DEBT FOR EQUITY SWAP

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CPA Kipkoech Victor

The main objective of any business is to increase and maximise shareholders wealth. This growth can only be archived and fuelled by raising funds for investments. An entity can raise funds through borrowings from banks in form of loans/debt or by issuing equity, loans/debt involves borrowing money to be repaid plus interest, while equity involves raising money by selling shares in the entity.

If an entity decides to take up a loan/ debt from a bank the benefits includes; the lender does not have a claim to equity in the entity, debt does not dilute the owner’s ownership interest in the entity. A lender is entitled only to repayment of the agreed loan principal plus interest, and has no direct claim on future profits of the business. If the entity is successful, the owners reap a larger portion of the rewards than they would if they had sold stock in the entity to investors in order to finance the growth. Except in the case of variable rate loans, principal and interest obligations are known amounts which can be forecasted and planned for. Interest on the debt can be deducted on the entity’s tax returns hence indirectly lowering the actual cost of the loan to the entity. Raising debt capital is less complicated because the entity is not required to comply with stock exchange laws and regulations.

If the borrowings continue without proper and prudent financial planning, this might turn out to be toxic to the entity. Interest is a fixed cost which raises the entity’s breakeven point. High interest costs during difficult financial periods can increase the risk of insolvency. Companies that are too highly leveraged (that have large amounts of debt as compared to equity) often find it difficult to grow because of the high cost of servicing the debt. Cash flow is required for both principal and interest payments and must be budgeted for. Most loans are not repayable in varying amounts over time based on the business cycles of the entity. Debt instruments often contain restrictions on the entity’s activities, preventing management from pursuing alternative financing options and non-core business opportunities. The larger an entity’s debt-equity ratio, the more risky the entity is considered by lenders and investors. Accordingly, a business is limited as to the amount of debt it can carry. The entity is usually required to pledge assets of the entity to the lender as collateral, and owners of the entity are in some cases required to personally guarantee repayment of the loan.

With the hard economic times and lack of disposable income among the consumers, the borrowing from the credit institution might prove too much for big, small and medium enterprises to service. This institution might opt to swap the debt for equity in order to ensure a healthy working capital, cash flow and most importantly ensure their business remain afloat.

An entity 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 for equity swap. In such a case, a debt is exchanged for a predetermined amount of equity. The value of the swap is determined usually at current stocks 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 debt is cancelled for the newly acquired equity class.

There are many possible reasons why management would wish to restructure an entity’s finances. One possible reason may be that the entity must meet certain contractual obligations, such as maintaining a debt to equity ratio below a certain number, or an entity 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 entity, as detailed in the entity’s articles of association. An entity may self-impose certain valuation requirements to entice investors to purchase its stock.

The debt for equity swap should be done in accordance with IAS 32 on financial instrument presentation and IFRS 9; a financial instrument which replaces IAS 39 as at 1st January 2018. The new IFRS 9 is built on a logical, single classification and measurement approach for financial assets that reflects the business model in which they are managed and their cash flow characteristics. Built upon this is a forward-looking expected credit loss model that will result in more timely recognition of loan losses and is a single model that is applicable to all financial instruments subject to impairment accounting. IAS 32 states that an instrument is a financial liability when an entity has a contractual obligation to deliver cash or another financial asset to the issuer.

When an entity takes up a loan in terms of billions of shillings, how such a loan will be repaid is no longer the sole responsibility of the company, but that of the bank as well.

In accordance with IAS 32, the initial carrying amount of a compound financial instrument is allocated between its equity and liability components. The equity component is assigned the residual amount after deducting from the fair value of the instrument as a whole.

A loan issued to an entity would be classified as equity instrument in the financial statements if an entity does not have an unconditional right to avoid delivering cash or another financial asset to settle a contractual obligation. The entity debits the debt and credits equity in the statement of financial position hence the debt issuer becomes a shareholder.

IAS 32 also requires an instrument to be classified in accordance with its substance rather than its legal form; for example, a share can be classified as a liability under IAS 32 if it obliges the entity to make payments. A debt or liability can be classified as equity if it contains no such obligation. However, anything outside the contractual terms is not considered when classifying an instrument under IAS 32. It is only the substance of the contractual terms of a financial instrument and whether these give rise to a contractual obligation that should be taken into consideration.

When an entity takes up a loan in terms of billions of shillings, how such a loan will be repaid is no longer the sole responsibility of the company, but that of the bank as well. The bank bears the highest risk when it issues such a credit facility, since the bank’s core capital will be affected if the loan is defaulted.

Commercial banks and other lending institutions are in the business of lending and as such are not willing to deviate from their objectives. The lender and their shareholders are not interested in swapping the bad debts or non-performing loans for equity as this might set up a bad precedent in the industry. The decision of accepting the swapping the debt for equity lies with the lender, their shareholders and respective regulators. kipkoechvictor@gmail.com

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