An Understanding Of Capital Gearing & Trading On Equity

“After heavy financial crunches in the economy, for a corporate entity, it is quite significant to have a perfect blend of various capital sources to ensure good returns and overcome from the depth of losses.”

Here, some crucial terms have been defined with reference to the financial system of a company:

CAPITAL STRUCTURE

The types of securities to be issued and proportionate amounts that make up the capitalization is known as capital structure or financial structure.

Capital structure refers to the proportion of different kinds of securities issued by a company to raise long-term finance. Thus capital structure denotes: (1) the types of securities issued (equity shares, preference shares and debentures), and (ii) the relative proportion of each type of security. In other words, capital structure represents the proportion of equity capital and dept capital used for financing the operations of a business. Proper balance must be obtained in the following securities or sources of finance to maximize the wealth of the equity shareholders of the company:

(a) equality shares,
(b) preference shares, and
(c) debentures

Features of Sound Capital Structure
A company’s capital structure is said to be optimum when the proportion of debt and equity is such that it results in maximizing the return for the equity shareholders. Such a structure would vary from company to company depending upon the nature and size of operations, availability of funds from different sources, efficiency of management, etc.

A SOUND CAPITAL STRUCTURE SHOULD POSSESS THE FOLLOWING FEATURES:

(i) MAXIMUM RETURNS.
(ii) LESS RISKY.
(iii) FLEXIBILITY
(iv) ECONOMY.
(v) DYNAMIC.

FINANCIAL LEVERAGE OR CAPITAL GEARING

A company can raise capital by issuing three types of securities: (a) equity shares, (b) preference shares, and (c) debentures. Preference shares carry a fixed rate of dividend and debentures carry a fixed rate of interest. The equity shares are paid dividend out of profits left after payment of interest on debentures, and dividend on preference shares. Thus, dividend on equity shares may vary year after year. Equity shares are known as variable return securities and debentures and preference shares as fixed return securities. If the rate of return on fixed return securities is lower than the rate of earnings of the company, the return on equity shares will be higher. This phenomenon is known as financial leverage or capital gearing.

Thus, financial leverage is an arrangement under which fixed return bearing securities (debentures and preference shares) are used to raise cheaper funds to increase the return to equity shareholders. It may be noted that a lever is used to lift something heavy by applying less force than required otherwise.

Capital gearing denotes the ratio between various types of securities and total capitalisation. Capitalisation of a company is highly geared when the proportion of equity to total capitalization is small and it is low geared when the equity capital dominates the capital structure.

Capital gearing is calculated by determining the ratio between the amount of equity capital (representing variable income bearing securities) and the total amount of securities (equity shares, preference shares and debentures) issued by a company. Here capital structure of two different companies is presented. Both the companies have issued the total securities worth Rs. 20,00,000 and they have equity shares worth Rs. 5,00,000 and Rs. 15,00,000 respectively. Company A is highly geared as the ratio between equity capital to total capitalization is small, i.e., 25%. But in case of company B, this ratio is 75%, so it is low geared.

ANALYSIS OF CAPITAL GEARING

Company

(Rs.)

(a) Equity share capital 5,00,000
(b) Debentures 15,00,000
(c) Total Capitalisation 20,00,000
(d) Capital Gearing (a /c × 100) = 5,00,000/ 2,00,000×100

= 25% (High Gearing)

The various securities issued should bear such ratio to total capitalization that capital structure is safe and economical.

Equity shares should be issued where there is uncertainty of earnings. Preference shares, particularly the cumulative ones, should be issued when the average earnings are expected to be fairly good. Debentures should be issued when the company expects fairly higher earnings in future to pay interest to the debenture-holders and increase the return of equity shareholders.

TRADING ON EQUITY
Trading on equity is an arrangement under which the financial management raises funds by issuing securities which carry a fixed rate of interest (or dividend) which is less than the average earnings of the company. This is done to increase the return on equity shares.

Let us suppose that a company requires an investment of Rs. 10 Lakhs to earn Rs. 2.5 lakhs @ 25 per cent p.a. In order to raise this amount, we may consider two proposals, namely, (A) to issue 1 lakhs equity shares of Rs. 10 each: and (B) to issue equity shares worth Rs. 2.5 lakhs (i.e., 25,000 shares of Rs. 10 each), 8 % preference shares worth Rs. 2.5 lakhs, and 10 per cent debentures worth Rs. 5 lakhs. The rate of tax is assumed to be 40 per cent. The earnings per share under proposal ‘B’ will be higher because of application of ‘trading on equity’. As shown in the following table, the earnings per share (EPS) under proposal B are Rs. 4.00 as compared to Rs. 1.50 under Proposal A because of the use of debentures and preference capital for raising funds.

EFFECT OF TRADING ON EQUITY

Particulars Proposal
Earning before Interest and Taxes (EBIT) Rs. 2,50,000
Less Interest on Debentures (10%) Nil
Earning after interest and before Taxes 2,50,000
Less Taxes (40%) 1,00,000
Earning after Interest and Taxes 1,50,000
Less Preference Dividend (8%) Nil
Earning available to Equity Shareholders 1,50,000
No. of Equity shares outstanding 1,00,000
Earning per share (EPS) Rs. 1.50