Explain the term ‘Trading on Equit | Class 12 Business Studies Chapter Financial Management, Financial Management NCERT Solutions

Question:

Explain the term ‘Trading on Equity’? Why, when and how it can be used by company.

Answer:

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.


Study Tips for Answering NCERT Questions:

NCERT questions are designed to test your understanding of the concepts and theories discussed in the chapter. Here are some tips to help you answer NCERT questions effectively:

  • Read the question carefully and focus on the core concept being asked.
  • Reference examples and data from the chapter when answering questions about Financial Management.
  • Review previous year question papers to get an idea of how such questions may be framed in exams.
  • Practice answering questions within the time limit to improve your speed and accuracy.
  • Discuss your answers with your teachers or peers to get feedback and improve your understanding.

Comments

Comment(s) on this Question

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.....