Meaning of Trading on Equity
Trading on Equity 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.
Conditions to be present for Trading on Equity:
Two conditions must be present to take the benefit of Trading on Equity:
- Presence of Fixed Cost bearing securities in the capital.
- 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:
Company has issued share capital of ₹ 2, 00,000 composed of 2000, Equity shares of ₹ 100/- each. If Rate of return is 15%, and rate of Income tax is 50%, The profit before tax comes ₹30,000 and profit after tax comes to be ₹ 15,000.It gives Earning per share equal to 15,000/2,000 i.e.₹7/50 .
Company issued ₹1,00,000 share capital in terms of 1,000,Equity shares of ₹100/- each and ₹1,00,000,in terms of1,000, 8% Debentures of ₹100/- each making the total capital of ₹ 2,00,000. If Rate of return is 15%, and rate of Income tax is 50%,The profit before interest and tax comes to be same ₹30,000.Profit after interest comes to be ₹30,000-₹8000=₹22,000.Profit after tax comes to be ₹11,000.In this case Earning per share equals to 11,000/1,000 i.e.₹11/-
This increase in Earnings per share (EPS) from ₹7/50 to ₹ 11/- is the result of Trading on Equity.