Calculating Rate of Return on Equity Share Capital

The rate of return on equity share capital is a key financial ratio used to measure how much profit a company generates with the money shareholders have invested. To calculate this rate, we need to determine the profit that is actually available for the equity shareholders.

Companies earn revenue and then incur various expenses and payments before arriving at the profit that can be distributed to equity shareholders or retained for future use. Let's look at the typical flow, starting from profit before interest:

• First, Interest on loans or debentures is paid. This is a fixed financial charge.
• After paying interest, we get the Profit Before Tax (PBT).
• Next, Tax on the profit is paid to the government.
• After paying tax, we get the Profit After Tax (PAT).
• If the company has issued preference shares, Preference Dividends are paid out of PAT. Preference shareholders have a priority claim on profits over equity shareholders, and their dividend rate is usually fixed.
• The remaining profit after paying preference dividends is the Profit Available for Equity Shareholders.

The rate of return on equity share capital is then calculated using this Profit Available for Equity Shareholders, usually divided by the average equity shareholders' funds.

The question asks what is deducted from the net profit before interest to arrive at the figure needed for calculating the rate of return on equity share capital. Following the steps above, starting from Net Profit Before Interest (EBIT):

1. Deduct Interest to get Earnings Before Tax (EBT).
2. Deduct Tax to get Earnings After Tax (EAT).
3. Deduct Preference Dividends to get Profit Available for Equity Shareholders.

Therefore, starting from the net profit before interest, the amounts that are effectively deducted (in the process of arriving at the profit figure relevant for equity holders) are interest and preference dividends.

Let's examine the options:

• Option 1: interest, equity dividend. Equity dividends are paid to equity shareholders from the profit available; they are not deducted to find that profit.
• Option 2: interest, preference dividend. Interest is deducted before tax, and preference dividends are deducted after tax, both before arriving at the profit available for equity shareholders. This aligns with the items that reduce the profit figure derived from 'net profit before interest' before it becomes the basis for the equity return calculation.
• Option 3: interest, interest. Deducting interest twice is incorrect.

Thus, the correct items deducted to determine the profit available for equity shareholders, starting from net profit before interest, are interest and preference dividend.