1

Project of Managerial Finance

FAUJI FERTILIZER COMPANY LIMITED

Fawad Ur Rahman

International Islamic University Islamabad

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References: Corporate Affairs

Senior Manager Corporate Affairs/Company Secretary

Brig. Sher Shah (Retired). Email ID: secretary@ffc.com.pk

Location: Head Office, 156-The Mall Rawalpindi

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COMPANY PROFILE

Vision

To be a leading national enterprise with global aspirations, effectively pursuing multiple growth

opportunities, maximizing returns to the stakeholders, remaining socially and ethically

responsible

Explanation:

In a nation of increasing population, there is substantial opportunity of growth for FFC in the

years to come. FFC’s vision is to play a leading role in the industrial and agricultural

advancement of the Country pursuing new growth opportunities offering the convenience of

multiple products, brands and channels within and beyond the territorial limits of Pakistan, to

the benefit of our customers and our shareholders, elevating our image as a socially responsible

and ethical company that is watched and emulated as a model of success.”

Mission

To provide our customers with premium quality products in a safe, reliable, efficient and

environmentally sound manner, deliver exceptional services and customer support, maximizing

returns to the shareholders through core business and diversification, providing a dynamic and

challenging environment for our employees.

Explanation:

FFC is a market-focused, process centered organization delivering successful performance

through a strong focus on quality. Our mission is to stand above the competition and provide

our customers with premium quality fertilizer products in a safe, reliable, efficient and

environmentally sound manner, deliver exceptional services and unparalleled customer

support, produce predictable earnings for our shareholders, and provide a dynamic and

challenging environment for our employees.”

Corporate Strategy:

Maintaining our competitive position in the core business, we employ our brand name, unique

organizational culture, professional excellence and financial strength diversifying in local and

multinational environments through acquisitions and new projects thus achieving synergy

towards value creation for our stakeholders.

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Company Ownership:

The company is a public company incorporated in Pakistan under the

companies Ordinance, 1984, and its shares are quoted on the stock exchange in Pakistan. FFC

was established in 1978 as a joint venture of Fauji Foundation and Haldor Topsoe. The first urea

complex was commissioned in 1982. Plant-1 was improved in 1992, and a second plant was built

in 1993. In the year 2002, FFC acquired ex Pak Saudi Fertilizers Limited (PSFL) Urea Plant

situated at Mirpur Mathelo, District Ghotki from National Fertilizer Corporation (NFC) through

a privatization process of the Government of Pakistan. This acquisition at Rs. 8,151 million

represents one of the largest industrial sector transactions in Pakistan. Fauji Fertilizer Bin Qasim

Limited, Karachi, Pakistan (FFBL) is another company where FFC has controlling shares – it

produces 1670 MTPD of granular urea plus 2250 MTPD DAP after revamping (1350 MTPD

before revamp) DAP. Ammonia and urea plants capacity factors right from the plants start-up

have been 100% or more. With a vision to acquire self - sufficiency in fertilizer production in the

country, FFC was incorporated in 1978 as a private limited company. This was a joint venture

between Fauji Foundation and Haldor Topsoe A/S.The initial share capital of the company was

813.9 Million Rupees. The present share capital of the company stands above Rs. 8.48 Billion.

Additionally, FFC has more than Rs. 8.3 Billion as long term investments which include stakes

in the subsidiaries FFBL, FFCEL and associate FCCL.

FFC participated as a major shareholder in a new DAPS/Urea

manufacturing complex with participation of major international/national institutions. The new

company Fauji Fertilizer Bin Qasim Limited (formerly FFC-Jordan Fertilizer Company Limited)

commenced commercial production with effect from January 01, 2000. The facility is designed

with an annual capacity of 551,000 metric tons of urea and 445,500 metric tons of DAP,

revamped to 670,000 metric tons of DAP.

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Product and Service Description:

1) Urea (Nitrogen) Fertilizer:

In grain and cotton crops, at the time of last cultivation before planting. In irrigated

crops, urea can be applied dry to the soil. During summer, often spread just before or during rain

to minimize losses from vitalization process.

