Practical Problems on Trading on Equity Class 12
Question: 1
Higher Debt Equity Ratio results in:
(a) Higer degree of operating risk
(b) Higer degree of financial risk
(c) Lower Degree of financial risk
(d) Higher earning
Answer: (b) Higer degree of financial risk
Question: 2
A person buys 600 shares of Trustworthy Industries at a price of ₹ 2200 per share. After a year the market price of the share is ₹ 2,600. How much wealth this shareholder will have in the company?
(a) ₹15,00,000
(b) ₹13,20,000
(c) ₹12,00,000
(d) ₹15,60,000
Answer: (d) ₹15,60,000
Question: 3
Financial leverage is called favourable if:
(a) Debt is more than the share capital
(b) Return on investment is higher than the cost of debt
(c) Return on investment is less than the cost of debt
(d) Return on investment is the same as that of cost of debt.
Answer: (b) Return on investment is higher than the cost of debt
Question: 4
Keerti Ltd. has Debt Equity ratio of 2:1 whereas Paali Ltd. has Debt Equity ratio of 1:1. Name the advantage Keerti Ltd will have over Paali Ltd, when their ROI is more than the Cost of Debt.
(a) Trading on equity
(b) Low risk
(c) Low cost of equity
(d) Greater flexibility.
Answer: (a) Trading on Equity
Question: 5
Moonlight Ltd., dealing in fancy lights, is planning to expand its business operations and decides to set up one more production unit at Ludhiana. For this purpose, the company needs additional funds ₹60,00,000. The company wishes to raise the required funds by issuing Debentures. The debt can be issued at an estimated cost of 12%. The EBIT for the previous year of the company was ₹ 10,00,000, and the total capital investment was ₹ 1,00,00,000.
As a Financial Manager, suggest whether the company should go for issuing Debentures. Give reasons to justify your answer.
Answer: ROI = EBIT/Total Capital = (10,00,000/1,00,00,000) = 10%
Cost of Debt > Return on Investment (COD > ROI)
No, the Cost of Debt 12% is more than ROI which is 10%.
Company should issue Debentures only when Cost of Debt is lower than Return on Investment. If company issues Debentures in the present situation, Earning Per Share (EPS) will decrease, ultimately going against the shareholders of the company.
Practical Problems on Trading on Equity Class 12
Question (Case Based): 6
Read the following and answer the questions that follow:
Moonlight Ltd., dealing in Sports Equipment, is planning to expand its business operations and decides to set up one more plant at Jallandhar. For this purpose, the company needs additional funds ₹70,00,000. The company wishes to raise the required funds by Equity Shares. But the debt can be issued at an estimated cost of 9%. The EBIT for the previous year of the company was ₹ 12,00,000, and the total capital investment was ₹1,00,00,000. The financial manager of the company would normally opt for a source which is the cheapest.
Choose the correct option in the following parts:
Part 1: What is the other name of long-term decisions in this case?
(a) Capital Budgeting
(c) Financial management
(b) Gross working capital
(d) Working Capital
Part 2: A decision to set up one more plant:
(a) Financing decision
(c) Investment decision
(b) Working capital decision
(d) None of the above
Part 3: A decision for raising fund of ₹ 70,00,000 either from 9% Debentures or Equity Shares is a:
(a) Financing decision
(c) Investment decision
(b) Dividend decision
(d) None of the above
Part 4: The financing decisions are affected by various factors. Which one of the following factor is discussed in the above case?
(a) Cash Flow Position of the Company
(b) Amount of Earnings
(c) Cost
(d) Taxation Policy
Answers:
Part 1: (a) Capital Budgeting
Part 2: (c) Investment decision
Part 3: (a) Financing decision
Part 4: (c) Cost
Question: 7
The Return on Investment (Rol) of a company ranges between 10% to 12% for the past three years. To finance its future fixed capital needs, it has the following options for borrowing debt.
Option ‘A’: Rate of interest 13%
Option ‘B’: Rate of interest 9%
(a) Which source of debt, ‘Option A’ or ‘Option B’, is better? Give reason in support of your answer. (b) State the concept being used in taking the decision.
Answer:
(a) The company should use ‘Option B’ as in this case the Return on Investment (10 - 12%) will be more than the Cost of Debt (9%).
(b) The concept being used in the above case is ‘Trading on Equity’.
