Module-2

Cost of Capital and Leverage

Cost of Capital
• The cost of capital of a firm refers to the cost that a firm incurs in
retaining the funds obtained from various sources.

• The different sources of funds are:

(A) Equity Shares
(B) Preference Shares
(C) Debt
(D) Retained Earnings
Cost of Debt
• If a company raises funds through loans, by issuing bonds and debentures
then all these sources of funds comes in debt category.

• Why they comes in Debt category?

Ans: Because on all these sources of funds, companies pay Interest.
Now, we have to calculate Cost of Debt (Kd)
Formula:

(1) Cost of Debt (Perpetual Debt) = I (1-t) *100 15% *Rs 1000= Rs 150
NP
Where,
I = Interest on Debt (Interest is always calculated on Face Value)
t= tax rate
NP = Net Proceed from the issue of debt
= Face value + Premium on issue or Discount on issue – floatation cost
(2) Cost of Redeemable Debt (Kd)

Kd = I (1- t) + (RV-SV)/n *100

(RV + SV)/2

Kd = Cost of debt
I = Interest on debt (Interest is always calculated on Face Value)
t= tax rate
RV = Redeemable Value
SV = Sale Value or Net Proceed
n = number of years or maturity period
Q1. Calculate cost of debenture of a company.Sol:
The company has issued 12 % debenture at the
face value of Rs. 100.
Cost of Debt (Kd) = I (1-t) *100
Flotation cost is 5 %.
NP
Applicable tax rate is 25 %.

= 12 (1-0.25) *100 = 9.47 %

95
Face Value = Rs 100
Interest = 12 % = 12% * Rs 100 = Rs 12
Formula:
Cost of Debt (Perpetual Debt) = I (1-t) *100 t= 25 % = 0.25
NP
Where, Net Proceed
I = Interest on Debt Issue Price Rs 100
t= tax rate Less: Flotation Cost 05
NP = Net Proceed from the issue of debt (5 % * Rs 100) Rs 95 Net Proceed
Q2. Calculate cost of bond of a company. Sol:
The company has issued 12% bond at 10 %
premium to its face value Rs. 100. Face Value = Rs 100
Flotation cost is 5 %. Interest = 12 % = 12 % * Rs 100 = Rs 12
Tax rate = 25% = 0.25
Applicable tax rate is 25 %.
Net Proceed
Issue price = Face Value + Premium
= 100 + (10% * 100)
= 100 +10 = Rs 110
Formula:
Cost of Debt (Perpetual Debt) = I (1-t) *100 Issue Price Rs 110
NP Less: Flotation Cost Rs 5.5
Where, (5 % * Issue Price) 104.5 Net Proceed
I = Interest on Debt = 5 % * 110
t= tax rate
NP = Net Proceed from the issue of debt Kd = I (1-t) *100 = 12 (1-0.25) *100 = 8.6 %
NP 104.5
Q3. Calculate cost of debenture of a
company.
The company has issued 11% debenture at a
discount of 10 % to its face value Rs. 100.
Flotation cost is 5 %.
Applicable tax rate is 25 %.

Formula:
Cost of Debt (Perpetual Debt) = I (1-t) *100
NP
Where,
I = Interest on Debt
t= tax rate
NP = Net Proceed from the issue of debt
Q4. Calculate cost of debenture of a Cost of debenture(Kd) = I (1-t) *100
company.
NP
The company has issued 11% debenture at a
discount of 10 % to its face value Rs. 100.
Flotation cost is 5 %.
Applicable tax rate is 25 %.

Formula:
Cost of Debt (Perpetual Debt) = I (1-t) *100
NP
Where,
I = Interest on Debt
t= tax rate
NP = Net Proceed from the issue of debt
Q5. A company borrows Rs. 1,00,000 Sol:
from a bank.
The company will be required to pay 9 %.
Kd = I (1-t) *100
Calculate the cost of debt if applicable tax
rate is 25 %. NP

Kd = ?
I = 9 % * Rs 1,00,000 = Rs 9000
Formula: t = 25 % =0.25
Cost of Debt (Perpetual Debt) = I (1-t) *100
NP NP = Rs 1,00,000
Where,
I = Interest on Debt
t= tax rate Kd = 9000 (1-0.25) *100 = 6.75 %
NP = Net Proceed from the issue of debt 1,00,000
Q6. Calculate cost of redeemable debenture Sol:
of a company. Kd = I (1- t) + (RV-SV)/n *100
The company has issued 12 % debenture at the (RV + SV)/2
face value of Rs. 100. Flotation cost is 5 %.
Debenture will be redeemed at Rs 105 after 5 = 12 (1-0.25) + (105-95)/5 *100
years. (105+95)/2
= 12*0.75 + 2 *100 = 9+2 = 11 %
Applicable tax rate is 25 %.
100

