Test 6: answer key

Question 1 · 2 marks · Ratio Analysis · medium

Scenario. Horizon Pharma Ltd has, after its expansion financing, equity share capital ₹600 lakh, reserves and surplus ₹300 lakh, long-term debt ₹600 lakh comprising existing 10 percent debt of ₹400 lakh and new 11 percent debt of ₹200 lakh, current liabilities ₹150 lakh and current assets ₹300 lakh. Expected EBIT is ₹300 lakh, depreciation ₹60 lakh, interest on debt ₹62 lakh and principal repayment ₹50 lakh. Ignore tax. Use closing balances.

What is the long-term debt to equity ratio of Horizon Pharma after expansion, using long-term debt only?

1. 0.50
2. 0.67 (correct answer)
3. 0.75
4. 1.00

Answer: B — 0.67

Working. Long-term debt = 400 + 200 = ₹600 lakh. Shareholders equity = 600 + 300 = ₹900 lakh. Long-term debt to equity = 600 / 900 = 0.6667, rounded to 0.67.

Explanation. Long-term debt is ₹600 lakh and shareholders equity is equity capital ₹600 lakh plus reserves ₹300 lakh, that is ₹900 lakh. Thus the ratio is 600 divided by 900 = 0.67. Option a uses ₹450 lakh debt incorrectly. Option c uses total outside liabilities of ₹750 lakh against ₹1,000 lakh. Option d treats total debt as equal to equity, which is not the case.

Where it goes wrong. Students may include current liabilities in the numerator when the question specifically asks for long-term debt to equity ratio.

Authority. Chapter 3: Financial Analysis and Planning - Ratio Analysis, Section 3.2 Long-term Solvency Ratios

Question 2 · 2 marks · Ratio Analysis · medium

What is the proprietary ratio of Horizon Pharma after expansion?

1. 45.45 percent
2. 50.00 percent
3. 54.55 percent (correct answer)
4. 60.00 percent

Answer: C — 54.55 percent

Working. Proprietary fund = 600 + 300 = ₹900 lakh. Total assets = 600 + 300 + 600 + 150 = ₹1,650 lakh. Proprietary ratio = 900 / 1,650 × 100 = 54.55 percent.

Explanation. Proprietary fund is equity capital plus reserves, that is ₹900 lakh. Total assets are equity ₹600 lakh plus reserves ₹300 lakh plus long-term debt ₹600 lakh plus current liabilities ₹150 lakh, that is ₹1,650 lakh. The ratio is 900 divided by 1,650 = 54.55 percent. Option a arises from using only equity capital. Option b ignores reserves. Option d uses a wrong total asset base.

Where it goes wrong. Students may exclude reserves from proprietary fund or may deduct current liabilities from total assets incorrectly.

Authority. Chapter 3: Financial Analysis and Planning - Ratio Analysis, Section 3.2.1 Capital Structure Ratios

Question 3 · 2 marks · Ratio Analysis · hard

Which pair gives the debt service coverage ratio and interest coverage ratio of Horizon Pharma after expansion?

1. DSCR 3.21 and interest coverage 4.84 (correct answer)
2. DSCR 2.50 and interest coverage 3.75
3. DSCR 3.21 and interest coverage 3.00
4. DSCR 4.84 and interest coverage 3.21

Answer: A — DSCR 3.21 and interest coverage 4.84

Working. DSCR = EBIT + depreciation divided by interest + principal repayment = 300 + 60 divided by 62 + 50 = 360 / 112 = 3.21. Interest coverage = EBIT / interest = 300 / 62 = 4.84.

Explanation. Earnings available for debt service are EBIT plus depreciation, that is ₹300 lakh plus ₹60 lakh = ₹360 lakh. Debt service is interest ₹62 lakh plus principal repayment ₹50 lakh = ₹112 lakh. DSCR is 360 divided by 112 = 3.21. Interest coverage is EBIT divided by interest = 300 divided by 62 = 4.84. Option b uses an incorrect interest and debt service base. Option c keeps DSCR right but distorts interest coverage. Option d swaps the two ratios.

Where it goes wrong. Students may use PAT instead of EBIT plus depreciation for DSCR or may divide EBIT by total debt service instead of interest for interest coverage.

Authority. Chapter 3: Financial Analysis and Planning - Ratio Analysis, Section 3.2.2 Coverage Ratios

Question 4 · 2 marks · Financing Decisions - Leverages · medium

Scenario. Alpine Resorts reports sales ₹1,000 lakh, variable cost 60 percent of sales and fixed operating cost ₹300 lakh. It has no interest-bearing debt for this analysis. The management examines the link between operating leverage, break-even sales and margin of safety.

What are the degree of operating leverage and margin of safety of Alpine Resorts at the current sales level?

1. DOL 2.50 and MOS 40.00 percent
2. DOL 3.00 and MOS 33.33 percent
3. DOL 4.00 and MOS 20.00 percent
4. DOL 4.00 and MOS 25.00 percent (correct answer)

Answer: D — DOL 4.00 and MOS 25.00 percent

Working. Contribution = 1,000 − 600 = ₹400 lakh. EBIT = 400 − 300 = ₹100 lakh. DOL = 400 / 100 = 4.00. MOS = EBIT / contribution = 100 / 400 = 25 percent.

