ABC Manufacturing Limited produces industrial components with a well-established market presence. The company operates under a special tax-free…

CA Intermediate · Financial Management and Strategic Management · RTP · May 2026
ABC Manufacturing Limited produces industrial components with a well-established market presence. The company operates under a special tax-free status granted by the government, which exempts it from corporate income tax obligations. Financial Information The company's financial parameters for the current fiscal year are as follows: Capital Structure Details Total Capital Invested:20,00,000 (20 lakhs)Cost of Equity (K e ): 12% per annumCost of Debt (K d ): 6% per annumWeighted Average Cost of Capital (WACC): 9% per annum Operational Information Annual Sales Revenue:24,00,000 (24 lakhs)Variable Costs: 50% of sales revenueFixed Costs:10,00,000 (10 lakhs) per annum General corporate tax is 25% As a financial analyst, you have been tasked with conducting a comprehensive financial analysis of ABC Manufacturing Limited. Specifically, you are required to: vi. EXPLAIN the concept of Leverage as a double edged sword by explaining the Leverage Effect when ROI > K d , ROI = K d , ROI < K d .

Suggested Answer and Working Notes:

When the cost of 'fixed cost fund' is less than the return on investment, financial leverage will help to increase return on equity and EPS. The firm will also benefit from the saving of tax on interest on debts etc. However, when cost of debt will be more than the return it will affect return of equity and EPS unfavourably and as a result firm can be under financial distress. Therefore, financial leverage is also known as "double edged sword”. Effect on EPS and ROE: When, ROI (10%) > Interest (6%) – Favourable – Advantage When, ROI (10%) < Interest (12%) – Unfavourable – Disadvantage When, ROI (10%) = Interest (10%) – Neutral – Neither advantage nor disadvantage

Topics: Part-A: Financial Management

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