Industrial: Raw material in manufacture of plastics, adhesives and industrial feedstock.

Percentage of use in Pakistan: 80%, Percentage of FFC Sales: 93%

2) DAP (Phosphate) Fertilizer:

Sona DAP is the most concentrated phosphatic fertilizer containing 46% P2O5 and

18% Nitrogen. From nutrients' concentration point of view, it has got the highest quantity of total

nutrients in a 50 KG bag i.e. 32 KG of nutrients / bag. The highest concentration of plant

nutrients in a bag helps saving costs of transportation, handling, storage and application. It is the

widely used phosphatic fertilizer in the world as well as Pakistan. The solubility of DAP is more

than 95%, which is highest among the phosphatic fertilizers available in the country. Due to high

solubility it can also be used through fertigation as well as by foliar application. Its nitrogen to

phosphoris ratio (1: 2.5) makes it an ideal fertilizer for Basal application to meet the initial

requirement of most of the crops. Having an ultimate acidic effect on the soil, it is well suited for

our alkaline soils.

Industrial: It is a fire retardant and is used in commercial firefighting products. Other uses are

as metal finisher, yeast nutrient, nicotine enhancer in cigarettes and sugar purifier.

Percentage of use in Pakistan: 19%, Percentage of FFC Sales: 6%

3) SOP (Potash) Fertilizer:

This fertilizer is an important source of Potash, which is a quality nutrient for production of

crops especially fruits and vegetables. Potash is an important nutrient for activation of enzymes

in the plant body and helps increasing sugar and starch contents. Potash improves the resistance

of the plants against pests, diseases and stresses like water / frost injury etc.

Industrial: Occasionally used in manufacture of glass.

Percentage of use in Pakistan: 1%, Percentage of FFC Sales: 1%

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4) SONA BORON:

Sona Boron is a crystalline fertilizer in the form of Sodium Tetra Borate Deca

hydrate in 3 Kg packing. It is an essential micronutrient required for plant nutrition, which pays

a vital role in a number of growth processes especially new cell development, pollination,

fruit/seed setting, translocation of sugars, starches, nitrogen and phosphorous, nodule formation

in legumes and regulation of carbohydrate metabolism. Boron deficiency results in curled leaves,

cracking and rotting of fruits, tubers or roots. Keeping in view increasing boron deficiency in

Pakistani soils FFCL is providing superior quality Sona Boron containing 11.3% Boron (Borax).

It is easily soluble in water and readily available to plants. It can be used as mixture with other

fertilizers.

Fauji Fertilizer Company Limited Fluctuation for the Years 1996-

2013

Year Date High Date Low

1998 14-APR-98 89.00 21-OCT-98 31.55

1999 15-MAR-99 57.30 08-FEB-99 39.30

2000 21-JAN-00 67.50 19-OCT-00 36.50

2001 02-FEB-01 50.00 24-SEP-01 28.40

2002 26-DEC-02 73.95 22-May-02 38.85

2003 29-AUG-03 105.95 28-FEB-03 69.15

2004 29-DEC-04 143.90 01-JAN-04 95.75

2005 16-MAR-05 180.00 27-JUN-05 118

2006 31-JAN-06 144.90 29-DEC-06 105.50

2007 13-JUL-07 131.90 05-JAN-07 103.00

2008 02-APR-08 149.85 31-DEC-08 54.30

2009 14-DEC-09 109.90 01-JAN-09 58.90

2010 30-DEC-10 128.50 15-JUN-10 101.10

2011 18-OCT-11 198.35 25-FEB-11 109.82

2013 23-DEC-13 116 27-DEC-13 113

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Production and Sale at a Glance:

Urea Production (Met/Year) Sale (Met/Year)

