What is Debt/Equity Swap?
Debt/Equity Swap is an arrangement relating to financial restructuring in which the debts of the company are converted into stock. Such an arrangement is sought for when the company is into financial crisis and the existing lenders are given an option to get the debt given by them converted into equity at a pre-decided swap ratio.
How Does Debt/Equity Swap Work?
When a company faces a serious financial crisisFinancial CrisisThe term "financial crisis" refers to a situation in which the market's key financial assets experience a sharp decline in market value over a relatively short period of time, or when leading businesses are unable to pay their enormous debt, or when financing institutions face a liquidity crunch and are unable to return money to depositors, all of which cause panic in the capital markets and among investors. or is near to the situation of liquidation, then the company is not in a position to repay its debt. In such a situation, the company has to find ways of its financial restructuring. One of the ways for the same is an option for a debt-equity swap.
In the debt/equity swap, debt will be exchanged for equity. Thus, the company will offer the lenders to get the outstanding amount converted into the equivalent amount of equityEquityEquity refers to investor’s ownership of a company representing the amount they would receive after liquidating assets and paying off the liabilities and debts. It is the difference between the assets and liabilities shown on a company's balance sheet. shares of the company. The shares are issuedShares Are IssuedShares Issued refers to the number of shares distributed by a company to its shareholders, who range from the general public and insiders to institutional investors. They are recorded as owner's equity on the Company's balance sheet. in lieu of the outstanding debt in accordance with the pre-determined ratio. The company is saved from immediate cash flows arising due to repayment.
Example of Debt/Equity Swap
The situation of debt/equity swap can be well understood by way of the following example.
Let us say, a company ABC Ltd was facing a financial crisis, and it owes to its lender a total amount of $2,00,000. ABC Ltd offers to its lender 25% shareholding in the company in exchange for the existing amount of outstanding debt.
This is a situation of debt/equity swap wherein the borrower asks its lender to exchange the existing debt for equity.
Reasons for Debt/Equity Swap
Basically, a company opts for debt/equity when it is into long term financial problems. In such a case company knows that it will not be able to make the repayment of its outstanding debts, which will bring negative publicity for the company. In order to avoid such negative publicity, the company plans financial restructuring by way of debit/ equity swap wherein it offers the debt holders to exchange the debt for equity so that it does not have to make repayments. Thus, a debt/equity swap helps the company in the sense that it is not required to make immediate repayments, and financial stress is reduced to this extent.
A debt/equity swap offers the following benefits to the company.
- The company is saved from defaults in repayment of the loan and outstanding interest, which it may incur since it is facing financial stress.
- The company is also saved from the negative image that arises when it is not able to repay the debts.
- Since repayments are not to be done, the company is able to maintain its cash flows.
- A debt/equity swap is a cheap alternative as compared to other methods of financing in case of financial stress. The reason is that as soon as the debt market becomes aware of the fact that companies on a larger scale are incurring financial difficulties in a country, the rate of interest will tend to increase. Thus, the company is better off in choosing a debt/equity swap rather than going for more debt.
On the other side, restructuring by way of a debt/equity swap incurs the following disadvantages.
- As the company offers its lenders to take ownership of its stock, it dilutes its control.
- The lenders may become demanding by asking for more than the fair value of the debt since they are giving away their ownership on debt.
- The problem of financial stress is not entirely solved as cash flowsCash FlowsCash Flow is the amount of cash or cash equivalent generated & consumed by a Company over a given period. It proves to be a prerequisite for analyzing the business’s strength, profitability, & scope for betterment. still remain a problem.
You will come across debt/equity swap in mostly those cases where the company is facing financial stress and is not having enough cash flows to make payments for the debt. In such situations, either the company itself may propose for the debt/equity swap, or the debt holders may ask the company for the same in order to save themselves from the risk of failure of payments in the future.
This has been a guide to what is Debt/Equity Swap. Here we discuss how does debt to equity works along with an example, reasons, advantages, and disadvantages. You can learn more about financing from the following articles –