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 earn a
reduced return because of this activity. Many companies use trading on equity rather than
acquiring more equity capital, in an attempt to improve their earnings per share.
Trading on equity has two primary advantages:

Enhanced earnings. It may allow an entity to earn a disproportionate amount on its assets.
Favorable tax treatment. In many tax jurisdictions, interest expense is tax deductible,
which reduces its net cost to the borrower.

However, trading on equity also 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. In short, earnings are likely
to become more variable when a trading on equity strategy is pursued.
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.
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 the concept.

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. Trading on equity is also known as financial
leverage, investment leverage, and operating leverage.