Years Goth Machi M.Mathelo Total Urea Domestic Urea Export

Urea Imported

Phos*/ Potassic

Total

Plant-I Plant-II Plant-III Sona FFC

1987

632,079

- - 632,079

587,891

- - 2,907

- 590,798

1988

637,737

- - 637,737

642,857

- - 22,542

- 665,399

1989

632,972

- - 632,972

678,430

- - 2,605

162,113/14,086

857,234

1990

652,665

- - 652,665

645,188

- - 134,366

169,943/24,229

973,726

1991

629,266

- - 629,266

643,608

- - 206,244

148,753/18,945

1,017,550

1992

648,178

- - 648,178

647,460

- - 187,058

153,025/16,040

1,003,583

1993

657,376

477,339

- 1,134,715

1,176,611

- - 129,006

207,038/7,147

1,519,802

1994

678,114

659,526

- 1,337,640

1,288,811

- - 33,387

192,002/8,210

1,522,410

1995

680,062

700,031

- 1,380,093

1,422,666

- - 60,604

122,640/9,527

1,615,437

1996

710,862

695,749

- 1,406,611

1,413,907

- - 238,130

144,969/1,446

1,798,452

1997

773,048

734,275

- 1,507,323

1,482,948

- - 146,813

81,181/0

1,710,942

1998

742,599

682,969

- 1,425,568

1,449,201

- - 169,610

187,392/0

1,806,203

1999

726,723

734,689

- 1,461,412

1,581,655

- - 26,277

291,499/0

1,899,431

2000

729,864

695,938

- 1,425,802

1,793,554

- 63,350

0

321,977/9,269

2,188,150

2001

737,607

756,417

- 1,494,024

1,883,849

- - 34,035

340,301/9,377

2,267,562

2002

801,825

713,889

368,575**

1,884,289

2,033,883

328,147

57,000

- 285,776/7,718

2,712,524

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2003

784,826

738,327

626,716

2,149,869

2,065,459

598,792

18,500

- 475,491/10,947

3,169,189

2004

741,831

716,621

715,577

2,174,029

2,708,544

148,832

13,500

105,693

515,993/11,451

3,504,013

2005

820,454

772,825

709,526

2,302,805

2,891,882

- - 314,701

572,990/45,293

3,824,866

2006

809,373

760,442

725,839

2,295,654

2,888,668

- - 321,601

824,361/20,426

4,055,056

2007

829,250

810,673

680,442

2,320,365

2,771,861

- - 96,976

562,276/17,305

3,448,418

2008

841,117

797,108

683,986

2,322,211

3,027,245

- - 58,370

348,275/19,364

3,453,254

2009

807,221

846,613

810,323

2,464,157

3,088,382

- - - 708,886/41,128

3,838,396

2010

867,346

806,589

810,706

2,484,641

3,006,074

- - - 722,766

3,728,840

2011

841,755

782,752

711,195

2,395,702

2,839,162

662,387/9,588

3,511,353

2012

799,432

772,307

834,054

2,405,784

2,677,668

677,917/6,489

3,362,286

2013

749,000

784,000

787,000

2,320,000

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Capital Budgeting: Cash Flow Estimation

KEY DEFINATIONS:

Capital Budgeting:

Capital budgeting, which is also called "investment appraisal," is the planning

process used to determine which of an organization's long term investments such as new

machinery, replacement machinery, new plants, new products, and research development

projects are worth pursuing. It is to budget for major capital investments or expenditures.

Cost of Capital: The firm's Cost of Capital is the discount rate which should be used in Capital Budgeting.

The Cost of Capital reflects the firm's cost of obtaining capital to invest in long term assets. Thus

it reflects a weighted average of the firm's cost of debt, cost of preferred stock, and cost of

common stock.

Net Present Value: Net present value (NPV) is used to estimate each potential project's value by

using a discounted cash flow (DCF) valuation. This valuation requires estimating the size and

timing of all the incremental cash flows from the project. The NPV is greatly affected by the

discount rate, so selecting the proper rate–sometimes called the hurdle rate–is critical to making

the right decision.

Internal Rate of Return: The internal rate of return (IRR) is defined as the discount rate

that gives a net present value (NPV) of zero. It is a commonly used measure of investment

efficiency.

