Trading on Equity is a financial process that involves taking more debt to increase the return of shareholders. It happens when the Company takes a new debt in the form of bonds, debentures, preferred stock or loans. These funds are used to acquire assets to generate a return which is greater than the interest cost of that new debt. This is done when the management expects to generate more profit than principal and interest payments for that new debt. This will increase the Wealth of the Equity Shareholders. Using this concept, the managers have chance to boost the value of the shares.
This concept will be profitable under the following scenarios :
- When the company is a well-established one
- Profits and sale of the company are stable
- The business of the company is non-speculative in nature
- By borrowing funds, there is chance of Enhanced Earnings of the equity shareholders.
- The interest expense is TAX deductible. So it lowers the tax burden on the borrower and company gets capital at a lesser cost.
- Trading on Equity is always not favorable. It may lead to losses if company is unable to pay the interest expenses, which are compulsory to be paid.
Thus, Trading on Equity has the potential to boost the returns of shareholders, but it also presents the risk of Bankruptcy, if the cash flows are below the expectations of the company. If this concept is used wisely by a Finance Manager, it can create wonders in the wealth of the shareholders of the company.