FREE IGNOU MCO-07 SOLVED ASSIGNMENT 2023

b) Firm ‘A’ has an annual sale of Rs 80,00,000, and the variable cost is Rs 50,00,000. The fixed cost is Rs 5,00,000 per year. The company has 11% debentures of Rs 30,00,000. Find out the operating leverage and financial leverage of the firm.

To find the operating leverage and financial leverage, we’ll use the formulas mentioned earlier:

Operating Leverage: Contribution Margin = Sales – Variable Costs Contribution Margin = Rs 80,00,000 – Rs 50,00,000 = Rs 30,00,000

EBIT = Sales – Variable Costs – Fixed Costs – Interest EBIT = Rs 80,00,000 – Rs 50,00,000 – Rs 5,00,000 – (Rs 30,00,000 * 0.11) = Rs 5,50,000

Operating Leverage = Contribution Margin / EBIT Operating Leverage = Rs 30,00,000 / Rs 5,50,000 ≈ 5.45

Financial Leverage: Interest = Rs 30,00,000 * 0.11 = Rs 3,30,000

Financial Leverage = EBIT / (EBIT – Interest) Financial Leverage = Rs 5,50,000 / (Rs 5,50,000 – Rs 3,30,000) ≈ 2.10

Significance:

• The operating leverage of approximately 5.45 indicates that the firm’s operating income is sensitive to changes in sales revenue. A 1% increase in sales is expected to result in a 5.45% increase in operating income, assuming all other factors remain constant.
• The financial leverage of around 2.10 means that the company is using debt financing to magnify the return on equity. This can be advantageous when the company’s return on assets (ROA) is higher than the cost of borrowing (interest rate on debentures). However, it also implies higher financial risk as the company has to meet fixed interest obligations.

In conclusion, firm ‘A’ has relatively high operating leverage and moderate financial leverage. Managers should be mindful of these leverage levels when making financial and operational decisions to maximize profitability and avoid excessive financial risk.