Question

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

Answer 1

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.