Question

Well-being Ltd. Is a company engaged in production of organic foods. Presently, it sells its products through indirect channels of distribution. But, considering the sudden surge in the demand for organic products, the company is now inclined to start its online portal for direct marketing. The financial managers of the company area planning to use debt in order to take advantage of trading on equity. In order to finance its expansion plans, it is planning to raise a debt capital of Rs. 40 lakhs through a loan @ 10% from an industrial bank. The present capital base of the company comprises of Rs. 9 lakh equity shares of Rs. 10 each. The rate of tax is 30%.

In the context of the above case:

1. What are the two conditions necessary for taking advantage of trading on equity?

2. Assuming the expected rate of return on investment to be same as it was for the current year i.e. 15%, do you think the financial managers will be able to meet their goal. Show your workings clearly.

Answer 1

1. The two conditions necessary for taking advantage of trading on equity are:

The rate of return on investment should be more than the rate of interest.

The amount of interest paid should be tax deductible.

2. Yes, the financial managers will be able to meet their goal as the projected EPS, with the issue of debt, is higher than the present EPS.