Explain the term 'Trading on Equity’. Why, when and how it can be used by a business organisation?

Trading on Equity: Trading on equity means to raise fixed cost capital (borrowed capital and preference share capital) on the basis of equity share capital so as to increase the income of equity shareholders. Although it is possible only when the rate of return of the company is greater than the rate of interest on borrowed capital or the rate of dividend on preference shares.

Now the question arises how the income (earning) of the equity shareholders can increase when the company raises fixed cost capital (borrowed capital). Following EBIT-EPS Analysis answers this question:

Example:

EBIT - EPS Analysis

It is clear from the above table that both the companies have raised र 10,00,000 as total capital. But X-Co. has raised it by issuing equity capital. On the other hand, Y-Co. has raised र 4,00,000 by issuing equity capital and र 6,00,000 by issuing debentures bearing 10% fixed interest rate. Suppose, both the companies have earned EBIT र 2 lakh each and Tax Rate is 30%.

EBIT - EPS Analysis

In the above example, shareholders of X-Co. are getting र 1.40 return on their investment as against र 2.45 return to shareholders of Y-Co. Both companies raised equal total capital 10 lakh each) and earned equal total profit 2 lakh each), yet the earning of Y-Co.’s shareholders is more. The reason being that Y-Co. has taken advantage of the process of “trading on equity”. In other words, Y-Co. has raised fixed cost capital (borrowed capital) along with equity share capital. On fixed cost capital (borrowed capital), it paid fixed interest at the rate of 10 per cent (10% debentures) and the remainder is distributed as dividend to equity shareholders. Obviously, return on equity shares of Y-Co. is greater than that of X-Co.