Question 2 (a)
Trading on equity and EPS
6 marks
- Time to write
- About 12 minutes
Question
Question 2 (a) · 6 marks“Trading on equity is resorted to so as to decrease EPS.” Comment on this statement.
Reworded from the university paper; the task is the same. The original paper belongs to the University of Delhi. See DU's question bank.
Before you write
Read off the question and its marks
Read from the question
- CommentA statement to judge: take a stand on it in your first line, and come back to it at the end.
Write it in this order
- Read; underline the asks; jot your points 1 min
- 1 The statement identified as incorrect: the aim is to increase EPS 1 mark 2 min
- 2 Meaning of trading on equity fixed-cost funds with equity 1 mark 1 min
- 3 How it raises EPS when the return exceeds the cost of funds; tax advantage of debt 2 marks 4 min
- 4 When it lowers EPS (unfavourable leverage) and the conclusion 2 marks 3 min
- Check: every ask answered, key terms underlined 1 min
Easy marks
- Meaning of trading on equity (step 2, 1 mark): a definition in one or two lines. A minute or two.
Short on time? Keep step 2 short. Trim steps 3 and 4 evenly rather than skip one: each is capped at its own marks.
Try it first. About 12 minutes for 6 marks. Write it out, then open the solution.
Solution
Hover or tap a marked figure, like 72,000, to see how it is made and where else it appears.
The statement is not correct. Trading on equity is resorted to in order to increase earnings per share, not to decrease it.
1The baker signs for the bank's money at a fixed interest.
Financial leverageThe use of fixed-charge funds (debt, preference shares) in the capital structure.
2The ovens run full, the queue is long—the loan earns more than it costs, and the owner's share swells.
FavourableThe fixed-charge funds earn more than they cost, so EPS rises.
3The same counter empty: the interest envelope still goes out, from a thinner cash box.
UnfavourableWhen ROI is below the cost of debt: EPS falls.
Meaning. Trading on equity, or financial leverage, is the use of long-term funds carrying a fixed charge (debt and preference share capital) alongside equity share capital. The equity shareholders "trade" on the fixed-cost funds of others.
Why it raises EPS. If the firm earns a return on its investment higher than the fixed cost of these funds, the surplus belongs to the equity shareholders, whose number has not increased; so earnings per share rise. That is why the DU text advises that when the return on investment exceeds the fixed cost of funds, the firm should prefer fixed-cost funds such as debentures, loans and preference capital: doing so increases earnings per share and the market value of the firm. Debt has the stronger effect, because interest is deducted in computing tax, while preference dividend is not.
When it lowers EPS. Leverage can also work adversely. If the rate of interest on the borrowed funds is higher than the rate the firm earns, the fixed charge eats into the equity shareholders' earnings and EPS falls. A fall in EPS is therefore the risk of trading on equity, not its purpose. That is why the use of debt calls for caution in planning the capital structure.
Conclusion. Firms trade on equity to magnify EPS when they expect to earn more than the cost of debt. The statement reverses this: a decrease in EPS is what happens when leverage turns unfavourable, which a firm seeks to avoid.
Where the 6 marks sit
| # | Component | Marks |
|---|---|---|
| 1 | The statement identified as incorrect: the aim is to increase EPS | 1 |
| 2 | Meaning of trading on equity (fixed-cost funds with equity) | 1 |
| 3 | How it raises EPS when the return exceeds the cost of funds; tax advantage of debt | 2 |
| 4 | When it lowers EPS (unfavourable leverage) and the conclusion | 2 |
| Total | 6 |
Report a problemopens an email to admin@getkunji.com with the question ID1403-Q2aalready filled in.