What is a debt/equity swap?

By Matt Lee AAA
A:

Occasionally, a company will need to undergo some financial restructuring to better position itself for long term success. One possible way to achieve this goal is to issue a debt/equity or an equity/debt swap. In the case of an equity/debt swap, all specified shareholders are given the right to exchange their stock for a predetermined amount of debt (i.e. bonds) in the same company. A debt/equity swap works the opposite way: debt is exchanged for a predetermined amount of equity (or stock). The value of the swap is determined usually at current market rates, but management may offer higher exchange values to entice share and debt holders to participate in the swap. After the swap takes place, the preceding asset class is canceled for the newly acquired asset class.

There are many possible reasons why management would wish to restructure a company's finances. One possible reason may be that the company must meet certain contractual obligations, such as a maintaining a debt/equity ratio below a certain number, or a company may issue equity to avoid making coupon and face value payments because they feel they will be unable to do so in the future. The contractual obligations mentioned can be a result of financing requirements imposed by a lending institution, such as a bank, or may be self-imposed by the company, as detailed in the company's prospectus. A company may self-impose certain valuation requirements to entice investors to purchase its stock.

For illustration, assume there is an investor who owns a total of $1,500 in ZXC Corp stock. ZXC has offered all shareholders the option to swap their stock for debt at a rate of 1:1, or dollar for dollar. In this example, the investor would get $1,500 worth of debt if he or she elected to take the swap. If, on the other hand, the company really wanted investors to trade shares for bonds, it can sweeten the deal by offering a swap ratio of 1:1.5. Since investors would receive $2,250 (1.5 * $1,500) worth of debt, they essentially gained $750 for just switching asset classes. However, it is worth mentioning that the investor would lose all respective rights as a shareholder, such as voting rights, if he swapped his equity for debt.

To learn more about evaluating a company's debt and financial strength, read Debt Reckoning or our Fundamental Analysis Tutorial.

RELATED FAQS

  1. How can I make equity investments in real estate?

    Invest in real estate equity through buying and selling real property or through other more liquid investments like real ...
  2. What is a derivative?

    A derivative is a contract between two or more parties whose value is based on an agreed-upon underlying financial asset, ...
  3. What is the difference between LIBOR, LIBID and LIMEAN?

    LIBOR, LIBID and LIMEAN are all reference rates used to benchmark short-term interest rates. The London Interbank Offered ...
  4. How do you use a back-to-back loan?

    Back-to-back loans or parallel loans are a financial move used by companies to curb foreign exchange rate risk or currency ...
RELATED TERMS
  1. ISDA Master Agreement

    A standard agreement used in over-the-counter derivatives transactions.
  2. Circus Swap

    A combination of an interest rate swap and a currency swap in ...
  3. Non-Deliverable Swap - NDS

    A currency swap between major and minor currencies that is restricted ...
  4. LIBOR-in-Arrears Swap

    A swap in which the interest paid on a particular date is determined ...
  5. Catastrophe Swap

    A customizable financial instrument traded in the over-the-counter ...
  6. Look-Alike Contracts

    A financial product, such as a swap or an option, that is traded ...
Related Articles
  1. Credit Default Swaps: What Happens In ...
    Insurance

    Credit Default Swaps: What Happens In ...

  2. Derivatives 101
    Fundamental Analysis

    Derivatives 101

  3. The Barnyard Basics Of Derivatives
    Investing Basics

    The Barnyard Basics Of Derivatives

  4. A Guide To Real Estate Derivatives
    Bonds & Fixed Income

    A Guide To Real Estate Derivatives

  5. America's Loss Is The Currency Market's ...
    Forex Education

    America's Loss Is The Currency Market's ...

Trading Center