Trading on Equity

What is Trading on Equity?

Trading on Equity refers to the corporate action in which a company raises more debt in order to boost the return on investment for the equity shareholders. This process of financial leverage is considered to be a success if the company is able to earn a greater ROI. On the other hand, if the company is unable to generate a rate of return higher than the cost of debt, then the equity shareholders end up earning much lower returns.

Types of Trading on Equity

On the basis of the size of debt funding relative to available equityEquityEquity refers to investor’s ownership of a company representing the amount they would receive after liquidating assets and paying off the liabilities and debts. It is the difference between the assets and liabilities shown on a company's balance sheet.read more, it is classified into two types –

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Source: Trading on Equity (wallstreetmojo.com)

1. Trading on Thin Equity: If the equity capital of a company is lesser than the debt capital, then it is known as trading on thin equity. In other words, the share of debt (such as bank loan, debenturesDebenturesDebentures refer to long-term debt instruments issued by a government or corporation to meet its financial requirements. In return, investors are compensated with an interest income for being a creditor to the issuer.read more, bonds, etc.) is higher than that of equity in the overall capital structure. Trading on thin equity is also known as trading on tiny or low equity.
2. Trading on Thick Equity: If the equity capital of a company is more than the debt capital, then it is known as trading on thick equity. In other words, the share of equity is higher than that of debt in the overall capital structureCapital StructureCapital Structure is the composition of company’s sources of funds, which is a mix of owner’s capital (equity) and loan (debt) from outsiders and is used to finance its overall operations and investment activities.read more. Trading on thick equity is also known as trading on high equity.

Examples

Let us understand with examples.

Example #1

Let us take the example of ABC Inc. to illustrate the impact of trading on thick equity on shareholder return. Let us assume that the company infused $2,000,000 of equity capital and raised $500,000 of bank debt to acquire a new factory. Determine the rate of returnRate Of ReturnRate of Return (ROR) refers to the expected return on investment (gain or loss) & it is expressed as a percentage. You can calculate this by, ROR = {(Current Investment Value – Original Investment Value)/Original Investment Value} * 100read more for the shareholdersShareholdersA shareholder is an individual or an institution that owns one or more shares of stock in a public or a private corporation and, therefore, are the legal owners of the company. The ownership percentage depends on the number of shares they hold against the company's total shares.read more assuming the cost of debtCost Of DebtCost of debt is the expected rate of return for the debt holder and is usually calculated as the effective interest rate applicable to a firms liability. It is an integral part of the discounted valuation analysis which calculates the present value of a firm by discounting future cash flows by the expected rate of return to its equity and debt holders.read more to be 5% and that there is no income tax if the factory is expected to generate an annual profit of:

1. $250,000
2. $50,000

Therefore, the rate of return for shareholders can be calculated as,

• = ($250,000 – $500,000 * 5%) / $2,000,000
• = 11.25%

Therefore, the shareholders earn a rate of return of 11.25%.

Therefore, the rate of return for shareholders can be calculated as,

• = ($50,000 – $500,000 * 5%) / $2,000,000
• = 1.25%

Therefore, the shareholders earn a rate of return of 1.25%.

Example #2

Let us take the above example again and illustrate the impact of trading on thin equity on shareholder returnShareholder ReturnTotal Shareholder Return (TSR) is a percentage indicator of the performance of the stock return over the time it is held. The return includes capital appreciation and the dividend earned on the stock. TSR = Current Price – Purchase Price + Dividend / Purchase Price read more. In this case, let us assume that the company raised $2,000,000 of debt and infused only $500,000 of equity to acquire the factory. Determine the rate of return for the shareholders assuming the cost of debt to be 5% and that there is no income tax if the factory is expected to generate an annual profit of:

1. $250,000
2. $50,000

Therefore, the rate of return for shareholders can be calculated as,

• = ($250,000 – $2,000,000 * 5%) / $500,000
• = 30.00%

Therefore, the shareholders earn a rate of return of 30.00%.

Therefore, the rate of return for shareholders can be calculated as,

• = ($50,000 – $2,000,000 * 5%) / $500,000
• = -10.00%

Therefore, the shareholders incurred loss at a rate of 10.00%.

Effects

From the examples illustrated in the previous section, it can be seen that trading on equity is just like a lever that magnifies the impact of variations in earnings. The impact of fluctuation in earnings is magnified on the rate of return earned by the shareholders. Further, the variation in the rate of return is higher in the case of trading on thin equity than that of trading on thick equity.

Advantages

• A company can earn higher revenue by purchasing new assets using borrowed money.
• Since the interest paid on debt is tax-deductible, it lowers the borrower’s tax burden.

Disadvantages

• Unstable income or volatile profits can impact the shareholders’ return adversely.
• At times it results in overcapitalizationOvercapitalizationOvercapitalization refers to a scenario wherein a Company raises a capital amount that is way more than the worth of its fixed assets. It means that a Company’s capitalized value becomes more than that of its actual market value. read more of the borrowing entity.

Recommended Articles

This has been a guide to what is trading on equity and its definition. Here we discuss types, examples, and its effects along with advantages and disadvantages. You may learn more about financing from the following articles –

• Return on Equity (ROE)
• Return on Investment Formula (ROI)
• Operating Leverage
• Financial Leverage