Test 2: Financing Decisions - Leverages: answer key
This chapter-wise practice test covers Financing Decisions - Leverages - Test 2 for CA Intermediate Group 2 students preparing for the May 2027 examination attempt. It carries 40 marks across 20 questions in case scenarios and standalone practical MCQs with a time limit of 45 minutes and no negative marking.
20 questions across 1 chapter, 40 marks and 45 minutes in the timed paper. Every answer below is shown with the working behind it and the authority it rests on.
Law and standards used: ICAI Study Material for CA Intermediate Paper 6: Financial Management and Strategic Management (relevant for 2027 attempt).
Questions
20
Marks
40
Time limit
45 minutes
Attempt
May 2027
Group
Group 2
Law basis
ICAI Study Material for CA Intermediate Paper 6: Financial Management and Strategic Management (relevant for 2027 attempt)
Content as of
2026-11-10
Chapters covered
Financing Decisions - Leverages (20 Q)
Questions, answers and explanations
Question 1 · 2 marks · Financing Decisions - Leverages · medium
Scenario. Aditya Automotive Ltd manufactures precision components for electric vehicles. The CFO is evaluating the firm's financial risk before finalizing the FY 2026-27 capital budget. The company has the following capital structure and earnings data:
| Particulars | Amount/Rate |
|---|---|
| EBIT | ₹60,00,000 |
| 12% term loan | ₹1,50,00,000 |
| 14% preference share capital | ₹50,00,000 |
| Equity shares of ₹10 each | 10,00,000 shares |
| Corporate tax rate | 30% |
There are no other borrowings, and the company does not expect any change in its operating cost structure during the year. The finance team is examining how fixed financial charges magnify the effect of changes in EBIT on earnings available to equity shareholders. The CFO has asked for the degree of financial leverage, earnings per share, financial break-even level of EBIT and the impact of a possible 16% decline in EBIT on EPS. The company wants to understand whether preference dividend should be grossed up for tax while computing financial break-even and DFL. All interest and preference dividend payments are expected to be made on time. The CFO is also concerned about the negative effect on EPS if EBIT falls sharply because of a temporary slowdown in the auto component market.
For Aditya Automotive Ltd, what is the Degree of Financial Leverage (DFL) at the current EBIT?
1.60 times
1.875 times (correct answer)
2.00 times
1.72 times
Answer: B — 1.875 times
Explanation. Interest = ₹1,50,00,000 × 12% = ₹18,00,000. Preference dividend = ₹50,00,000 × 14% = ₹7,00,000. Preference dividend grossed up = ₹7,00,000 / (1 − 0.30) = ₹10,00,000. DFL = EBIT / [EBIT − Interest − PD/(1 − t)] = ₹60,00,000 / [₹60,00,000 − ₹18,00,000 − ₹10,00,000] = ₹60,00,000 / ₹32,00,000 = 1.875 times. Option d is a trap from ignoring the tax gross-up on preference dividend.
Where it goes wrong. Ignoring the gross-up of preference dividend for tax while computing DFL.
Question 3 · 2 marks · Financing Decisions - Leverages · hard
What is the financial break-even level of EBIT for Aditya Automotive Ltd?
₹18,00,000
₹25,00,000
₹30,00,000
₹28,00,000 (correct answer)
Answer: D — ₹28,00,000
Explanation. Financial break-even EBIT is the EBIT at which EPS is zero. It must cover interest and preference dividend grossed up for tax. Interest = ₹18,00,000. Grossed-up preference dividend = ₹7,00,000 / 0.70 = ₹10,00,000. Financial BEP = ₹18,00,000 + ₹10,00,000 = ₹28,00,000. Option b is a trap from adding preference dividend without gross-up: ₹18,00,000 + ₹7,00,000 = ₹25,00,000.
Where it goes wrong. Adding preference dividend without grossing it up for tax.
Question 4 · 2 marks · Financing Decisions - Leverages · hard
If EBIT of Aditya Automotive Ltd declines by 16%, what will be the new EPS?
₹1.568 (correct answer)
₹1.680
₹1.792
₹1.904
Answer: A — ₹1.568
Explanation. DFL = 1.875, so a 16% fall in EBIT reduces EPS by 16% × 1.875 = 30%. New EPS = ₹2.24 × (1 − 0.30) = ₹2.24 × 0.70 = ₹1.568. Alternatively, new EBIT = ₹50,40,000; EBT = ₹32,40,000; PAT after tax = ₹22,68,000; less preference dividend ₹7,00,000 = ₹15,68,000; EPS = ₹1.568. Option c applies only the EBIT decline and ignores leverage magnification.