The IRR method will result in the same decision as the NPV method for non-mutually exclusive

projects in an unconstrained environment, in the usual cases where a negative cash flow occurs at

the start of the project, followed by all positive cash flows. Nevertheless, for mutually exclusive

projects, the decision rule of taking the project with the highest IRR, which is often used, may

select a project with a lower NPV.

Payback Period: Payback period in capital budgeting refers to the period of time required for the return on an

investment to "repay" the sum of the original investment. Payback period intuitively measures

how long something takes to "pay for itself." All else being equal, shorter payback periods are

preferable to longer payback periods.

Profitability Index: Profitability index (PI), also known as profit investment ratio (PIR) and value investment ratio

(VIR), is the ratio of payoff to investment of a proposed project. It is a useful tool for ranking

projects, because it allows you to quantify the amount of value created per unit of investment.

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Equivalent Annuity: The equivalent annuity method expresses the NPV as an annualized

cash flow by dividing it by the present value of the annuity factor. It is often used when

comparing investment projects of unequal life spans. For example, if project A has an expected

lifetime of seven years, and project B has an expected lifetime of 11 years, it would be improper

to simply compare the net present values (NPVs) of the two projects, unless the projects could

not be repeated.

Real Options Analysis The discounted cash flow methods essentially value projects as if they were risky bonds, with the

promised cash flows known. But managers will have many choices of how to increase future

cash inflows or to decrease future cash outflows. In other words, managers get to manage the

projects, not simply accept or reject them. Real options analysis try to value the choices–the

option value–that the managers will have in the future and adds these values to the NPV.

Capital Budgeting: Cash Flow Estimation

Fauji Fertilizer Company Limited is considering purchase of new organic fertilizer machine by

replacing it with existing one. The existing unit cost 2,000,000 and is being depreciated under

MACRS using a five year recovery period. The existing unit is expected to have useful life of 5

more years. The new unit can be purchased at 2,809,000 and requires 65,000 installation cost, it

has a 5-year usable life and would be depreciated by using a five year recovery period. Fauji

Fertilizer Company can currently sell the exiting unit for Rs. 1,305,000 without incurring any

removal or cleanup cost. The new unit would be sold out to net 1,585,000, after removal and

cleanup cost and before taxes. The Firm is subject to a 35% tax rate. We have raised three

questions which are answered in this section. We will calculate initial investment associated with

the replacement of the existing asset by the new one. We shall find out the operating cash

inflows associated with the proposed asset replacement. The initial investment and operating

cash inflows are given below.

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Initial Investment:

Installed Cost Of New Asset

Cost of New Asset 2809000

Installation Cost 6500

Total Installed Cost 2815500

After tax sales proceeds from old asset

Net sales proceeds from old asset 1305000

Tax 243250

Total After Tax Sales Proceeds 1548250

Net working capital

Initial Investment 1267250

Operating cash flows CASH INFLOWS OF NEW MACHINERY

YEARS 1 2 3 4 5 6

Revenues 30000000 33000000 50000000 50050000 65000000 72000000

Expenses 1200000 1200000 1350000 1000000 987000 967000

Income before depreciation and tax

28800000 31800000 48650000 49050000 64013000 71033000

Depreciation 561800 898880 533710 337080 337080 140450

Income before tax

28238200 30901120 48116290 48712920 63675920 70892550

Tax 9883370 10815392 16840701.5 17049522 22286572 24812393

Net Income 18354830 20085728 31275588.5 31663398 41389348 46080158

Add Depreciation expense

561800 898880 533710 337080 337080 140450

Cash Flows 18916630 20984608 31809298.5 32000478 41726428 46220608

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CASH INFLOWS OF OLD MACHINERY

