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6. A company has net worth of ` 5,00,000. Its debt to equity ratio is 2. Interest on debt is 10%. The company earns an operating profit of ` 4,00,000. Tax rate is 30%. What will be the financial leverage of the company?

Options

A1.11
B1.33
C1.43
D1.90 (2 Marks)
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Correct Answer

Option B1.33

All Options:

  • A1.11
  • B1.33
  • C1.43
  • D1.90 (2 Marks)

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Detailed Solution & Explanation

Correct Answer: Option **B**

**Explanation:**
To determine the financial leverage of the company, we calculate it from first principles using the formula:
textFinancialLeverage=fractextOperatingProfit(EBIT)textEarningsBeforeTax(EBT)\\text{Financial Leverage} = \\frac{\\text{Operating Profit (EBIT)}}{\\text{Earnings Before Tax (EBT)}}

**Step 1: Calculate the Total Debt of the company**
The company has a net worth (Equity) of ₹ 5,00,000, and its debt to equity ratio is 2.
textDebt=textEquitytimestextDebttoEquityRatio\\text{Debt} = \\text{Equity} \\times \\text{Debt to Equity Ratio}
textDebt=5,00,000times2=text10,00,000\\text{Debt} = 5,00,000 \\times 2 = \\text{₹ } 10,00,000

**Step 2: Calculate the Interest on Debt**
The interest rate on the debt is 10% per annum.
textInterestExpense=textDebttimestextInterestRate\\text{Interest Expense} = \\text{Debt} \\times \\text{Interest Rate}
textInterestExpense=10,00,000times10\\text{Interest Expense} = 10,00,000 \\times 10\\% = \\text{₹ } 1,00,000

**Step 3: Calculate the Earnings Before Tax (EBT)**
The company earns an operating profit (EBIT) of ₹ 4,00,000.
textEBT=textEBITtextInterestExpense\\text{EBT} = \\text{EBIT} - \\text{Interest Expense}
textEBT=4,00,0001,00,000=text3,00,000\\text{EBT} = 4,00,000 - 1,00,000 = \\text{₹ } 3,00,000

**Step 4: Calculate the Financial Leverage**
textFinancialLeverage=fractextEBITtextEBT=frac4,00,0003,00,000approx1.33\\text{Financial Leverage} = \\frac{\\text{EBIT}}{\\text{EBT}} = \\frac{4,00,000}{3,00,000} \\approx 1.33

Hence, **Option B** is the correct answer.

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