In this article we will discuss about the concept of trading on equity.
The use of fixed return bearing securities like preference share capital, debentures, bonds, term loans etc. to increase the earnings available to equity shareholders is termed as ‘trading on equity’. It refers to the practice of using borrowed funds and preference capital carrying a fixed charge in expectation of obtaining a higher return to the equity shareholders.
The suppliers of debt and preference share capital will participate in firm’s profits to the extent of fixed interest charges and fixed preference dividend, and the remaining profits are available for the owners of equity. Since the equity shareholders are considered as the owners of the company and all investment, financing and dividend decisions are taken in view of maximisation of wealth of the owners.
Therefore, the concept of trading on equity has direct impact on shareholders wealth. The debt funds are less risk bearing as compared to equity funds. The providers of debt have prior claims on income and assets of the firm over equity holders. Therefore, the return payable on debt should be less than the return available to equity holders.
The tax deductibility of interest payable leads to magnification of return on equity capital. The financial leverage explains the impact on EPS whereas trading on equity shows the impact on equity capital.
Trading on equity is calculated by taking the difference of rate of return on equity capital by having equity and debt components in capital structure, to rate of return on equity by having only equity share capital in the capital structure.
The phenomenon is explained in the following illustration:
In all equity capital structure ‘A’, the company can earn only 20% return on equity. By having debt component in capital structure, the return on equity increases.
But it is important to note that if the debt component exceeds the desired level, the firm is prone to financial risk and bankruptcy risk. In a highly geared firm the providers of debt expects more return to compensate for accepting higher levels of risk, ultimately leads to decrease the return on equity.