YEARS 1 2 3 4 5 6

Revenues 20700000 23700000 26300000 29400000 25900000 23900000

Expenses 800000 800000 900000 750000 987000 967000

Income before depreciation and tax

19900000 22900000 25400000 28650000 24913000 22933000

Depreciation 400000 640000 380000 240000 240000 100000

Income before tax

19500000 22260000 25020000 28410000 24673000 22833000

Tax 6825000 7791000 8757000 9943500 8635550 7991550

Net Income 12675000 14469000 16263000 18466500 16037450 14841450

Add Depreciation expense

400000 640000 380000 240000 240000 100000

Cash Flows 13075000 15109000 16643000 18706500 16277450 14941450

INCREMENTAL CASH INFLOWS

YEARS NEW OLD INCREMENTAL CASH INFLOWS

1 18916630 13075000 5841630

2 20984608 15109000 5875608

3 31809298.5 16643000 15166299

4 32000478 18706500 13293978

5 41726428 16277450 25448978

6 46220607.5 14941450 31279158

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RISK AND REFINEMENTS IN CAPITAL BUDGETING:

RISK AND CASH FLOWS:

In the context of capital budgeting, the term risk refers to the uncertainty

surrounding the cash flows that a project will generate. More formally, risk in capital budgeting

is the degree of variability of cash flows. Projects with a broad range of possible cash flows are

more risky than projects that have a narrow range of possible cash flows.

NPV is used in capital budgeting to analyze the profitability of an investment or project.

NPV analysis is sensitive to the reliability of future cash inflows that an investment or project

will yield. If the NPV of a prospective project is positive, it should be accepted. However, if

NPV is negative, the project should probably be rejected because cash flows will also be

negative.

NPV is an indicator of how much value an investment or project adds to the firm. With a

particular project,

If Means Then

NPV > 0 The investment would add value to the firm.

The project may be accepted.

NPV < 0 The investment would subtract value from the firm.

The project should be rejected.

NPV = 0 The investment would neither gains nor loss value for the firm.

We should be indifferent in the decision whether to accept or reject the project. This project adds no monetary value. Decision should be based on other criteria, e.g. strategic positioning or other factors not explicitly included in the calculation.

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ILLUSTRATION:

Fauji Fertilizing company an urea retailer with a 9% cost of capital, is considering investing in

either of two mutually exclusive projects, X and Z. Each requires a $1500000 initial investment,

and both are expected to provide equal annual cash inflows over their 10-years lives. For either

to be acceptable according to the net present value technique, its NPV must be greater than

zero. If we let CF equal the annual cash inflow and let CF0 equal the initial investment , the

following condition must be met for projects with annuity cash inflows , such as X and Z, to be

acceptable.

NPV= [CF (PVIFA k, n)]-CFO

K=9% n=10years CFO=150000, we can find the breakeven cash inflow necessary for

Fauji projects to be acceptable.

NPV= [CF (PVIFA 9%, 10)-$1500000

NPV=CF (6.418)-$1500000

CF=$1500000/6.418

CF=$233717.66

I n this example we didn’t say that project x is less risky than project z in this example clearly

identifies risk as it is related to the chance that a project is acceptable, but it doesn’t address the

issue of cash flow variability because both project has equal net present value so the project x

has greater chance of loss than project z or vise versa or it might result in higher potential NPVs.

SENSITIVITY AND SCENARIO ANALYSIS:-

Sensitivity analysis can be used to deal with project risk to capture the variability of cash inflows

and NPVs. Sensitivity analysis is a behavioral approach that uses several possible alternative

outcomes (scenarios), to obtain a sense of the variability of returns, measured here by NPV. This

technique is often useful in getting a feel for the variability of return in response to changes in a

key outcome. In capital budgeting, one of the most common scenario approaches is to estimate

the NPVs associated with pessimistic (worst), most likely (expected), and optimistic (best)

estimates of cash inflow. The range can be determined by subtracting the pessimistic-outcome

NPV from the optimistic-outcome NPV.

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The Scenario analysis is also a behavioral approach similar to sensitivity analysis but broader in

scope.

EXAMPLE: Fuji fertilizing company, assume that the financial manager made in pessimistic,

most likely, and optimistic estimates of the cash inflows for each project. The cash inflows

estimates and resulting NPV’s in each case are summarized in below table.

