# Trading on Equity

Trading on equity means raising debts and loans on the basis of equity capital as a foundation.

## Why Lenders Want Equity Cushion

Providers of debt have a limited share in the firm's earnings (capped at the interest amount). They therefore want to be protected by an equity cushion that absorbs first-loss risk.

## The Magnification Effect

Because fixed financial charges do not vary with EBIT, a magnified effect is produced on EPS. Small changes in EBIT translate into larger percentage changes in EPS.

## When Trading on Equity is Favourable

Whether leverage is favourable (i.e., increase in EPS is more than proportionate to the increase in EBIT) depends on the profitability of the investment proposal:

> If Rate of Return on Investment > Explicit Cost of Debt => Financial leverage is positive (favourable).

If ROI is less than the cost of debt, leverage becomes unfavourable and EPS suffers disproportionately when EBIT falls.

Worked example

### Example 1

Illustration: Firm has Equity Capital Rs. 10 lakh and borrows Rs. 40 lakh at 10%. ROI = 15%.

EBIT = 15% * 50 lakh = Rs. 7.5 lakh
Interest = Rs. 4 lakh
Earnings to equity = Rs. 3.5 lakh => Return on equity = 35%

Without the borrowing, return on equity would have been only 15%. The 'trading on equity' magnified the return.

⚠️ Common exam mistakes

Assuming trading on equity is always beneficial — it cuts both ways when ROI < Kd
Confusing trading on equity (a strategy) with financial leverage (the measurement)
Ignoring the increase in financial risk that accompanies the EPS magnification

Reference:

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