Question 3 OR (a)
Trading on equity
8 marks
- Time to write
- About 16 minutes
From an older CBCS paper
Question
Question 3 OR (a) · 8 marksDiscuss in detail the concept of trading on equity.
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
- DiscussEach point named and explained, not just listed.
Write it in this order
- Read; underline the asks; jot your points 1 min
- 1 Meaning 1½ marks 1 min
- 2 How it works: favourable and unfavourable leverage 2 marks 4 min
- 3 Illustration 2½ marks 5 min
- 4 When to use it and its limits 2 marks 4 min
- Check: every ask answered, key terms underlined 1 min
Easy marks
- Meaning (step 1, 1½ marks): a clear definition and a line on what it covers. It opens the answer, so it takes a minute or two.
Short on time? Keep step 1 short. Trim steps 2–4 evenly rather than skip one: each is capped at its own marks.
Try it first. About 16 minutes for 8 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.
Meaning. Financial leverage, or trading on equity, means financing part of the firm's assets with funds that carry a fixed charge (long-term debt at a fixed rate of interest, and preference shares at a fixed rate of dividend) alongside the equity shareholders' funds. The firm "trades" on its equity: the owners' capital serves as the base on which borrowed funds are raised, and the fixed-cost funds are employed to earn more than their cost, so as to increase the return on the owners' equity.
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.
How it works. The capital structure cannot change the firm's total earnings, but it changes the share of them that goes to equity shareholders. If the return on total investment exceeds the fixed cost of debt, the surplus accrues to the equity holders and EPS rises; if it falls below the cost of debt, the leverage works adversely and EPS falls. Debt has the further advantage that interest is tax-deductible.
Illustration (figures supplied by the answer). A firm with ₹10,00,000 of equity (₹100 shares) needs ₹5,00,000 more; tax 30%. It can issue 5,000 shares or borrow at 10%.
| Particulars (₹) | EBIT 3,00,000: equity | EBIT 3,00,000: debt | EBIT 1,00,000: equity | EBIT 1,00,000: debt |
|---|---|---|---|---|
| EBIT | 3,00,000 | 3,00,000 | 1,00,000 | 1,00,000 |
| Less: interest @ 10% | — | 50,000 | — | 50,000 |
| EBT | 3,00,000 | 2,50,000 | 1,00,000 | 50,000 |
| Less: tax @ 30% | 90,000 | 75,000 | 30,000 | 15,000 |
| PAT | 2,10,000 | 1,75,000 | 70,000 | 35,000 |
| Number of shares | 15,000 | 10,000 | 15,000 | 10,000 |
| EPS | 14.00 | 17.50 | 4.67 | 3.50 |
At EBIT of ₹3,00,000 the return on investment is 20%, above the 10% cost of debt: borrowing raises EPS from ₹14 to ₹17.50 (favourable trading on equity). At ₹1,00,000 the return is 6.67%, below 10%: borrowing cuts EPS from ₹4.67 to ₹3.50 (unfavourable). Leverage is a double-edged sword.
When to trade on equity. It is suitable when earnings are stable and expected to exceed the cost of debt comfortably, the firm has assets to offer as security, and the tax rate is high. It is risky for firms with fluctuating earnings, since fixed interest must be paid even in bad years and excessive debt raises financial risk, the cost of further debt and the cost of equity.
Limits. Beyond a point the rising financial risk lowers the market value of the shares; lenders impose restrictive conditions; and the firm's flexibility to borrow in future is reduced.
Where the 8 marks sit
| # | Component | Marks |
|---|---|---|
| 1 | Meaning | 1.5 |
| 2 | How it works: favourable and unfavourable leverage | 2 |
| 3 | Illustration | 2.5 |
| 4 | When to use it and its limits | 2 |
| Total | 8 |
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