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IAI Actuarial Core Principles · Business Finance · Structure and methods of financing a company

A firm's operating profit (EBIT) is Rs 20 lakh and its interest charge is Rs 8 lakh. What is its interest cover, and what happens to profit after interest if EBIT falls by 10%?

Interest cover is 2.5 times. A 10% fall in EBIT cuts it by Rs 2 lakh, so profit after interest drops from Rs 12 lakh to Rs 10 lakh, a 16.7% fall, because fixed interest magnifies the effect of the operating decline.

  1. A2.5 times; profit after interest falls by 10%
  2. B2.5 times; profit after interest falls by 16.7%Correct
  3. C0.4 times; profit after interest falls by 10%
  4. D2.5 times; profit after interest falls by 25%
  5. 1.6 times; profit after interest falls by 16.7%

Explanation

Interest cover is 20/8 = 2.5 times. Profit after interest is 12 lakh. A 10% EBIT fall gives EBIT 18 lakh, so profit is 10 lakh, a fall of 2/12 = 16.7%. Option 0 ignores the financial gearing effect.

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