Question

How do loan components or debentures in the capital structure act as factor to raise the return on equity share capital?

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 carry 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.