Trading on Equity
Overview
Trading on equity occurs when a company incurs new debt (such as from bonds, loans, or preferred stock) to acquire assets on which it can earn a return greater than the interest cost of the debt. If a company generates a profit through this financing technique, its shareholders earn a greater return on their investments. In this case, trading on equity is successful. If the company earns less from the acquired assets than the cost of the debt, its shareholders earn a reduced return because of this activity. Many companies use trading on equity rather than acquiring more equity capital, in an attempt to improve their earnings per share.
Given:
Defination
Meaning
Examples and illustrations
Types
Advantages
Limitations
Financial Concepts
Definition:
Trading on equity, which is also referred to as financial leverage, occurs when a corporation uses bonds, other debt, and preferred stock to increase its earnings rather than equity on its common stock.
Meaning:
Equity means equity capital or capital of the owners, whereas trading means earning of profits. In composite form, the method of earning profits by equity capital is known as trading on equity. In a narrow sense, when trading in any business institution is done on the basis of debt capital, rather than equity capital, then it is known as trading on equity.
The term owes its name also to the fact that the creditors are willing to advance funds on the strength of the equity supplied by the owners. Trading feature here is simply one of taking advantage of the permanent stock investment to borrow funds on reasonable basis.
When the amount of borrowing is relatively large in relation to capital stock, a company is said to be ‘trading on this equity’ but where borrowing is comparatively small in relation to capital stock, the company is said to be trading on thick equity.
However, in a broader sense, when the managers/directors of any company depend upon debt or debentures or issue of preference shares to fulfill the financial requirements of the company, aiming at earning maximum profits on equity shares held by them, it is known as trading on equity.
Example of Trading on Equity:
To illustrate trading on equity, let's assume that a corporation uses long term debt to purchase assets that are expected to earn more than the interest on the debt. The earnings in excess of the interest expense on the new debt will increase the earnings of the corporation's common stockholders. The increase in earnings indicates that the corporation was successful in trading on equity. If the newly purchased assets earn less than the interest expense on the new debt, the earnings of the common stockholders will decrease.
Example 1:
Izhaan Company is capitalized with Rs. 10, 00,000 dividends in 10,000 common shares of Rs. 100 each. The management wishes to raise another Rs. 10, 00,000 to finance a major programme of expansion through one of four possible financing plans.
A) May finance the company with all common stock,
B) Rs. 5 lakhs in common stock and Rs. 5 lakhs in debt at 5% interest,
C) All debt at 6% interest or
D) Rs. 5 lakhs in common stock and Rs. 5 lakhs in preferred stock with 5% dividend.
The company’s existing earnings before interest and taxes (EBIT) amounted to Rs. 1,20,000 corporation tax is assumed to be 50%
Solution:
Impact on trading on equity, will be reflected in earnings per share available to common stock holders. To calculate the EPS in each of the four alternatives EBIT has to be first of all calculated.
| Proposal A Rs. | Proposal B Rs. | Proposal C Rs. | Proposal D Rs. |
EBIT | 1,20,000 | 1,20,000 | 1,20,000 | 1,20,000 |
Less interest |
| 25,000 | 60,000 |
|
Earnings before taxes | 1,20,000 | 95,000 | 60,000 | 1,20,000 |
Less taxes @ 50% | 60,000 | 47,500 | 30,000 | 60,000 |
Earnings after taxes | 60,000 | 47,500 | 30,000 | 60,000 |
Less Preferred stock dividend |
|
| 25,000 | |
Earnings available to common stock holders | 60,000 | 47,500 | 30,000 | 35,000 |
No. of common shares | 20,000 | 15,000 | 10,000 | 15,000 |
EPS | Rs. 3.00 | 3.16 | 3.00 | 2.33 |
Thus, when EBIT is Rs. 1,20,000 proposal B involving a total capitalisation of 75% common stock and 25% debt, would be the most favourable with respect to earnings per share. It may further be noted that proportion of common stock in total capitalisation is the same in both the proposals B and D but EPS is altogether different because of induction of preferred stock.
While preferred stock dividend is subject to taxes whereas interest on debt is tax deductible expenditure resulting in variation in EPS in proposals B and D, with a 50% tax rate the explicit cost of preferred stock is twice the cost of debt.
Thus, the meaning of trading on equity is the technique, by which attempt is made to earn more income on equity capital getting capital through fixed cost securities. There is a limit to the proportion of debt that can be added before the corporation's financial future is jeopardized.
Following are the important points regarding trading on equity:
- Trading on equity is a technique to earn profits.
- In equity capital, the amount of both equity shares and free reserves and Debt capital are included.
- The proportion of debt capital is higher in it, as compared to owners capital.
- Operation of own regular trade is done in it by taking the capital, along with owners capital.
- This policy is adopted only when the owners feel confident on the basis of certain and sufficient Grounds that the amount of interest payable on loans was taken will be less than the income to accrue on account of the Debt capital.
