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    Case Study On Leverages

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    Santosh Kumar Roul
    The document analyzes the impact of two new project proposals on a company's financial leverage and earnings. [1] Without the new projects, the company has favorable financial leverage from earning a 20.3% return on capital employed while paying 10% interest on debt. [2] Accepting the EXE/Wye project would adversely affect operating leverage, return on capital employed, and asset leverage, while the Zed project would affect return on capital employed and asset leverage. [3] Financing the projects through new debt at 9% would increase earnings per share, while financing through new preference shares at 10% would decrease earnings per share for both projects.

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    Case Study On Leverages

    Uploaded by

    Santosh Kumar Roul
    1K views5 pages
    The document analyzes the impact of two new project proposals on a company's financial leverage and earnings. [1] Without the new projects, the company has favorable financial leverage from earning a 20.3% return on capital employed while paying 10% interest on debt. [2] Accepting the EXE/Wye project would adversely affect operating leverage, return on capital employed, and asset leverage, while the Zed project would affect return on capital employed and asset leverage. [3] Financing the projects through new debt at 9% would increase earnings per share, while financing through new preference shares at 10% would decrease earnings per share for both projects.

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    Case Study On leverages

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    The document analyzes the impact of two new project proposals on a company's financial leverage and earnings. [1] Without the new projects, the company has favorable financial leverage from earning a 20.3% return on capital employed while paying 10% interest on debt. [2] Accepting the EXE/Wye project would adversely affect operating leverage, return on capital employed, and asset leverage, while the Zed project would affect return on capital employed and asset leverage. [3] Financing the projects through new debt at 9% would increase earnings per share, while financing through new preference shares at 10% would decrease earnings per share for both projects.

    Copyright:

    Attribution Non-Commercial (BY-NC)
    Download as PDF, TXT or read online from Scribd
    Download as pdf or txt
    1K views5 pages

    Case Study On Leverages

    Uploaded by

    Santosh Kumar Roul
    The document analyzes the impact of two new project proposals on a company's financial leverage and earnings. [1] Without the new projects, the company has favorable financial leverage from earning a 20.3% return on capital employed while paying 10% interest on debt. [2] Accepting the EXE/Wye project would adversely affect operating leverage, return on capital employed, and asset leverage, while the Zed project would affect return on capital employed and asset leverage. [3] Financing the projects through new debt at 9% would increase earnings per share, while financing through new preference shares at 10% would decrease earnings per share for both projects.

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    Attribution Non-Commercial (BY-NC)
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    The company is currently profitable and has favorable financial leverage. Two new projects are being evaluated and two financing options are available.

    The company is currently earning a 20.3% return on capital employed and has a favorable financial leverage ratio compared to normal industry standards of 20% profit margin and 1.2 asset turnover ratio.

    Acceptance of the EXE/Wye project would negatively impact operating leverage, return on capital employed and asset leverage ratios while the Zed project would negatively impact return on capital employed and asset leverage ratios.

    Case Study: Impact of Leverages on new Project Proposals

    Creative Products ltd. Is the manufacturer of three products viz EXE, wye and zed. The las years Income
    Statement and Balance Sheet are as follows:

    Income Statement (Rs.)

    Sales 75,00,000
    Variable Cost 46,90,000
    Contribution 28,10,000
    Fixed Cost 14,00,000
    EBIT 14,10,000
    Interest 2,00,000
    EBT 12,10,000
    Taxation 6,05,000
    EAT 6,05,000

    Balance Sheet

    LIABILITIES Rs. ASSETS Rs.


    Equity Capital 10,00,000 Fixed Assets 60,00,000
    Reserve & Surplus 42,00,000 Inventory 6,00,000
    Long – Term Debt (10%) 20,00,000 Receivables 7,00,000
    Current Liabilities 5,00,000 Cash 4,00,000
    77,00,000 77,00,000
    Figures for Industry comparison: Normal asset turnover 1.2:1 ,Normal Profit Margin 20%

    For the current year, the forecasted sales are Rs.80,00,000 and it is likely that variable costs will remain
    at approximately the same % of sales as was in the last year.( figures could be rounded off.) Fixed costs
    will rise by 10%

    G has short listed the following two product lines to be sold through its existing distribution channels:

    1. Production and sale of EXE and Wye products will require an investment of Rs. 20,00,000 which
    would involve installation of manufacturing and packaging machinery. Sales forecast are
    Rs.15,00,000 pa , variable cost 2/3 of sales value, fixed costs are Rs.2,00,000 and no additional
    working capital is needed.
    2. For Production of product zed will require and investment of Rs.30,00,000 with forecasted sales
    pa of Rs.25,00,000 variable costs 64% of sales value and fixed costs of Rs.5,00,000.

