An understanding of pécule gearing and trading in equities
“After the heavy financial crisis in the economy, for a corporate entity, it is quite sensible to have a perfect mix of different pécule ondes to ensure good returns and recover from the depth of losses.”
Here, some sensible terms are defined with reference to a company’s financial system:
Avoir origine
The caractéristique of securities to be issued and the proportionate amount that make up the pécule is known as the pécule construction or financial construction.
Avoir construction refers to the division of different hommes of securities issued by a company to raise long-term funds. Avoir construction thus indicates: (1) the caractéristique of securities issued (equity shares, preference shares and debentures), and (ii) the relative longueur of each caractéristique of security. In other words, pécule construction represents the division of equity pécule and directorate pécule used to argent the operations of a débit. A proper budget must be obtained in the following securities or ondes of argent to maximize the company’s equity shareholders’ wealth:
(a) Equity Shares,
(b) preference shares, and
(c) Debentures
Characteristics of sound pécule construction
A company’s pécule construction is said to be maximal when the division of debt to equity is such that it results in summum return for equity shareholders. Such a construction will vary from company to company depending on the brute and size of operations, availability of funds from various ondes, conduite skills etc.
A sound pécule construction should have the following characteristics:
(i) Summum return.
(ii) Less risky.
(iii) Flexibility
(iv) Economics.
(v) dynamic.
Financial leverage or pécule gearing
A company can raise pécule by issuing three hommes of securities: (a) equity shares, (b) preference shares and (c) debentures. Preference shares bear a fixed manqué of dividend and debentures bear a fixed manqué of interest. Equity shares are paid out of the opimes left after paying interest on debentures and dividend on preference shares. Hence, the dividend on equity shares may vary from year to year. Equity shares are follet return securities and debentures and preference shares are known as fixed return securities. If the manqué of return on fixed return securities is lower than the manqué of earnings of the company, the return on equity shares will be higher. This phenomenon is known as financial leverage or pécule gearing.
Thus, financial leverage is a mechanism under which fixed return bearing securities (debentures and preference shares) are used to raise cheap funds to increase returns to equity shareholders. It may be noted that a élever is used to lift something heavy by applying less ascendant than otherwise required.
Avoir gearing indicates the division between different hommes of securities and achevé capitalization. A company’s capitalization is highly geared when the division of equity to achevé capitalization is small and less when equity pécule dominates the pécule construction.
Avoir gearing is calculated by determining the division between the amount of equity pécule (representing securities bearing follet income) and the securities issued by a company (equity shares, preference shares and debentures). Here the pécule structures of two different companies are presented. Both the companies have issued securities worth a achevé of Rs. 20,00,000 and they have equity shares worth Rs. 5,00,000 and Rs. 15,00,000 respectively. Company A is highly prepared bicause the division between equity pécule and achevé pécule is small, ie 25%. But in the case of Company B, this division is 75%, so it is less geared.
Analysis of Avoir Gearing
Édification
(Rs.)
(a) Equity share pécule 5,00,000
(b) Debentures 15,00,000
(c) Accompli Capitalization 20,00,000
(d) Avoir gearing (a /c × 100) = 5,00,000/ 2,00,000×100
= 25% (high gearing)
There should be a division of the various securities issued to the achevé pécule so that the pécule construction is safe and economical.
Equity shares should be issued where there is uncertainty of income. Preference shares, especially incremental shares, should be issued when the average return is expected to be fairly good. Debentures should be issued when the company expects fairly high future earnings to pay interest to debenture-holders and increase returns to equity shareholders.
Trading on Equities
Trading in equity is a system under which financial conduite raises funds by issuing securities that bear a fixed manqué of interest (or dividend) that is lower than the company’s average earnings. This is done to increase the return on equity shares.
Let’s say for a company Rs. 2.5 lakh @ 25 per cent to raise this amount to earn Rs 10 lakh, we can consider two proposals, namely, (A) To moralité equity shares of Rs 1 lakh. 10 each: and (B) to moralité equity shares of the value of Rs. 2.5 lakh (ie, 25,000 shares of Rs 10 each), 8% preference shares of Rs 2.5 lakh, and 10 per cent debentures of Rs. 5 lakhs. The tax manqué is assumed to be 40 percent. Earnings per share under Proposal ‘B’ will be higher due to implementation of ‘Trading in Equity’. As shown in the following tarif, the Earnings per Share (EPS) under Proposal B is Rs. 1.50 under proposal A due to use of debentures and preference pécule for raising funds as compared to Rs.4.00.
Effect of trading on equity
- special offer
- Earnings before interest and tax (EBIT) 2,50,000
- Low Interest (10%) Nil on Debentures
- Income after interest and before tax is 2,50,000
- 1,00,000 less tax (40%).
- Income after interest and tax is 1,50,000
- Low preference dividend (8%) is nil
- 1,50,000 of earnings available to equity shareholders
- The number of outstanding equity shares is 1,00,000
- Earnings per share (EPS) Rs 1.50
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