. The Famine state has a 40 percent
chance of occurring and the EBIT is expected to be $20,000. Further, if the firm selects the conservative
capital structure its cost of debt will be 10 percent, while with the aggressive capital structure its debt
cost will be 12 percent. The firm will have $400,000 in total assets, it will face a 40 percent marginal tax
rate, and the book value of equity per share under either scenario is $10.00 per share.
a. What is the difference between the EPS forecasts for Feast and Famine under the aggressive capital
structure?
b. What is the difference between the EPS forecasts for Feast and Famine under the conservative capital
structure?
5. Bell Brothers has $3,000,000 in sales. Its fixed costs are estimated to be $100,000, and its variable
costs are equal to fifty cents for every dollar of sales. The company has $1,000,000 in debt outstanding
at a before-tax cost of 10 percent. If Bell Brothers' sales were to increase by 20 percent, how much of a
percentage increase would you expect in the company's net income?
6. A firm expects to have a 15 percent increase in sales over the coming year. If it has operating leverage
equal to 1.25 and financial leverage equal to 3.50, then what will be the percentage change in EPS?
7. Emerson Co. Ltd wants to take up a new project that requires a capital of $ 15, 00, 000. Interest on
Debt is 12 % and the Tax rate is 30 %. The company is contemplating either an all equity financing or
financing in debt equity ratio of 2:1, where the equity shares are going can be issued at $ 50 (par value).
Assuming no incidence of taxes, calculate the EBIT-EPS Indifference point.
8. Debarathi Co. Ltd., is planning an expansion programme. It requires Rs 20 lakhs of external financing
for which it is considering two alternatives. The first alternative calls for issuing 15,000 equity shares of
Rs 100 each and 5,000 10% Preference Shares of Rs 100 each; the second alternative requires 10,000
equity shares of Rs 100 each, 2,000 10% Preference Shares of Rs 100 each and Rs 8,00,000 Debentures
carrying 9% interest. The company is in the tax bracket of 50%. You are required to calculate the
indifference point for the plans and verify your answer by calculating the EPS.
Solution
1. Under Normal Economic Conditions
EPS = EBIT/shares outstanding = $14,000/2,500 = $5.60
Under Expansionary Times:
EPS = [EBIT x 1.60]/shares outstanding = $14,000(1.3)/2,500 $18,200/2,500 = $7.28
Under a Recession:
EPS = [EBIT x (1-.60)]/shares outstanding =$14,000(.40)/2,500 $5,600/2,500 = $2.24
% Δ EPS going from Normal Expansion: ($7.28 - $5.60)/$5.60 = .30 or 30% %
Δ EPS going from Normal Recession: ($2.24 - $5.60)/$5.60 = -.60 or -60%
2. Firm A Firm B Firm C
Output (units) 60,000 15,000 1,00,000
Selling price per unit (Rs) 0.60 5.00 0.10
Variable cost per unit (Rs.) 0.20 1.50 0.02
Contribution per unit 0.40 3.50 0.08
Total Contribution Rs.24,000 Rs.52,500 RS.8,000
Less fixed costs 7,000 14,000 1,500
EBIT 17,000 38,500 6,500
Less Interest 4,000 8,000 ---
Profit before Tax 13,000 30,500 6,500
Degree of Operating Leverage
Contribution/EBIT 24,000/17,000 52,500/38,000 8,000/6,500
= 1.41 =1.36 = 1.23
Degree of Financial Leverage
EBIT/PBT 17,000/13,000 38,500/30,500 6,500/6,500
= 1.31 = 1.26 = 1.00
Degree of Combined Leverage
Contribution/ EBIT 24,000/13,000 52,500/30,500 8,000/6,500
= 1.85 = 1.72 = 1.23
3. Company A Company B
Output (units) per annum 60,000 15,000
Selling price/unit Rs.30 250
Sales Revenue 18,00,000 37,50,000
Less variable costs
@ Rs.10 and Rs.75 6,00,000 11,25,000
Contribution 12,00,000 26,25,000
Less fixed costs 7,00,000 14,00,000
EBIT 5,00,000 12,25,000
Less Interest @ 12%
on debentures 48,000 78,000
PBT 4,52,000 11,47,000
DOL = Contribution/EBIT 12,00,000/5,00,000 26,25,000/12,25,000
= 2.4 = 2.14
DFL = EBIT/ PBT 5,00,000/4,52,000 12,25,000/11,47,000
=1.11 =1.07
DCL = DOL x DFL 2.14 x 1.11 = 2.66 2.14 x 1.07 = 2.2
4.a. Debt = 75% = $300,000; Equity = 25% = $100,000; Total assets = $400,000.
Feast Famine
Probability 0.6 0.4
EBIT $60,000 $20,000
Interest (36,000) (36,000)
EBT $24,000 ($16,000)
Taxes (9,600) 6,400
NI $14,400 ($ 9,600)
# shares 10,000 10,000
EPS $1.44 -$0.96
Difference in EPS for aggressive capital structure:
EPSFeast - EPSFamine = $1.44 - ($0.96) = $2.40.
b. Debt = 25% = $100,000; Equity = 75% = $300,000; Total assets = $400,000.
Feast Famine
Probability 0.6 0.4
EBIT $60,000 $20,000
Interest (10,000) (10,000)
EBT $50,000 $10,000
Taxes (20,000) 4,000
NI $30,000 ($6,000)
# shares 30,000 30,000
EPS $1.00 $0.20
Difference in EPS for conservative capital structure:
EPSFeast - EPSFamine = $1.00 - $0.20 = $0.80.
5.
Step 1: Find Degree of Total Leverage (DTL):
DTL =
S−V $ 3,000,000−0.5( $ 3,000,000)
= =1.1538
S−V −F−I $ 3,000,000−0.5 ( $ 3,000,000 )−$ 100,000−0.1($ 100,000)
Step 2: Find percentage increase in net income:
%NI = (0.20) (DTL) = (0.20) (1.1538) = 0.2308 = 23.08%.
6.
DTL = DOL DFL = (1.25)(3.50) = 4.375
%EPS = %Sales DTL = (0.15)(4.375) = 65.63%
7. So, there are 2 alternatives to the capital investment:" Debt and Equity " or just " Equity "
Option 1: All Equity Financing
No. of shares (with equity of $ 15, 00, 000) = 15, 00, 000/50 = 30, 000
Option 2: Debt -Equity Financing in ratio of 2:1
Debt and Equity, required for second option:
Debt = $ 10, 00,000, Equity = $ 5, 00,000
Interest on debt, 12 % = 10,00,000 *12/100 = 1, 20, 000
No. of shares (with equity of $ 5, 00, 000) = 5, 00, 000/50 = 10, 000
Calculation of the indifference point:
Without Debt, the EPS would be: (EBIT - 0)/30000
With Debt, the EPS would be: (EBIT - 1,20,000)/10, 000
The indifference EBIT is obtained when the alternatives are equated:
(EBIT - 0)/30000 = (EBIT - 120000)/10000
Solving it, we get:
EBIT = $ 3, 60, 000
8.