I = 12 % * Face value = 12 % *100 = Rs 12

Formula: t = 25 % = 0.25
Kd = I (1- t) + (RV-SV)/n *100 RV = Rs 105
(RV + SV)/2 n = 5 years
Where, SV(NP) = Rs 95
I = Interest on Debt
t= tax rate SV or NP
RV= Redeemable Value of debenture Issue Price Rs 100
SV= Sale Value or Net Proceed from issue of debenture. Less: Flotation cost Rs 05
N= number of years (5 % * 100) 95
Q7. Calculate cost of redeemable bond of a Sol:
company.
Kd=?
The company has issued 10 % bond at the premium
of 10 % to its face value Rs. 100. I = 10 % = 10 % * Rs 100 = Rs 10
Flotation cost is 5 %. t = 25 % = 0.25
Bond will be redeemed at Rs 105 after 5 years. RV = Rs 105
Applicable tax rate is 25 %. N = 5 years
Formula: SV (NP) = Rs 104.5
Kd = I (1- t) + (RV-SV)/n *100
(RV + SV)/2 SV or NP
Issue Price = Face Value + Premium
= 10 (1-0.25) + (105-104.5)/5 *100 = 100 + (10% * 100)
(105+104.5)/2 = Rs 110
= 10 *0.75 + 0.1 *100 Issue Price Rs 110
104.75 Less: Flotation Cost Rs 5.5
= 7.25 % (5 % * Rs 110) 104.5
Q8. Calculate cost of redeemable debenture of a Calculate cost of redeemable debt using
company.
the following information:
The company has issued 10 % debenture at the
discount of 10 % to its face value Rs. 100. 12 % Bond
Flotation cost is 5 %. Time = 5 year
Debenture will be redeemed at Rs 105 after 10 years. Face value = Rs 10000
Applicable tax rate is 25 %.
Issued at premium of 10 %
Formula:
Kd = I (1- t) + (RV-SV)/n *100
No Flotation cost
(RV + SV)/2 Tax rate = 25 %.
Where,
I = Interest on Debt
Question is silent on redemption value.
t= tax rate
RV= Redeemable Value of debenture
SV= Sale Value or Net Proceed from issue of debenture.
N= number of years
Cost of Equity
• If a company raises funds by issuing equity shares, then the company has to pay
dividend on it.

• Cost of Equity is calculated using the formula:

(I) Dividend Price Ratio Approach (D/P)

K e = D1
P0

Ke= Cost ofy

equitD1= Dividend declared at the end of year 1
P0 = Current price of share
(II) Dividend Price Plus Growth Approach

Ke = D1 + g
P0

Ke= Cost of equity

D1= Dividend declared at the end of year 1 = D0 (1+g)
g = growth rate in dividend
P0 = Current price per share.
(III) Earning Price Ratio Approach

Ke = E1
P0

Ke= Cost of equity

E1= Earnings per share at the end of year 1 = E0 (1+g)
P0 = Current price per share.
(IV) Earnings Price Plus Growth Approach

Ke = E1 + g
P0

Ke= Cost of equity

E1= Expected earnings per share at the end of year 1 = E0 (1+g)
g = growth rate in earning
P0 = Current price per share.
(V) Capital Asset Pricing Model (CAPM)

Ke = Rf + β (Rm-Rf)

Ke= Cost of equity

Rf = Risk free rate of return.
β = Beta (Measure of volatility of an individual security relative to the
return on market.
(Rm-Rf) = Risk Premium
Rm = Return on market index or market portfolio.
Q1. Calculate cost of equity of X Ltd Sol:
having expected dividend per share at
the end of year is Rs. 6 and the current
market price of the share is Rs. 50. Ke=?
D1 = Rs 6
P0= Rs 50

Formula: Ke = 6 *100 = 12 %
50
Ke = D1 * 100
P0
Q2. Calculate cost of equity of X Ltd Sol:
having expected dividend per share at
the end of year is Rs. 5 and the current
market price of the share is Rs. 25. Ke = D1 + g * 100
Growth rate in dividend is 10 %. P0
= [ 5 +0.10] *100
25
= 30 %
Formula:
Ke = D1 + g * 100 Ke=?
P0 D1= Rs 5
P0 = Rs 25
g=10% = 0.10
Q3. Calculate cost of equity of X Ltd Sol:
having last year dividend is Rs 7.6 and D0 = Rs 7.6
the current market price of the share is P0= Rs 80
Rs. 80. Growth rate in dividend is 5 %. g = 5 %

Ke = D1 + g * 100
P0
= 7.98 + 0.05 = 14.975 %
Formula: 80

Ke = D1 + g * 100
D1 = Do (1+g)
P0
= 7.6 ( 1+ 0.05) = Rs 7.98
D1 = D0 (1+g)
Q. Q.
Ke = 15 % Ke = 18 %
D1 = Rs 5 D0 = Rs 5
P0 = Rs 50 g = 10 %
Calculate growth rate in Calculate Po.
dividends?
Q4. Calculate cost of equity of X Ltd Sol:
having expected earning per share at
the end of year is Rs. 10 and the
current market price of the share is E1 = Rs 10
Rs. 50. P0= Rs 50

Ke = 10 *100 = 20 %
50

Formula:
Ke = E1 * 100
P0
Q5. Calculate cost of equity of X Ltd Sol:
having expected earning per share at
the end of year is Rs. 10 and the
current market price of the share is Rs. Ke = ?
100. Growth rate in dividend is 10 %. E1= Rs 10
P0= Rs 100
g = 10 %

Ke = 20 %
Formula:
Ke = E1 + g * 100
P0
Q6. Calculate cost of equity of X Ltd Sol:
having last year dividend is Rs. 5 and
the current market price of the share
is Rs. 50. growth rate of dividend = D1 = D0 (1+g)
10 % = 5 (1+0.10) = Rs 5.5

D2=D1 (1+g)
or,
D2 =D0(1+g)2

Formula: Ke = 21%
Ke = D1 +g
P0
Q6. Calculate cost of equity of XYZ Ltd. Sol:
Risk free Rate on T-Bills = 5.5 %
Rate of return on Market Portfolio = Ke=?
13.5 % Rf = 5.5%
Beta of the company is 1.1875. Rm = 13.5 %
Beta = 1.1875