Question: 8
A company raised funds by raising debt @12% for ₹15 lakhs. Rate of income tax is 40%. It’s ROI is 15%.
(a) Calculate effective Cost of Debt.
(b) Is company’s Capital Structure bringing gains to its shareholders?
Answer: (a) Effective cost of debt = 7.2% [ Saving of 40% Tax on Interest 12%]
= 12% - 40% of 12% = 12% - 4.8% = 7.2%
(b) Yes, Capital Structure is good and resulting net gain to the shareholders as ROI is more than its Cost of Debt.
Question: 9
Teenu Ltd. has equity share capital of ₹10,00,000 (Face Value ₹10 each). Its earnings before Interest and Taxes are ₹1,50,000. The company needs ₹5,00,000 for Research and Development Project. The prevailing Tax rate is 30%. It has decided to go for Debt which is available in the market @ 9% p.a. Should the company proceed with its plan? Give reasons.
Answer: The company should go for Debt financing as company’s ROI is 1,50,000/10,00,000 = 15%, which is more than the Cost of Debt i.e. Rate of Interest which is 9% only. This will give net gain to the shareholders i.e. increase of Earning per share (EPS).
Question: 10
Beebo Ltd. is a company manufacturing traditional carpets. It has a share capital of ₹60 lakh, the face value of share being ₹10 each. The earning per share in the previous year was ₹0.50. For increasing its exports, it needs to pump in more funds for additional machinery of ₹40 lakh. The company raised funds by issuing 10% Debentures for the same. During the current year the company earned a profit of ₹8 lakh on capital employed. It paid tax 40%.
State whether the shareholders gained or lost, in respect of earning per share, as a result of extended business operations for increasing exports. Show your working clearly.
Answer: EBIT = ₹8,00,000
Less Interest = 10% on ₹40,00,000 = 4,00,000
Earnings before Tax = 8,00,000 – 4,00,000 = 4,00,000
Less Tax = 40% of 4,00,000 = 1,60,000
Earning After Tax = 4,00,000 – 1,60,000 = 2,40,000
Earning Per Share = (2,40,000/6,00,000) = ₹0.40 per share.
Thus, the shareholders have lost wealth as earning per share (EPS) has decreased from ₹0.50 to ₹0.40 i.e. by ₹0.10.
Practical Problems on Trading on Equity Class 12
Question: 11
Ganga Ltd. is a manufacturer of steel utensils at S.A.S.Nagar. The company wants to set up a new plant at Chandigarh also. The company will require ₹600 crore to set up the new plant. The company decides to issue Equity Shares for ₹170 crores (of ₹100 each), issue 9% Debentures for ₹230 crore (of ₹1,000 each), arrange long term Loans from banks for ₹80 crores, attract Public Deposits for ₹50 Crores and utilise reserves and surpluses for the remaining amount (available).
(a) What is the capital structure of this company? Explain.
(b) Identify the financial decision when the company decides to raise ₹600 crores from different long-term sources.
Answer: Capital structure consists of owners' funds and borrowed funds i.e. Debt and Equity.
It is = Debt/Equity
In this case the Debt = Debenture + Long term loans + Public Deposits
=230 + 80 + 50 = 360 crores
Equity = Equity Share Capital + Reserves and Surplus
= 170 + 70 = 240 Crores
So, Debt/Equity = 360/240 = 1.5:1
Question: 12
Moonlight Ltd., dealing in Sports Equipment, is planning to expand its business operations and decides to set up one more plant at Jallandhar. For this purpose, the company needs additional funds ₹ 70,00,000. The company wishes to raise the required funds by Equity Shares. But the debt can be issued at an estimated cost of 9%. The EBIT for the previous year of the company was ₹12,00,000, and the total capital investment was ₹ 1,00,00,000. The financial manager of the company however is advising to opt for a source which is the cheapest.
Analyse this situation and clear the position of Finance Manager. Is he right in suggesting that particular source of funds? Elaborate your answer.
Answer: ROI = EBIT/Total Capital = (12,00,000/1,00,00,000) = 12%
Cost of Debt < Return on Investment (COD < ROI)
Cost of Debt 9% is less than ROI which is 12%.
Company should issue Debentures when Cost of Debt is lower than Return on Investment.
If company issues Debentures in the present situation, Earning Per Share (EPS) will increase, ultimately going against the shareholders of the company.
