- Relevant information about three companies are given below:
| BIL | PIL | MIL | |
| Annual production capacity | 1,00,000 | 1,50,000 | 2,50,000 |
| Capacity Utilization and sales | 75% | 75% | 75% |
| Unit Selling Price (Rs.) | 40 | 50 | 50 |
| Unit Variable Cost (Rs.) | 15 | 15 | 20 |
| Fixed Cost p.a. (Rs.) | 2,00,000 | 3,00,000 | 5,00,000 |
| Equity Capital (Rs.) [1000 shares for each company] | 5,00,000 | 7,00,000 | 10,00,000 |
| 10% Preference Share Capital (Rs.) | – | 50,000 | 1,00,000 |
| 15% Debentures | 1,00,000 | 2,00,000 | 3,00,000 |
Calculate Operating Leverage, Financial Leverage, Combined Leverage and EPS of these three companies and comment.
SOLUTION:
To calculate the operating leverage, financial leverage, combined leverage, and earnings per share (EPS) of the three companies, we’ll use the following formulas:
Operating Leverage (OL) = Contribution Margin / Operating Profit
Financial Leverage (FL) = EBIT / Profit before Tax (PBT)
Combined Leverage (CL) = OL * FL
Earnings per Share (EPS) = (Profit after Tax – Preference Dividend) / Number of Equity Shares
Let’s calculate these values for each company:
For BIL (Company B): Contribution Margin = Unit Selling Price – Unit Variable Cost = Rs. 40 – Rs. 15 = Rs. 25
Operating Profit = Capacity Utilization and Sales * Contribution Margin = 75% * 1,00,000 * Rs. 25 = Rs. 18,75,000
OL = Contribution Margin / Operating Profit = Rs. 25 / Rs. 18,75,000 ≈ 0.0013
EBIT = Operating Profit – Fixed Cost = Rs. 18,75,000 – Rs. 2,00,000 = Rs. 16,75,000
PBT = EBIT – Interest = Rs. 16,75,000 – Rs. 1,00,000 = Rs. 15,75,000
FL = EBIT / PBT = Rs. 16,75,000 / Rs. 15,75,000 ≈ 1.0635
CL = OL * FL ≈ 0.0013 * 1.0635 ≈ 0.0014
EPS = (Profit after Tax – Preference Dividend) / Number of Equity Shares Profit after Tax = PBT – Tax = Rs. 15,75,000 – (0.3 * Rs. 15,75,000) = Rs. 11,02,500 EPS = (Rs. 11,02,500 – 0) / 1000 = Rs. 11.02
For PIL (Company P): Contribution Margin = Unit Selling Price – Unit Variable Cost = Rs. 50 – Rs. 15 = Rs. 35
Operating Profit = Capacity Utilization and Sales * Contribution Margin = 75% * 1,50,000 * Rs. 35 = Rs. 39,37,500
OL = Contribution Margin / Operating Profit = Rs. 35 / Rs. 39,37,500 ≈ 0.0009
EBIT = Operating Profit – Fixed Cost = Rs. 39,37,500 – Rs. 3,00,000 = Rs. 36,37,500
PBT = EBIT – Interest = Rs. 36,37,500 – Rs. 2,00,000 = Rs. 34,37,500
FL = EBIT / PBT = Rs. 36,37,500 / Rs. 34,37,500 ≈ 1.0588
CL = OL * FL ≈ 0.0009 * 1.0588 ≈ 0.001
EPS = (Profit after Tax – Preference Dividend) / Number of Equity Shares Profit after Tax = PBT – Tax = Rs. 34,37,500 – (0.3 * Rs. 34,37,500) = Rs. 24,06,250 EPS = (Rs. 24,06,250 – Rs. 50,000) / 1000 = Rs. 23.56
For MIL (Company M): Contribution Margin = Unit Selling Price – Unit Variable Cost = Rs. 50 – Rs. 20 = Rs. 30
Operating Profit = Capacity Utilization and Sales * Contribution Margin = 75% * 2,50,000 * Rs. 30 = Rs. 56,25,000
OL = Contribution Margin / Operating Profit = Rs. 30 / Rs. 56,25,000 ≈ 0.0005
EBIT = Operating Profit – Fixed Cost = Rs. 56,25,000 – Rs. 5,00,000 = Rs. 51,25,000
PBT = EBIT – Interest = Rs. 51,25,000 – Rs. 3,00,000 = Rs. 48,25,000
FL = EBIT / PBT = Rs. 51,25,000 / Rs. 48,25,000 ≈ 1.0615
CL = OL * FL ≈ 0.0005 * 1.0615 ≈ 0.0005
EPS = (Profit after Tax – Preference Dividend) / Number of Equity Shares Profit after Tax = PBT – Tax = Rs. 48,25,000 – (0.3 * Rs. 48,25,000) = Rs. 33,77,500 EPS = (Rs. 33,77,500 – Rs. 1,00,000) / 1000 = Rs. 32.77
Comments:
- The operating leverage of all three companies is relatively low, indicating that a small change in sales volume will have a minimal impact on operating profit.
- The financial leverage of all three companies is close to 1, suggesting a moderate level of financial risk.
- The combined leverage is also low for all three companies, indicating a relatively lower level of risk in terms of the impact on earnings.
- Among the three companies, MIL (Company M) has the highest EPS, followed by PIL (Company P) and BIL (Company B). This suggests that MIL generates the highest earnings per share for its shareholders.
- MIL (Company M) has the highest production capacity and generates the highest operating profit, leading to higher EPS compared to the other two companies.
- BIL (Company B) has the lowest EPS, which may be due to its lower production capacity and lower unit selling price compared to the other companies.
Overall, MIL appears to be the most profitable among the three companies, while BIL has the lowest profitability. The differences in production capacity, unit selling price, and variable cost contribute to the variations in EPS.
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