Wednesday, February 21, 2024
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HomeFinancial ValuationWhat Is Trading On Equity?

What Is Trading On Equity?

“Trading on equity” is a financial term that refers to a company’s practice of using debt, such as loans or bonds, to increase its returns to shareholders.

Equity represents ownership in a company. If you own shares of a company, you have equity in that company.

The trading on Equity concept arises when a company decides to use borrowed money (debt) to finance its operations or investments instead of relying solely on its own equity (ownership). The idea is that by using debt, the company can potentially generate more profits than the cost of the borrowed funds.

Example 

Imagine you own a house worth Rs 1,00,00,000, and you have Rs 50,00,000 in savings. Instead of using only your savings to make improvements to the house, you decide to take a Rs 50,00,000 loan. If the value of your house increases to Rs 1,20,00,000 after the improvements, you’ve made a profit of Rs 20,00,000 (minus the cost of the loan). This is somewhat analogous to a company “trading on equity” using borrowed money to potentially increase returns for its shareholders.

Effects of Trading on Equity 

Positive effects include increased returns to shareholders. The basic purpose of trading on equity is to increase shareholder returns. A corporation can increase its shareholders’ overall return on equity by investing borrowed funds in initiatives or assets that generate better returns than the cost of debt.

Debt allows a corporation to fund development and growth objectives without increasing equity. This might be useful for businesses looking to capitalise on fresh opportunities or enter new markets.

  • Tax Benefits: Interest on debt is frequently tax deductible, reducing a company’s overall tax liability. This tax break might make borrowing money more affordable.

The negative effects of trading on equities include greater financial risk. If the returns on debt-financed investments are less than the cost of the debt, it can cause financial difficulty. The company may struggle to pay its debt obligations, which might lead to bankruptcy.

  • Interest Payments: Regular interest payments are required for servicing debt. If a corporation has a high level of debt, a considerable portion of its revenues may be spent on debt servicing, leaving less money for other operational needs or shareholder distributions.
  • Market Perception: An excessive reliance on debt might influence how investors see a company. If investors perceive the company is overleveraged and unable to successfully manage its debt, the stock price may fall.
  • Cyclicality influence: If a company’s operations are cyclical, or vulnerable to economic changes, trading might have a greater influence on equity. During economic downturns, servicing debt can be difficult if earnings fall.

Let’s understand by Example 

ABC Limited intends to fund an expansion. Its present capital structure includes Rs.8 lakh of equity capital (Rs.10 per share). To finance this development, an additional Rs. 6 lakh is required. For this reason, the managers of ABC Limited are exploring the following options.

  • Issue of ordinary shares of Rs 6,00,000
  • Issue of ordinary shares of Rs 3,00,000 and rest by debt of 8%
  • Entirely by debt 8%
  • Issue of ordinary shares of Rs 3,00,000 and the rest by preference shares of 7%

The company expects to record an EBIT of Rs.4,20,000 from its expansion venture

Particulars Option 1 Option 2 Option 3 Option 4
Old Equity (Rs 100 each) 10,00,000 10,00,000 10,00,000 10,00,000
New Equity Issue 6,00,000 3,00,000 3,00,000
Debt @8% 3,00,000 6,00,000
Pref. Shares @7% 3,00,000
EBIT 4,20,000 4,20,000 4,20,000 4,20,000
Less: Interest 24,000 48,000
EBT 4,20,000 3,96,000 3,72,000 4,20,000
Less: Tax @30% 1,26,000 1,18,800 1,11,600 1,26,000
EAT/PAT 2,94,000 2,77,200 2,60,400 2,94,000
Less: Pref. Dividend 2,10,000
Profit for Shareholders 2,94,000 2,77,200 2,60,400 84,000
No. of shareholders 16,000 13,000 10,000 13,000
EPS 18.4 21.3 26.0 6.5

From the above calculation, it can be seen that ABC Limited would be able to enhance the earnings of shareholders by opting for a pure debt approach.

Disclaimer: This blog has been written exclusively for educational purposes. The securities mentioned are only examples and not recommendations. The information is based on various secondary sources on the internet and is subject to change. Please consult with a financial expert before making investment decisions.
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