Where it goes wrong. Applying the EBIT decline directly to EPS without DFL magnification.
Question 5 · 2 marks · Financing Decisions - Leverages · medium
Scenario. Nova Consumer Care Ltd is a mid-sized FMCG company with a simple but fixed-charge-heavy capital structure. The management is reviewing the financing mix for the coming year. The following figures are available:
| Particulars | Amount/Rate |
|---|---|
| EBIT | ₹40,00,000 |
| 10% debentures | ₹1,00,00,000 |
| 15% preference share capital | ₹25,00,000 |
| Equity shares of ₹10 each | 5,00,000 shares |
| Corporate tax rate | 25% |
No other debt or preference capital is outstanding. The company's products are mature, and EBIT is expected to remain stable. The CFO wants to measure financial leverage as a tool of trading on equity and understand the magnification of EPS when EBIT changes. The board has asked for the degree of financial leverage, current EPS, financial break-even EBIT and the percentage increase in EPS if EBIT rises by 10%. The finance team has also been asked to confirm whether preference dividend is a fixed financial charge and whether it should be considered before or after tax. The company is not planning any new equity issue in the immediate future, and the tax rate is expected to remain unchanged. The CFO wants to assess whether the existing debt and preference capital expose equity shareholders to high financial risk.
For Nova Consumer Care Ltd, what is the Degree of Financial Leverage (DFL) at the current EBIT?
1.25 times
1.60 times (correct answer)
1.75 times
1.50 times
Answer: B — 1.60 times
Explanation. Interest = ₹1,00,00,000 × 10% = ₹10,00,000. Preference dividend = ₹25,00,000 × 15% = ₹3,75,000. Grossed-up preference dividend = ₹3,75,000 / 0.75 = ₹5,00,000. DFL = ₹40,00,000 / [₹40,00,000 − ₹10,00,000 − ₹5,00,000] = ₹40,00,000 / ₹25,00,000 = 1.60 times. Option d is a trap from using pre-tax preference dividend and ignoring gross-up.
Where it goes wrong. Ignoring the tax gross-up on preference dividend while calculating DFL.
Question 6 · 2 marks · Financing Decisions - Leverages · medium
What is the Earnings Per Share (EPS) of Nova Consumer Care Ltd at the current EBIT?
₹3.00
₹3.40
₹3.75 (correct answer)
₹4.00
Answer: C — ₹3.75
Explanation. EBT = ₹40,00,000 − ₹10,00,000 = ₹30,00,000. Tax = 25% × ₹30,00,000 = ₹7,50,000. PAT = ₹22,50,000. Preference dividend = ₹3,75,000. Earnings available to equity shareholders = ₹22,50,000 − ₹3,75,000 = ₹18,75,000. EPS = ₹18,75,000 / 5,00,000 shares = ₹3.75. Option d is a trap from omitting preference dividend and using the full PAT.
Where it goes wrong. Forgetting to deduct preference dividend before computing EPS.
Question 7 · 2 marks · Financing Decisions - Leverages · hard
What is the financial break-even level of EBIT for Nova Consumer Care Ltd?
₹10,00,000
₹12,50,000
₹18,00,000
₹15,00,000 (correct answer)
Answer: D — ₹15,00,000
Explanation. Financial BEP = Interest + Preference dividend / (1 − tax). Interest = ₹10,00,000. Grossed-up preference dividend = ₹3,75,000 / 0.75 = ₹5,00,000. Financial BEP = ₹10,00,000 + ₹5,00,000 = ₹15,00,000. Option b is a trap from adding only half the grossed-up dividend or using an incorrect tax adjustment.
Where it goes wrong. Failing to gross up preference dividend correctly for tax.
Question 9 · 2 marks · Financing Decisions - Leverages · medium
Scenario. Ravi Ltd has EBIT of ₹24,00,000 and 12% debt of ₹50,00,000. There is no preference share capital. What is its Degree of Financial Leverage (DFL)?
Ravi Ltd has EBIT of ₹24,00,000 and 12% debt of ₹50,00,000. There is no preference share capital. What is its Degree of Financial Leverage (DFL)?
1.20 times
1.333 times (correct answer)
1.50 times
1.60 times
Answer: B — 1.333 times
Explanation. Interest = ₹50,00,000 × 12% = ₹6,00,000. EBT = EBIT − Interest = ₹24,00,000 − ₹6,00,000 = ₹18,00,000. DFL = EBIT / EBT = ₹24,00,000 / ₹18,00,000 = 1.333 times. Option d is a trap from using EBIT / (EBIT − interest − tax) or applying an incorrect tax adjustment despite no preference dividend.
