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007A company has revenue of 100. Variable costs are 50% of revenue, fixed costs are 40, interest is 5 and the tax rate is 25%. Revenue rises 10%. By how much do EBIT and net income grow?Sell-side equity researchBuy-side equity research
Try it first
Revenue is up 10%. What happens to net income?
Show the worked solution
EBIT grows 50% and net income 100%. Revenue of 110 leaves 55 after variable costs; less fixed costs of 40, EBIT is 15 against 10. Less interest of 5, pre-tax profit is 10 against 5, and after 25% tax net income is 7.5 against 3.75. Fixed costs magnify the change five times and interest doubles it again.
Why does a 10% revenue change become a 50% EBIT change?
Think of a tea stall with a fixed monthly rent. Once the rent is covered, every extra cup sold is almost pure profit, so a busy month feels far better than the extra sales alone suggest. Fixed costs do not grow with revenue, so the whole extra contribution lands in EBIT, and a thin EBIT makes that addition a large percentage. Here revenue up 10 adds 5 of contribution, and 5 on an EBIT of 10 is 50%.
Revenue rises from 100 to 110 while fixed costs stay at 40, so EBIT rises from 10 to 15; interest stays at 5, so net income rises from 3.75 to 7.5, a 100% increase from a 10% revenue gain. Why does net income grow twice as fast as EBIT?
Interest is a second fixed charge, sitting below EBIT. With interest of 5 taking half of an EBIT of 10, the next 5 of EBIT doubles pre-tax profit, and tax at a flat rate keeps that doubling intact. The shortcut: operating leverageHow much operating profit moves for a given change in revenue, driven by the share of costs that are fixed. is contribution over EBIT, 50 over 10, which is 5; financial leverage is EBIT over pre-tax profit, 10 over 5, which is 2. Together 5 x 2 = 10, and 10 x 10% = 100%.
The relationship50 contribution: revenue less variable costs 10 EBIT before the change 5 pre-tax profit before the change What it says in wordsOperating leverage times financial leverage times the revenue change gives the change in net income.The same arithmetic runs in reverse, which is the point a research analyst should add. A 10% revenue fall would halve EBIT and wipe out net income entirely. Leverage magnifies both directions, so a highly geared, high fixed cost company is the one whose earnings estimates move most on a small change in the top line. The limit of the shortcut: it holds only while costs behave as fixed, and over a few years most costs flex.
Where candidates lose it
The fast answer is 10% for everything, because it assumes every line scales with revenue. The question is built to see whether you notice which costs do not move.
The second loss is getting 50% for EBIT and stopping, forgetting that interest is a second fixed layer. Walk the income statement all the way to net income out loud.
What the interviewer asks next
- What happens to net income if revenue falls 10% instead?
- At what revenue does net income reach zero?
- How would you spot a company with high operating leverage from its annual report?
082A company earns net income of Rs 200 crore on 100 crore shares. It has a Rs 300 crore convertible bond paying 8% that would convert into 15 crore shares, and the tax rate is 25%. What is diluted EPS?Sell-side equity researchBuy-side equity research
Try it first
Which diluted EPS is right?
Show the worked solution
Diluted EPS is about Rs 1.90, against basic EPS of Rs 2.00. Assume the bond converts. Earnings rise by the after-tax interest no longer paid: Rs 300 crore at 8% is Rs 24 crore, Rs 18 crore after tax. Shares rise by 15 crore. Rs 218 crore over 115 crore shares is Rs 1.90, a dilution of 5.2%. Check first that the bond dilutes at all.
Why do earnings go up when the bond converts?
Imagine a friend who lent you money and agrees to take a share of your business instead of repayment. From that day you stop paying them interest, so your profit rises, but you now split it with one more owner. A convertible works the same way: conversion removes the coupon and adds the shares, and the if-converted methodThe standard way to include a convertible in diluted EPS: assume it converts at the start of the year, add back its after-tax interest and add the new shares. captures both. The add-back is after tax, because the interest was saving tax: Rs 24 crore of interest cost only Rs 18 crore of profit.
Assuming conversion adds Rs 18 crore of saved after-tax interest to Rs 200 crore of earnings and 15 crore shares to 100 crore, so diluted EPS is Rs 1.90 against basic Rs 2.00, and forgetting the add-back gives Rs 1.74. When would you leave the bond out altogether?
When including it would raise EPS. Work out what the bond costs per new share: Rs 18 crore of after-tax interest over 15 crore shares is Rs 1.20 a share. If that figure is below basic EPS, conversion dilutes and the bond goes in; if it is above, the bond is antidilutiveA security whose assumed conversion would increase EPS. Accounting standards exclude it from diluted EPS. and is left out. Here Rs 1.20 is below Rs 2.00, so it goes in. If the same bond converted into only 5 crore shares, its cost per share would be Rs 3.60 and it would be excluded.
The relationship200 net income, Rs crore 300 x 8% x (1 - 25%) after-tax interest saved if the bond converts, Rs 18 crore 115 existing 100 crore shares plus 15 crore from conversion What it says in wordsAssume conversion: earnings rise by the interest no longer paid, after tax, and the share count rises by the conversion shares.An analyst uses diluted EPS for valuation because a convertible that is in the money will convert, and the market prices the stock on the larger share count. The limit is that diluted EPS is a snapshot: it counts only securities that dilute at today's numbers, and a rise in the share price can bring more of them in.
Where candidates lose it
The fast wrong answer is 200 over 115, Rs 1.74: counting the new shares but forgetting that the coupon goes away. The second wrong answer adds back the full Rs 24 crore of interest instead of the Rs 18 crore after tax.
The third miss is skipping the antidilution test. Saying the per-share cost of the bond, Rs 1.20, against basic EPS of Rs 2.00 takes five seconds and shows the interviewer you know when the rule flips.
What the interviewer asks next
- The bond converts into 5 crore shares instead. What is diluted EPS?
- The company also has 10 crore options at a strike of Rs 20 with the share at Rs 40. How do they enter diluted EPS?
- Why might an analyst use diluted shares in a valuation even when the accounts show basic?