    Two financial plans are available:

    a) It could borrow on a 10 years note at 9% for either or both of the projects of an amount not to
    exceed Rs.60,00,000.
    b) Cumulative preference shares with a 10% dividend upto an amount of Rs.30,00,000.
    Financing through the issue of equity shares would not be possible at the present time.
    Analyse :

    1) Without the new proposals , what would be the companies operating , fixed charges and
    combined leverages next year? Would the company have favorable financial leverage?
    2) How does the acceptance of each project affect the differing leverages including asset
    leverages?
    3) With each financing alternatives, do the companys future earnings per share increase or
    decrease, why?
    Analysis:

    Income Statement

    Particulars Last Year Current Year


    Sales 75,00,000 80,00,000
    Less: VC (62.5%) 46,90,000 50,00,000
    Contribution 28,10,000 30,00,000
    Less: Fixed Cost 14,00,000 15,40,000
    EBIT 14,10,000 14,60,000
    Less: Interest 2,00,000 2,00,000
    EBT 12,10,000 12,60,000
    Less: Tax @ 50% 6,05,000 6,30,000
    EAT 6,05,000 6,30,000

    Current years profitability

    Operating leverage=Con/EBIT= 30,00,000/14,60,000=2.055

    Financial Leverage=EBIT/EBT=14,60,000/12,60,000=1.158

    Combine Leverage=Con/EBT=30,00,000/12,60,000=2.38

    ROCE=(EBIT/CE)×100=(14,60,000/72,00,000)× 100=20.3%

    Profit Margin=(EBIT/Sales) × 100 =(14,60,000/80,00,000)×100=18.25%

    Asset Leverage= Sales/CE= 80,00,000/72,00,000=1.11

    The company is having favourable financial leverage by earning 20.3% return on capital employed and
    by paying only 10% on long term debt.

    2) Evaluation of New Projects

    Project EXE & Wye units Zed Unit


    Additional Investment 20,00,000 30,00,000
    Sales 15,00,000 25,00,000
    Less: VC (15 lac ×2/3) (25 lac 10,00,000 16,00,000
    ×(64/100))
    Contribution 5,00,000 9,00,000
    Less: Fixed Cost 2,00,000 5,00,000
    EBIT 3,00,000 4,00,000
    I. Operating Leverage= con/EBIT
    Exe & wye units=5,00,000/3,00,000=1.67
    Zed Unit=9,00,000/4,00,000=2.25

    II. Asset Leverage=Sales/CE


    Exe & wye units=15,00,000/20,00,000=0.75
    Zed Unit=25,00,000/30,00,000=0.83

    III. ROCE=(EBIT/CE)×100
    Exe & wye units=(3,00,000/20,00,000)×100=15%
    Zed Unit=(4,00,000/30,00,000)×100=13.33%

    IV. Profit Margin=(EBIT/Sales)×100


    Exe & wye units=(3,00,000/15,00,000)×100=20%
    Zed Unit=(4,00,000/25,00,000)×100=16%

    Analysis

    The acceptance of Exe and wye projects adversely affects:

    OL, ROCE, AL

    The acceptance of Zed Project would adversely affects:

    ROCE, AL

    Option I

    Borrowing on a 10 years note at 9% for either or both the projects. The total borrowing should not
    exceed Rs. 60 lac.

    Exe and wye Project: the cost of debt is 9%, ROCE is 15% and additional return added to equity
    shareholders is 6% (15%-9%)

    Zed Project: the cost of debt is 9%, ROCE is 13.33% and the aditinal return added to equity shareholders
    is 4.33% (13.33% -9%)

    Companies EPS will increase for both the projects

    Option II

    Issue of 10% cumulative Pre. Shares upto and amount of Rs.30 lac.
    Cost of Pre. Share Capital is 10%

    Pre tax cost of Pre. Share is 10%/1-t=10%/1-0.5=20%

    Exe and wye project-

    Pre tax cost of pre. Share is 20%, and ROCE is 15% , this will reduce overall profits and EPS.

    Zed Project-Pre tax cost or pre. Share is 20%, ROCE is 13.33%, this will reduce overall profits and EPS.

    Debt financing is preferable.

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