Q.Name the concept of financial management which increases the return to equity shareholders due to the presence of fixed financial charges.
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Start your 14-day free trial to unlock the full solution →The concept is Trading on Equity (also called financial leverage): using fixed-charge funds such as debt in the capital structure to increase the return earned by the equity shareholders.
The question describes, almost word for word, the chapter's definition of trading on equity: the increase in profit earned by the equity shareholders due to the presence of fixed financial charges like interest. It is also referred to as financial leverage -- the proportion of debt in the overall capital, computed as Debt divided by Equity, or Debt divided by (Debt plus Equity).
The logic is straightforward. When a company raises part of its money as debt, it commits to paying a fixed rate of interest regardless of how much profit it makes. If the company then earns a return on its total investment that is higher than that fixed cost, the surplus left after paying the interest belongs entirely to the equity shareholders. Because the equity base is smaller than it would be under all-equity financing, that surplus is spread over fewer shares, so the earnings per share (EPS) rises. Employing more of the cheaper debt in this way to lift the EPS of equity shareholders is exactly what "trading on equity" means. …
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