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➢ Calculating Financial Leverage

Debt- to- Assets ratio Debt- to- Equity ratio

= Total Debt/ Total Assets = Total Debt/ Total Equity

Debt-to EBIDTA ratio Interest Coverage ratio

= Total Debt /EBIDTA = EBIT/ Interest expense

Du-Pont analysis uses the “equity

multiplier” as a measure of financial
leverage.
Equity Multiplier = Total assets/
Total Equity

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Degree of Financial Leverage (DFL) = Earnings before interest and
tax(EBIT) / Earnings before tax(EBT)
Where, EBIT = Sales - (Variable cost + Fixed cost excluding interest)
EBT = EBIT – Interest

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OPERATING LEVERAGE
Degree of Operating Leverage (DOL) = % Change in EBIT /
% Change in Sales
DOL = Contribution / Earnings Before Interest and Taxes (EBIT)

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COMBINED OR TOTAL LEVERAGE
Degree of Total leverage (DTL) = % change in EBT /% change in Sales
DTL = DFL × DOL
= EBIT/EBT × Contribution/ EBIT
= Contribution/EBT

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➢ ILLUSTRATION 4 A firm has sales of Rs. 10,00,000, variable cost of Rs.
7,00,000 and fixed costs of Rs. 2,00,000 and debt of Rs. 5,00,000 at
10% rate of interest. What are the operating, financial and combined
leverages?

Particulars Rs. OL = Contribution/ EBIT

Sales 10,00,000 = 3,00,000/ 1,00,000
Less : VC 7,00,000 = 3 times
Contribution 3,00,000
FL = EBIT/ EBT
Fixed Cost 2,00,000
= 1 lakh/ 50k = 2
Profit (EBIT) 1,00,000
Less: Int (10% on 5 lakh) 50,000 CL = Contribution / EBT
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Capital Asset Pricing Model
Calculation of CAPM
Cost of Equity (re) = Risk-Free Rate + Levered Beta x Market Risk
Premium
Cost of Equity (re) = rf + βL x (rm – rf)
where: rf = risk-free rate
βL = levered beta
rm = expected return on the market
rm – rf = market risk premium

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Example : rf = 7% , βL = 1.20 Rm – rf = 6%, Calculate Cost of equity using
CAPM method
Cost of Equity (re) = rf + βL x (rm – rf)
= 7% + 1.2 (6%) = 7% + 7.2%
= 14.2%

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Arbitrage Pricing Theory
E(ri) = rf + βi1 * RP1 + βi2 * RP2 + ... + βkn * RPn

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▪ ILLUSTRATION 1 For example, the following four factors have been
identified as explaining a stock’s return and its sensitivity to each factor
and the risk premium associated with each factor have been calculated:
(RP means Risk Premium)
• Gross domestic product (GDP) growth: ß = 0.6, RP = 4%
• Inflation rate: ß = 0.8, RP = 2%
• Gold prices: ß = -0.7, RP = 5%
• Sensex index return: ß = 1.3, RP = 9%
• The risk-free rate is 3%
• Using the APT formula, the expected return is calculated as:
E(ri) = rf + βi1 * RP1 + βi2 * RP2 + ... + βkn * RPn

• Expected return = 3% + (0.6 x 4%) + (0.8 x 2%) + (-0.7 x 5%) + (1.3 x

9%) = 15.2%
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ILLUSTRATION: The following data is provided:
a. The risk-free discount rate in USA is 4%
b. The risk-free discount rate in India is 7%
c. The risk-adjusted discount rate, required by the company in India is 12%
We have to calculate the risk-adjusted discount rate in USA, which will be
acceptable to the company.
(1 + ra) = (1 + rf) * (1 + rp)
▪ (1 + 0.12) = (1 + 0.07) * (1 + rp)
▪ (1 + rp) = 1.12/ 1.07 = 1.0467
➢ calculate the risk adjusted discount rate for US$, as under:
▪ (1 + ra) = (1 + rf) * (1 + rp) or,
▪ (1 + ra) = (1 + 0.04) * 1.0467 = 1.0888 = 8.88%
▪ risk-adjusted discount rate, applicable for cash flows in US$
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ILLUSTRATION: The following data is provided:
a. The notional risk-free interest rate in USA is 4%
b. The notional risk-free interest rate in India is 7%
c. Current Spot rate of 1 US$ is Rs. 80
▪ We have to calculate the estimated spot rate of US$ at the end of each
of the years of the project life.
St = S0 * [(1 + rh)/ (1 + rf)]t
Where,
St is the spot rate of US$ at time t,
S0 is the spot rate today.
rh is the notional risk-free interest rate in India,
rf is the risk-free interest rate in Foreign country (USA in this case)

