SELECT * FROM question_mgmt as q WHERE id=5267 AND status=1 SELECT id,question_no,question,chapter FROM question_mgmt as q WHERE courseId=3 AND subId=20 AND chapterId=598 and ex_no='3' AND status=1 ORDER BY CAST(question_no AS UNSIGNED)

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.


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