Where it goes wrong. Applying an unnecessary tax adjustment when no preference dividend exists.
Question 10 · 2 marks · Financing Decisions - Leverages · hard
Scenario. Meera Ltd has interest on debt of ₹8,00,000 and preference dividend of ₹3,00,000. The tax rate is 25%. What is its financial break-even EBIT?
Meera Ltd has interest on debt of ₹8,00,000 and preference dividend of ₹3,00,000. The tax rate is 25%. What is its financial break-even EBIT?
₹8,00,000
₹9,00,000
₹10,50,000
₹12,00,000 (correct answer)
Answer: D — ₹12,00,000
Explanation. Financial BEP = Interest + Preference dividend / (1 − tax). Grossed-up preference dividend = ₹3,00,000 / 0.75 = ₹4,00,000. Financial BEP = ₹8,00,000 + ₹4,00,000 = ₹12,00,000. Option b is a trap from adding preference dividend without gross-up: ₹8,00,000 + ₹3,00,000 = ₹11,00,000.; option c uses an incorrect tax factor.
Where it goes wrong. Adding preference dividend directly without grossing it up for tax.
Question 11 · 2 marks · Financing Decisions - Leverages · hard
Scenario. Sohan Ltd has EBIT of ₹50,00,000, interest of ₹10,00,000, preference dividend of ₹6,00,000, tax rate of 30% and 8,00,000 equity shares. What is its EPS?
Sohan Ltd has EBIT of ₹50,00,000, interest of ₹10,00,000, preference dividend of ₹6,00,000, tax rate of 30% and 8,00,000 equity shares. What is its EPS?
₹2.50
₹2.75 (correct answer)
₹3.00
₹3.25
Answer: B — ₹2.75
Explanation. EBT = ₹50,00,000 − ₹10,00,000 = ₹40,00,000. Tax = 30% × ₹40,00,000 = ₹12,00,000. PAT = ₹28,00,000. Less preference dividend ₹6,00,000 = ₹22,00,000 available to equity shareholders. EPS = ₹22,00,000 / 8,00,000 shares = ₹2.75. Option c is a trap from deducting preference dividend before tax and then applying tax to the residual.
Where it goes wrong. Deducting preference dividend before tax instead of after tax.
Question 12 · 2 marks · Financing Decisions - Leverages · medium
Scenario. A firm has a Degree of Financial Leverage (DFL) of 2.5. If EBIT increases by 8%, by what percentage will EPS increase?
A firm has a Degree of Financial Leverage (DFL) of 2.5. If EBIT increases by 8%, by what percentage will EPS increase?
8%
12%
20% (correct answer)
25%
Answer: C — 20%
Explanation. DFL = Percentage change in EPS / Percentage change in EBIT. Therefore, percentage change in EPS = DFL × percentage change in EBIT = 2.5 × 8% = 20%. Option a ignores financial leverage. Option d is a trap from dividing the EBIT change by DFL instead of multiplying.
Where it goes wrong. Dividing the EBIT change by DFL instead of multiplying.
Question 13 · 2 marks · Financing Decisions - Leverages · hard
Scenario. Kiran Ltd has EBIT of ₹30,00,000, 10% debt of ₹1,00,00,000 and equity of ₹50,00,000. The tax rate is 30%. Its return on investment (EBIT / total capital) is 20%, while the after-tax cost of debt is 7%. If the company replaces some equity with additional debt at the same rate, what will happen to return on equity?
Kiran Ltd has EBIT of ₹30,00,000, 10% debt of ₹1,00,00,000 and equity of ₹50,00,000. The tax rate is 30%. Its return on investment (EBIT / total capital) is 20%, while the after-tax cost of debt is 7%. If the company replaces some equity with additional debt at the same rate, what will happen to return on equity?
ROE will increase because ROI of 20% exceeds the after-tax cost of debt of 7%. (correct answer)
ROE will decrease because debt increases financial risk.
ROE will remain unchanged because EBIT is constant.
ROE cannot be determined without the dividend payout ratio.
Answer: A — ROE will increase because ROI of 20% exceeds the after-tax cost of debt of 7%.
Explanation. Trading on equity is favourable when ROI exceeds the after-tax cost of debt. Here ROI = 20% and after-tax cost of debt = 10% × (1 − 0.30) = 7%. The spread of 13% accrues to equity shareholders, so replacing equity with debt increases ROE, although it also increases financial risk. Option b confuses risk with return; option c ignores the financing mix effect.