Ke = Rf + β (Rm-Rf) Ke = Rf + β (Rm-Rf)
= 5.5 + 1.1875 (13.5-5.5)
= 5.5 +9.5 = 15 %
Q6. Calculate cost of equity of XYZ Ltd. Ke = Rf + β (Rm-Rf)
Risk free Rate on T-Bills = 3.5 %
Risk premium = 11 % = 3.5 + 2 (11)
Beta of the company is 2 = 25.5 %

Ke = Rf + β (Rm-Rf)

Rm-Rf = Risk Premium

 Cost of New Equity Share

Cost of New Equity Share Ke = D1 + g

Pn

Ke = cost of equity
D1 = Dividend declared at the end of year 1
g = growth rate in dividend
Pn = Net Price to the firm = Issue Price – Flotation cost
Q7. X ltd issues a share at Rs. 200 and Sol:
incurs 5 % flotation costs. If the Pn = 200 – (200 * 5%) = Rs 190
expected dividend is Rs 20 with 10 %
growth rate. Calculate Ke D1 = Rs 20
G = 10 %
Flotation cost = 5 %

Ke = 20 + 0.10 = 20.52 %
Formula:
190
Ke = D1 + g
Pn
Q7. If X ltd issues a share at Rs. 90 and Sol:
incurs 5 % flotation costs, If the
expected dividend is Rs 15 with 10 %
growth rate. Calculate Ke D1 = RS 15
G = 10%
Pn = 90 – (90*5%) = Rs 85.50

Ke = 15 + 0.10 = 27.54 %
Formula:
85.50
Ke = D1 + g
Pn
Cost of Preference Shares
• Perpetual/ Irredeemable Preference Shares

Kp = Dp (1+Dt) * 100 = ……. %

Net Proceed

Kp = cost of preference shares

Dp = Preference Dividend
Dt= Dividend Distribution Tax
Net Proceed = Issue Price – Flotation cost
Q1. XYZ ltd has issued 15 % Preference Kp = Dp (1+Dt) * 100 = ……. %
share to the investors.
Net Proceed
The face value of PS is Rs 100. Flotation
cost is 5 %.
DDT = 25 %. Calculate the cost of Sol:
Preference share. (I) At Par (Face value = Rs 100)
Dp = 15 % * Rs 100 = Rs 15
Issued Dt = 25 % = 0.25
(1) At par (at face value) Net Proceed
(2) At Premium of 10 % Issue Price 100
(3) At Discount of 10% Less: Flotation cost 5
(Rs 100 * 5 %) 95 Net Proceed
Pref Dividend will be calculated on
face value.
Kp = 15 (1+0.25) *100 = 19.73 %
95
Q1. XYZ ltd has issued 15 % Preference Kp = Dp (1+Dt) * 100 = ……. %
share to the investors.
Net Proceed
The face value of PS is Rs 100. Flotation
cost is 5 %.
Sol:
DDT = 25 %. Calculate the cost of (II) At premium of 10 %
Preference share.
Dp = 15 % * Rs 100 = Rs 15
Dt = 25 % = 0.25
Issued Net Proceed
(1) At par (at face value) Issue Price = 100 + (10% * 100) = Rs 110
(2) At Premium of 10 %
(3) At Discount of 10% Issue Price 110
Less: Flotation cost 5.5
(Rs 110 * 5 %) 104.5 Net Proceed
Pref Dividend will be calculated on
face value.
Kp = 15 (1+0.25) *100 = 17.94 %
104.5
Q2. XYZ ltd has issued 12 % Kp = Dp (1+Dt) * 100
Preference share to the investors.
Net Proceed
The face value of PS is Rs 100. The
company has issued the PS at the
premium of 10 % to its face value.
Flotation cost is 5 %. DDT = 25 %.
Calculate the cost of Preference
share.
Q3. XYZ ltd has issued 15 % Kp = Dp (1+Dt) * 100
Preference share to the investors.
Net Proceed
The face value of PS is Rs 1000.
The company has issued the PS at
the discount of 10 % to its face
value. Flotation cost is 5 %. DDT =
25 %. Calculate the cost of
Preference share.
 Cost of Preference Shares
• Redeemable Preference Shares

Kp = Dp (1+Dt) + (RV-SV)/n * 100 = …… %

(RV + SV)/2

Kp = Cost of preference shares

Dp = Preference Dividend
Dt= Dividend Distribution Tax
SV = Net Proceed = Issue Price – Flotation cost
RV = Redeemable Value
N= number of years or duration
 Kp = Dp (1+Dt) + (RV-SV)/n * 100 = …… %
Q1. XYZ ltd has issued 11 %
Preference share to the investors (RV + SV)/2
for 5 years. The face value of PS is
Rs 100. The company has issued Kp =?
the PS at par. Flotation cost is 5 %.
Dp = 11% * Rs 100 = Rs 11
DDT = 25 %. After 5 years, the
company has decided to redeem Dt = 25 % = 0.25
the preference share at Rs 105. RV = Rs 105
Calculate the cost of redeemable N = 5 years
Preference share.
SV = Net Proceed = 100 – (5%*100) = Rs 95

