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Keywords:

  • capital structure;
  • swaps;
  • debt;
  • equity;
  • asymmetric information
  • G30;
  • G32

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 analyse 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.