ABC Engineering Ltd., a mid-sized capital-intensive manufacturing company, is evaluating the risk-return profile of its operations. The company…

CA Intermediate · Financial Management and Strategic Management · MTP · September 2025
ABC Engineering Ltd., a mid-sized capital-intensive manufacturing company, is evaluating the risk-return profile of its operations. The company currently operates at 75% of its production capacity. The following information relates to its current operations: Income Statement at 75% Capacity Particulars Amount (₹) Sales Revenue 7,50,00,000 Variable Cost 4,50,00,000 Fixed Operating Costs 1,20,00,000 EBIT (Earnings Before Interest & Tax) ? Interest on Debt (12% Debentures) ? EBT (Earnings Before Tax) ? Tax Rate 30% Additional Information: The company has equity share capital of 2,00,00,000 (shares of 10 each, fully paid-up).The current Debt-Equity ratio is 0.75:1, and the company is considering increasing its production to 90% capacity.At 90% capacity:Sales and variable cost per unit will increase proportionately.Fixed operating costs will increase by - 10,00,000 due to additional maintenance, supervisory staff, and overheads.To finance the additional working capital and fixed overheads, the company is considering issuing additional - 50,00,000 in 13% debentures.The management wants to analyze the impact of increased capacity on Operating Leverage, Financial Leverage, and Combined Leverage and the change in EPS (Earnings Per Share) under the new financial plan. You are required to: (i) At 75% Capacity (Current Scenario) (a) CALCULATE EPS by filling the missing figures. (b) CALCULATE Degree of Operating Leverage (DOL), Degree of Financial Leverage (DFL) and Degree of Combined Leverage (DCL). (ii) At 90% Capacity with Revised Financial Plan (a) CALCULATE new DOL, DFL, and DCL. (b) Revised EPS. (iii) ADVICE as to whether the company proceed with the capacity expansion and debt issue.

Suggested Answer and Working Notes:

2. (a) (i) Current Scenario at 75% Capacity (a) Calculation of EBIT, EBT, Profit after tax and Earning Per Share Particulars Amount (₹) Sales Revenue 7,50,00,000 Less: Variable Cost 4,50,00,000 Contribution 3,00,00,000 Less: Fixed Cost 1,20,00,000 EBIT 1,80,00,000 Less: Interest (1,50,00,000 x 12%) 18,00,000 EBT 1,62,00,000 Less: Tax@30% 48,60,000 Profit after tax 1,13,40,000 No. of Equity Shares 20,00,000 Earnings Per Share 5.67 (b) Calculation of Various Leverages Degree of Operating Leverage (DOL): DOL = Contribution / EBIT = 3,00,00,000 / 1,80,00,000 = 1.67 Degree of Financial Leverage (DFL): DFL = EBIT / EBT = 1,80,00,000 / 1,62,00,000 = 1.11 Degree of Combined Leverage (DCL): DCL = DOL × DFL = 1.67 × 1.11 = 1.85 (ii) New Scenario at 90% Capacity (a) Revised calculation of EBIT, EBT, Profit after tax and Earning Per Share: Particulars Amount (₹) Sales Revenue [7,50,00,000 × (90/75)] 9,00,00,000 Less: Variable Cost [4,50,00,000 × (90/75)] 5,40,00,000 Contribution 3,60,00,000 Less: Fixed Cost (1,20,00,000 + 10,00,000) 1,30,00,000 EBIT 2,30,00,000 Less: Interest (1,50,00,000 × 12%) + (50,00,000 × 13%) 24,50,000 EBT 2,05,50,000 Less: Tax@30% 61,65,000 Profit after tax 1,43,85,000 No. of Equity Shares 20,00,000 Earning Per Share (1,43,85,000 / 20,00,000) 7.19 (b) Revised Calculation of Various Leverages DOL = 3,60,00,000 / 2,30,00,000 = 1.57 DFL = 2,30,00,000 / 2,05,50,000 = 1.12 DCL = 1.57 × 1.12 = 1.76 (c) At higher capacity utilization, the company is able to generate higher EBIT and EPS. However, it takes on slightly more financial risk by issuing 13% debentures. The company should go ahead with the capacity expansion and new financing plan, as the overall risk has been slightly reduced as indicated in the combined leverage while shareholder return by way of EPS has significantly increased.

Topics: Part-A: Financial Management

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