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knowledge bank -basic learning Leverage - 2

Q1.ABC paint company has fixed operating costs of Rs 3 million a year. Variable operating costs are Rs 1.75 per half pint of paint produced, and the average selling price is Rs 2 per half pint. a- What is the annual break even point in half pints? In rupees of sales? b- If variable operating costs decline to Rs 1.68 per half pint, what would happen to the operating break even point? c- If fixed costs increase to Rs 3.75 million per year, what would be the effect on the operating break even point? d- Compute the degree of operating leverage at the current sales level of 16 million half pints. e- If sales are expected to increase by 15 % from the current sales position of 16 million half pints , what would be the resulting percentage change in operating profit(EBIT) from its current position?

Q2.ABC Ltd has a DOL of 2 at its current production and sales level of 10,000 units. The resulting operating income figure is Rs 1,000. 1. If sales are expected to increase by 20 percent from the current 10,000 unit sales position, what would be the resulting operating profit figure? 2. At the company’s new sales position of 12,000 units, what is the firm’s new DOL figure?

Q3.Somesh Cricket Bat Company currently has Rs 3 million in debt outstanding, bearing an interest rate of 12%. It wishes to finance a Rs 4 million expansion programme and is considering three alternatives: additional debt at 14 percent (option 1), preferred stock with a 12% dividend (option 2), and the sale of common stock at Rs 16 per share (option 3). The company currently has 8,00,000 shares of common stock outstanding and is in 40% tax bracket. 1. If earnings before interest and taxes are currently Rs 1.5 million, what would be earnings per share for the three alternatives, assuming no immediate increase in operating profit? 2. Develop a breakeven or indifference chart for these alternatives. What are the approximate indifference points? 3. Compute the degree of financial leverage for each alternative at the expected EBIT level of Rs 1.5 million? 4. Which alternative do you prefer? How much would EBIT need to increase before the next alternative would be better (in terms of EPS)

Q4.Geetika Regulator Company currently has 100,000 shares of common stock outstanding with a market price of Rs. 60 per share. It also has Rs. 2 million in 6 percent bonds. The company is considering a Rs. 3 million expansion program that it can finance with all common stock at Rs. 60 a share (option 1), straight bonds at 8 percent interest (opton 2), preferred stock at 7 percent (option 3), and half common stock at Rs. 60 per share and half 8 percent bonds (option 4). a. For an expected EBIT level of Rs. 1 million after the expansion program, calculate the earnings per share for each of the alternative methods of financing. Assume a tax rate of 50 percent. b. Calculate the indifference points between alternatives. What is your interpretation of them?

Q5.Geetika Regulator Company (See Problem above) expects the EBIT level after the expansion program to be Rs. 1 million, with a two-thirds probability that it will be between Rs. 600,000 and Rs. 1,400,000. a. Which financing alternative do you prefer? Why? b. Suppose that the expected EBIT level were Rs. 1.5 million and that there is a two-thirds probability that it would be between Rs. 1.3 million and Rs. 1.7 million. Which financing alternative would you prefer? Why?

Q6.A firm has sales of Rs 75 lakhs. Its variable cost and fixed costs are Rs 42 lakhs and Rs 6 lakhs respectively. It has a debt of Rs 45 lakhs at 9% and equity of Rs 55 lakhs. a- What is the firms ROI b- Does the firm have a favourable financial leverage? c- If the firm belongs to an industry whose asset turnover is 3, does it have a high or low asset leverage? d- What are the operating, financial and combined leverage of the firm? e- If sales drop to Rs 50 lakhs, what will be the new EBIT? f- At what level the EBT of the firm will be equal to zero?

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