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FL = EBIT
OL = Contribution/EBIT or [EBT-(PD*(1+CDT)] CL = OL*FL
DOL = % change in EBIT (1-TR) CL = % change in EPS/EBT
% Change in Sales % Change in Sales
DFL = % change in EPS/EBT
Operating Break Even Point (OBEP) % Change in EBIT
Combined Break Even Point (CBEP)
It the level of sales at which EBIT is
zero Financial Break Even Point (FBEP) It the level of total sales at which
It the level of sales at which PATESH is PATESH is zero
zero
OBEP (Units) = Fixed Cost/
Contribution per unit FBEP (Units) = [Intt + PD*(1+CDT)/(1- CBEP = OBEP + FBEP
OBEP (Amt) = Fixed Cost/PV Ratio TR)]/(Contribution per unit)
OBEP (Amt) = [Intt + PD*(1+CDT)/(1-
TR)]/PV Ratio
At OBEP
Contribution = Fixed Cost or
At FBEP
EBIT = 0
EBIT = Intt + PD*(1+CDT)/(1-TR)
PATESH = 0
Other Points
a) When the firm has fixed costs, the % change in profits due to change in sales level is greater
than the % change in sales.
b) The operating leverage at any level of sales is called its Degree. The Degree of operating leverage
varies with a change in the level of sales.
C) The fixed financial charges do not vary with the EBIT. They are fixed and are to be paid irrespective of
level of EBIT.
Question-1***
Equity Share Capital of Rs.10 each Rs.100000
10% Debt Rs.50000
12% PSC Rs.100000
Total Capital Invested in Business Rs.250000
Sales Rs.100000
Variable Cost Rs.40000
Fixed Cost includes depreciation Rs.10000
Fixed Cost excludes (Depreciation) Rs.7000
Equity Dividend Rs.5000
Tax Rate 30%
CDT 10%
Solution-1
Rs.
Sales 100,000
Less: Variable Cost-40% 40,000
PV Ratio = Contribution/Sales =
Contribution-60% (Profit Volume Ratio) 60,000 60000/100000 = 0.6
Less: Fixed Cost (Excluding Depreciation) 7,000
Less: Depreciation 3,000
Business Profit. EBIT does not change with
change in Capital Structure. But it changes
EBIT or Operating Profit or Profit of Business 50,000 with changes with change in total capital.
Less: Intt 5,000 Profit to debt
EBT/PBT 45,000
Less: Tax-30% 13,500
EAT/PAT 31,500
Less: Preference Dividend 12,000
Profit to Equity. It changes with change in
PATESH 19,500 CS.
No of Equity Shares 10,000
EPS (Earning per Equity Share) = PATESH/No of Equity Share 1.95
ROI [Before Tax] = 50000*100/250000 20% It shows business is earning 20% on Rs.100 of Capital Employed
ROI [After Tax] = 20%*0.7 14%
Capital Employed in
Equity Profit for Equity (Amt) Return of Equity (%)
EPS
(Equity Fund/Equity)
PATESH - It is profit ROE (r) =
against total Equity PATESH/Equity Fund
Equity = ESC + R&S + Fund EPS = PATESH/No of
PL ± Change in Value
Equity Share
of Assets and
Liabilities - Fictitious It is known as profit of It is a profit against
Assets Equity after deducting Rs.100 Equity Fund
fixed finance cost
It is a profit against 1
ROE changes with the Equity Share
Equity = MV of Assets PATESH change with change in capital
- MV of Liabilties change in Capital structure & total
Structure & Total capital
It changes with the
Capital change in capital
ROE is always after structure & total
tax capital
Return on Equity = ROE (r) = 19500/100000 = 19.50% It says return on Equity Fund
ROE Segment wise = ROIAfter Tax + [(ROIAfter Tax - KdAfter Tax)]*Debt/Equity + [(ROIAfter Tax - Kp)]*Preference/Equity
For present case = 14% + [14% - 7%]*50000/100000 + [14%-12%]*100000/100000
= 14% + 3.5% + 2% = 19.50%
1.1.6 Book Value per share or Intrinsic Value per share or Net Assets Value
a) It is calculated on the basis of Assets and liabilities appearing in the balance sheet.
b) Market Value of Assets & Liabilities is taken for calculation of intrinsic value of share
c) If Market Value is not given, then book value of Assets and Liabilities is taken.
