Question

Trading on equity is double edged sword.

Answer 1

This statement is 'True' because of the following reasons :
(i) The use of borrowed capital for financing a firm is known as Trading on equity.
(ii) If the rate of interest on debt is lower then the rate of earning of the company, the shareholders will get extra dividend out of additional profit.
(iii) Higher the rate of dividend to shareholders, better the goodwill of the company.
(iv)It increases the market value of shares.
(v) Which helps to raise further loan at lower rate of interest.
(vi) If the earnings of the company are insufficient to pay even interest on the debts, there are financial crisis.
(vii) So in case of losses also interest has to be paid.
(viii) Thus no dividend has to be declared to share holders.
(ix) It affects the goodwill and creditworthiness of the company adversely.
(x) company will not be able to raise further loans.
(xi) So it may increase income of the shareholders, if things go right and may increase the risk of loss in adverse conditions. So trading on equity is double edged sword.