18. Explain the term ‘Trading on equity’. Why, when and how it can be used by a company?
Answers
SOLUTION :
Trading on equity :
The concept of trading on equity refers to the use of debt component in the capital employed. A company is required to create a capital structure in such a way which help in increase wealth of equity shareholders.
If use of debt in the capital structure increase the earning before equity shareholders , such situation is called trading on equity. They stand to gain of their earning per share increase with the inclusion of debt component in the capital employed.
Why trading on equity is used :
Trading on equity is used to increase the earning per share and to maximise the wealth of equity shareholders. This is possible when a company needs more funds and raises debt funds for its financial requirements. For this Return on Investment (ROI) should be more than the Rate of Interest on Debt.
Where it can be used :
Trading on equity can be used when the company is financially strong and is capable of paying fixed commitments in the form of interest and preference dividend and repayment of long term funds raised in time.
How it can be used :
Let's understand with the help of practical example.
Understanding trading on equity :
Basic information :
Total capital employed = ₹ 30,00,000
Interest on debt = 10%
Tax Rate = 30%
Earnings before interest and tax = ₹ 4,50,000
Return on investment = (Net profit before interest and tax / capital employed) × 100
= ( ₹ 4,50,000 / ₹ 30,00,000) × 100
Return on investment = 15%
Table of earning per share is in the attachment.
CONCLUSION :
In the above situation , though capital employed as well as rate of tax are same but with the inclusion of debt in the second situation, earning per share has increased from ₹ 12. 25 per share to 17.5 per share. Hence, there is trading on equity and the wealth of equity shareholders has been increased. It is due to the reason that ROI is 15% which is more than Rate of Debt of 10%.
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Answer:
Explanation:
If use of debt in the capital structure increase the earning before equity shareholders , such situation is called trading on equity. They stand to gain of their earning per share increase with the inclusion of debt component in the capital employed.