Question 2 25 marks August Holdings’ capital structure comprises 100 000 ordinar

Question

Question 2 25 marks August Holdings’ capital structure comprises 100 000 ordinary shares of N$100 each and 12% debentures of N$10 million. In 2017, the sales of the company increased by 20% from 1million units to 1.2 million units. The selling price increased from N$10 to N$12.50 per unit while the variable costs remained fixed N$8 per unit and fixed costs at N$2 million. The tax rate is 50%. Required: (a) Calculate the following: (i) The percentage increase in earnings per share. (ii) The degree of financial leverage at 1 000 000 and 1 200 000 units. (iii) The degree of operating leverage at 1 000 000 and 1 200 000 units (b) Comment on the behaviour of operating and financial leverage under the two conditions.

Explanation / Answer

1 The percentage increase in earning per share Calculation of EBIT, EAT and EPS 2016 2017 Selling units 1,000,000 1,200,000 Selling Price per unit $10 $12.50 Sales $10,000,000 $15,000,000 Less: Variable cost 8,000,000 9,600,000 Contribution Margin $2,000,000 $5,400,000 Fixed cost $2,000,000 $2,000,000 Earning before interest and taxes $0 $3,400,000 Interest $1,200,000 $1,200,000 Earning before tax ($1,200,000) $2,200,000 Taxes @ 50% $1,100,000 Earning after tax ($1,200,000) $1,100,000 Number of shares 100,000 100,000 Earning per share ($12) $11 Percentage increase in EPS ($11-($12)/-$12) x 100 192% 2 The degree of financial leverage at 1000000 and 1200000 units DFL at 1000000 units DFL = EBIT/EBIT-I           = $0/$0-$1200000            = 0 DFL at 1200000 units DFL = EBIT/EBIT-I           = $3400000/$3400000-$1200000            = 1.55 3 The degree of operating leverage at 1000000 and 1200000 units DOL at 1000000 units DOL = Contribution Margin/EBIT           = $2000000/$0            = 0 DOL at 1200000 units DOL = Contribution Margin/EBIT           = $5400000/$3400000            = 1.59 4 Both the financial leverage and operating leverage are 0 at 1,000,000 units where as financial leverage is 1.55 and operating leverage is 1.59 at 1,200,000 units Thus the company decision to increase the unit sale and sales price is correct

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