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

Situation 1
Total Capital - Rs. 50 lakhs
Equity -   Rs. 50 lakhs (4 lakhs share of Rs. 10 each)
Debt -  Nil
Tax rate  - 30% 
E BIT - 7 Lakhs

Situation 2.
Total Capital - Rs. 50 lakhs
Equity -   Rs. 40 lakhs (4 lakhs share of Rs. 10 each)
Debt - 10 lakhs
Tax rate - 30% p.a
Interest on debt - 10% 
E BIT - 7 Lakhs

Situation. 3 
Total Capital - Rs. 50 lakhs
Equity -   Rs. 30 lakhs 
Debt - Rs. 20 lakhs
Tax rate - 30% p.a
Interest on debt - 10% 
E BIT - 8 lakhs

Dear student,

Your answer is correct.

The debt content in capital increases the Earning per share, but it does not mean that company should entirely go with debt. A company should maintain a proper ratio between Debt and Equity.

Regards
 

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