Financial Manager is absolutely right in giving his advice of issuing the cheapest source i.e. 9% Debentures in this case.
Question: 13
PT Garments Ltd. wants to raise funds of ₹ 50,00,000 for its new project. The management is considering the following alternate mix of Debt and Equity to raise this amount:
Capital Structure Situation I (₹) Situation II (₹) Situation III (₹)
Equity 50,00,000 20,00,000 30,00,000
Debt Nil 30,00,000 20,00,000
Other details are as follows:
Interest Rate on Debt: 9%
Face Value of Equity Shares: ₹100 each
Tax Rate: 40%
Earning Before Interest and Tax (EBIT): ₹ 12,00,000
Under which of the three situations will the company be able to take advantage of Trading on Equity?
Answer: First of all, EPS will be calculated in all the situations:
Situation I
EBIT = ₹ 12,00,000
Tax = 40% on 12,00,000 = 4,80,000
Earning After Tax = 12,00,000 – 4,80,000 = 7,20,000
EPS = 7,20,000/50,000 = ₹ 14/40
Situation II
EBIT = ₹ 12,00,000
Interest = 9% on 30,00,000 = 2,70,000
Earning after Interest = 12,00,000 – 2,70,000 = 9,30,000
Tax = 40% on 9,30,000 = 3,72,000
Earning After Tax = 9,30,000 – 3,72,000 = 5,58,000
EPS = 5,58,000/20,000 = ₹ 27/90
Situation III
EBIT = ₹12,00,000
Interest = 9% on 20,00,000 = 1,80,000
Earning after Interest = 12,00,000 – 1,80,000 = 10,20,000
Tax = 40% on 10,20,000 = 4,08,000
Earning After Tax = 10,20,000 – 4,08,000 = 6,12,000
EPS = 6,12,000/30,000 = ₹ 20/40
The company can take advantage of Trading on Equity in situation II as EPS is more in this case than situation III. (and highest in all situations taken together. i.e. ₹27/90).
Practical Problems on Trading on Equity Class 12
Question: 14
BTS Garments Ltd. wants to raise funds of ₹ 50,00,000 for its new project. The management is considering the following alternate mix of Debt and Equity to raise this amount:
Capital Structure Situation I (₹) II (₹) III (₹)
Equity 20,00,000 30,00,000 10,00,000
Debt 30,00,000 20,00,000 40,00,000
Other details are as follows:
Interest Rate on Debt: 9%
Face Value of Equity Shares: ₹ 100 each
Tax Rate: 40%
Earning Before Interest and Tax (EBIT) : ₹12,00,000
As a Financial Manager, which situation is the Optimum Capital Structure to be suggested to the company? Justify your answer with reasons.
Answer: First of all, EPS will be calculated in all the situations:
Situation I
EBIT = ₹12,00,000
Interest = 9% on 30,00,000 = 2,70,000
Earning after Interest = 12,00,000 – 2,70,000 = 9,30,000
Tax = 40% on 9,30,000 = 3,72,000
Earning After Tax = 9,30,000 – 3,72,000 = 5,58,000
EPS = 5,58,000/20,000 = ₹ 27/90
Situation II
EBIT = ₹12,00,000
Interest = 9% on 20,00,000 = 1,80,000
Earning after Interest = 12,00,000 – 1,80,000 = 10,20,000
Tax = 40% on 10,20,000 = 4,08,000
Earning After Tax = 10,20,000 – 4,08,000 = 6,12,000
EPS = 6,12,000/30,000 = ₹ 20/40
Situation III
EBIT = ₹12,00,000
Interest = 9% on 40,00,000 = 3,60,000
Earning after Interest = 12,00,000 – 3,60,000 = 8,40,000
Tax = 40% on 8,40,000 = 3,36,000
Earning After Tax = 8,40,000 – 3,36,000 = 5,04,000
EPS = 5,04,000/10,000 = ₹ 50/40
Conclusion for answer:
The company can take advantage of Trading on Equity in situation I as EPS is ₹ 27/90 which is more in this case than situation II.
Though the highest EPS in all situations taken together is in situation III i.e. ₹ 50/40, this Capital Mix is not advisable, as the position of the company will be too risky. Debt Equity Ratio is also 4:1 which in this case is more than 2:1
Before doing Practical Problems on Trading on Equity, students must understand this concept well.