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Trading on Equity

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Meaning of Trading on Equity

When a co. uses fixed interest bearingcapital along with owned capital in

raising finance, is said Trading on

Equity. (Owned Capital = Equity ShareCapital + Free Reserves )

Trading on equity represents an

arrangement under which a company

uses funds carrying fixed interest or

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Contd.

It is possible to raise the rate ofdividend on equity capital only whenthe rate of interest on fixedinterest

bearingsecurity is less than the rateof return earned in business.

Two other terms:

Trading on Thick Equity :-Whenborrowed capital is less than ownedcapital

Trading on Thin Equity :-When

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Definition

Gerstenberg : When a person or acorporation uses borrowed capital as

well as owned capital in the regular

conduct of its business, he or she issaid to be Trading on equity.

Guthmann and Dougall :The use of

borrowed funds or preferred stock for

financing, is known as trading on

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Contd.

Hast ings:The degree to which debt

is used in acquiring assets is calledTrading on Equity.

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Conditions of success

The rate of interest on borrowed capitalmust be lower than the rate of earnings

on owned capital.

If the capital can be borrowed only onthe security of assets, assets of the

company will gradually be reduced with

every increase in borrowed capital.Trading on equity will weaken the

borrowing capacity of the company.

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Contd.

Trading on Equity can be used only

when companys earnings are stableand certain .

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Limitations

When the rate of interest on borrowed

capital is less than the rate of return

being earned by the company.

It will reduce the borrowing capacity of

the co. as assets are required to place

as security.

Income is more or less fixed are able to

bear the burden of fixed interest

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Contd.

Low proportion of Fixed Assets, havelimited scope of trading on equity.

Legal restrictions on the amount to beborrowed. e.g. it can be borrowed up tothe total amount of paid up share

capital and free reserves only.

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Contd.

The Declining trend of profitability ofbusiness also limits the use of trading on

equity.

Attitude of management restricts the use

of trading on equity.

The nature of companys business may

also restrict the use of trading on equity.

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Useful Suggestions

The rate of dividend on equity share iscalculated.:

Rate of Dividend = Distributable Profit*100

Equity Share Capital If the rate of dividend is not given assumed @

50%

Adjustment regarding transfer to General Reserve

will be given.