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For 1st year
S1 = 80 * (1 + 0.07)/ (1 + 0.04) or,
S1 = 80 * (1.07)/ (1.04)
= 80 * 1.0288 = Rs. 82.310

For 2nd year,

S2 = 80 * (1.0288)2
= 80 * 1.0585 = 84.6820

For 3rd year,

S3 = 80 * (1.0288)3
= 80 * 1.0889 = 87.1130

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ILLUSTRATION: The following data is provided:
a. The cash flows of the project are as under (in US$, lakh):
▪ Initial investment 100
▪ First year net cash inflow 30
▪ Second year net cash inflow 40
▪ Third year net cash inflow 50
▪ Fourth year net cash inflow 50
b. The risk-adjusted rupee discount rate, required by the company, which is
envisaging project in USA, is 12%
c. The notional risk-free interest rate in USA is 4%
d. The notional risk-free interest rate in India is 7%
e. Current Spot rate of 1 US$ is Rs. 80
We have to calculate the PV of the cash inflows of the project which has a
useful life of 4 years, using the Home Currency approach.
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Solution:
➢ 1st calculate the estimated spot rate for 1 US$, as under:
S1 = 80 * (1 + 0.07)/ (1 + 0.04) or,
S1 = 80 * (1.07)/ (1.04) = 80 * 1.0288
= Rs. 82.310
➢ For 2nd year,
S2 = 80 * (1.0288)2 = 80 * 1.0585
= 84.6820
➢ For third year,
S3 = 80 * (1.0288)3 = 80 * 1.0889
= 87.1130
➢ For fourth year,
S4 = 80 * (1.0288)4 = 80 * 1.1203
= 89.6250
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Particulars 0 1 2 3 4
Cash Flow ($) (100) 30 40 50 50
Spot rate 80 82.310 84.6820 87.1130 89.6250
Cash Flow (Rs.) (8000) 2469 3387 4356 4481
PV@12% 1 0.893 0.797 0.7117 0.635
PV of Cash Flow (8000) 2204 2700 3100 2848
Total 10852
NPV 2852
ILLUSTRATION: The following data is provided:
a. The cash flows of the project are as under (in US$, lakh):
▪ Initial investment 100
▪ First year net cash inflow 30
▪ Second year net cash inflow 40
▪ Third year net cash inflow 50
▪ Fourth year net cash inflow 50
b. The risk-free discount rate in USA is 4%
c. The risk-free discount rate in India is 7%
d. The risk-adjusted discount rate, required by the company, in India, is
12%
e. Current Spot rate of 1 US$ is Rs. 80
We are required to calculate the PV of the cash inflows of the project,
which has a useful life of 4 years, using the Foreign Currency approach.
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 (1 + ra) = (1 + rf) * (1 + rp)
▪ (1 + 0.12) = (1 + 0.07) * (1 + rp)
▪ (1 + rp) = 1.12/ 1.07 = 1.0467
➢ calculate the risk adjusted discount rate for US$, as under:
▪ (1 + ra) = (1 + rf) * (1 + rp) or,
▪ (1 + ra) = (1 + 0.04) * 1.0467 = 1.0888 = 8.88%

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Particulars 0 1 2 3 4
Cash Flow ($) (100) 30 40 50 50
PV@8.89 1 0.918 0.843 0.774 0.711
PV of Cash Flow (100) 27.55 33.73 38.72 35.55
Total 135.55
Rs. 135.55*80 = 10844
NPV 2844
Payback Period = Amount to be initially invested/
Estimated Annual Net Cash Inflow per year

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ARR = Profit After Depreciation / Investment in the beginning
of the year *100

ARR = Average Annual Profit/ Investment in the beginning of

the year *100
ARR = Average Annual Profit/ Investment in the beginning of
the year *100
Average Investment = ½ (Initial Investment – Salvage Value)
+ Salvage Value

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▪ PVC = Terminated Value / (1+MIRR)n

Profitability Index (PI) = Sum of discounted cash inflows/ Initial cash

outlay or Total discounted cash outflow (as the case may be

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➢ SENSITIVITY ANALYSIS
Particulars NPV
A SP (I) NPV (I)
B VC (I) NPV (D)
C FC (I) NPV (D)
D Volume (I) NPV (I)
E Initial Investment (I) NPV (D)
F Life of Project (I) NPV (I)
G Cost of Capital (I) NPV (D)

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SCENARIO ANALYSIS
▪ This method is an extension of or a step forward compared to the
sensitivity analysis where only one variable was changed at a time.
▪ In this method, one plans for say, three scenarios namely, normal or the
expected, optimistic and the pessimistic scenario.
▪ In the normal scenario, all the variables show expected values and the
best values are taken for the optimistic scenario.
▪ It is in the pessimistic scenario the worst values are placed.
▪ Thus, all the variables move in the same directions at the same time.
▪ To explain the analysis in figures, the following table is presented.
Table