Kp = 11 (1+0.25) + (105-95)/5 *100

(105+95)/2
= 13.75 + 2 *100 = 15.75 %
100
 Kp = Dp (1+Dt) + (RV-SV)/n * 100 = …… %
Q2. XYZ ltd has issued 10 %
(RV + SV)/2
Preference share to the investors
for 10 years. The face value of PS
is Rs 1000. The company has Kp =?
issued the PS at the premium of Dp = 10% * 1000 = Rs 100
10 % to its face value. RV = Rs 1100
Flotation cost is 5 %. N = 10 years
Dt = 25 %. SV = Net Proceed = 1100 – (5 % *1100) = Rs 1045
After 10 years, the company has Dt = 25 % = 0.25
decided to redeem the preference
share at Rs 1100. Calculate the Kp = 12.16 %
cost of redeemable Preference
share. Working Note:
Issue price = 1000 + (10% *1000) = Rs 1100
 Kp = Dp (1+Dt) + (RV-SV)/n * 100 = …… %
Q3. XYZ ltd has issued 15 %
(RV + SV)/2
Preference share to the investors
for 10 years. The face value of PS
is Rs 1000. The company has
issued the PS at the discount of 5
% to its face value.
Flotation cost is 10 %.
DDT = 20 %.
Calculate the cost of redeemable
Preference share.

Question is silent of redemption

price.
Cost of retained earnings (Kr)
is equals to Cost of Equity
(Ke)
Weighted average cost of capital
• WACC ( Ko)

• WACC is the average after tax cost of company’s various sources of

funds like equity share, Preference Share, Debt, retained earnings.
Source of Fund Amount Cost (Kc) Weight/Proportion Kc* Wi
Equity Share Capital 5,00,000 15% 0.5 7.5
Preference Share 2,00,000 12% 0.2 2.4
Debentures 1,00,000 10% (after tax) 0.1 1
Retained Earnings 2,00,000 15% 0.2 3
10,00,000 1 Ko= 13.9 %
 Calculate Weighted Average Cost of Capital (WACC)
using book value weights?
Sources of Capital Amount of each Weight or Proportion After Tax cost of each Wi*Ci
source of capital of each source of source (Ci)
capital (Wi)

Equity Share Capital 15,00,000 15%

Preference Share Capital 10,00,000 10%
Bonds 5,00,000 7% (after tax)
Retained Earnings 5,00,000 15%
 Calculate Weighted Average Cost of Capital (WACC)
using book value weights? A-1
Sources of Capital Amount of each Weight or Proportion Cost of each source Wi*Ci
source of capital of each source of (Ci)
capital (Wi)

Equity Share Capital 5,00,000 0.25 15% 3.75

Preference Share Capital 2,00,000 0.10 12% 1.2
Debenture 2,00,000 0.10 13% 1.3
Pre tax 10% Bank Loan 6,00,000 0.3 6% 1.8
Retained Earnings 5,00,000 0.25 15% 3.75
20,00,000 1 11.80 %
WACC (Ko) =
Post Tax Kd = 10% (1-t)
= 10% (1-0.40) = 6 %
 Calculate WACC using Market Value Weights?
CMP: Equity share = RS 65, PS= RS 90, Debenture = Rs 95

apital Amount of each Number of Shares/PSC/Debentures (N) Market Value Wi Ci wi*ci

source of fund
(N * CMP)
alue = RS 10) 5,00,000 5,00,000/10 = 50000 shares 32,50,000 0.69 15% 10.35
100) 4,00,000 4,00,000/100 = 4000 pref shares 3,60,000 0.08 12% 0.96
Rs 100) 6,00,000 6,00,000/100 = 6000 debentures 5,70,000 0.12 13% 1.56
5,00,000 5,00,000 0.11 8% 0.88
20,00,000 46,80,000 1 K0 = 13.75 %
 Calculate WACC using Market Value Weights?
CMP: ESC = RS 50, PS= RS 120, Debenture = Rs 90, Bond = Rs 105 (Tax Rate =30%)

urce of Capital Amount of each Number of Market Wi Ci Wi*Ci

source of fund Shares/PSC/Debentures/Bonds Value
(N)
(N * CMP)
C (Face Value = RS 5,00,000 500000/10 = 50000 shares 25,00,000 0.825 15% 12.375

C (FV = Rs 100) 2,00,000 2,00,000/100 = 2000 pref shares 2,40,000 0.08 14% 1.12
benture (Rs 100) 1,00,000 1,00,000/100 = 1000 debentures 90,000 0.03 13% (1-0.30) 0.273
nd (Rs 100) 1,00,000 1,00,000/100 = 1000 bonds 1,05,000 0.03 12% (1-0.30) 0.252
m loan 1,00,000 1,00,000 0.03 9 % (1-0.30) 0.189
30,35,000 0.995 WACC (Ko) = 14.209%
 Calculate Weighted Average Cost of Capital (WACC)
using book value weights?
Sources of Capital Amount of each Weight or Proportion After Tax cost of each Wi*Ci
source of capital of each source of source (Ci)
capital (Wi)

Equity Share Capital 15,00,000 16%

Preference Share Capital 10,00,000 12%
Debenture 5,00,000 11%
Bank Loan 10,00,000 9%
Retained Earnings 10,00,000 16%
 Calculate Weighted Average Cost of Capital (WACC) using market
value weights? ESC = RS 50, PS= RS 120, Debenture = Rs 90,
Sources of Capital Amount of each Number of Market Weight or After Tax cost of Wi*Ci
source of capital Shares/P.S./ Value Proportio each source (Ci)
Debenture. n of each
source of
capital
(Wi)

ESC (FV= Rs 10) 15,00,000

PSC (FV Rs 100) 10,00,000
Debenture (FV Rs 100) 5,00,000
Bank Loan 10,00,000
Retained Earnings 10,00,000
Q1. Following is the capital structure of XYZ Sol:
ltd. Step (1) Calculation of cost of specific source of fund.