d) Equity Fund = (MV of all Assets – MV of Liabilities – Value of Debt)
Equity Fund = (ESC + R&S +- Change in value of Assets and Liabilities – Fictitious Assets)
e) BVPS or Intrinsic Value = Equity Fund/No of Equity Shares = 100000/10000 = Rs.10
Dividend = PATESH - Retained Profit DPS = Total Dividend/N DPR = (1-b) = DPS/EPS
Retained Profit = PATESH - Dividend RPPS = Total Retained Profit/N RR (b) = RPPS/EPS or (1-b)
Working
PATESH = Rs.19500 EPS = 19500/10000 = Rs.1.95 If EPS = Rs.1
Dividend = Rs.5000 DPS = 5000/10000 = Rs.0.50 DPR = DPS/EPS = 0.5/1.95 = 0.25
Retained Profit = Rs.14500 RPPS = 13500/10000 = Rs.1.45 RR (b) = RPPS/EPS = 1.45/1.95 = 0.75
Calculation of EPS
Working
EPS = 19500/10000 = Rs.1.95 EPS = ROE*BVPS = Rs.10*19.5% = Rs.1.95 EPS = DPS/DPR = 0.25/0.50 = Rs.1.95
If PATESH is given If Rate of dividend is given If Dividend Yield is given If DP Ratio is given
DPS = PATESH/n DPS = Face Value*Rate of Div DPS = MPS*Div Yield DPS = EPS*DP Ratio
Summary of Question
Relationship between Profit and Capital
Purpose Name of Profit Capital
Business EBIT = 50000 TCE = 250000
Business ROI = 14% TCE = 100
Equity PATESH = 19500 Equity Fund = 100000
Equity ROE = 19.5% Equity Fund = 100
Equity EPS = Rs.1.95 Equity Fund = FV of equity Share = Rs.10
Breakup of PATESH
Particulars Distributed Profit Retained Profit
PATESH Equity Dividend Retained Profit
EPS DPS RPS
If EPS = 1 DP Ratio Retention Ratio
[Calculation of Financial Leverage and Financial Break even Point if there is preference share
capital]
Question-3 [M02-10] [ICWA-D01-10] [SP]
The net Sales of A Ltd. is Rs.30 crores. EBIT of the company as a percentage of net sales is 12%. The
capital employed comprises Rs.10 crores of equity, Rs.2 cores of 13% Cumulative Preference Share Capital
and 15% Debentures of Rs.6 crores. Income-tax rate is 40%.
Calculate the Return-on-equity for the company and indicate its segments due to the presence of Preference
Share Capital and Borrowing (Debentures). [Ans: 13.6%] [M-6]
Calculate the Operating Leverage of the Company given that combined leverage is 3. [Ans: 1.89]
BALANCE SHEET
Share Capital Equity Fund Shareholder’s Fund Capital Employed in Business
Reserves and Surplus
Preference Share Capital
Term Loan from Financial Institution Other Borrowings External Borrowings
(Debentures, Bonds, Other Debts instruments) Debt Capital
a) Cost of capital is the finance cost (Interest, Dividend) that is paid to capital provider on debt, equity,
preference from EBIT
b) Cost of capital for business will be return for capital provider.
c) Cost of capital is also known as ‘cut-off’ rate, ‘hurdle rate’, ‘minimum rate of return’ etc.
Preference Share
Term Equity Debt Business
Capital
Return for
ROE CR CR ROI
Investor
Apply formula of constant cash flow for indefinite Apply formula of actual return of cash flow for
period definite period
Kd = Constant CO p.a./Issue Price or Net Actual Kd (AT) = YTM = LR + (NPVLR/NPVLR –
Proceeds NPVHR)*(HR-LR)
Note: In absence of any specific information, students may use any of the above formulae to calculate the
Cost of Debt (Kd) with logical assumption.
I Annual interest payment = IR*FV
t Tax Rate
NP/P0 Net proceeds of debentures or current market price = Issue Price – Floatation Cost
RV Redemption Value
n Life of Debenture
LR Lower Discount rate
Kp (AT) = PD*(1+CDT)/NP
Note
1. Cost of redeemable preference share could also be calculated as the discount rate that equates the net
proceeds of the sale of preference shares with the present value of the future dividends and principal
payments.
