Clearly, in the second situation the EPS is greater than in the first situation. In the second situation the company takes advantage of the Trading on Equity and raises the EPS. Here, the return on investment calculated as [{Earning Before Tax (EBT)}/Total Investment]=100000/500000 is 20% while the interest on the borrowings is 10%. Thus, the Trading on Equity is profitable.
However, it should be noted that Trading on Equity is profitable and should be used only when the return on investment is greater than the interest on borrowed funds. In case the return on investment is less than the rate of interest to be paid, the Trading on Equity should be avoided.
Suppose instead of Rs 1,00,000 the company earns just Rs 25,000. In such a case the EPS are calculated as follows.
|
Situation I |
Situation II |
| Earnings before interest and tax (EBIT) |
40,000 |
40,000 |
| Interest |
|
10,000 |
| Earnings Before Tax (EBT) |
25,000 |
10,000 |
| Tax |
30,000 |
3,000 |
| Earnings After Tax (EAT) |
70,000 |
7,000 |
| No. Of equity shares |
50,000 |
20,000 |
| EPS=EAT/Number of equity shares |
70000/50000=1.4 |
70000/20000=3.5 |
Clearly in this case, the EPS in Situation II falls. Here the return on investment is only 8% [{Earning Before Tax (EBT)}/Total Investment] = 40000/500000 while the interest on the borrowings is 10%.
Thus, in this situation the Trading on Equity is not favourable and should be discouraged. Hence, it can be said that a firm can use Trading on Equity if it is earning high profits and can increase the EPS by raising more funds through borrowings.