Equity Share Capital (Rs 10 each) Rs 5 lakhs (A) Ke = D1 + g = 5 + 0.05 = 0.175 = 17.5 %
12% Pref. Share Capital (Rs 100 each) Rs 5 P0 40
lakhs
12% Debenture (Rs 100 each) Rs 4 Lakhs (B) Kp = Dp = 12 % *100 = 12 % (On Single PS)
9% Term loan Rs 6, lakhs NP 100
Or
Additional Information: Kp = Dp = 12 % * 5,00,000 = 12 % (Total Amt)
Tax rate 30% NP 5,00,000
Expected Dividend Rs 5 (C ) (Debenture) Kd = I (1-t) = 12% *4,00,000 (1-0.30)
NP 4,00,000
Current Market Price is Rs 40
= 48,000 (1-0.30) = 8.4 %
Growth rate in dividend 5%
4,00,000
Calculate WACC using Book Value Weights? Or Kd = 12 % (1-0.30) = 8.4 %
(D) Kt = I (1-t) = 9% * 6,00,000 (1-0.30) = 6.3 %
NP 6,00,000
Q1. Following is the capital structure of XYZ Sol:
ltd. Step (1) Calculation of cost of specific source of fund.

Equity Share Capital (Rs 10 each) Rs 5 lakhs (A) Ke = D1 + g = 5 + 0.05 = 0.175 = 17.5 %
12% Pref. Share Capital (Rs 100 each) Rs 5 P0 40
lakhs
12% Debenture (Rs 100 each) Rs 4 Lakhs (B) Kp = Dp = 12 % *100 = 12 % (On Single PS)
9% Term loan Rs 6, lakhs NP 100
Or
Step _02 Calculation of WACC using Book Kp = Dp = 12 % * 5,00,000 = 12 % (Total Amt)
Value NP 5,00,000
Source Amount Ki wi Wi*Ki (C ) (Debenture) Kd = I (1-t) = 12% *4,00,000 (1-0.30)
ESC 5,00,000 17.5 % 0.25 4.375 NP 4,00,000
PSC 5,00,000 12 % 0.25 3 = 48,000 (1-0.30) = 8.4 %
Deb 4,00,000 8.4 % 0.20 1.68 4,00,000
Term L 6,00,000 6.3 % 0.30 1.89 Or Kd = 12 % (1-0.30) = 8.4 %
(D) Kt = I (1-t) = 9% * 6,00,000 (1-0.30) = 6.3 %
20,00,000 1 10.945 %
NP 6,00,000
 Leverage
• Leverage analysis is the technique to quantify the risk return relationship
of different alternatives of capital structure.

• Two types of risk:

(A) Business Risk
 Related to Capital Budgeting Decision.

(B) Financial Risk

 Related to Capital Structure Decision.
Sales 1000
Less: Variable Cost 400
Contribution 600
Less: Fixed Cost 100
EBIT 500
Less: Interest 50
EBT 450
Less: Taxes (30%) 135
EAT 315
Less: Pref Dividend 15
EAOS 300
EPS = EAOS/number of share = 300/100 = Rs 3 per share
Degree of Operating Leverage (DOL)
Operating Leverage is a measure of business risk.
It shows the impact of change in sales on operating income (EBIT) in
presence of fixed cost.

• DOL = Percentage Change in EBIT

Percentage Change in Sales

• DOL = Contribution
EBIT
Degree of Financial Leverage (DOL)
Financial Leverage is a measure of financial risk.
It shows the impact of change in EBIT on EPS in presence of fixed financing cost.

• DFL = Percentage Change in EPS

Percentage Change in EBIT

• DFL = EBIT
EBT

• DFL = EBIT
EBT- (Pref Dividend)
1-t
 Sol:
Q1. Calculate the degree of operating
leverage.
Sales 10,00,000
Less: VC 4,00,000
Sales : Rs 10,00,000
Contribution 6,00,000
Variable cost = Rs 4,00,000
Less: Fixed Cost 35,000
Fixed Cost = Rs 35000
EBIT 5,65,000

Formula: DOL (OL) = Contribution = 6,00,000 = 1.06 times

DOL = Percentage Change in EBIT EBIT 5,65,000
Percentage Change in Sales
• DOL = Contribution
EBIT
 Sol:
Q2. Calculate the degree of operating
leverage.
• DOL = Percentage Change in EBIT
Percentage Change in Sales
Decrease in operating income 66.66 %
Decrease in Sales Revenue 33.33 %
= -66.66 % = 2 times
-33.33%

Formula:
• DOL = Percentage Change in EBIT
Percentage Change in Sales

• DOL = Contribution
EBIT
Q3. Calculate the degree of operating leverage. Sol:
Sales (10000 *Rs 10) 1,00,000
Sales units : 10000 units Less: VC (60% * 1,00,000) 60,000
Selling Price per unit = Rs 10 Contribution 40,000
Less: Fixed Cost 30,000
Variable Cost = 60 %
EBIT 10,000
Total Operating cost 90 %
(Note :Total Operating cost = Fixed cost +
Variable cost) OL = Contribution = 40,000 = 4 times
EBIT 10,000

Formula:
• DOL = Percentage Change in EBIT
Working Notes:
Percentage Change in Sales
Total Operating Cost = Fixed Cost + Variable Cost
90 % * Sales = Fixed Cost + 60,000
• DOL = Contribution
90,000 = FC + 60,000
EBIT
FC = Rs 30,000
Q4. Calculate degree of operating leverage?