Where it goes wrong. Rejecting favourable leverage because debt increases financial risk.
Question 14 · 2 marks · Financing Decisions - Leverages · hard
Scenario. What is the Degree of Financial Leverage (DFL) when EBIT is exactly equal to interest plus grossed-up preference dividend?
What is the Degree of Financial Leverage (DFL) when EBIT is exactly equal to interest plus grossed-up preference dividend?
Zero
One
Negative one
Undefined or infinite (correct answer)
Answer: D — Undefined or infinite
Explanation. DFL = EBIT / [EBIT − Interest − PD/(1 − t)]. If EBIT equals interest plus grossed-up preference dividend, the denominator becomes zero. Therefore, DFL is undefined or infinite. This is the financial break-even point, where EPS is zero. Option a is a trap from assuming DFL is zero when EPS is zero; option b is the DFL when there are no fixed financial charges.
Where it goes wrong. Assuming DFL equals zero at financial break-even instead of being undefined.
Question 15 · 2 marks · Financing Decisions - Leverages · hard
Scenario. A firm has EBIT of ₹8,00,000 and interest of ₹10,00,000. There is no preference dividend. What is its Degree of Financial Leverage (DFL)?
A firm has EBIT of ₹8,00,000 and interest of ₹10,00,000. There is no preference dividend. What is its Degree of Financial Leverage (DFL)?
-4.00 (correct answer)
4.00
-1.25
1.25
Answer: A — -4.00
Explanation. DFL = EBIT / (EBIT − Interest) = ₹8,00,000 / (₹8,00,000 − ₹10,00,000) = ₹8,00,000 / (−₹2,00,000) = −4.00. Negative DFL indicates that EBIT is below the financial break-even level and EPS is negative. Option b ignores the negative sign. Option c is a trap from dividing interest by EBIT or using the reciprocal.
Where it goes wrong. Dropping the negative sign when EBIT is below interest.
Question 16 · 2 marks · Financing Decisions - Leverages · hard
Scenario. A firm has sales of ₹1,00,00,000, variable cost of ₹60,00,000, fixed operating cost of ₹20,00,000, interest of ₹5,00,000 and preference dividend of ₹2,00,000. The tax rate is 20%. What is its Degree of Combined Leverage (DCL)?
A firm has sales of ₹1,00,00,000, variable cost of ₹60,00,000, fixed operating cost of ₹20,00,000, interest of ₹5,00,000 and preference dividend of ₹2,00,000. The tax rate is 20%. What is its Degree of Combined Leverage (DCL)?
2.00 times
2.67 times
3.20 times (correct answer)
4.00 times
Answer: C — 3.20 times
Explanation. Contribution = ₹1,00,00,000 − ₹60,00,000 = ₹40,00,000. EBIT = ₹40,00,000 − ₹20,00,000 = ₹20,00,000. Grossed-up preference dividend = ₹2,00,000 / 0.80 = ₹2,50,000. DCL = Contribution / [EBIT − Interest − PD/(1 − t)] = ₹40,00,000 / [₹20,00,000 − ₹5,00,000 − ₹2,50,000] = ₹40,00,000 / ₹12,50,000 = 3.20 times. Option b is a trap from using EBT without grossing up preference dividend.
Where it goes wrong. Using post-tax EBT and ignoring the gross-up of preference dividend in DCL.
Question 17 · 2 marks · Financing Decisions - Leverages · hard
Scenario. A firm has EBIT of ₹20,00,000, interest of ₹8,00,000, tax rate of 30% and 4,00,000 equity shares. If EBIT increases by 20%, what will be the new EPS?
A firm has EBIT of ₹20,00,000, interest of ₹8,00,000, tax rate of 30% and 4,00,000 equity shares. If EBIT increases by 20%, what will be the new EPS?
₹2.10
₹2.80 (correct answer)
₹3.20
₹3.50
Answer: B — ₹2.80
Explanation. Current EPS = (EBIT − Interest) × (1 − t) / shares = (₹20,00,000 − ₹8,00,000) × 0.70 / 4,00,000 = ₹8,40,000 / 4,00,000 = ₹2.10. DFL = ₹20,00,000 / ₹12,00,000 = 1.667. A 20% EBIT increase raises EPS by 20% × 1.667 = 33.33%. New EPS = ₹2.10 × 1.3333 = ₹2.80. Option a is the current EPS, not the new EPS.
Where it goes wrong. Reporting the current EPS instead of the post-increase EPS.