Comparing the ranges of cash inflows ($100000 for project X and $150000 for Z) and more

important, the range of NPV’s ($624700 for project X and $863850 for Z ) makes it clear that

project X is less risky than project Z. Given that both projects have the same most likely NPV’s

of $450000 the assumed risk averse decision maker will take project X because it has less risk or

smaller NPV range and no possibility of losses (all NPVs>$0).

Sensitivity analysis of Fauji fertilize of project X and Z.

Note: The Present Values are calculated keeping the discount rate of 8% for project X and 10%

for Project Z and 9 years of Project life for both Projects.

Project X Project Z

Initial Investment 500000 500000

Outcome:-

Pessimistic 800000 700000

Most likely 450000 450000

Optimistic 900000 850000

Range 100000 150000

Outcome:-

Pessimistic 4497600 3531300

Most likely 2311150 2091550

Optimistic 5122300 4395150

Annual Cash inflows

Net Present Values

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APPLYING THE RISK ADJUSTED DISCOUNT RATE:

An estimation of the present value of cash for high risk investments is known as risk-adjusted

discount rate.

A very common example of risky investment is the real estate. Risk adjusted discount rate is

representing required periodical returns by investors for pulling funds to the specific property. It

is generally calculated as a sum of risk free rate and risk premium. The variation of risk premium

is depending on the risk aversion of investor and the perception of investor about the size of

property’s investment risk.

Under Capital Asset Pricing Model

Risk-adjusted discount rate = Risk free rate + Risk premium

Risk premium= (Market rate of return - Risk free rate) x beta of the project

The risk-adjusted discount rates declare for that by altering the rate depending on possibility of

risks of investment projects. For higher risk investment project a higher rate will be used and for

a lower risk investment project, a low rate will be used. The net present value is inversely

proportional to risk-adjusted discount rate as an increase in adjusted rate will decrease net

present value, representing that the task is less acceptable and perceived as riskier one.

Plus points of adjusted rate

It is quite simple and easy to understand.

Risk adjusted rate has a good deal of intuitive appeal in the eyes of risk averse business person.

It integrates an attitude towards uncertainty.

The risk-adjusted discount rate (RADR) is the rate of return that must be earned on a given

project to compensate the firm’s owners adequately—that is, to maintain or improve the firm’s

share price. The higher the risk of a project, the higher the RADR, and therefore the lower the

net present value for a given stream of cash inflows.

For assets traded in an efficient market, the diversifiable risk, which results from uncontrollable

or random events, can be eliminated through diversification. The relevant risk is therefore the no

diversifiable risk—the risk for which owners of these assets are rewarded. No diversifiable risk

for securities is commonly measured by using beta, which is an index of the degree of movement

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of an asset’s return in response to a change in the market return. Using beta, bj, to measure the

relevant risk of any project, the CAPM is

Any security that is expected to earn in excess of its required return would be acceptable, and

those that are expected to earn an inferior return would be rejected.

Risk adjusted discount rate for the projects by using the CAPM

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Project A: Project E:

Risk free rate 9.32% Risk free rate 9.32 %

Market rate 20% Market rate 10%

Beta 1. Beta 0.90

CAPM 20% CAPM 10%

Project B: Project F:

Risk free rate 9.32% Risk free rate 9.32%

Market rate 17% Market rate 07%

Beta 1.10. Beta 0.50

CAPM 18% CAPM 08%

Project C: Project G:

Risk free rate 9.32% Risk free rate 9.32%

Market rate 15% Market rate 05%

Beta 1.05. Beta 0.75

CAPM 15% CAPM 06%

NPV at the Risk Adjusted Discount Rate:

Project CFO RADR PVIFA Cash Flow PV NPV

A 750000 20% 2.990 300000 897000 147000

B 660000 18% 3.127 350000 1094450 434450

C 450000 15% 3.352 400000 1340800 890800

E 550000 10% 3.790 550000 2084500 1534500

F 325000 8% 3.992 700000 2794400 2469400

G 200000 6% 4.212 450000 1895400 1695400

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LEVERAGE AND CAPITAL STRUCTURE

Leverage in finance is a general term for any technique to multiply gains and losses.

