Trading on equity definition
/What is Trading on Equity?
Trading on equity occurs when a company incurs new debt (such as from bonds, loans, or preferred stock) to acquire assets on which it can earn a return greater than the interest cost of the debt. If a company generates a profit through this financing technique, its shareholders earn a greater return on their investments. In this case, trading on equity is successful. If the company earns less from the acquired assets than the cost of the debt, its shareholders instead earn a reduced return. Many companies use trading on equity rather than acquiring more equity capital, in an attempt to improve their earnings per share.
Advantages of Trading on Equity
Trading on equity has two primary advantages. First, it may allow an entity to earn a disproportionate amount on its assets, especially when a large amount of debt financing is used. And second, interest expense is tax deductible in many tax jurisdictions, which reduces the net cost to the borrower.
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Disadvantages of Trading on Equity
There are several disadvantages associated with the trading on equity concept, which are as follows:
Can trigger losses. Trading on equity presents the possibility of disproportionate losses, since the related amount of interest expense may overwhelm the borrower if it does not earn sufficient returns to offset the interest expense. The concept is especially dangerous in situations where a company relies upon short-term borrowings to fund its operations, since a sudden spike in short-term interest rates may cause its interest expense to overwhelm earnings, resulting in immediate losses. This risk can be mitigated through the use of interest rate swaps, where a company swaps its variable interest payments for the fixed interest payments of another entity. Thus, trading on equity can earn outsized returns for shareholders, but also presents the risk of outright bankruptcy if cash flows fall below expectations.
More variable earnings. In an environment where interest rates are fluctuating rapidly, or when the earnings from purchased assets are variable, the outcome can be highly variable earnings. Investors may not like this, especially if they put a higher value on consistent, reliable earnings.
More expensive stock options. Because of the increased variability in earnings, a side effect of trading on equity is that the recognized cost of stock options increases. The reason is that option holders are more likely to cash in their options when earnings spike, and since trading on equity leads to more variable earnings, the options are more likely to earn a higher return for their holders.
Who Uses Trading on Equity
The trading on equity concept is more likely to be employed by professional managers who do not own a business, since the managers are interested in increasing the value of their stock options with this aggressive financing technique. A family-run business is more interested in long-term financial stability, and so is more likely to avoid it.
Example of Trading on Equity
Able Company uses $1,000,000 of its own cash to buy a factory, which generates $150,000 of annual profits. The company is not using financial leverage at all, since it incurred no debt to buy the factory.
Baker Company uses $100,000 of its own cash and a loan of $900,000 to buy a similar factory, which also generates a $150,000 annual profit. Baker is using financial leverage to generate a profit of $150,000 on a cash investment of $100,000, which is a 150% return on its investment.
Baker's new factory has a bad year, and generates a loss of $300,000, which is triple the amount of its original investment.
Terms Similar to Trading on Equity
Trading on equity is also known as financial leverage, investment leverage, and operating leverage.