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IAI Actuarial Core Principles · Business Finance · Corporate growth, restructuring and divestment

A company with accumulated losses and heavy debt agrees with creditors to cancel part of its debt in exchange for newly issued equity shares. What is the most direct effect of this debt-for-equity swap on the company's balance sheet?

Liabilities fall and equity rises by the amount converted, so gearing is reduced. No cash is received, so total assets stay the same, but the capital structure shifts from debt towards equity and lowers fixed interest obligations.

  1. ALiabilities fall and equity rises, reducing gearingCorrect
  2. BBoth liabilities and equity fall
  3. CTotal assets rise by the value of debt cancelled
  4. DLiabilities rise and equity falls
  5. There is no change in gearing because total capital is unchanged

Explanation

Converting debt into shares extinguishes a liability and creates equity of a corresponding amount, so the debt-to-equity ratio falls. No cash moves, so total assets are unchanged. Total capital is unchanged but its mix changes, so gearing does change.

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