# MCQs on Financial and Strategic Management | Leverage

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• By Taxmann
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• Last Updated on 30 July, 2022

1. Practical Problem & Solution

1.1 MCQs ON THEORY

2. MCQs ON THEORY ( With Answer Key )

2.1 PRACTICAL MCQs

2.3 HINTS FOR IMPORTANT PRACTICAL MCQs

## 1. Practical Problem & Solution

Problem No. 1] Prepare the income statement and calculate the degree of operating leverage, degree of financial leverage, and the degree of combined leverage for the following companies:

 Company P Q R Output (units) 3,00,000 75,000 5,00,000 Fixed costs (Rs.) 3,50,000 7,00,000 75,000 Unit variable cost (Rs.) 1.00 7.50 0.10 Interest expenses (Rs.) 25,000 40,000 25,000 Unit selling price (Rs.) 3.00 25.00 0.50

Applicable tax rate is 35%.

Ans.: Statement showing income & leverage of each company:

 Particulars P Q R Output (units) 3,00,000 75,000 5,00,000 Sales 9,00,000 18,75,000 2,50,000 Variable cost (3,00,000) (5,62,500) (50,000) Contribution 6,00,000 13,12,500 2,00,000 (-) Fixed cost (3,50,000) (7,00,000) (75,000) Earnings before interest & tax (EBIT) 2,50,000 6,12,500 1,25,000 (-) Interest (25,000) (40,000) (25,000) Earnings before tax (EBT) 2,25,000 5,72,500 1,00,000 (-) Tax @ 35% (78,750) (2,00,375) (35,000) Profit after tax (PAT) 1,46,250 3,72,125 65,000 Operating Leverage = 2.40 2.1429 1.60 Financial Leverage = 1.11 1.0699 1.25 Combined Leverage = 2.67 2.2926 2.00 Or (Operating Leverage × Financial Leverage)

Problem No. 2] The capital structure of a company consists of the following securities.

 Rs. 10% Preference Share Capital 1,00,000 Equity Share Capital (Rs. 10 Shares) 1,00,000 12% Debenture 75,000

The amount of operating profit is Rs. 69,000. The company is in 35% tax bracket.

You are required to calculate the financial leverage of the company.

Ans.:

 Operating Profit (EBIT) 69,000 (-) Interest (9,000) Earnings before tax (EBT) 60,000 (-) Tax @ 35% (21,000) Profit after tax (PAT) 39,000

If there are preference shares in capital structure then following formula has to be used to calculate the financial leverage.

= 1.5466

Problem No. 3] A company has the following capital structure

 Rs. 10,000 Equity Share of Rs. 10 each 1,00,000 2,000 10% Preference Share of Rs. 100 each 2,00,000 2,000 10% Debentures of Rs. 100 each 2,00,000

Calculate the EPS for each of the following levels of EBIT:

(i)   ` 1,00,000

(ii)   ` 60,000 and

(iii)   ` 1,40,000

The company in 50% tax bracket.

Calculate the financial leverage taking EBIT level under (i) base.

Ans.:

 Particulars I II III EBIT 1,00,000 60,000 1,40,000 (-) Interest (20,000) (20,000) (20,000) Earnings before tax (EBT) 80,000 40,000 1,20,000 (-) Tax @ 50% (40,000) (20,000) (60,000) Profit after tax (PAT) 40,000 20,000 60,000 (-) Preference dividend (20,000) (20,000) (20,000) Profit available for equity shareholders 20,000 – 40,000 No. of equity shares 10,000 10,000 10,000 EPS (Profit available for equity shareholders/No. of shares) × 100 2 – 4

Computation of financial leverage under different level of EBIT:

Problem No. 4] The following data relate of company XYZ Ltd.

 Rs. Sales 2,00,000 Less: Variable expenses (30%) (60,000) Contribution 1,40,000 Fixed operating expenses (1,00,000) EBIT 40,000 Less: Interest (5,000) Taxable income 35,000

(a) Using the concept of operating leverage state by what percentage will EBIT increase if there is a 10 per cent increase in sales?

