What is trading on equity?
One of
the many financial strategies that corporates use to secure funding is ‘trading
on equity’ also called financial leverage. Although the name says trading
on equity, it is not the same as equity trading. In fact, it does not involve equity, instead, it
involves debt capital in the form of debentures, bonds, preference shares, etc.
secured by the company to fund the day-to-day business operations.
As a
trader, it is crucial for you to understand what is trading on equity to better
assess the financial position and future growth prospects of a company. So, let
us explain more about it.
What is Trading on Equity?
Trading on equity is a strategy where a company procures new
debt instruments in the form of debentures, bonds, preference shares, or loans
to acquire new assets or invest in a new avenue with the aim of generating
returns. The intention of the company is to earn a return greater than the interest cost
of the debt thus generating returns for its shareholders.
If the company generates a profit through this financing technique, earning
greater returns on investment for its shareholders, the strategy carried out by
the company can be called fruitful. However, if the strategy results in lower
earnings compared to interest expense, decreasing shareholders' income, that
shows that the strategy was unsuccessful.
Instead of acquiring more equity
capital, many corporates resort to trading on equity with an eye towards improving their
earnings per share.
Let us simplify the concept of trading on equity with the help of an
example.
Example of Trading on Equity
Let us
say, Max Limited has a current capital structure of Rs. 6 lakh as equity
capital (Rs. 10 per share). They plan for an expansion for which they are
looking out for financing options to secure further Rs. 4 lakh. Their options
are as follows:
·
Option 1 - Issue ordinary shares worth Rs. 4
lakh
·
Option 2 - Issue ordinary shares worth Rs. 2
lakh and procure Rs. 2 lakh by way of debt at 5%
·
Option 3 - procure Rs. 4 lakh by way of debt at
6%
·
Option 4 - Issue common stocks worth Rs. 2 lakh
and issue 5% preference shares worth Rs. 2 lakh
Max
Limited expects an EBIT of Rs. 240000.
Trading on equity Formula
Rate of Return for Shareholders = (Profit – Debt * Cost of Debt) / Equity.
Particulars
|
Option
1
|
Option
2
|
Option
3
|
Option
4
|
Earnings Before Interest and Tax (Rs.)
|
240000
|
240000
|
240000
|
240000
|
Less: Interest (Rs.)
|
-
|
10000
|
24000
|
-
|
Earnings Before Tax (Rs.)
|
240000
|
230000
|
216000
|
240000
|
Less: Taxes @50% (Rs.)
|
120000
|
115000
|
108000
|
120000
|
Earnings After Taxes (Rs.)
|
120000
|
115000
|
108000
|
120000
|
Less: Dividend to preference shareholders
(Rs.)
|
-
|
-
|
-
|
10000
|
Earnings available to shareholders (Rs.)
|
120000
|
115000
|
108000
|
110000
|
Number of shareholders
|
100000
|
80000
|
60000
|
80000
|
Earnings
Per Share (Rs.)
|
1.2
|
1.43
|
1.8
|
1.37
|
The
above example highlights that Max Limited can increase the earnings of
shareholders by choosing option 3 which is a pure debt approach.
Types of Trading on Equity
Based
on the size of debt funding relative to available equity, it is classified
into two types:
·
Trading
on Thin Equity - Where the equity capital of a company is less than its debt
capital.
·
Trading
on Thick Equity - Where the equity capital of a company is more than its debt
capital.
Advantages of Trading on Equity
·
Enhanced
Earnings
It
allows the company to enhance its earnings by investing
in new avenues and assets which can further generate more returns.
·
Tax
Benefit
The
interest expense on borrowed funds is tax deductible this means the company has
to pay lower tax thus resulting in a lower cost of borrowing.
Wrapping up
In
simple words, we can say that trading on equity is a strategy for companies to
procure more funds to purchase new assets, and uses these new assets to pay for
their debt.
After
reading this article we hope that you are in a better position to evaluate
companies that utilize this strategy before investing your hard-earned money.
Open demat account with Indira Securities, the best equity broker in India
and start trading today!