Friday, February 7, 2025

Financial Management: Trading on Equity and Return on Investment


Introduction

Welcome back to Bache Bhat Parishanasa, where we dive into the world of financial management. In this blog, we will explore the concepts of trading on equity and return on investment. These numerical calculations may seem daunting at first, but fear not! We will break them down step by step, ensuring that you grasp the concepts easily. So, let’s get started!

Understanding Return on Investment (ROI)

Return on Investment is a crucial concept in financial management. It measures the profitability of an investment relative to its cost. The formula to calculate ROI is as follows:

Return on Investment (ROI) = (Profit before Interest and Tax / Capital) x 100

Now, let’s break down the components of this formula:

  • Profit before Interest and Tax: This is the amount of profit generated by a company before deducting interest and tax expenses.
  • Capital: The capital employed by the company to generate the profit.

Trading on Equity

Trading on equity refers to the practice of using debt to finance a company’s expansion or investment activities. By taking on debt, the company aims to benefit from the favorable difference between the return on investment (ROI) and the cost of debt (interest rate).

In order to take advantage of trading on equity, two conditions need to be met:

  1. The ROI should be greater than the rate of interest.
  2. The interest on debt should be tax deductible.

Numerical Example: Well Being Limited

Let’s apply these concepts to a real-life example. Consider Well Being Limited, a company engaged in the production of organic foods. The company is planning to start an online portal to sell its products due to a sudden surge in demand. To finance this expansion, they are considering raising a debt capital of ₹40 lakhs through a loan with a 10% interest rate.

Calculation of Return on Investment (ROI)

The company’s current capital base consists of 1.2 crore equity shares valued at ₹10 each. The profit before interest and tax for the current year is ₹8 lakhs. Let’s calculate the ROI:

ROI = (Profit before Interest and Tax / Capital) x 100

Substituting the values:

ROI = (₹8 lakhs / ₹1.2 crore) x 100

Calculating the ROI:

ROI = 0.67%

As the ROI is lower than the rate of interest (10%), the company might not be able to take full advantage of trading on equity.

Effect of Debt on Earnings per Share (EPS)

Let’s analyze the impact of the debt on the earnings per share (EPS) of the company. Currently, the company has an EPS of ₹0.50 per share. After the expansion, if the debt is introduced, the EPS is expected to decrease to ₹0.40 per share.

This indicates that the shareholders might experience a loss in earnings per share after the expansion. The decrease in EPS can be attributed to the additional interest expense incurred due to the debt.

Numerical Example: Sakshi Limited

Let’s consider another numerical example to solidify our understanding. Sakshi Limited is a company manufacturing electronic goods. The company has an earning per share of ₹0.50 and a share capital of ₹60 lakhs.

Calculation of Return on Investment (ROI)

Sakshi Limited raised funds by issuing 10% debentures. During the current year, the company earned a profit of ₹9 lakhs. Let’s calculate the ROI:

ROI = (Profit before Interest and Tax / Capital) x 100

Substituting the values:

ROI = (₹9 lakhs / ₹60 lakhs) x 100

Calculating the ROI:

ROI = 15%

As the ROI is greater than the rate of interest (10%), Sakshi Limited can take advantage of trading on equity.

Effect of Debt on Earnings per Share (EPS)

Assuming a tax rate of 30%, let’s calculate the effect of debt on the earnings per share (EPS). The company plans to raise a debt capital of ₹40 lakhs with a 10% interest rate.

First, we calculate the interest expense:

Interest Expense = Debt x Interest Rate

Interest Expense = ₹40 lakhs x 10%

Interest Expense = ₹4 lakhs

Next, we calculate the earning before tax:

Earning Before Tax = Earning Before Interest and Tax – Interest Expense

Earning Before Tax = ₹9 lakhs – ₹4 lakhs

Earning Before Tax = ₹5 lakhs

Now, we calculate the earning after tax:

Earning After Tax = Earning Before Tax – Tax

Earning After Tax = ₹5 lakhs – (₹5 lakhs x 30%)

Earning After Tax = ₹3.5 lakhs

Finally, we calculate the new earnings per share (EPS):

EPS = Earning After Tax / Number of Equity Shares

EPS = ₹3.5 lakhs / 9 lakhs

EPS = ₹0.40 per share

After introducing debt, the earnings per share (EPS) of Sakshi Limited would decrease from ₹0.50 per share to ₹0.40 per share.

Conclusion

Trading on equity and return on investment are essential concepts in financial management. By understanding these concepts, companies can make strategic decisions regarding their financial structure and expansion plans.

In this blog, we explored the calculations involved in trading on equity and the impact of debt on earnings per share (EPS). Remember, the key is to ensure that the ROI is higher than the rate of interest, and the interest expense on debt is tax deductible.

Now that you have a solid understanding of these concepts, you are better equipped to analyze and make informed financial decisions.

Disclaimer

The information provided in this blog is for educational purposes only and should not be considered as financial advice. Consult with a financial professional for personalized advice based on your unique circumstances.

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