Explain the term ‘Trading on Equity’? Why, when and how it can be used by company.
Trading on equity means the use of fixed cost sources of finance such as preference shares, debentures and long-term loans in the capital structure, so as to increase the return on equity shares. This is also known as financial leverage. It is advisable to use trading on equity when the rate of return on investment is more than the rate of interest payable on debentures and loans. The use of more debt along with equity increases Earning per share(EPS). Let us take an example of companies A and B.
Company A | Company B | |
---|---|---|
Share capital (100 each) Loan @ 15% p.a. |
₹ 10,00,000 | ₹ 4,00,000 |
- | ₹ 6,00,000 | |
Total Capital | ₹ 10,00,000 | ₹ 10.00.000 |
Profit Before Interest and Tax (30% ROI) (-) Interest (15% of ₹ 6,00,000) Profit Before Tax (-) Tax @ 50% |
₹ 3,00,000 | ₹ 3,00,000 |
Nil | ₹ 90,000 | |
₹ 3,00,000 | ₹ 2,10,000 | |
₹ 1,50,000 | ₹ 1,05,000 | |
Profit After Tax | ₹ 1,50,000 | ₹ 1,05,000 |
Earning per Share (EPS) = Profit After Tax ÷ Number of Equity Shares
A = 150000 ÷ 10000 = ₹ 15
B= 105000 ÷ 4000 = ₹ 26.25
Thus, from the above example, it is clear that shareholders of company B receive higher EPS than the shareholders of company A due to more debt in the total capital of company B.
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Welcome to the NCERT Solutions for Class 12 Business Studies - Chapter . This page offers a step-by-step solution to the specific question from Excercise 3 , Question 5: Explain the term ‘Trading on Equity’? Why, when and how it can be used by company.....
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