2 Types of Trading on Equity
1. Trending on Low or Tiny Equity
When the quantity of share capital of the company is less than the debt capital than that situation is known as trading on Low or thin equity. In other words, when the share of fixed cost securities (Debt, Debentures or Preference shares) is more than equity capital, it is said that the company is trading on low or thin equity.
2. Trading on High or Thick Equity
When the share capital of the company is more than the debt capital, that situation is known as trading on high or thick equity. In other words, when a company collects more funds from equity shares and less by the fixed cost securities, then it is said that the company is trading on high or thick equity.
Importance or Advantages of Trading on Equity
Following are the advantages or importance of trading on equity to the company and its several parties:
1. Continuous Operation of Trading
The most important advantages of trading on equity to the company are that its trade operates quite regularly, because the company also rises the debt capital, along with ownership capital.
2. Payment of Dividend on High Rate
The company may increase its income by using the policy of trading on equity and may make payment of dividend at a higher rate on the equity capital. As a result, the income of shareholders also increases.
3. Minimize Tax Burden
The tax burden on the company gets minimized, by trading on equity, because the tax is levied only on profits accruing after payment of interest on loans and debentures.
4. Increase in Goodwill of Company
Since as a result of trading on equity, the dividend is paid at high rates, it has good effects on the Goodwill of the company, as well. With the increase in Goodwill of the company, the per share price of the company also goes high. As a result, the company is able to easily obtain loans from the market and owners of the company become capable to expand their trade with the help of Debt capital.
5. Control on Financial Sources
The company may gain control over maximum financial sources, even with the investment of very low capital, by using the policy of trading on equity.
6. Control on Business
By trading on equity, the promoters or establishers of the business may exercise control on the business, because if the quantity of equity capital gets reduced, then it is issued to a small group. As a result, the voting power gets centralized in the hands of a small group and control over the business may be gained, easily.
Limitations of Trading on Equity
Along with various advantages of a policy of trading on equity, it has some limitations or disadvantages also, which are as follows:
1. Uncertainty of Income
The policy of trading on equity may be profitable only when the income of the business has certainty, stability, and continuity
2. Low Rate of Return
When the rate of return received on invested capital goes on decreasing and rate of return becomes even lower than the rate of interest and rate of preference dividend, then the company is not in a position to carry out trading on equity. Hence, the company will get deprived of the benefits of trading on equity on reduction in the rate of return.
3. Limitations Relating to Management Support
If the financial position of the company is so good that it may arrange funds by issuing debentures or mortgage deeds and this debt capital is economical, in comparison to the share capital. Even then, its management may decline to support this policy.
4. Loan on High Rate of Interest
The rate of interest on the amount taken on loan gradually goes on rising, as a result of the policy of trading on equity, because every fresh loan increases the risks.Hence, the investor taking high risks wants its reward also. As a result, the company has to reduce the rate of the dividend of the shareholders.
5. Legal and Contractual Difficulties
Many times, trading on equity is beneficial. But, obstacles arise in taking loans, due to restrictions by the existing legal provisions, like – Company act, and other Nation act, and also according to the contract.
6. Fear of Over Capitalisation
Trading on equity is operated on the strength of debt, but it may be the to a certain limit only, reason being that due to interest not decided rates the burden of expenses on the company becomes so heavy that after some time, the business becomes overcapitalization. It reduces the loan taking capacity of the company and the market value of the shares also starts declining due to a reduction in the rate of dividend.
7. Under Intervention of Loan Givers
Besides other economic reasons the influence and intervention of the loan givers increases, while adopting the policy of “Trading on Equity”.In such a situation, whenever the need for additional capital arises, the business faces difficulty because for each such scheme of increasing the capital requires the approval of the loan givers.
8. Difficulty in Extra Capital
If the activities of the company are directed by Finance Corporation, Industrial Development Bank, and other specific financial institutions, then such Institutions may even limit the maximum amount of loan which may be taken by the company and may stop the issue of next debentures and Mortgage Loans.
Limitations of Debt
Now, the question arises, to what extent debt should be availed by the management to take profit of trading and increasing the utility.
In response, it may be said that the debt capital should be used until the additional income generated by Debt capital is more than the cost of the debt capital.
When the additional cost and additional income are equal, that is the maximum limit of the debt capital. At this level, Earning per share (EPS) will always be the same, irrespective of the debt-equity mix.
This is known as the abstract point of earning before tax and interest (EBIT).
Abstract point is that point where the rate of return on investment of debt capital is equal to the rate of interest of this capital.
If the probable income of the companies is much above this point, It will be beneficial to arrange funds through the debentures.
On the contrary, if the income is expected to be less than this point, The use of equity share capital will be beneficial, because in such condition, Earning per share will be high.
If the expected income is less than even the fixed costs, the company will incur losses.
In addition to it, use of equity shares will also not prove useful for the company and hence, the closer of the business will be worthwhile, keeping in view of safeguarding the interests of the owners.
Thus, the best form of the capital structure may be determined with the help of abstract point analysis.