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Question
Explain the term ‘Trading on Equity’? Why, when and how it can be used by company.
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Solution
Trading on equity refers to a practice of raising the proportion of debt in the capital structure such that the earnings per share increases. A company resorts to Trading on Equity when the rate of return on investment is greater than the rate of interest on the borrowed fund. That is, the company resorts to Trading on Equity in situation of favourable financial leverage. As the difference between the return on investment and the rate of interest on debt increases, the earnings per share increase.
The use of Trading on Equity is explained in detail with the help of the following example.
Suppose there are two situations for a company. In situation I it raises a fund of Rs 5,00,000 through equity capital and in situation II, it raises the same amount through two sources- Rs 2,00,000 through equity capital and the remaining Rs3,00,000 through borrowings.
Also suppose the tax rate is 30% and the interest on borrowings is 10%. The earnings per share (EPS) in the two situations is calculated as follows.
|
|
Situation I |
Situation II |
|
Earnings before interest and tax (EBIT) |
1,00,000 |
1,00,000 |
|
Interest |
|
30,000 |
|
Earnings Before Tax (EBT) |
1,00,000 |
70,000 |
|
Tax |
30,000 |
21,000 |
|
Earnings After Tax (EAT) |
70,000 |
79,000 |
|
No. Of equity shares |
50,000 |
20,000 |
| `"EPS"="EAT"/"Number of equity shares"` | `70000/50000=1.4` | `79000/20000=3.95` |
Clearly, in the second situation the EPS is greater than in the first situation. In the second situation the company takes advantage of the Trading on Equity and raises the EPS. Here, the return on investment calculated as `("Earnings Before Tax (EBT)"/"Total Investment"=100000/500000)` is 20% while the interest on the borrowings is 10%. Thus, the Trading on Equity is profitable.
However, it should be noted that Trading on Equity is profitable and should be used only when the return on investment is greater than the interest on borrowed funds. In case the return on investment is less than the rate of interest to be paid, the Trading on Equity should be avoided.
Suppose instead of Rs 1,00,000 the company earns just Rs 25,000. In such a case the EPS are calculated as follows.
|
|
Situation I |
Situation II |
|
Earnings before interest and tax (EBIT) |
40,000 |
40,000 |
|
Interest |
|
10,000 |
|
Earnings Before Tax (EBT) |
25,000 |
10,000 |
|
Tax |
30,000 |
3,000 |
|
Earnings After Tax (EAT) |
70,000 |
7,000 |
|
No. Of equity shares |
50,000 |
20,000 |
| `"EPS"="EAT"/"Number of equity shares"` | `70000/50000=1.4` | `7000/20000=0.35` |
Clearly in this case, the EPS in Situation II falls. Here the return on investment is only 8% `("Earnings Before Tax (EBT)"/"Total Investment"=40000/500000)` while the interest on the borrowings is 10%. Thus, in this situation the Trading on Equity is not favourable and should be discouraged.
Hence, it can be said that a firm can use Trading on Equity if it is earning high profits and can increase the EPS by raising more funds through borrowings.
RELATED QUESTIONS
Viyo Ltd.' is a company manufacturing textiles. It has a share capital of Rs 60 lakhs. The earnings per share in the previous year was Rs 0.50. For diversification, the company requires additional capital of Rs 40 lakhs. The company raised funds by issuing 10% debentures for the same. During the current year the company earned profit of Rs 8 lakhs on capital employed. It paid tax @ 40%.
a. State whether the shareholders gained or lost, in respect of earning per share on diversification. Show you calculations clearly.
b. Also, state any three factors that favour the issue of debentures by the company as part of its capital structure.
Explain briefly any four factors which affect the choice of capital structure of a company.
What is meant by Trading on Equity?
How do ‘Floatation costs’ affect the choice of capital structure of a company? State
Explain the following as factors affecting the choice of capital structure:
Cost of equity
Explain the following as factors affecting the choice of capital structure:
Risk Consideration
Explain the following as factors affecting the choice of capital structure:
Control
Explain any four factors that affect the choice of capital structure of a company.
Write notes on Capital structure and its components.
What is meant by capital structure?
Sunrises Ltd. dealing in readymade garments, is planning to expand its business operations in order to cater to international market. For this purpose the company needs additional Rs. 80,00,000 for replacing machines with modern machinery of higher production capacity. The company wishes to raise the required funds by issuing debentures. The debt can be issued at an estimated cost of 10%. The EBIT for the previous year of the company was Rs. 8,00,000 and total capital investment was Rs. 1,00,00,000. Suggest whether issue of debenture would be considered a rational decision by the company. Give reason to justify your answer. (Ans. No, Cost of Debt (10%) is more than ROI which is 8%).
“Capital structure decision is essentially optimisation of risk-return relationship.” Comment.
Answer the following question.
'Determining the overall cost of capital and the financial risk of the enterprise depends upon various factors.' Explain any six such factors.
Read the following text and answer the following questions on the basis of the same:
Mr. A. Bose is running a successful business. Mr. Bose is the owner of R. K. Cement Ltd. Mr. Bose decided to expand his business by acquiring a Steel Factory. This required an investment of Rs. 60 crores. To seek advice in this matter, he called his financial advisor Mr. T. Ghosh who advised him about the judicious mix of equity (40%) and Debt (60%). Employ more of cheaper debt may enhance the EPS. Mr. Ghosh also suggested him to take loan from a financial institution as the cost of raising funds from financial institutions is low. Though this will increase the financial risk but will also raise the return to equity shareholders. He also apprised him that issue of debt will not dilute the control of equity shareholders. At the same time, the interest on loan is a tax deductible expense for computation of tax liability. After due deliberations with Mr. Ghosh, Mr. Bose decided to raise funds from a financial institution.
“Mr. T. Ghosh who advised him about the judicious mix of equity (40%) and Debt (60%)”
The proportion of debt in the overall capital is called _______.
ICR = ______
Assertion (1): Higher the flotation cost, less attractive the source.
Reason (R): The choice between the payment of dividend and retaining the earnings is, to some extent, affected by the difference in the tax treatment of dividends and capital gains.
Krish limited is in the business of manufacturing and exporting carpets and other home decor products. It has a share capital of ₹ 70 lacs at the face value of ₹ 100 each. Company is considering a major expansion of its production facilities and wants to raise ₹ 50 lacs. The finance manager of the company Mr. Prabhakar has recommended that the company can raise funds of the same amount by issuing 7% debentures. Given that earning per share of the company after expansion is ₹ 35 and tax rate is 30%, did Mr. Prabhakar give a justified recommendation?
Show the working.
The Board of directors of Medex Pharma Ltd. decided to issue debentures worth ₹ 40 lakhs in order to finance a major Research and Development project. This would increase the Debt Equity ratio from 1:1 to 2:1.However, at the same time it would increase the Earnings per share.
The reason that will justify the above situation is ______.