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Example:
Particulars Figure
Cost of the Project 35,00,000
Annual Cash Inflows 12,00,000
Project Life (Years) 6
Discounting rate 10%

Determine NPV under the following scenario

Best Case Scenario 1: All variable remain unchanged
Scenario 2: Most likely case scenario:
Initial Project cost (I) by 20%, life remain same, decrease in annual cash
inflow by 10% & increase in cost of capital to 12%
Scenario 3 : Worst case
Initial Project cost (I) by 20%, life of the project (d) to 5 years, decrease in
annual cash inflow by 20% & increase in cost of capital to 12%
Scenario 1 Rs
Initial Project Cost (35,00,000)
Life of the project 6 years
Annual Cash Inflow 12,00,000
PV @10% 4.355
PV of Cash inflows 52,26,000
NPV 17,26,000
Scenario 3 Rs Initial Project cost (I) by 20%
Initial Project Cost (42,00,000) 35,00,000 + 20% = 42,00,000
Life of the project 6 years
Annual Cash Inflow 10.80,000 ACF (D) by 10% = 108000
PV @12% 4.1114 Cost of Capital (I) to 12%
PV of Cash inflows 44,40,312
NPV 2,40,312
Scenario 3 Rs Initial Project cost (I) by 20%
Initial Project Cost (42,00,000) 35,00,000 + 20% = 42,00,000
Life of the project 5 years
Annual Cash Inflow 9,60,000 ACF (D) by 20% = 9,60,000
PV @12% 3.604 Cost of Capital (I) to 12%
PV of Cash inflows 34,59,840
NPV (7,40,160)
ILLUSTRATION 3 XYZ Ltd. is considering a project “A” with an initial outlay
of Rs. 14,00,000 and the possible three cash inflow attached with the
project as follows: ‘000
Particulars Year 1 Year 2 Year 3
Worst Case 450 400 700
Most likely 550 450 800
Best Case 650 500 900
Determine the net present value of each scenario based on the
assumption that the cost of capital is 9%. If XYZ Ltd is sure about the most
likely result in the first two years but uncertain about the cash flow in the
third year, then analyse what the NPV will be assuming the worst case
scenario in the third year.
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 Worst Case Most Likely Best Case
Year PVF @9% Cash Flow PV Cash Flow PV Cash Flow PV
‘000 ‘000 ‘000 ‘000 ‘000 ‘000
0 1 (1400) (1400) (14000 (14000 (1400) (1400)
1 0.917 450 412.65 550 504.35 650 596.05
2 0.842 400 336.80 450 378.90 500 421
3 0.772 700 540.40 800 617.60 900 694.80
NPV -110.15 100.85 311.85
most likely result in the first two years but uncertain about the cash flow in
the third year, then analyse what the NPV will be assuming the worst case
scenario in the third year.
= 550000 * 1/1.09 + 450000* (1/1.09) + 700
HILLIER MODEL

where Ct =expected cash

flow for year t,
σt = standard deviation of
cash flow for year t, i is the
risk-free rate, and I is the
initial investment.

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Illustration 1 A company manufactures cycles for both adults and children.
Given below is information about cycles made for children
Particulars Traditional CVP Activity based
analysis CVP analysis
Monthly Demand and Production 10,000 units 10,000 units
Selling Price 8,000 per unit 8,000 per unit
Variable Cost per unit 7,500 per unit 7,500 per unit
Fixed Cost p.m. (as identified under each Rs. 10,00,000 p.m. Rs. 8,00,000 p.m.
cost system)

Monthly demand = 10000 units

Determine the break-even point and profit per month using both the
classic(traditional) CVP method and the Activity Based CVP method.

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(ii) You suggest that the batch size of the children’s steer support be
increased to 50 individual units in a single batch.
The current number of set-ups, 400 (10,000 units divided by 25 units), will
be reduced to 200 (10,000 units divided by 50 units). The fabrication of
larger batches will necessitate the leasing of more inventory storage space,
which will result in an additional expense of Rs. 50,000 per month for the
business.
Analyse the impact on BEP (units per month) and PPM (earnings per
month).

