Capital Structure Swaps and Shareholder Wealth

Abstract

We show how capital structure swaps can increase the wealth of a firm's long-term shareholders when a firm's debt or equity is misvalued. We review the conventional rule that a firm should issue equity and use the proceeds to retire outstanding debt (an equity-for-debt swap) when equity is overvalued, or repurchase equity with proceeds of new debt (a debt-for-equity swap) when equity is undervalued. We also analyze the more complex case where a firm's debt and equity are both undervalued, showing the optimal swap may be to issue undervalued equity, contrary to the conventional rule.

Note: Previously titled: A Review of Debt/Equity Choice when Securities are Mispriced

Keywords: Debt/equity, swaps, mispricing, timing, intrinsic value

JEL Classification: G30, G32