ALTERNATIVES AND IMPLICATIONS

Debt settled through the use of an asset – Debtor must have an asset available for payment of the loan – Debtor may need to adjust the carrying amount of the asset to its fair value prior to recording its exchange for a debt How does bank determine fair value? – Difference between carrying amount and fair value of the asset is recorded as an ordinary gain or loss on disposition of assets. – Difference between the carrying amount of the debt and the fair value of the asset given up is also recorded as an ordinary gain on debt restructuring.

An asset swap will reduce total assets and total liabilities. Total financial resources available for business operations will decline – Liquidity and long term solvency will suffer because decrease in total assets will affect ability of business to meet future commitments – Limited financial assets may hamper the company’s access to credit thereby hampering business operations – Financial leverage should improve Important that bank consider above before pursuing asset swap.

 Asset swap should have a positive effect on the income statement if …  Recognition of accounting gain due to debt restructuring and a follow-on increase to reported stockholders’ equity.  Increase in income may have tax affect

 Business owners: mixed feelings  Favorable and unfavorable? ▪ Favorable: positive effect on the income performance brought about by the recognition of the accounting gain on debt restructuring ▪ Higher return on investment ▪ Higher EPS

 Business owners: mixed feelings ▪ Unfavorable: equity holders may find an asset swap uncomfortable because asset decreases may have negative financial and operating impact. ▪ Creditors wary of the paying ability even after debt restructuring agreement because asset payment has impact on liquidity/solvency position

Payment to settle debt in the form of shares of the debtor’s stock Debtor must have available unissued shares available for issuance. Stochastic valuation should be completed Balance sheet effect ▫ Equity swap has no effect on total assets because no asset was used to settle debt ▫ Liabilities decline as a result of debt payment ▫ Stockholders’ equity increases as a result of the issuance of the shares of stock ▫ Debt to equity ratio will improve because of the decrease in total liabilities. ▫ No Income statement effect - no accounting gain is recognized ▫ No cash flow statement effect

 Equity dilution  Voting powers and policy making powers may be curtailed by the new stockholders.

 Local creditors of Maynilad Water Services agreed to convert three billion pesos of debt to coupon, convertible and redeemable preferred shares  After restructuring, Maynilad would be 39% owned by shareholders, 19% by an investment group, 2% by the bank, 4% by employees and 36% by a holding corporation. .

 Key Stockholders’ Concern  Stockholders will find modification of debt terms favorable ▪ overall effect on the financial position and income performance limited effect ▪ The debt paid but at a later date ▪ Hence, on date of the debt restructure no effect on balance sheet ▪ If a gain is to be recognized, the effect on the income statement is positive but this represents non operating credit

 Key Stockholders’ Concern  Payment of debt is usually postponed to a later date.  Hence, corresponding effect on the financial statements is likewise spread over the new repayment period

 Key Stockholders’ Concern  Payment of debt is usually postponed to a later date. ▪ Hence, corresponding effect on the financial statements is likewise spread over the new repayment period