Explain trading on equity with the help of a suitable example?
Answers
Trading on equity is the financial process of using debt to produce gain for the residual owners. The practice is known as trading on equity because it is the equity shareholders who have only interest (or equity) in the business income.Effects of Trading on Equity:
Trading on equity acts as a lever to magnify the influence of fluctuations in earnings. Any fluctuation in earnings before interest and taxes (EBIT) is magnified on the earnings per share (EPS) by operation of trading on equity larger the magnitude of debt in capital structure, the higher is the variation in EPS given any variation in EBIT.Example:
Prakash Company is capitalized with Rs. 10, 00,000 dividends in 10,000 common shares of Rs. 100 each. The management wishes to raise another Rs. 10, 00,000 to finance a major programme of expansion through one of four possible financing plans.
Then management
A) may finance the company with all common stock,
B). Rs. 5 lakhs in common stock and Rs. 5 lakhs in debt at 5% interest,
C) all debt at 6% interest or
D) Rs. 5 lakhs in common stock and Rs. 5 lakhs in preferred stock with 5-4 dividend.
The company’s existing earnings before interest and taxes (EBIT) amounted to Rs. 12,00,000, corporation tax is assumed to be 50%
Thus, when EBIT is Rs. 1,20,000 proposal B involving a total capitalisation of 75% common stock and 25% debt, would be the most favourable with respect to earnings per share. It may further be noted that proportion of common stock in total capitalisation is the same in both the proposals B and D but EPS is altogether different because of induction of preferred stock.
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