Here are the solutions to the

financial management questions:

1. XYZ Ltd
Sales = $2,000,000
Variable Cost = $500,000
Fixed Cost = $200,000
EBIT = Sales - Variable Cost -
Fixed Cost
= $2,000,000 - $500,000 -
$200,000
= $1,300,000

Financial Management II Page 6

Debt = $3,000,000
Interest = 10% of $3,000,000 =
$300,000
Operating Leverage =
Contribution/EBIT
= ($2,000,000 -
$500,000)/$1,300,000
= 1.54

Financial Leverage = EBIT/EBT

 = $1,300,000/($1,300,000 -
$300,000)
= 1.30

Combined Leverage = Operating

Leverage x Financial Leverage
= 1.54 x 1.30
= 2.00

2. Sales = $120 million

Variable Cost = $70 million
Fixed Cost = $30 million
EBIT = Sales - Variable Cost -
Fixed Cost
= $120 million - $70 million -
$30 million = $20 million

Contribution = Sales - Variable

Cost
 = $120 million - $70
million = $50 million
DOL = Contribution/EBIT
= $50 million/$20 million
 = 2.5

3. Sales = $200 million

Variable Cost = $80 million
Fixed Cost = $90 million
EBIT = Sales - Variable Cost -
Fixed Cost
= $200 million - $80 million -
$90 million
= $30 million
Debt = $30 million
Interest = 10% of $30 million =
$3 million

EBT = EBIT - Interest

= $30 million - $3 million
= $27 million
DFL = EBIT/EBT
 = $30 million/$27 million
= 1.11

4. Situation 1:
Contribution = Sales - Variable
Cost
= 2,000 units x $20 per
unit - 2,000 units x $10 per unit
= $40,000
EBIT = Contribution - Fixed Cost
= $40,000 - $4,000
= $36,000
DOL = Contribution/EBIT
= $40,000/$36,000
= 1.11
EBT = EBIT - Interest
= $36,000 - 10% of $15,000
= $36,000 - $1,500
= $34,500
DFL = EBIT/EBT
= $36,000/$34,500
= 1.04
Combined Leverage = DOL x
DFL
= 1.11 x 1.04
= 1.15
Situation 2:
Contribution = 2,000 units x $20
per unit - 2,000 units x $10 per
unit
= $40,000
EBIT = Contribution - Fixed Cost
= $40,000 - $5,000
= $35,000
DOL = Contribution/EBIT
= $40,000/$35,000
= 1.14
EBT = EBIT - Interest
= $35,000 - 10% of $15,000
= $35,000 - $1,500
 = $33,500
DFL = EBIT/EBT
= $35,000/$33,500
= 1.04
Combined Leverage = DOL x
DFL
= 1.14 x 1.04
= 1.19

5. Firm A
DOL = Contribution/EBIT
= (Sales - Variable Cost)/EBIT
= (60,000 units x $0.60 per
unit - 60,000 units x $0.22 per
unit)/($0.60 per unit x 60,000
units - $7,000)
= $22,800/$23,000
= 0.99
DFL = EBIT/EBT
= $23,000/($23,000 - $4,000)
 = 1.17
DCL = DOL x DFL
= 0.99 x 1.17
= 1.16
Firm B
DOL = (15,000 units x $5 per unit
- 15,000 units x $1.50 per
unit)/($5 per unit x 15,000 units -
$14,000)
= $37,500/$41,000
= 0.91
DFL = $41,000/($41,000 -
$8,000)
= 1.20
DCL = 0.91 x 1.20
= 1.09
Firm C
DOL = (100,000 units x $0.10 per
unit -
100,000 units x $0.02 per
unit)/($0.10 per unit x 100,000
units - $1,500)
= $8,000/$8,500
= 0.94
DFL = 1 (No financial leverage)

DCL = DOL x DFL

= 0.94 x 1
= 0.94
6. Sales = $120,000
Variable Cost = $75,000
Fixed Cost = $25,000
EBIT = Sales - Variable Cost -
Fixed Cost
= $120,000 - $75,000 -
$25,000
= $20,000
Interest = 10% of $40,000 =
$4,000

EBT = EBIT - Interest

 = $20,000 - $4,000
= $16,000
DOL = (Sales - Variable
Cost)/EBIT
= ($120,000 -
$75,000)/$20,000
= 1.25
DFL = EBIT/EBT
= $20,000/$16,000
= 1.25
Combined Leverage = DOL x
DFL
= 1.25 x 1.25
= 1.56

7. a) EBIT = $80,000
Interest = 16% of $250,000 =
$40,000
 EBT = $80,000 - $40,000 =
$40,000
Taxes @ 40% = $16,000
Net Income = $24,000
EPS = Net Income/Shares =
$24,000/2,000 = $12
EBIT = $120,000
Interest = 16% of $250,000 =
$40,000
EBT = $120,000 - $40,000 =
$80,000
Taxes @ 40% = $32,000
Net Income = $48,000
EPS = $48,000/2,000 = $24
b) Base EBIT = $80,000
EBT = $80,000 - $40,000 =
$40,000
DFL = EBIT/EBT =
$80,000/$40,000 = 2
c) EBIT = $80,000
Interest = 16% of $100,000 =
$16,000
EBT = $80,000 - $16,000 =
$64,000
Taxes @ 40% = $25,600
Net Income = $38,400
EPS = $38,400/3,000 = $12.80
DFL = $80,000/$64,000 = 1.25
8. Sales = $1,000,000
Variable Cost = $700,000
Fixed Cost = $200,000
EBIT = Sales - Variable Cost -
Fixed Cost
= $1,000,000 - $700,000 -
$200,000
= $100,000
Interest = 10% of $500,000 =
$50,000