Increase in EBIT = 200 %

Increase in Sales = 50 %

Formula:

DOL = Percentage Change in EBIT

Percentage Change in Sales

• DOL = Contribution
EBIT
Q5. Calculate degree of operating Sol:
leverage? DOL = Percentage Change in EBIT = 200 = 4 times
Percentage Change in Sales 50
Sales units 1000 1500
Selling Price Per unit Rs 10 Rs 10 Sales 10000 15000
EBIT Rs 1500 Rs 4500
EBIT 1500 4500

Formula:
Percentage Change in Sales = (15000-10000) *100
= 50%
DOL = Percentage Change in EBIT
10000
Percentage Change in Sales

• DOL = Contribution Percentage Change in EBIT = (4500-1500) *100 =

200%
EBIT
1500
Financial Leverage
Q1. Calculate degree of financial leverage?

Sales units 2000 2800

EBIT Rs 2400 Rs 7200 DFL = Percentage Change in EPS = 1.5 times
EPS Rs 9.60 Rs 38.40 Percentage Change in EBIT

Formula:

• DFL = Percentage Change in EPS

Percentage Change in EBIT

• DFL = EBIT
EBT
Q2. Calculate degree of financial leverage? Sol:
Sales Rs 50,000
Variable cost Rs 30,000 Sales 50,000
Fixed Cost Rs 15,000 Less: VC 30,000
10 % Debt Rs 37,500 Contribution 20,000
Tax Rate 40 % Less: FC 15,000
EBIT 5,000
Formula: Less: Interest 3750
(10% * Rs 37,500)
• DFL = Percentage Change in EPS EBT 1250
Percentage Change in EBIT Less: Tax (40% ) 500
EAOS 750
• DFL = EBIT
EBT DFL = 5000 = 4 times
1250
 Sol:
Q3. Calculate degree of financial leverage?
Sales 50,000
Sales Rs 50,000
Less: VC 30,000
Variable cost Rs 30,000
Contribution 20,000
Fixed Cost Rs 15,000 Less: FC 15,000
10 % Debt Rs 37,500 EBIT 5,000
15 % Preference Share Capital Rs 3,000 Less: Interest 3750
Tax Rate 40 % (10% * Rs 37,500)
EBT 1250
Formula: Less: Tax (40% ) 500
EAT 750
• DFL = Percentage Change in EPS Less: Pref Div 450
(15 % * Rs 3,000)
Percentage Change in EBIT
EAOS 300

• DFL = EBIT
DFL = 5000 = 10 times
EBT- (Pref Dividend) 1250 – (450)
1-t 1-0.40
Combined Leverage
• Combined Leverage = Operating Leverage * Financial Leverage

• DCL = DOL * DFL

• DCL = Percentage Change in EBIT * Percentage change in EPS

Percentage Change in Sales Percentage change in EBIT
DCL = Percentage Change in EPS
Percentage change in Sale
DCL = Contribution * EBIT = Contribution
EBIT EBT EBT
Q3. Calculate DOL, DFL, DCL, EPS?
Sales Rs 10,00,000
Variable cost Rs 6,00,000
Fixed Cost Rs 2,00,000
15 % Debt Rs 5,00,000
Taxes 40 %
Number of Equity Shares
= 1,00,000 shares

DOL = Contribution / EBIT

DFL = EBIT / EBT
DCL = DOL * DFL
Q3. Calculate DOL, DFL, DCL, EPS? Sol:
Sales 10,00,000
Sales Rs 10,00,000 Less: VC (50%) 5,00,000
Variable cost 50 % Contribution 5,00,000
Fixed Cost Rs 1,50,000 Less: Fixed Cost 1,50,000
15 % Debt Rs 5,00,000 EBIT 3,50,000
Taxes 25 % Less: Interest 75,000
Number of Equity Shares (15%* 5,00,000)
= 50000 shares EBT 2,75,000
Less: Taxes (25%) 68,750
DOL = 1.42 times
EAT (EAOS) 2,06250
DFL = 1.27 times
DCL = 1.80 times
EPS = EAT/n = 2,06,250/50000 = Rs 4.125
 Sol:
Q4. Sales Rs 10,00,000
Sales 10,00,000
VC 40 % ; Fixed Cost Rs 1,00,000
Less: VC (40%) 4,00,000
Interest Rs 50,000 Contribution 6,00,000
Tax Rate 30 % Less: Fixed Cost 1,00,000
Number of shares 10000 EBIT 5,00,000
Calculate Less: Interest 50,000
(1) EPS, Operating Leverage, Financial Leverage EBT 4,50,000
Less: Tax (30%) 1,35,000
(2) Combined Leverage
EAT 3,15,000
(3) If sales dropped to Rs 8,00,000 then what is
Less: PD -
the new EBIT?
EAOS 3,15,000
(4) P/V Ratio, MOS, BEP.
EPS = EAOS/n = 3,15,000/10000 = Rs 31.5
(5) Calculate Percentage change in drop in sales DOL = Contribution = 6,00,000 = 1.2 times
to make EBIT zero.
EBIT 5,00,000
(6) Calculate Percentage change in drop in EBIT to
DFL = EBIT = 5,00,000 = 1.11 times
make the EPS zero.
EBT 4,50,000
(7) Calculate Percentage change drop in sales to
DCL = DOL * DFL = 1.2 * 1.11 = 1.332 times
make EPS zero.
 Sol:
Q4. Sales Rs 10,00,000
Sales 10,00,000
VC 40 % ; Fixed Cost Rs 1,00,000
Less: VC (40%) 4,00,000
Interest Rs 50,000 Contribution 6,00,000
Tax Rate 30 % Less: Fixed Cost 1,00,000
Number of shares 10000 EBIT 5,00,000
Calculate Less: Interest 50,000
(1) EPS, Operating Leverage, Financial Leverage EBT 4,50,000
Less: Tax (30%) 1,35,000
(2) Combined Leverage
EAT 3,15,000
(3) If sales dropped to Rs 8,00,000 then what is
Less: PD -
the new EBIT?
EAOS 3,15,000
(4) P/V Ratio, MOS, BEP.
EPS = EAOS/n = 3,15,000/10000 = Rs 31.5
(5) Calculate Percentage change in drop in sales P/V ratio = Contribution = 6,00,000 = 0.60 =60 %
to make EBIT zero.
Sales 10,00,000
(6) Calculate Percentage change in drop in EBIT to
MOS = 1/DOL = 1/1.2 = 0.83
make the EPS zero.
BEP = Fixed Cost = 1,00,000 = Rs 1,66,667
(7) Calculate Percentage change drop in sales to
P/V Ratio 60%
make EPS zero.

