question_answer 24)

Explain the term 'trading on equity'. Why, when and how it can used by a business organization?

Answer:

Trading on equity refers to the increase in profit earned by the equity shareholders due to presence of fixed financial charges. When the rate of earning or Return on Investment (ROI) of a company is higher than the rate of interest on borrowed funds only then a company should opt for trading on equity. Let us consider the following example  

	Company ‘X’	Company ‘Y’
Share Capital	Rs. 10 lakhs	Rs. 04.00 lakhs
Loan @ 15% pa.a	-	Rs. 06.00 lakhs
	Rs. 10 lakhs	Rs. 10.00 lakhs
Profit before interest + Tax	Rs. 3 lakhs	Rs. 03.00 lakhs
Interest	Nil	Rs. 00.09 lakhs
Profit before tax	Rs. 3 lakhs	Rs. 02.01 lakhs
Tax @ 50%	Rs. 1.5 lakhs	Rs. 1.05 lakhs
Profit after tax	Rs. 1.5 lakhs	Rs. 1.05 lakhs
Share capital	Rs. 10 lakhs	Rs. 4.00 lakhs
Rate of return on share	15%	26.25%

  It should be clear from the above example, that shareholders of the company 'X' have a higher rate of return than company 'Y' due to loan component in the total capital of the company.