Sometimes a company will have a number of financial obligations to undergo restructuring to better position itself for long-term success. A possible way to achieve this goal is to issue a debt / equity or equity / debt swap. In the case of an equity / debt swap, all specific shareholders are entitled to exchange their shares for a predetermined amount of debts (ie bonds) in the same company. A debt / share exchange works the opposite: debt is exchanged for a predetermined amount of equity (or shares). The value of the swap is usually determined at current market rates, but management can offer higher exchange rates to encourage shareholders and holders of shares to participate in the swap. After the swap has taken place, the previous asset class is canceled for the newly acquired asset class.
There are many possible reasons why management would want to restructure the finances of a company. A possible reason may be that the company must fulfill certain contractual obligations, such as maintaining a debt / equity ratio below a certain number, or a company may issue equity to avoid coupon and face value payments because they think they are will not be able to do this in the future. The contractual obligations stated may be the result of financing requirements imposed by a lending institution, such as a bank, or may be imposed by the company itself, as detailed in the company’s prospectus. A company can impose certain valuation requirements itself to entice investors to purchase its shares.
To illustrate, assume that there is an investor who owns a total of $ 1, 500 in ZXC Corp shares. ZXC has offered all shareholders the opportunity to exchange their shares at a rate of 1: 1 or dollar for the dollar. In this example, the investor gets a $ 1, 500 debt if he or she chooses to take the swap. On the other hand, if the company really wanted investors to trade shares for bonds, it could sweeten the deal by offering a swap ratio of 1: 1. Since investors would receive $ 2, 250 (1.5 * $ 1, 500) in value of debt, they mainly reached $ 750 for changing asset classes. However, it is worth noting that the investor would lose all respective rights as a shareholder, such as voting rights, if he exchanged his equity for debt.
Read Debt Reckoning or our Fundamental Analysis tutorial for more information about evaluating a company’s debt and financial strength.