DOL = (Sales - Variable

Cost)/EBIT
= ($1,000,000 -
$700,000)/$100,000
=3
DFL = EBIT/EBT
 = $100,000/($100,000 -
$50,000)
=2
Combined Leverage = DOL x
DFL
=3x2
=6
To double EBIT:
New EBIT = 2 x $100,000 =
$200,000
Let new sales be x
Contribution = x - $700,000
New EBIT = Contribution -
$200,000
= x - $700,000 - $200,000
= x - $900,000
$200,000 = x - $900,000
x = $1,100,000
% increase in sales needed =
(New sales - Current
sales)/Current sales x 100
= ($1,100,000
- $1,000,000)/$1,000,000 x 100
= 10%
Therefore, a 10% increase in
sales is needed to double EBIT.

9.
Debt Kd Ke EPS
0% 10% 13% $1.30
10% 10% 15% $1.43
20% 12% 16% $1.44
30% 13% 17% $1.35
40% 15% 19% $1.14
50% 16% 20% $0.80
60% 18% 22% $0.30

The optimal capital structure is at

20% debt where EPS is
maximized at $1.44.
The company should maintain a
debt level of 20% to maximize
shareholders' value.

10. Net income = $1,000,000

Interest = 10% of $1,500,000 =
$150,000
EBIT = Net income + Interest
= $1,000,000 + $150,000 =
$1,150,000

Ke = 11%
Capitalization rate = Kd x (1-t) x
(D/V) + Ke
x (E/V)
= 0.1 x (D/V) + 0.11 x
(E/V) (No taxes)
Where:
D = Market value of debt
E = Market value of equity
V=D+E

D = $1,500,000 (Face value of

debt is taken as market value)

Let V = x
E = x - $1,500,000

Capitalization rate = 0.1 x

($1,500,000/x) + 0.11 x ((x -
$1,500,000)/x)
= 0.1 + 0.11
= 0.21
NOI/Capitalization rate =
EBIT/0.21
=
$1,150,000/0.21
 = $5,476,190
Value of firm V = Value of equity
+ Value of debt
= EBIT/Ke + Face value
of debt
= $1,150,000/0.11 +
$1,500,000 = $5,476,190
11. Net Income = $1,000,000
Interest = 10% of $2,000,000 =
$200,000
EBIT = $1,000,000 + $200,000 =
$1,200,000

Ke = 11%

D = $2,000,000
E = V - $2,000,000
Capitalization rate = 0.1x(D/V) +
0.11x(E/V)
= 0.1 + 0.11
= 0.21
NOI/Capitalization rate =
EBIT/0.21
= $1,200,000/0.21
= $5,714,286
Value of firm V = $1,200,000/0.11
+ $2,000,000
= $5,714,286

12. NOI = $200,000

Interest = 12% of $600,000 =
$72,000
EBIT = NOI + Interest =
$200,000 + $72,000 = $272,000

Capitalization rate = Kd(1-t)(D/V)

+ Ke(E/V)
= 0.12(D/V) + Ke(E/V)
D = $600,000
Let V = x
E = x - $600,000
0.2 = 0.12(600,000/x) + Ke(x -
600,000)/x
0.2 = 0.12 + Ke(1 - 600,000/x)
On solving, Ke = 0.2(1 - 0.6) =
0.08

Value of firm V =
NOI/Capitalization rate
= $200,000/0.2
= $1,000,000
13. NOI = $200,000
Interest = 12% of $750,000 =
$90,000
EBIT = NOI + Interest =
$200,000 + $90,000 = $290,000

Capitalization rate = 0.12(D/V) +

0.08(E/V)

D = $750,000
Let V = x
E = x - $750,000

0.2 = 0.12($750,000/x) + 0.08(1 -

$750,000/x)
On solving,
V = $1,250,000

Increase in debt increased the

value of the firm.

14. A Ltd:
EBIT = $200,000
Interest = 8% of $1,000,000 =
$80,000
EBT = $120,000

Equity capitalization rate (Ke) =

12%

Z Ltd:
EBIT = $200,000
EBT = $200,000 (No debt)
Equity capitalization rate (Ke) =
11%

Arbitrage:
A Ltd EBT + Ke(Equity) = Z Ltd
EBT + Ke(Equity)
$120,000 + 0.12(Equity of A) =
$200,000 + 0.11(Equity of Z)

On solving,
Equity of A = $1,000,000
Equity of Z = $909,091

So, an arbitrage opportunity

exists since the two firms with
same EBIT have different equity
values. An investor could buy the
undervalued stock and sell the
overvalued stock to make risk-
free profits.

15. (i) Issue of shares:

Number of shares after issue =
40,000 + 2,500 = 42,500

EBIT = $312,500
Earnings to shareholders
= EBIT(1-t) + Interest(1-t)
= $312,500(0.5)
= $156,250
EPS = Earnings to
shareholders/Number of shares
= $156,250/42,500
= $3.67
(ii) Loan of $250,000 @ 8%
Interest = $250,000 x 0.08 =
$20,000

EBIT = $312,500
EBT = $312,500 − $20,000 =
$292,500

Earnings after tax = EBT(1-t)

= $292,500(0.5)
 = $146,250
Number of shares = 40,000
EPS = Earnings after
tax/Number of shares
= $146,250/40,000
= $3.65
EPS is lower when loan option is
taken instead of issuing new
shares.