Q.Explain the term 'Trading on Equity'? Why, when and how it can be used by company.

Trading on equity is the practice of using borrowed funds (debt) to finance a company's assets, with the goal of increasing the return for equity shareholders. The core idea is that if the company earns a rate of return on its total investment that is higher than the interest rate paid on the debt, the surplus profit belongs entirely to the shareholders, thereby magnifying their earnings per share (EPS).

A company uses this strategy when it expects its return on investment (ROI) to be greater than the cost of debt (interest rate). It is most suitable when the business has stable and high earnings, because the fixed interest payments must be paid regardless of profit levels. The company raises debt capital (e.g., debentures or loans) and invests it in operations. The profit left after paying interest is distributed among a smaller equity base, boosting EPS. …

What it means. A company can raise money from owners (equity) and from outsiders (borrowed funds like loans and debentures). Debt is cheaper than equity, partly because interest is tax-deductible and partly because a lender bears less risk than a shareholder. When a company deliberately uses more of this cheaper debt so that the extra profit -- after paying the fixed interest -- flows to the equity shareholders, the practice is called trading on equity. The chapter defines it directly: trading on equity refers to the increase in profit earned by the equity shareholders due to the presence of fixed financial charges like interest. It is also called financial leverage, the proportion of debt in the overall capital.

Why a company uses it. The aim is to raise the earnings per share (EPS) of the equity shareholders. If a company earns a return on its total investment that is higher than the interest it pays on debt, the surplus over the interest cost belongs to the equity shareholders. Because the equity base is smaller than it would be under all-equity financing, that surplus is spread over fewer shares and the EPS rises.

When it works -- and when it does not. Trading on equity is favourable only when the return on investment (RoI) exceeds the cost of debt. The chapter's own EBIT-EPS example shows this: when a company earning a RoI of 13.33% borrows at 10%, adding more debt lifts the EPS (a favourable-leverage situation). But when another company earns a RoI of only 6.67% against the same 10% interest, adding debt pushes the EPS down (an unfavourable-leverage situation), and trading on equity is clearly unadvisable. …