Q4. Sales Rs 10,00,000
VC 40 % ; Fixed Cost Rs 1,00,000
Interest Rs 50,000
Tax Rate 30 %
Number of shares 10000
Calculate
(1) EPS, Operating Leverage, Financial
Leverage
(2) Combined Leverage
(3) If sales dropped to Rs 8,00,000 then
what is the new EBIT?
(4) P/V Ratio, MOS, BEP.
(5) Calculate Percentage change in drop
in sales to make EBIT zero.
(6) Calculate Percentage change in drop
in EBIT to make the EPS zero.
(7) Calculate Percentage change drop in
Sol:
(3) If sales dropped to Rs 8,00,000, then new EBIT?
OL = 1.2 times
Percentage Change in Sales = (8,00,000-10,00,000) *100
10,00,000
= -20 %
DOL = Percentage Change in EBIT
Percentage Change in Sales
1.2 = Percentage Change in EBIT
-20%
Percentage change in EBIT = 1.2 * -20 % = -24 %
Change in EBIT = 5,00,000 * 24 % = Rs. 1,20,000
New EBIT = 5,00,000 – 1,20,000 = Rs 3,80,000
Formula: New Sales = Fixed Cost + New EBIT
PV Ratio
8,00,000 = 1,00,000 + New EBIT
60%
New EBIT = Rs 3,80,000
 Sol:
Q4. Sales Rs 10,00,000
Sales 10,00,000
VC 40 % ; Fixed Cost Rs 1,00,000 Less: VC (40%) 4,00,000
Interest Rs 50,000 Contribution 6,00,000
Tax Rate 30 % Less: Fixed Cost 1,00,000

Number of shares 10000 EBIT 5,00,000

Less: Interest 50,000
Calculate
EBT 4,50,000
(1) EPS, Operating Leverage, Financial Leverage Less: Tax (30%) 1,35,000
(2) Combined Leverage EAT 3,15,000
(3) If sales dropped to Rs 8,00,000 then what is Less: PD -
the new EBIT? EAOS 3,15,000
(4) P/V Ratio, MOS, BEP. EPS = EAOS/n = 3,15,000/10000 = Rs 31.5

