ShirtCo is a garment manufacturing company producing and selling 10,000 shirts every year. The company's cost and revenue structure is as follows:…

CA Intermediate · Financial Management and Strategic Management · MTP · January 2026
ShirtCo is a garment manufacturing company producing and selling 10,000 shirts every year. The company's cost and revenue structure is as follows: Particulars Amount (₹ / per unit) Selling Price 500 Variable Cost 200 Fixed Cost (Total) 25,00,000 The company's Chief Accountant has calculated the Degree of Operating Leverage (DOL) as 6 times and the Degree of Combined Leverage (DCL) as 12 times, based on the current level of production and sales. He claims that “If sales increase by 10%, the EBIT will increase by 60%.” As a financial analyst, you are asked to verify whether his contention is correct under the following independent situations: 1. Case 1: Production and sales quantity increase by 10%, while selling price and costs remain unchanged. 2. Case 2: The selling price per shirt increases by 10%, while the sales quantity and cost remains unchanged. 3. Case 3: The selling price per shirt increases by 10%, but the price elasticity of demand is 1.2, leading to a change in sales quantity accordingly. Required: (i) CALCULATE the new EBIT under each case. (ii) DETERMINE the percentage change in EBIT compared to the original level under each case. (iii) COMMENT on the accuracy of the Chief Accountant's claim in each situation. If not correct, give reasons. (iv) Assuming the company is tax exempt and the company has 10% Debentures amounting to INR 25 Lakhs and 10% Preference Shares amounting to INR 10 Lakhs, Comment whether the financial leverage computed by the Chief Accountant is correct. If not, COMPUTE the correct DFL and DCL. [Consider the base case for this part. Ignore the changes in quantity and price.]

Suggested Answer and Working Notes:

Calculation of Current EBIT Particulars Amount (₹) Sales (10,000 × 500) 50,00,000 Variable cost (10,000 × 200) 20,00,000 Contribution 30,00,000 Fixed cost 25,00,000 EBIT 5,00,000 Case 1 – Quantity (production & sales) increases by 10% (price & costs unchanged) New quantity = 10,000 × 1.10 = 11,000 units Particulars Amount (₹) Contribution (11,000 × 300) 33,00,000 Fixed cost 25,00,000 New EBIT 8,00,000 % Change in EBIT = (8,00,000 - 5,00,000) / 5,00,000 × 100 = 60% Conclusion (Case 1): The accountant's statement is correct here. A 10% rise in quantity produces a 60% rise in EBIT. Case 2 – Selling price per unit increases by 10% (quantity unchanged; variable cost unchanged) New price = 500 × 1.10 = 550 per unit Variable cost per unit = 200 Contribution per unit = 350 Quantity = 10,000 Particulars Amount (₹) Contribution (10,000 × 350) 35,00,000 Fixed cost 25,00,000 New EBIT 10,00,000 % Change in EBIT = (10,00,000 - 5,00,000) / 5,00,000 × 100 = 100% Conclusion (Case 2): The accountant's 60% prediction is not correct. A 10% price increase (with volume fixed) doubles EBIT here — a 100% increase — because unit contribution rises from 300 to 350 (a 16.67% increase in contribution per unit) while fixed costs stay the same. Case 3 – Price increases by 10% but demand responds with price elasticity = 1.2 Price elasticity of demand (absolute value) = 1.2 means a 10% price increase causes a 12% decrease in quantity (elastic demand). Price and Quantity demanded are inversely correlated. New price = 550 per unit (10% ↑) New quantity = 10,000 × (1 - 0.12) = 8,800 units Contribution per unit = 350 Particulars Amount (₹) Total contribution (8,800 × 350) 30,80,000 Fixed cost 25,00,000 New EBIT 5,80,000 % Change in EBIT = (5,80,000 - 5,00,000) / 5,00,000 × 100 = 16% Conclusion (Case 3): The accountant's 60% prediction is wrong. Because quantity falls (elastic demand) the net effect is only a 16% increase in EBIT. Reason: Operating Leverage means percentage change in EBIT with respect to percentage change in sales quantity. OL is a function of Fixed cost, variable contribution margin and Sales Volume. Hence, OL will be justified if there is change in sales volume i.e. Quantity. (iv) DCL = DOL x DFL 12 = 6 x DFL DFL = 2 Earnings Before Tax (EBT) EBT = EBIT - Interest - Preference Dividend Interest on Debentures = 10% of 25,00,000 = 2,50,000 Preference Dividend = 10% of 10,00,000 = 1,00,000 EBT = 5,00,000 - 2,50,000 - 1,00,000 = 1,50,000 Correct Degree of Financial Leverage (DFL) DFL = EBIT / (EBT - Preference Dividend) = 5,00,000 / (1,50,000 - 0) = 5,00,000 / 1,50,000 = 3.33 Hence, DCL = 6 x 3.33 = 20 Therefore, the financial leverage computed by the Chief Accountant is not correct.

Topics: Part-A: Financial Management

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