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 equity, it is classified into two types –
- 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, debentures, 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.
- 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 structure. 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 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:
- $250,000
- $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,
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- = ($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 return. 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:
- $250,000
- $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 overcapitalization 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 –
