Question

How does "Trading on Equity" affect the choice of capital structure of a company? Explain with the help of a suitable example.

Answer 1

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.