Question 18 · 2 marks · Financing Decisions - Leverages · hard
Scenario. A company has EBIT of ₹40,00,000, interest of ₹12,00,000, preference dividend of ₹4,00,000, tax rate of 25% and 10,00,000 equity shares. What is its EPS?
A company has EBIT of ₹40,00,000, interest of ₹12,00,000, preference dividend of ₹4,00,000, tax rate of 25% and 10,00,000 equity shares. What is its EPS?
₹1.50
₹1.60
₹1.70 (correct answer)
₹1.80
Answer: C — ₹1.70
Explanation. EBT = ₹40,00,000 − ₹12,00,000 = ₹28,00,000. Tax = 25% × ₹28,00,000 = ₹7,00,000. PAT = ₹21,00,000. Less preference dividend ₹4,00,000 = ₹17,00,000. EPS = ₹17,00,000 / 10,00,000 shares = ₹1.70. Option d is a trap from forgetting to deduct preference dividend and using PAT of ₹21,00,000, which gives ₹2.10.; option b deducts tax after preference dividend incorrectly.
Where it goes wrong. Omitting preference dividend from the EPS numerator.
Question 19 · 2 marks · Financing Decisions - Leverages · hard
Scenario. Company A has EBIT of ₹30,00,000 and interest of ₹10,00,000. Company B has EBIT of ₹45,00,000 and interest of ₹20,00,000. Which company has higher financial risk, and why?
Company A has EBIT of ₹30,00,000 and interest of ₹10,00,000. Company B has EBIT of ₹45,00,000 and interest of ₹20,00,000. Which company has higher financial risk, and why?
Company A, because its interest cover is lower.
Company B, because its EBIT is higher.
Both have the same financial risk because both have debt.
Company B, because its DFL of 1.80 is higher than Company A's DFL of 1.50. (correct answer)
Answer: D — Company B, because its DFL of 1.80 is higher than Company A's DFL of 1.50.
Explanation. DFL of A = ₹30,00,000 / (₹30,00,000 − ₹10,00,000) = ₹30,00,000 / ₹20,00,000 = 1.50. DFL of B = ₹45,00,000 / (₹45,00,000 − ₹20,00,000) = ₹45,00,000 / ₹25,00,000 = 1.80. Higher DFL indicates higher financial risk, so Company B has higher financial risk. Option b is flawed because higher EBIT does not by itself mean higher financial risk.
Where it goes wrong. Judging financial risk by absolute EBIT or interest amount instead of DFL.
Question 20 · 2 marks · Financing Decisions - Leverages · hard
Scenario. A firm has return on investment (ROI) of 8% and pre-tax cost of debt of 14%. The tax rate is 30%. If the firm increases debt in its capital structure, what will be the effect on EPS?
A firm has return on investment (ROI) of 8% and pre-tax cost of debt of 14%. The tax rate is 30%. If the firm increases debt in its capital structure, what will be the effect on EPS?
EPS will decline because the after-tax cost of debt of 9.8% exceeds ROI of 8%. (correct answer)
EPS will increase because interest is tax deductible.
EPS will remain unchanged because the tax shield offsets the high interest rate.
EPS will increase because the pre-tax cost of debt exceeds ROI.
Answer: A — EPS will decline because the after-tax cost of debt of 9.8% exceeds ROI of 8%.
Explanation. After-tax cost of debt = 14% × (1 − 0.30) = 9.8%. Since ROI of 8% is lower than the after-tax cost of debt of 9.8%, financial leverage is unfavourable. Additional debt will reduce the return available to equity shareholders and lower EPS. Option b correctly notes the tax shield but ignores that the after-tax cost still exceeds ROI. Option d reverses the leverage condition.
Where it goes wrong. Assuming tax deductibility always makes debt beneficial even when after-tax cost exceeds ROI.
What does this Financing Decisions - Leverages - Test 2 practice test cover?
This practice test carries 40 marks across 20 questions covering core concepts, mathematical financial models, strategic management frameworks, and practical ICAI case scenarios.
How many questions are there and what is the time limit?
There are 20 questions carrying 2 marks each, giving a maximum score of 40 marks in 45 minutes with no negative marking.
Which study material and syllabus apply to these questions?
Questions strictly reflect the official ICAI Study Material for CA Intermediate Paper 6 Financial Management and Strategic Management for the 2027 examination sessions.
Can I sit this test in both exam and practice modes?
Yes. Practice mode gives immediate answers with step-by-step workings and trap explanations after each question. Exam mode simulates actual exam conditions with a live timer and issues a downloadable performance certificate.
