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. What would motivate an entity to enter into a swap agreement?

    Learn why parties enter into swap agreements to hedge their risks, and understand how the different legs of a swap agreement ... Read Answer >>
  2. Can bond traders trade on interest rate swaps?

    Read about interest rate swaps and why these transactions are performed by institutional actors in the bond market, not individual ... Read Answer >>
  3. When was the first swap agreement and why were swaps created?

    Learn about the history of swap agreements, the first swap agreement between IBM and the World Bank, and how swaps have evolved ... Read Answer >>
  4. What are some risks a company takes when entering a currency swap?

    Read about the risks associated with performing a currency swap, including counterparty credit risk in the event that one ... Read Answer >>
  5. How do companies benefit from interest rate and currency swaps?

    An interest rate swap involves the exchange of cash flows between two parties based on interest payments for a particular ... Read Answer >>
  6. Do interest rate swaps trade on the open market?

    Learn how interest rate swaps are traded on the OTC and interbank markets, and how these swaps can be used to arbitrage different ... Read Answer >>
Related Articles
  1. Investing

    What Warren Buffet Calls "Weapons of Mass Destruction": Understanding the Swap Industry

    A full analysis of how the swap industry works.
  2. Investing Basics

    How Are Interest Rate Swaps Valued?

    When trading in financial markets, higher returns are generally associated with higher risk. Hedge your risk with interest rate swaps.
  3. Forex Education

    Currency Swap Basics

    Find out what makes currency swaps unique and slightly more complicated than other types of swaps.
  4. Professionals

    Swaps

    CFA Level 1 - Swaps. Learn how swaps can change the characteristics of assets or liabilities. Discusses the cash flows of interest rate and currency swaps.
  5. Investing

    What's an Interest Rate Swap?

    An interest rate swap is an exchange of future interest receipts. Essentially, one stream of future interest payments is exchanged for another, based on a specified principal amount.
  6. Professionals

    Swap Markets and Contracts

    CFA Level 1 - Swap Markets and Contracts. Learn the basics of swaps, including how they are used and settled. Includes various methods for terminating a swap contract.
  7. Investing Basics

    Different Types of Swaps

    Investopedia explores the most common types of swap contracts.
  8. Investing

    How To Read Interest Rate Swap Quotes

    Puzzled by interest rate swap quotes terminology? Investopedia explains how to read the interest rate swap quotes
  9. Professionals

    Interest Rate and Equity Swaps

    CFA Level 1 - Interest Rate and Equity Swaps. Learn the components of plain vanilla interest rate swaps and equity swaps. Contains sample calculations finding the payments for each swap.
  10. Professionals

    Currency Swaps

    CFA Level 1 - Currency Swaps. Discusses the features of a currency swap. Learn how comparative advantage affects the payments made during a swap agreement.
RELATED TERMS
  1. Debt/Equity Swap

    A transaction in which the obligations (debts) of a company or ...
  2. Swap

    A derivative contract through which two parties exchange financial ...
  3. Reverse Swap

    An exchange of cash flow streams that undoes the effects of an ...
  4. Forward Swap

    A swap agreement created through the synthesis of two swaps differing ...
  5. Swap Bank

    A financial institution that acts as an intermediary for interest ...
  6. Bond Swap

    Selling one debt instrument in order to use the proceeds to purchase ...

You May Also Like

Hot Definitions
  1. Return On Invested Capital - ROIC

    A calculation used to assess a company's efficiency at allocating the capital under its control to profitable investments. ...
  2. Law Of Demand

    A microeconomic law that states that, all other factors being equal, as the price of a good or service increases, consumer ...
  3. Cost Of Debt

    The effective rate that a company pays on its current debt. This can be measured in either before- or after-tax returns; ...
  4. Yield Curve

    A line that plots the interest rates, at a set point in time, of bonds having equal credit quality, but differing maturity ...
  5. Stop-Limit Order

    An order placed with a broker that combines the features of stop order with those of a limit order. A stop-limit order will ...
  6. Keynesian Economics

    An economic theory of total spending in the economy and its effects on output and inflation. Keynesian economics was developed ...
Trading Center