TRADING ON THE EQUITY shall borrow from an English usage the term "trading on the equity," as express ing better than any other brief phrase a fun damental business procedure. Its origin is from the expression "equity of redemption," which describes a mortgagor's right in the property he has mortgaged, that is, the right to get back the title he has pledged to the mortgagee as security for the capital ad vanced. The business man mortgages his property to get more money in his business, in order that he may engage in it on a larger scale, and all to the end that he may make a greater return on his own capital invested. To do this he undergoes the disadvantage that he must assume the greater risk. We shall not use the term "equity" in its strict legal sense, but in the common loose accept ance of the word in business, of any owner ship in a property that assumes a larger risk than some other interest.
To take the simplest possible case, a man ufacturer, say, finds that in good years he is making 15 per cent on his capital of $20,000.
He reasons that if he can make 15 per cent or even 10 per cent on capital in his business, he will make much more for himself by borrow ing money at 6 per cent, or even at 8 or 9 per cent. Thereupon he goes into the money market in one form or another and finds that, though he can borrow $20,000 at a nominal face interest of 6 per cent, a further actual discount brings the real interest up to 8 per cent. He borrows $20,000 on these terms. Suppose he is able to continue making 15 per cent on the invested capital. Before borrow ing, his affairs at the end of his fiscal year stood like this: — Personal capital invested . . . $20,000 Percentage earned on capital . 15 per cent Return on capital . . . . . 3,000 After borrowing, his annual statement would show: Personal capital invested . . . $20,000 Borrowed capital invested . . . 20,000 Total capital . . . . . $40,000 Percentage earned on capital . 15 per cent Total return on capital. . . $6,000 8 per cent on borrowed capital . 1,600 Return on personal capital . . $4,400 That is to say, by borrowing at 8 per cent he has increased the return on his own invest ment from 15 per cent to a point where it now makes him per cent.
Suppose, however, an especially bad year, either in business of that particular kind, or in general business conditions, comes along, and the proprietor can make his enterprise earn only 5 per cent on the capital invested. How would his annual statement stand then? It would show: — Personal capital invested . . . $20,000 Borrowed capital invested . . . 20,000 Total . . ... . . $40,000 Percentage earned on capital . 5 per cent Total return on capital . . . $2,000 8 per cent on borrowed capital . 1,600 Return on personal capital . . $400 In this bad year the proprietor has made only $400, or per cent on his own capital, as a result of borrowing, whereas, if he had not borrowed at all, he would have made 5 per cent, or $1000. In the bad year he has lost $600 by trading on the equity against the $1400 he made in the good year by following the same policy. Of course the proprietor ex pects that the gains of his good years will much more than offset the losses of his bad years.
Notice that in the bad year the proprie tor's equity in the property "protected " the lender, so that he received his full 8 per cent in the bad year when the capital as a whole yielded a return of only 5 per cent, and, more over, that, he has not had the worry of con ducting the business in a year of comparative misfortune.
In a very elementary way this explains the whole principle of trading on the equity. It illustrates a simple case of the adjust ment of risk and control dwelt on in the chap ter on "The Instruments of Finance." The trader on the equity in the case of a corporation is the common shareholder. Holders of other corporation securities are taking shelter under the protection of the equity of the invested capital of the common shareholders, and the common shareholder takes advantage of the protection he offers by his capital to get other funds into the busi ness on terms that he expects will make his own capital more profitable than it would be otherwise.