ABC Ltd. has debt equity ratio of 3:1, whereas XYZ Ltd. has debt equity ratio of 1:1. Name the advantage ABC Ltd will have over XYZ Ltd., when the rate of interest is lower than the rate of return on investment of the company.
Answer & explanation
Correct answer: option 1
The correct answer is Option (1) → Trading on Equity
Option (1) Trading on Equity — Correct. ABC Ltd. uses much more debt (3:1) than XYZ Ltd. (1:1). Interest on debt is a fixed charge. When the firm earns a return on investment higher than the rate of interest, the extra profit goes to the equity shareholders. So their earning per share (EPS) goes up. Using more cheap debt to raise the EPS is called trading on equity. With more debt, ABC Ltd. gains more from it than XYZ Ltd.
Option (2) Low Risk — Incorrect. It is the other way round. More debt means more fixed payments of interest and loan. So ABC Ltd. has a higher financial risk than XYZ Ltd.
Option (3) Trading on Debt — Incorrect. There is no such term. The correct name is trading on equity.
Option (4) Greater flexibility — Incorrect. A firm that has already borrowed a lot finds it harder to borrow more later. So ABC Ltd. has less flexibility, not more.
NCERT (2026-27 Edition): “Capital Structure … This is higher than the 10% interest it is paying on debt funds. With higher use of debt, this difference between RoI and cost of debt increases the EPS. This is a situation of favourable financial leverage. In such cases, companies often employ more of cheaper debt to enhance the EPS. Such practice is called Trading on Equity.” “Trading on Equity refers to the increase in profit earned by the equity shareholders due to the presence of fixed financial charges like interest.” “Return on Investment (RoI): If the RoI of the company is higher, it can choose to use trading on equity to increase its EPS, i.e., its ability to use debt is greater. …” |