Operating and Financial Leverage^89
basis over its economic life of five years. The project, however, has only a three-
year life and the machine will be sold after three years for an estimated Rs 30,000.
In addition, the firm will be able to recover Rs 6,000 of working capital investment.
What is the after-tax cash flow in year 3 from the sale of this machine and the
recovery of the working capital investment? Assume that the firm's marginal tax
rate is 40 percent.Solution
The net cash flow in the final year are after-tax cash flows, including the tax
effect of any asset sale. Note that there is no tax effect on the recovery of
working capital investment since the recovery involves the collection of accounts
receivable and the sale of inventory which has no tax effect (other than those
represented by revenues and expenses).
Gain or loss on asset sale :
Market value of asset 30,000
Less : Book value of aset [200-(3)(40)] 80,000
Loss of sale of asset 50,000
Calculating year 3 after-tax cash flows :
Taxes saved due to loss on sale [(50)(0.40)] 20,000
Decreases in working capital investmen 6,000
Net after-tax cash flow in year 3 56,000- The following figures relate to two companies: (Rs lakhs)
P Ltd. Q Ltd.
Sales 500 1,000
Variable costs 200 300
Contribution 300 700
Fixed costs 150 400
150 300
Interest 50 d 100
Profit before Tax 100 200
You are required to:
(i) Calculate the operating, financial and combined leverages for the two companies;
and
(ii) Comment on the relative risk position of them.