Question

How are shareholders likely to gain with loan component in capital employed?

Explain with suitable example?

Answer 1

With a debt component in the total capital, shareholders are likely to have the benefit of a higher rate of return on the share capital. This is because debt/loan carries a fixed charge and the amount of interest paid is deductible from the earnings before tax payment. The benefit to the shareholders will be realised only if the average rate of return on total capital invested is more than the rate of interest payable on loan/debt.

For example, Trading on equity refers to the use of fixed cost sources of finance such as debentures and

preference share capital in the capital structure so as to increase the return on equity shares. There

are two conditions to use trading on equity:

(i) The rate of interest on loan/debentures should be less than the rate of Return on Investment.

(ii) The interest should be deducted from profit before tax.

For example, Let us consider two public companies X Ltd and Y Ltd.

Y ltd have 35lacs as equity shares and 15 lacs as 12% debentures hence int on debentures= 12% of 15 lacs

	rupees(X)	rupees (Y)
Capital	5000000	5000000
Ebit	1000000	100000
less intrest		180000
less tax@50%	500000	410000
earning after tax	500000	410000

Therefore earning per share= earning after tax / no. of shareholders

For X ltd. 500000/500000 = re 1

For Y ltd 410000/350000 = re 1.17

Thus, it can be concluded that Y Ltd using fixed cost sources, i.e. debentures, earn a relatively high rate of return on equity capital.