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Explain the Term ‘Trading on Equity’? Why, When and How It Can Be Used by Company. - Business Studies

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ConceptConcept of Capital Structure

Question

Explain the term ‘Trading on Equity’? Why, when and how it can be used by company.

Solution

Trading on equity refers to a practice of raising the proportion of debt in the capital structure such that the earnings per share increases. A company resorts to Trading on Equity when the rate of return on investment is greater than the rate of interest on the borrowed fund. That is, the company resorts to Trading on Equity in situation of favourable financial leverage. As the difference between the return on investment and the rate of interest on debt increases, the earnings per share increase.

The use of Trading on Equity is explained in detail with the help of the following example.

Suppose there are two situations for a company. In situation I it raises a fund of Rs 5,00,000 through equity capital and in situation II, it raises the same amount through two sources- Rs 2,00,000 through equity capital and the remaining Rs3,00,000 through borrowings.

Also suppose the tax rate is 30% and the interest on borrowings is 10%. The earnings per share (EPS) in the two situations is calculated as follows.

 

Situation I

Situation II

Earnings before interest and tax (EBIT)

1,00,000

1,00,000

Interest

­

30,000

Earnings Before Tax (EBT)

1,00,000

70,000

Tax

30,000

21,000

Earnings After Tax (EAT)

70,000

79,000

No. Of equity shares

50,000

20,000

`"EPS"="EAT"/"Number of equity shares"` `70000/50000=1.4` `79000/20000=3.95`

Clearly, in the second situation the EPS is greater than in the first situation. In the second situation the company takes advantage of the Trading on Equity and raises the EPS. Here, the return on investment calculated as `("Earnings Before Tax (EBT)"/"Total Investment"=100000/500000)` is 20% while the interest on the borrowings is 10%. Thus, the Trading on Equity is profitable.

However, it should be noted that Trading on Equity is profitable and should be used only when the return on investment is greater than the interest on borrowed funds. In case the return on investment is less than the rate of interest to be paid, the Trading on Equity should be avoided.

Suppose instead of Rs 1,00,000 the company earns just Rs 25,000. In such a case the EPS are calculated as follows.

 

Situation I

Situation II

Earnings before interest and tax (EBIT)

40,000

40,000

Interest

­

10,000

Earnings Before Tax (EBT)

25,000

10,000

Tax

30,000

3,000

Earnings After Tax (EAT)

70,000

7,000

No. Of equity shares

50,000

20,000

`"EPS"="EAT"/"Number of equity shares"` `70000/50000=1.4` `7000/20000=0.35`

 

Clearly in this case, the EPS in Situation II falls. Here the return on investment is only 8% `("Earnings Before Tax (EBT)"/"Total Investment"=40000/500000)` while the interest on the borrowings is 10%. Thus, in this situation the Trading on Equity is not favourable and should be discouraged.

Hence, it can be said that a firm can use Trading on Equity if it is earning high profits and can increase the EPS by raising more funds through borrowings.

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Solution Explain the Term ‘Trading on Equity’? Why, When and How It Can Be Used by Company. Concept: Concept of Capital Structure.
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