Debt-Equity Swap, Subsidy and Optimal Government Policy

33 Pages Posted: 10 Mar 2020

See all articles by Ei Yang

Ei Yang

Shanghai University of Finance and Economics, School of Finance

Shaoxuan Zheng

Shanghai University of Finance and Economics

Date Written: February 15, 2020

Abstract

In 2016, the Chinese government proposed a one-time debt-equity swap (DES) program to assist firms in financial distress and to reduce the leverage ratio of non-financial firms. We use a dynamic capital structure model to study the effects of this program on firms with and without subsidy. A DES can increase a firm’s value by lowering its leverage ratio and reducing its expected bankruptcy cost. The subsidized firms initially take more debt and are thus more incentivized to undertake a DES. Notably, a firm’s undertaking a DES can have opposite effects on government value: on the one hand, it can increase government value from the tax-benefit channel, but on the other hand, it can reduce government value by extending the period of tax shields and subsidies granted to a firm. Consequently, we show that the optimal government policy depends on the characteristics of firms and the ultimate goals of government. In particular, the optimal policy for subsidized weak firms is a DES with subsidy removal, which introduces a tradeoff between a DES and a subsidy.

Keywords: Debt-Equity Swap, Subsidy, Government Policy, China

JEL Classification: G33, G38, H26

Suggested Citation

Yang, Ei and Zheng, Shaoxuan, Debt-Equity Swap, Subsidy and Optimal Government Policy (February 15, 2020). Available at SSRN: https://ssrn.com/abstract=3538702 or http://dx.doi.org/10.2139/ssrn.3538702

Ei Yang (Contact Author)

Shanghai University of Finance and Economics, School of Finance ( email )

777 Guoding Road
Tongde Building 304
Shanghai, Shanghai 200433
China
86-2165904797 (Phone)

HOME PAGE: http://https://sites.google.com/site/eiyangecon

Shaoxuan Zheng

Shanghai University of Finance and Economics ( email )

777 Guoding Road
Shanghai, AK Shanghai 200433
China

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