Archive for May, 2008

Debt for Equity swap

Thursday, May 29th, 2008

Companies have many options for financing operating activities, issue debt, issue stock, and using cash flow from operations among other things. One stock I have been following for a while now is E*Trade (NYSE:ETFC), which has been engaging in something called a debt for equity swap recently. I wanted to go into detail why I believe these swaps are good for shareholders.The basic idea behind one of these swaps is to issue equity equaling a debt load to pay off the debt. I am going to construct a simple example to explain the concept below.Consider the following:

Company Acme

  • Revenue of $1,000,000
  • Cost of running business $500,000/yr
  • Original shares outstanding 100000
  • Debt of 10 year $300,000 at 5%
  • Shares trading at $50

Revenue $1,000,000
COGS $ 500,000
Interest Payment $ 15,000

Net Income = $485,000
Earnings per share = $485,000/100000 = $4.85/share

The company issues 6,000 shares at $50 bringing the share count to 106,000 and lowering the earnings per share from $4.85 to $4.57. The share count was increased by 6% and the earnings per share decreased by 6%. Now lets take a look at year two:

Revenue $1,000,000
COGS $ 500,000
Interest Payment $ 0

Net Income = $500,000
Earnings per share = $500,000/106,000 = $4.71/share

The earnings per share increased 3% from the reduction of the debt. This leaves more money in the company for operation, or dividends for shareholders. The company can initiate a share buyback to reduce the dilution from the swap. The company also has discretion about buying back stock, this freedom does not exist with a debt issue. Because of the freedom the company could buy back some of the stock if the price of the issue falls.

Ideally a company should never have to dilute shareholders in some situations it’s much better than being saddled with a big debt load. The debt for equity swap gives a company freedom in their financing activities and can allow a company to gain footing much quicker than issuing debt.

The news item that relates to E*Trade and this post can be found here: link

Disclaimer: I own a very small option position in E*Trade.

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