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.
Explanation of Trading on Equity with an Example:
Let us take two situations:
First Situation
Company has issued share capital of ₹2, 00,000 composed of 2000, Equity Shares of ₹100/- each
Rate of Return is 15%,
Rate of Income Tax is 50%,
Profit Before Tax (PBT) comes ₹30,000 (15% on ₹2,00,000)
Profit After Tax comes (PAT) to be ₹15,000 (50% of ₹30,000)
It gives Earning per share (EPS) equal to 15,000/2,000 i.e.₹7/50 (Profit after Tax/ No. of Equity Shares)
Second Situation
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.
If Rate of Return is 15%, and Rate of Income tax is 50% (Same as in Situation 1 above)
Profit Before Interest and Tax (PBIT) comes ₹30,000.
Profit After Interest comes to be ₹30,000 - ₹8000=₹22,000 (Interest is 8% on Debentures)
Profit After Tax (PAT) comes to be ₹11,000.
It gives 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.
Shareholders have the benefit of increase in EPS by ₹3/50 .