Explanation. Contribution is sales ₹1,000 lakh less variable cost ₹600 lakh = ₹400 lakh. EBIT is contribution ₹400 lakh less fixed cost ₹300 lakh = ₹100 lakh. DOL is contribution divided by EBIT = 400 divided by 100 = 4.00. MOS is EBIT divided by contribution = 100 divided by 400 = 25 percent. Option a and b use wrong contribution or EBIT figures. Option c has correct DOL but wrongly uses 20 percent MOS.

Where it goes wrong. Students may calculate MOS as fixed cost divided by sales or may invert the DOL formula.

Authority. Chapter 6: Financing Decisions - Leverages, Section 3 Operating Leverage and Section 3.3 Margin of Safety

Question 5 · 2 marks · Financing Decisions - Leverages · hard

If Alpine Resorts fixed operating cost rises by ₹50 lakh with sales unchanged, what is the new degree of operating leverage?

1. 6.00
2. 8.00 (correct answer)
3. 4.00
4. 5.00

Answer: B — 8.00

Working. Contribution = ₹400 lakh. New EBIT = 400 − 350 = ₹50 lakh. New DOL = contribution / EBIT = 400 / 50 = 8.00.

Explanation. Contribution remains ₹400 lakh because sales and variable cost do not change. New fixed cost is ₹350 lakh. New EBIT is ₹50 lakh. New DOL is 400 divided by 50 = 8.00. Option a results from using an incorrect EBIT of ₹66.67 lakh. Option c ignores the fixed cost increase. Option d uses an incorrect contribution base.

Where it goes wrong. Students may recalculate contribution after a fixed cost change, but fixed cost does not affect contribution.

Authority. Chapter 6: Financing Decisions - Leverages, Section 3.1 Degree of Operating Leverage

Question 6 · 2 marks · Financing Decisions - Leverages · hard

At the original fixed cost of ₹300 lakh, what sales level gives Alpine Resorts a margin of safety of 20 percent?

1. ₹875.00 lakh
2. ₹900.00 lakh
3. ₹937.50 lakh (correct answer)
4. ₹1,000.00 lakh

Answer: C — ₹937.50 lakh

Working. MOS = 1 − FC / contribution = 0.20. So FC / contribution = 0.80. Contribution = 300 / 0.80 = ₹375 lakh. Sales = contribution / P/V ratio = 375 / 0.40 = ₹937.50 lakh.

Explanation. P/V ratio is 40 percent. MOS equals 1 minus fixed cost divided by contribution. For MOS of 20 percent, fixed cost divided by contribution must be 80 percent. Contribution required is ₹300 lakh divided by 0.80 = ₹375 lakh. Sales required is ₹375 lakh divided by 0.40 = ₹937.50 lakh. Option a is the break-even sales at the original fixed cost. Option b and d do not satisfy the 20 percent MOS condition.

Where it goes wrong. Students may set fixed cost divided by sales equal to 20 percent instead of using contribution and P/V ratio.

Authority. Chapter 6: Financing Decisions - Leverages, Section 3.3 Margin of Safety

Question 7 · 2 marks · Financing Decisions - Leverages · medium

Scenario. Orion Components has revenue ₹800 lakh, variable cost 60 percent of revenue, fixed operating cost ₹160 lakh, interest ₹40 lakh and tax rate 25 percent. It has no preference dividend. The finance team tests combined leverage and EPS sensitivity.

What is the degree of combined leverage of Orion Components, and what is the percentage change in EPS for a 10 percent increase in revenue?

1. 2.67 and 26.67 percent (correct answer)
2. 2.00 and 20.00 percent
3. 1.33 and 13.33 percent
4. 3.20 and 32.00 percent

Answer: A — 2.67 and 26.67 percent

Working. Contribution = 800 − 480 = ₹320 lakh. EBIT = 320 − 160 = ₹160 lakh. DOL = 320 / 160 = 2.00. DFL = 160 / 120 = 1.333. DCL = 2.00 × 1.333 = 2.667. EPS change = 10 percent × 2.667 = 26.67 percent.

Explanation. Contribution is ₹320 lakh and EBIT is ₹160 lakh, so DOL is 2.00. Interest is ₹40 lakh, so EBT is ₹120 lakh and DFL is 160 divided by 120 = 1.333. DCL is 2.00 × 1.333 = 2.667. A 10 percent rise in revenue raises EPS by 10 × 2.667 = 26.67 percent. Option b is only DOL. Option c is only DFL. Option d assumes interest of ₹60 lakh.

Where it goes wrong. Students may use DFL instead of DCL for the EPS sensitivity or may apply the sales change only to DOL.

Authority. Chapter 6: Financing Decisions - Leverages, Section 5 Combined Leverage

Question 8 · 1 marks · Financing Decisions - Leverages · medium

If Orion Components interest rises to ₹60 lakh with EBIT unchanged, what is the revised degree of combined leverage?

1. 2.00
2. 2.67
3. 1.60
4. 3.20 (correct answer)

Answer: D — 3.20

Working. DOL = 2.00. New EBT = 160 − 60 = ₹100 lakh. New DFL = 160 / 100 = 1.60. New DCL = 2.00 × 1.60 = 3.20.

Explanation. DOL remains 2.00 because EBIT is unchanged. Revised EBT is ₹160 lakh less ₹60 lakh = ₹100 lakh. Revised DFL is 160 divided by 100 = 1.60. Revised DCL is 2.00 × 1.60 = 3.20. Option a is DOL only. Option b is the original DCL. Option c is the revised DFL only.

Where it goes wrong. Students may forget to multiply DOL and DFL after changing interest.

Authority. Chapter 6: Financing Decisions - Leverages, Section 4 Financial Leverage and Section 5 Combined Leverage