Majestic Ltd., a manufacturing company, is evaluating its financial performance and considering an expansion plan. The financial controller provides…

CA Intermediate · Financial Management and Strategic Management · MTP · September 2025
Majestic Ltd., a manufacturing company, is evaluating its financial performance and considering an expansion plan. The financial controller provides the following information for the financial year 2025: Equity Share Capital - 10,00,000 (10 per share) Retained Earnings - 10,00,000 12% Debentures - 41,66,667 EBIT - 20,00,000 Interest Expense - 5,00,000 Contribution Margin Ratio 40% Tax Rate 30% Operating Leverage 2.5 Financial Leverage 1.333 Combined Leverage 3.333 Working Capital 20,00,000 Current Ratio 2 Fixed Asset Turnover Ratio 3 The company is now considering an expansion project costing - 25,00,000. It anticipates the following changes post-expansion in 2026: (i) Sales are expected to increase by - 50,00,000. (ii) Variable costs will constitute 55% of sales. (iii) Additional fixed costs due to expansion are - 10,00,000. The company is evaluating two financing options for the expansion: Option 1: Raise - 25,00,000 by issuing new equity shares at 10 each. Option 2: Raise - 25,00,000 by issuing new debt at 12% interest. From the above information, you are required to: (1) Prepare the Income Statement and Balance Sheet of 2025 based on the data provided. (3 Marks) (2) Compute the EPS under each financing option. (2 Marks) (3) Compute the Operating Leverage, Financial Leverage and Combined Leverage of both the financing options. (2 Marks) (4) Recommend the best financing option based on the EPS and impact of leverage giving reasons. (1 Mark)

Suggested Answer and Working Notes:

2. (a) Working Notes: Contribution = DOL × EBIT = 2.5 × 20,00,000 = 50,00,000 Sales = Contribution / Contribution Margin Ratio = 50,00,000 / 0.40 = 1,25,00,000 Calculation of Current Assets and Current Liabilities Let Current Liabilities be X Then, 2X - X = 20,00,000 So, Current Liabilities = 20,00,000 Current Ratio = Current Assets / Current Liabilities = 2 Current Liabilities So, Current Assets = 20,00,000 x 2 = 40,00,000 Calculation of Fixed Assets Sales = 1,25,00,000 Fixed Assets Turnover Ratio = Sales / Fixed Assets So, Fixed Assets = 1,25,00,000 / 3 = 41,66,667 (1) Income Statement for the Financial Year ended 2025 Particulars Amount (₹) Sales 1,25,00,000 Less: Variable Costs @ 60% 75,00,000 Contribution 50,00,000 Less: Fixed Costs (b.f.) 30,00,000 EBIT 20,00,000 Less: Interest 5,00,000 EBT 15,00,000 Less: Tax (30%) 4,50,000 EAT 10,50,000 EPS (10,50,000/1,00,000) 10.50 Balance Sheet as at Year 2025 Liabilities ₹ Assets ₹ Equity Capital 10,00,000 Fixed Assets 41,66,667 Retained Earnings 10,00,000 Current Assets 40,00,000 12% Debentures 41,66,667 Current Liabilities 20,00,000 81,66,667 81,66,667 (2) Calculation of EPS in each option under expansion plan Post-Expansion Financials (2026) Sales = 1,25,00,000 + 50,00,000 = 1,75,00,000 Variable Cost (55%) = 1,75,00,000 x 55% = 96,25,000 Contribution = 78,75,000 Fixed Costs = 30,00,000 +10,00,000 = 40,00,000 EBIT = 38,75,000 Particulars Equity Option Debt Option EBIT 38,75,000 38,75,000 Interest (old) 5,00,000 5,00,000 Interest (new) - 3,00,000 EBT 33,75,000 30,75,000 Tax@30% 10,12,500 9,22,500 EAT 23,62,500 21,52,500 No. of Shares 3,50,000 1,00,000 EPS 6.75 21.525 (3) Calculation of Operating Leverage, Financial Leverage and Combined Leverage for each option under expansion plan 2025 Equity Option (2026) Debt Option (2026) EPS 10.50 6.75 21.525 Operating Leverage 2.5 = Contribution / EBIT = 78,75,000 / 38,75,000 = 2.03 = Contribution / EBIT = 78,75,000 / 38,75,000 = 2.03 Financial Leverage 1.333 = EBIT / EBT = 38,75,000 / 33,75,000 = 1.15 = EBIT / EBT = 38,75,000 / 30,75,000 = 1.26 Combined Leverage = OL x FL 3.333 = 2.03 x 1.15 = 2.33 = 2.03 x 1.26 = 2.56 (4) Recommendation of the best financing option Debt financing results in a higher EPS of 21.525 and offer better returns to shareholders. Though financial risk increases slightly, the leverage ratios remain within manageable limits. Therefore, if the company is confident in its ability to generate stable cash flow, debt financing is the better option.

Topics: Part-A: Financial Management

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