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Trading on Equity

Introduction
• Entire capital won’t be raised by issuing Equity
Share Capital.
• External sources of funds may be used.
• Its proportion ranges from 40 to 70 percent.
• It’s found profitable if such funds raised at a lower
rate of interest.
• Dividend can be paid at higher rate on equity
shares, is known as “Trading on Equity”.
Meaning of Trading on Equity
• When a co. uses fixed interest bearing capital
along with owned capital in raising finance, is
said “Trading on Equity”. (Owned Capital =
Equity Share Capital + Free Reserves )

• Trading on equity represents an arrangement


under which a company uses funds carrying
fixed interest or dividend in such a way as to
increase the rate of return on equity shares.
Contd.
• It is possible to raise the rate of dividend on
equity capital only when the rate of interest on
fixed – interest – bearing – security is less than
the rate of return earned in business.
• Two other terms:
• Trading on Thick Equity :- When borrowed
capital is less than owned capital
• Trading on Thin Equity :- When borrowed
capital is more than owned capital, it is called
Trading on Equity.
Definition
• Gerstenberg: “ When a person or a
corporation uses borrowed capital as well
as owned capital in the regular conduct of
its business, he or she is said to be
Trading on equity.”

• Guthmann and Dougall: “The use of


borrowed funds or preferred stock for
financing, is known as trading on equity”
Contd.

• Hastings: “The degree to which debt


is used in acquiring assets is called
Trading on Equity.”
Conditions of success
• The rate of interest on borrowed capital must be
lower than the rate of earnings on owned capital.
• If the capital can be borrowed only on the
security of assets, assets of the company will
gradually be reduced with every increase in
borrowed capital. Trading on equity will weaken
the borrowing capacity of the company.
Contd.

• Trading on Equity can be used only


when company’s earnings are stable
and certain .
Limitations
• When the rate of interest on borrowed capital
is less than the rate of return being earned by
the company.

• It will reduce the borrowing capacity of the co.


as assets are required to place as security.

• Income is more or less fixed are able to bear


the burden of fixed interest charge.
Contd.
• Low proportion of Fixed Assets, have
limited scope of trading on equity.

• Legal restrictions on the amount to be


borrowed. e.g. it can be borrowed up to
the total amount of paid up share
capital and free reserves only.
Contd.
• The Declining trend of profitability of business
also limits the use of trading on equity.

• Attitude of management restricts the use of


trading on equity.

• The nature of company’s business may also


restrict the use of trading on equity.
Useful Suggestions
• The rate of dividend on equity share is
calculated.:
• Rate of Dividend = Distributable Profit*100
Equity Share Capital
• If the rate of dividend is not given assumed @
50%
• Adjustment regarding transfer to General Reserve
will be given.

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