Operating Leverage:

A measurement of the degree to which a firm or project incurs a combination of fixed and

variable costs. A business that has a higher proportion of fixed costs and a lower proportion of

variable costs is said to have used more operating leverage. Those businesses with lower fixed

costs and higher variable costs are said to employ less operating leverage.

Financial Leverage:

Financial leverage is the degree to which a company uses fixed-income securities such as debt

and preferred equity. The more debt financing a company uses, the higher its financial leverage.

A high degree of financial leverage means high interest payments, which negatively affect the

company's bottom-line earnings per share.

Break Even Analysis of FFC:

Break Even Analysis is an analysis to determine the point at which revenue received equals the

costs associated with receiving the revenue. Break-even analysis calculates what is known as a

margin of safety, the amount that revenues exceed the break-even point. This is the amount that

revenues can fall while still staying above the break-even point. Break-even analysis is a supply-

side analysis; that is, it only analyzes the costs of the sales. It does not analyze how demand may

be affected at different price levels.

FFC uses the following rates for its production of Urea bags: the Selling Price per bag is

Rs.1700, with a variable cost of Rs.500 per bag. The Operating Fixed Cost is Rs.48000000.

The formula used to determine the breakeven point is:

Breakeven Point = Fixed Costs/ (Unit Selling Price - Variable Costs)

In our case:

B.E = 48000000/ (1700-500)

= 40,000 Bags of Urea.

20

Changing Costs and Operating Breakeven Points

The breakeven Point varies with different elements such as the Fixed Cost, the Sales Price per

unit, and the variables operating costs per unit. In order to assess the effects of increase or

decrease in these variables, we consider the following scenarios.

Assume that FFC wants to assess the effects of the following scenario: (1) to keep the variables

as where mentioned above, that is: the Selling Price per bag is Rs.1700, with a variable cost of

Rs.500 per bag. The Operating Fixed Cost is Rs.48000000. (2) to increase the Fixed Cost up to

Rs.52000000. (3) to increase the selling price to Rs.1800. (4) to increase the variable cost per bag

up to Rs.700. (5) to perform all the mentioned changes simultaneously.

We calculate the effects of the above changes:

B.E = 48000000/ (1700-500) = 40,000 bags.

B.E = 52000000/ (1700-500) = 43,333 bags.

B.E = 48000000/ (1800-500) = 36,923 bags.

B.E = 48000000/ (1700-700) = 48,000 bags.

B.E = 52000000/ (1800-700) = 47272 bags.

The following table summarizes the changes and the effects of each:

Situation S.P F.C V.C Revenue Explanation Break Even

Point

Scenario 1 1700 48000000 500 68000000 Normal scenario 40000

Scenario 2 1700 52000000 500 73666666.67 Increased FC 43333.33333

Scenario 3 1800 48000000 500 66461538.46 Increased SP 36923.07692

Scenario 4 1700 48000000 700 81600000 Increase VC 48000

Scenario 5 1800 52000000 700 85090909.09 All three changes 47272.72727

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Operating Leverage:

Referring to the data used in the previous illustration, here we show EBIT for various levels of

sales, and what are the effects of each level:

Case 2 Base Case 1

Sales in

Units

40,000

60,000

80,000

Sales

Revenue

68,000,000

102,000,000

136,000,000

Less: V.C

20,000,000

30,000,000

40,000,000

Less: F.C

48,000,000

48,000,000

48,000,000

EBIT

-

24,000,000

48,000,000

We used the sales of 60000 in units as a reference point. It is evident how operating leverage

works in both directions, either in increasing or decreasing the sales level:

Case 1: a 33 percent increase in sales level (from 60,000 to 80,000) results in a in a 100 percent

increase in EBIT.

Case 2: a 33 percent decrease in sales level (from 60,000 to 40,000) results in a 100 percent

decrease in EBIT.