2. As per the Companies Act 2013, issuances of irredeemable preference shares are not allowed but for
the academic knowledge it is studied here
1.3.3.2 Various Methods for calculation of cost of equity/ Equity Capitalisation Rate
Calculation of Ke Existing Shares
On the basis of PE ratio Ke = 1/PE ratio = 1/MP/EPS = EPS/MP *[Earning Price Ratio]
Question-8A
A company's share is quoted in market at Rs.40 currently. A company pays a dividend of Rs.2 per share and
investors expect a growth rate of 10% per year, compute:
(a) The company's cost of equity capital or Equity Capitalisation Rate.
Question-8B [SP]
The share of ABC Ltd. is presently traded at Rs.50 and the company is expected to pay dividend of Rs.4 per
share with a growth rate of 8% p.a. It plans to raise fresh equity share capital at a discount of Rs.1 and the
floating cost is Rs.0.50 per share. Find out the cost of existing equity shares as well as the new equity.
Question-9
MP of share = Rs.150
EPS = Rs.10
Calculate Ke
Question-10
Po = Rs.100
P1 = Rs.120
D1 = Rs.10
Question-11
Suppose following is the capital structure of a firm:
Rs
Equity capital 5,00,000
Reserves 2,00,000
Debt 3,00,000
10,00,000
The component costs (before tax) are: Equity capital 18%, Debt 10%. Tax Rate = 30%
Assume that the current levels of dividends are generally expected to continue indefinitely and the income
tax rate at 50%.
You are required to compute the weighted average cost of capital of each company.
1.4 Ratio
Q No ICAI RTP PM
12 N12-5b-8, M09-O-1b-6 56
12A M03-6c-8
13 57
Debt to Total Total Outside Liabilities It measures how much of total assets is financed by the
assets Ratio Total Assets debt.
Or
Total Debt/Total Assets
Capital Gearing PSC + Deb + Other Borrowed funds Proportion of fixed interest (dividend) bearing capital to
Ratio ESC + R&S – Losses funds belonging to equity shareholders i.e. equity funds or
net worth
Proprietary Ratio Proprietary Fund It measures the proportion of total assets financed by
Total Assets shareholders.
Fixed Charges EBIT + Depreciation This ratio shows how many times the cash flow before
Coverage Ratio [Intt + Repayment of loan/(1-TR)] interest and taxes covers all fixed financing charges. The
ideal ratio is > 1.
Working Capital Sales /COGS It measures the efficiency of the firm to use working capital.
Turnover Ratio Working Capital
Inventory/Stock COGS/Sales It measures the efficiency of the firm to manage its inventory.
Turnover Ratio Average Inventory
Debtors Turnover Credit Sales It measures the efficiency at which firm is managing its receivables.
Ratio Average Receivable
Receivables Average Receivables It measures the velocity of collection of receivables. It indicates the
(Debtors’) Average Daily Credit Sales average collection period
Velocity
Or
12 months/360 days
Receivable Turnover Ratio
Payables Credit Purchases It measures the velocity of payables payment.
Turnover Ratio Average Payables
Payable Velocity/ Average Payable
Average payment Avg Daily Credit Purchases
period Or
12months/52weeks/360days
Payables Turnover Ratio
The sales of the company is growing and to support this the company proposes to obtain additional
borrowing of Rs. 50 Lakhs expected to cost 16%. The increase in EBIT is expected to be 16%.
Calculate the change in interest coverage ratio after the additional borrowing and commitment.
Question-13 [PM-J15-57]
XYZ Ltd. has Rs.8 Cr of 10% mortgage bonds outstanding. The additional bonds to be issued as long as all
the following conditions are met:
(a) Pre-tax interest coverage [EBIT/ bond interest] remains greater than 4.
(b) Net depreciated value of mortgaged assets remains more than twice the amount of mortgage debt.
(c) Debt-to-equity ratio remains below 5.
XYZ Ltd. has net income after taxes of Rs.2 Cr and a 40% tax rate. Rs.40 Cr in equity, and Rs.30 Cr in
depreciated assets, covered by the mortgage.
How much more 10% debt could be sold under each of the three conditions assuming that 50% of the
proceeds of a new issue would be added to the base of mortgaged assets? Which condition is protective?