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a.
Selling price p.u 8000
Variable cost p.u 7500
Contribution p.u 500
Fixed cost p.m. 10,00,000
Break even point [p.m.in unit](FC/ contribution) 10,00,000/500 = 2000 unit
Monthly demand [units] 10000 units
Profit p.m. [Monthly demand *Contribution p.u – FC 50,00,000- 10,00,000
p.u] = 40 lakh

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(b) Number of units produced per batch is 25. Therefore, number of set-ups
will be 10,000 units/ 25 units = 400 per month. (400*500 = 200000)
Number of units produced per batch is 50 Therefore, number of set-ups will
be 10,000 units/ 50 units = 200 per month. (200*500 = 100000) + 50k
Selling price p.u 8000
Variable cost p.u 7500
Contribution p.u 500
IIBF. ADVANCED BUSINESS & FINANCIAL MANAGEMENT (p. 250). Kindle
Fixed cost p.m.
Edition. 8,50,000
Set-up cost 1,00,000
Break even point [p.m.in unit] (9,50,000/500) 1900 unit
Monthly demand [units] 10000 units
Profit p.m. [Monthly demand *Contribution p.u – FC 50,00,000- 9,50,000
p.u] = 40,50,000
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Example of Make or Buy Decision using Relevant Cost Concept
▪ For example; The ABC Company is in the business of producing auto
parts, some of which require very precise pieces of machinery.
▪ When purchasing from a supplier, the unit price is Rs. 5 (five rupees).
▪ However, the identical component can also be manufactured by the
company itself.
▪ The company needs a total of 50,000 individual units of spare parts
each year.
▪ The following costs are incurred by the company when the goods are
produced internally:
▪ Direct materials = Rs. 2/unit
▪ Direct labour = Rs. 2/unit
▪ Overhead costs = Rs. 1/unit
▪ Special tools = Rs. 40,000 Item
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Items Cost per units (Rs) Total Cost for 50000 units
Direct Material 2 1,00,000
Direct Labour 4 1,00,000
Overhead cost 1 50,000
Special Toots 40,000
Total 2,90,000

▪ According to the above illustration, it will cost ABC Rs. 2,50,000 to buy
from a supplier. And it will cost Rs. 2,90,000 to make the same
internally. Therefore, ABC should continue outsourcing.

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DECISION MAKING USING ACTIVITY BASED COSTING (ABC)

Activity cost driver rate = Total cost of activity / Activity driver

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▪ Company SW Ltd purchases CKD (Completely Knocked Down) packs of
2 wheelers and 3 wheelers and assembles them to sell in the market.
▪ The material and labour cost of each pack, till it reaches the assembly
line, is Rs. 50,000 and Rs. 80,000 respectively.
▪ Total cost incurred by assembly line, during the year, is Rs. 20,00,000,
utilising 20,000 labour hours.
▪ Assembly of a 2 wheeler takes, on an average, 20 labour hours while
the assembly of a 3 wheeler takes 30 labour hours. We have to find the
cost of each 2-wheeler and 3wheeler using the ABC costing method.

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 Solution:
▪ Direct cost of material and labour for each pack is known, viz. Rs.
50,000 and Rs. 80,000 respectively.
▪ In the activity of assembly, the main cost constituent (cost driver) is the
labour, which is paid on hourly basis.
▪ Rate of the cost driver is total assembly cost/labour hours used =
20,00,000/ 20,000 = Rs. 100 per labour hour.
▪ So, the assembly cost allocated to each 2-wheeler is Rs. 20*100 and
for 3-wheeler, it is Rs. 30*100.
▪ So, the total cost of each 2-wheeler is Rs. 52,000 and that of each 3
wheeler, Rs. 83,000.

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▪ Let’s say that the management of a company that manufactures certain
electronic devices has taken a decision to install an ABC system.
▪ The management comes to the conclusion that there should only be
three cost drivers for all overhead expenses, and those are direct labour
hours, machine hours, and the quantity of purchase orders.
▪ The following are the company’s overhead costs, as shown in the
general ledger:

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General ledger Amount
Payroll taxes 1000
Machine maintenance 500
Purchasing Dept, labour 4000
Fringe benefits 2000
Purchasing Dept, Supplies 250
Equipment depreciation 750
Unemployment Insurance 1500
Electricity 1250
Total 11250
Differentiate which overheads are driven by direct labour hours?
General ledger Amount
Payroll taxes 1000
Fringe benefits 2000
Unemployment Insurance 1500
Total 4500
Differentiate which overheads are driven by direct machine hours?
General ledger Amount
Machine maintenance 500
Equipment depreciation 750
Electricity 1250
Total 2500
Differentiate which overheads are driven by no of purchase orders?
General ledger Amount
Purchasing Dept, labour 4000
Purchasing Dept, Supplies 250
Total 4250

▪ Now, overhead rate is calculated by the formula

Total cost in the activity pool ÷ Base,
▪ base = total number of labour hours, machine hours and total number of
purchase orders in the given case.
▪ Assume that the total number of labour hours be 1,000 hours, machine
hours be 250 hours and total purchase orders be 100 orders. So, Cost
driver rate would be
Cost Drive Cost Rs.
4500/100 4.5 per labour hour
2500/250 10 per machine hour
4250/100 42.50 per purchase order
YTS20