Definition of 'Degree of Operating Leverage - DOL'

A type of leverage ratio summarizing the effect a particular amount of operating leverage has on

a company's earnings before interest and taxes (EBIT). Operating leverage involves using a large

proportion of fixed costs to variable costs in the operations of the firm. The higher the degree of

operating leverage, the more volatile the EBIT figure will be relative to a given change in sales,

all other things remaining the same. The formula is as follows:

Degree of Operating Leverage of FFC

The degree of operating leverage (DOL) is a numerical measure of the firm’s operating leverage.

It can be derived using the following equation:

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DOL= Percentage change in EBIT/Percentage change in Sales

Whenever the percentage change in EBIT resulting from a given percentage change in sales is

greater than the percentage change in sales, operating leverage exists. This means that as long as

DOL is greater than 1, there is operating leverage.

Taking in consideration the previous illustration at FFC, we get the following results:

Case 1: +100% / +33% = 3.

Case 2: -100% / -33% = 3

Financial Leverage

The use of fixed financial costs to magnify the effects of changes in

earnings before interest and taxes on the firm’s earnings per share. Financial leverage results

from the presence of fixed financial costs that the firm must pay. The two most common fixed

financial costs are (1) interest on debt and (2) preferred stock dividends. These charges must be

paid regardless of the amount of EBIT available to pay them.

The effect of financial leverage is such that an increase in the firm’s EBIT results in a more-than-

proportional increase in the firm’s earnings per share, whereas a decrease in the firm’s EBIT

results in a more-than-proportional decrease in EPS.:

Case 2 Base Case 1

EBIT

14,400,000

24,000,000

33,600,000

Less: Interest

4,000,000

4,000,000

4,000,000

Net Profit Before Tax

10,400,000

20,000,000

29,600,000

Less: Tax

3,640,000

7,000,000

10,360,000

Net Profit

6,760,000

13,000,000

19,240,000

Less: Pref. Dividend 3,000,000 3,000,000 3,000,000

Earnings Available for

C.S

3,760,000

10,000,000

16,240,000

No of CS outstanding

10,000,000

10,000,000

10,000,000

Earnings Per Share 0.376 1 1.624

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We used the EBIT of 24,000,000 in units as a reference point. The interest payable on Bonds

equals to Rs.4000, 000. The annual dividends on preferred stock are Rs.3, 000,000. The tax rate

applies is 35%. The previous table shows EPS for various EBIT levels. Two Scenarios are

shown:

Case 1: a 40% increase in EBIT (from 24,000,000 to 33,600,000) resulting in a 62% increase in

EPS (from 1 to 1.624).

Case 2: a 40% decrease in EBIT (from 24,000,000 to 14,400,000) resulting in a 62% decrease in

EPS (from 1 to 0.376).

The degree of Financial Leverage of FFC

The degree of financial leverage (DFL) is a numerical measure of the firm’s financial leverage.

Computing it is much like computing the degree of operating leverage. The following equation

presents one approach for obtaining the DFL. Whenever the percentage change in EPS resulting

from a given percentage change in EBIT is greater than the percentage change in EBIT, financial

leverage exists. This means that whenever DFL is greater than 1, there is financial leverage.

The formula used to calculate the degree of financial leverage is as follows:

DFL= Percentage change is EPS/Percentage change in EBIT

Refereeing to the data illustrated in the table above; we can calculate the degree of financial

leverage at FFC:

Case 1: +62%/+40% = 1.55.

Case 2: -62%/-40% = 1.55.

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Total Leverage:

The combined effect of Operating and financial leverage on the firm’s risk is called Total

leverage. It can be defined as the potential use of fixed costs, both operating and financial to

magnify the effects of changes in sales on the firm’s earnings per share. Total leverage can

therefore be viewed as the total impact of the fixed costs in the firms’ operating and financial

structure.

To calculate the degree of total leverage, we use the following formula:

DTL=DOL * DFL

If we take cases 1 of each leverage consideration, we will end up with a DOL of 3 and a DFL of

1.55

Hence:

DTL = 3 X 1.55 = 4.65