(b) Using the concept of financial leverage, state by what percentage will taxable income increase if EBIT increases by 6%?

(c) Using the concept of combined leverage, State by what percentage taxable income will increase if sales increase by 6%.

Ans.:

 Operating Leverage = = = 3.5 Financial Leverage = = = 1.1429 Combined Leverage = = = 4.0

(1) Operating leverage is 3.5, this means that 1% change in sales will cause 3.5% change in EBIT.

(2) Financial leverage is 1.1429, this means that 1% change in EBIT will cause 1.1429% change in EBT.

(3) Combined leverage is 4, this means that 1% change in sales will cause 4% change in PAT/EPS.

(a) If there is a 10% increase in sale, EBIT increase by 35% (10 × 3.5). Concept of operating leverage applied.

(b) If EBIT increases by 6% taxable income increase by 6.9% (6 × 1.15). Concept of financial leverage applied.

(c) If sales increase by 6% taxable income will increase by 24% (6 × 4). Concept of combined leverage applied.

Problem No. 5] The balance sheet of Alpha Company is given below:

 Liabilities Rs. Assets Rs. Equity Capital (Rs. 10 per share) 90,000 Net Fixed Assets 2,25,000 10% Long Term Debt 1,20,000 Current Assets 75,000 Retained Earnings 30,000 Current Liabilities 60,000 3,00,000 3,00,000

The company’s total assets turnover ratio is 3, its fixed operating cost is Rs. 1,50,000 and its variable operating cost ratio is 50%. The income-tax rate is 50%.

Required to:

(i) Calculate the different type of leverages for the company.

(ii) Determine the likely level of sales & EBIT if EPS is:

(a)   Rs. 1            (b)  Rs. 2               (c) Rs. 0

Ans.:

Assets Turnover Ratio =

3 =

Sales = 9,00,000

 Sales 9,00,000 (-) Variable cost (4,50,000) Contribution 4,50,000 (-) Fixed cost (1,50,000) Earnings before interest & tax (EBIT) 3,00,000 (-) Interest (12,000) Earnings before tax (EBT) 2,88,000 (-) Tax @ 50% (1,44,000) Profit after Tax (PAT) 1,44,000

 Operating Leverage = Contribution/EBIT = 4,50,000/3,00,000 = 1.5 Financial Leverage = Contribution/EBIT = 3,00,000/2,88,000 = 1.042 Combined Leverage = Contribution/EBIT = 4,50,000/2,88,000 = 1.5625

Statement showing the likely level of sales & EBIT if EPS is 1, 2 & 0:

 Sales 3,60,000 3,96,000 3,24,000 (-) Variable cost (@ 50% of sales) (1,80,000) (1,98,000) (1,62,000) Contribution 1,80,000 1,98,000 1,62,000 (-) Fixed cost (1,50,000) (1,50,000) (1,50,000) Earnings before interest & tax (EBIT) 30,000 48,000 12,000 (-) Interest (12,000) (12,000) (12,000) Earnings before tax (EBT) 18,000 36,000 0 (-) Tax @ 50% (9,000) (18,000) 0 Profit after tax (PAT) 9,000 18,000 0 No. of shares 9,000 9,000 9,000 EPS 1 2 0

Perform reverse working downward to upward.

Problem No. 6] Calculate operating leverage and financial leverage under situations A, B and C and financial Plans I, II, and III respectively from the following information relating to the operating and capital structure of XYZ Co. Also find out the combinations of operating and financial leverages which give the highest value and the least value. How are these calculations useful to the financial manager in a company?

 Installed capacity 1,200 units Actual production & sales 800 units Selling price per unit Rs. 15 Variable cost per unit Rs. 10 Fixed Cost: Situation A Rs. 1,000 Situation B Rs. 2,000 Situation C Rs. 3,000

 Capital Structure: Financial Plan I Financial Plan II Financial Plan III Equity Rs. 5,000 Rs. 7,500 Rs. 2,500 Debt Rs. 5,000 Rs. 2,500 Rs. 7,500 Cost of debt 12% 12% 12%

Ans.: Sales – Variable Cost = Contribution; 15 – 10 = 5

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