How are the shareholders likely to gain with loan components in capital employed? Explain with suitable example.

With a loan (borrowed capital) component in the total capital, shareholders are likely to have the benefit of a higher rate of return on the share capital. This is is because loans carry a fixed charge and the amount of interest paid is deductible from the Earning Before Tax (EBT). Although it is possible only when the rate of return of the company is greater than the rate of interest on borrowed capital.

Example:

EBIT - EPS Analysis

It is clear from the above table that both the companies have raised र 10,00,000 as total capital. But X-Co. has raised it by issuing equity capital. On the other hand, Y-Co. has raised र 4,00,000 by issuing equity capital and र 6,00,000 by issuing debentures bearing 10% fixed interest rate. Suppose, both the companies have earned EBIT र 2 lakh each and Tax Rate is 30%.

EBIT - EPS Analysis

In the above example, shareholders of X-Co. are getting र 1.40 return on their investment as against र 2.45 return to shareholders of Y-Co. Both companies raised equal total capital 10 lakh each) and earned equal total profit 2 lakh each), yet the earning of Y-Co.’s shareholders is more. The reason being that Y-Co. has taken advantage of the process of “trading on equity.” In other words, Y-Co. has raised fixed cost capital (borrowed capital) along with equity share capital. On fixed cost capital (borrowed capital), it paid fixed interest at the rate of 10 per cent (10% debentures) and the remainder is distributed as dividend to equity shareholders. Obviously, return on equity shares of Y-Co. is greater than that of X-Co.