(5) Calculate Percentage change in drop in sales

(5) DOL = Percentage Change in EBIT
to make EBIT zero.
Percentage Change in Sales
(6) Calculate Percentage change in drop in EBIT to
1.2 = 100%
make the EPS zero.
Percentage Change in Sale
(7) Calculate Percentage change drop in sales to Percentage Change in Sales = 100/1.2 = 83.33 %
make EPS zero.
 Sol:
Q4. Sales Rs 10,00,000
Sales 10,00,000
VC 40 % ; Fixed Cost Rs 1,00,000
Less: VC (40%) 4,00,000
Interest Rs 50,000 Contribution 6,00,000
Tax Rate 30 % Less: Fixed Cost 1,00,000
Number of shares 10000 EBIT 5,00,000
Calculate Less: Interest 50,000
(1) EPS, Operating Leverage, Financial Leverage EBT 4,50,000
Less: Tax (30%) 1,35,000
(2) Combined Leverage
EAT 3,15,000
(3) If sales dropped to Rs 8,00,000 then what is
Less: PD -
the new EBIT?
EAOS 3,15,000
(4) P/V Ratio, MOS, BEP.
EPS = EAOS/n = 3,15,000/10000 = Rs 31.5
(5) Calculate Percentage change in drop in sales (6) DFL = Percentage Change in EPS
to make EBIT zero.
Percentage Change in EBIT
(6) Calculate Percentage change in drop in EBIT to
1.11 = 100 %
make the EPS zero.
Percentage Change in EBIT
(7) Calculate Percentage change drop in sales to
Percentage Change in EBIT = 90.09%
make EPS zero.
 Sol:
Q4. Sales Rs 10,00,000
Sales 10,00,000
VC 40 % ; Fixed Cost Rs 1,00,000
Less: VC (40%) 4,00,000
Interest Rs 50,000 Contribution 6,00,000
Tax Rate 30 % Less: Fixed Cost 1,00,000
Number of shares 10000 EBIT 5,00,000
Calculate Less: Interest 50,000
EBT 4,50,000
(1) EPS, Operating Leverage, Financial Leverage
Less: Tax (30%) 1,35,000
(2) Combined Leverage EAT 3,15,000
(3) If sales dropped to Rs 8,00,000 then what is Less: PD -
the new EBIT? EAOS 3,15,000
(4) P/V Ratio, MOS, BEP. EPS = EAOS/n = 3,15,000/10000 = Rs 31.5
(5) Calculate Percentage change in drop in sales (7) DCL = Percentage Change in EPS
to make EBIT zero. Percentage change in Sale
(6) Calculate Percentage change in drop in EBIT to 1.332 = 100 %
make the EPS zero.
Percentage Change in Sales
(7) Calculate Percentage change drop in sales to
make EPS zero. Percentage Change in Sales = 100/1.332 = 75.07 %
 EBIT-EPS Analysis
• To examine the impact of leverage on the EPS.
• It shows the impact of various alternative financial plans on EPS at various
alternative financial plans on EPS at various level of EBIT.
Q1 Show the effect of financial Sol:
leverage on EPS. Total Fund Required = Rs 10,00,000
EBIT = RS 2,00,000
EBIT 2,00,000
Total Funds Required = Rs Less: Interest -
10,00,000 EBT 2,00,000
Financial Plan: Less: Taxes (40%) 80,000
100 % Fund raised by issuing EAT 1,20,000
equity shares of Rs 10 each. Less: PD -
EAOS 1,20,000
Tax rate 40 %.
EPS = 1,20,000/100000 = Rs 1.2
Number of shares = Equity Share Capital
Face Value
= 10,00,000 = 100000 shares
10
Q2 Show the effect of financial Sol:
leverage on EPS.
EBIT 2,00,000
EBIT = RS 2,00,000
Less: Interest 75,000
Total Funds Required = Rs 10,00,000 (15 % *5,00,000)
Financial Plan: EBT 1,25,000
50 % Fund raised by issuing equity Less: Taxes (40%) 50,000
shares of Rs 10 each. EAT 75,000
Less: PD -
50 % fund raised through 15 % Debt.
EAOS 75,000
Tax rate 40 %.
EPS = EAOS/n = 75,000/50000 = Rs 1.5
Equity = Rs 5,00,000
Number of shares = 50 % * 10,00,000 =50000
Debt = Rs 5,00,000
10
Q2 Show the effect of financial leverage on Sol:
EPS. EBIT 2,00,000
EBIT = RS 2,00,000 Less: Interest 37,500
Total Funds Required = Rs 10,00,000 (2,50,000 *15%)
Financial Plan: EBT 1,62,500
50 % Fund raised by issuing equity shares of Rs Less: Taxes (40%) 65,000
10 each.
EAT 97,500
25 % fund raised through 15 % Debt.
Less: PD 37,500
25% fund raised through 15 % Pref Shares
(2,50,000*15%)
Tax rate 40 %.
EAOS 60,000
EPS = EAOS/n = 60000/50000 = Rs 1.2
Total Fund Rs 10,00,000
Number of shares = 50 % *10,00,000
Equity = 50 % * 10 lakhs = Rs 5 lakhs
10
Debt = 25 % *10 lakhs = Rs 2.5 lakhs
= 50000 shares
Pref Share = 25 % * 10 lakhs = Rs 2.5 lakhs
Q3 Which financial plan would you recommend.
Total Funds Required = Rs 10,00,000
EBIT = 5 % on Capital Employed.
Financial Plan A :
100 % Fund raised by issuing equity shares of Rs
10 each. CMP Rs 25
Financial Plan B :
40 % Fund raised by issuing equity shares of Rs
10 each, CMP Rs 20.
60 %, 10 % Debentures of Rs 100 each.
Financial Plan C :
40 %, Equity Shares of Rs 10 each, Premium in
market 100 %.
40 %, 10 % Debentures of Rs 100 each.
20%, 15 % Preference Shares of Rs 100 each.
Tax rate 40 %.
Q3 Which financial plan would you recommend.
Total Funds Required = Rs 10,00,000
EBIT = 5 % on Capital Employed.
Financial Plan A :
100 % Fund raised by issuing equity shares of Rs
10 each.
Financial Plan B :
40 % Fund raised by issuing equity shares of Rs
10 each, CMP Rs 20.
60 %, 10 % Debentures of Rs 100 each.
Financial Plan C :
40 %, Equity Shares of Rs 10 each, Premium in
market 100 %. (Issue Price = Rs 20)
40 %, 10 % Debentures of Rs 100 each.
20%, 15 % Preference Shares of Rs 100 each.
Tax rate 40 %.
Q3 Which financial plan would you recommend.
Total Funds Required = Rs 10,00,000
EBIT = 5 % on Capital Employed.
Financial Plan A :
100 % Fund raised by issuing equity shares of Rs
10 each.
Financial Plan B :
40 % Fund raised by issuing equity shares of Rs
10 each, CMP Rs 20.
60 %, 10 % Debentures of Rs 100 each.
Financial Plan C :
40 %, Equity Shares of Rs 10 each, Premium in
market 100 %.
40 %, 10 % Debentures of Rs 100 each.
20%, 15 % Preference Shares of Rs 100 each.
Tax rate 40 %.