Understanding the Limitations of Equity Shares Issuance Without Leveraging

Every business thrives by maximizing its financial performance and efficiency. One such key metric is the Return on Capital Employed (ROCE), which measures the profitability of a company's assets relative to its total capital invested. While understanding ROCE is crucial, it is equally important to explore the dynamics of leveraging to unlock additional profitability. This article delves into why a company cannot fully benefit from trading on equity if it solely issues equity shares.

The Basics of ROCE and Capital Employed

Let's begin with a simple example. Suppose you pour 100,000 Rs into your business and earn a return of 20,000 Rs on it. In this scenario, your ROCE is 20%. This is because the capital employed and the own capital are the same, as the business has not utilized any external financing.

Introducing Leveraging through Equity

Now, consider the game of trading on equity, which comes into play when a company's cost of capital (COC) is lower than its ROCE. For instance, if you manage to borrow 100,000 Rs from HDFC Bank at an interest rate of 12%, this would significantly boost your capital employed while not diluting your existing equity. Your total capital employed would now stand at 200,000 Rs, and the profit would be 40,000 Rs after deducting the interest expense of 12,000 Rs on the borrowed amount. The key is that the incremental profit of 8,000 Rs is realized without increasing the denominator, i.e., the own capital, as it remains at 100,000 Rs.

Real-World Considerations

However, it is important to note that real-world scenarios often include tax considerations, which may impact the profitability. Despite these considerations, the fundamental principle remains valid: leveraging enhances profitability when the returns on investment (ROI) are higher than the cost of capital.

Legal and Regulatory Requirements

It's worth emphasizing that for companies to engage in certain financial activities, such as buying back their own shares or issuing new equity, specific approval from the Securities and Exchange Board of India (SEBI) is necessary. These activities, whether picnic market buyback or public offer, require careful compliance with SEBI guidelines and regulations.

Why a Company Cannot Trade on Its Own Shares

From a regulatory standpoint, a company cannot trade on its own shares in the same manner as a common trader due to legal restrictions. This means that companies are not allowed to directly participate in the trading of their own shares in the market. Instead, they must seek approval and follow strict procedures for activities such as buybacks or public offerings, which require adherence to SEBI norms.

Conclusion

In summary, while issuing equity shares can provide equity financing, a company cannot fully benefit from trading on equity unless it employs leverage through financing or other capital-raising activities. Such actions require careful consideration and compliance with the necessary regulatory frameworks, particularly the approval from SEBI for activities like buybacks and public offers. Understanding these nuances is crucial for both businesses and investors to make informed financial decisions.