Trading on Equity:

Meaning: It refers to the use of fixed cost bearing securities by the company along with share capital in the total capital, so as to provide increase in net gain to the shareholders.

Trading on Equity is also called Financial Leverage.

It is called Financial Leverage as Debt is used to raise the net gain or return to the shareholders.

Another term used for the same is Capital Gearing. 

 

Trading on Equity - Two Conditions to Apply:

Two conditions must be present to take the benefit of Trading on Equity:

  1. Presence of Fixed Cost bearing securities in the capital.
  2. The Rate of Return on capital must be more than the Rate of Interest on such fixed cost bearing securities.

 

Let us take two situations:

Situation I

Information Given:

Company has issued share capital of ₹2, 00,000 composed of 2000, Equity Shares of ₹100/- each

Rate of Return: 15%

Rate of Income Tax: 50%

We can calculate:

Profit Before Tax (PBT) --> (15% on ₹2,00,000) = ₹30,000

Profit After Tax comes (PAT) --> (₹30,000 - 50% of ₹30,000) = ₹15,000

It gives Earning per share (EPS) = Profit After Tax/ No. of Equity Shares = 15,000/2,000 = ₹ 7/50

 

Situation II

Information Given:

Company issued 1,000, Equity shares of ₹100/- each and 1,000, 8% Debentures of ₹100/- each making the total capital of ₹2,00,000.

Rate of Return is 15%, and Rate of Income tax is 50% (Same as in Situation 1 above)

Trading on Equity Class 12

We can calculate:

Profit Before Interest and Tax (PBIT) comes ₹30,000.

Profit After Interest = ₹30,000 - ₹8000=₹22,000 (Interest is 8% on Debentures)

Profit After Tax (PAT) = ₹11,000.

Earning per share equals to 11,000/1,000 = ₹11/-

 

This increase in Earnings per share (EPS) from ₹7/50 to ₹11/- is the result of Trading on Equity.

Shareholders have the benefit of increase in EPS by ₹3/50.

 

Company can use Debt upto a point of increasing EPS. At the same time, the Financial Position of the company must be checked. It should not be so risky in the greed of increasing EPS.

 

Trading on Equity - Practical Problems

You will get numerical questions on Capital Structure and Trading on Equity. Whatever may be the question, it will be based on the above explanation in both situations. Sequence of steps mentioned in Situation II should be followed. So, understand it thoroughly.

 

Practical Problems on Trading on Equity Class 12

Financial Management – Keywords and Brief Notes

Mind Maps for Business Studies

 

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