Exchangeable debt gives the purchaser the option to exchange the debt for stock of a second company, referred to as the ''convert'' firm. For example, in March of 1985, Petrie Stores issued $150 million of exchangeable callable debt, due in 2010. The exchange feature enabled the purchaser of the debt to exchange each $1 000 face value of debt for just over 27 shares of Toys ''R'' Us common stock. Petrie Stores owned a minority interest in Toys ''R'' Us and deposited a sufficient number of Toys ''R'' Us common with an escrow agent to guarantee the exchange option. Exchangeable debt has been offered by firms since the early 1970s and accounted for approximately six percent of all equity-linked debt in the early 1980s. Firms issued 37 exchangeable debentures from 1971 through 1987 (see Exhibit 1). This research investigates the motivations for issuing exchangeable debt and the valuation effects to the issuing and convert firms. The evidence cited in this research indicates that firms issue exchangeable debt once they decide to divest of a security holding. A significant proportion of firms issuing exchangeable debt had previously pursued the ''convert'' firm in a takeover attempt (see Exhibit 2). Though issuing firms experience no significant valuation effects, convert firms, on average, experience a -1% abnormal return (see Exhibit 4). Since exchangeable debt is a divestment strategy with a potentially informed investor (the issuer) disposing of a block of stock (the convert firm), the negative valuation effect to the ''convert'' firms is predictable. Nonetheless, the documented price response is less pronounced than the negative price response associated with secondary distributions or block sales, which are the likely alternative forms of disposing of the security holding. The less pronounced negative price response on the announcement of an exchangeable debt offering is consistent with the notion that exchangeable debt offers an investor a repurchase guarantee limiting the losses of investors to the price of the implicit call option (see Appendix C). Unlike secondary offerings or block sales, exchangeable debt offers an investor the guarantee of a ''floor'' should the stock price of the convert firm fall subsequent to issue. The guarantee of a floor on losses to investors appears to mitigate the information effects of the announcement relative to the information effects of, for example, secondary offerings. Firms issuing exchangeable debt often cite one of two possible tax motivations for issuing exchangeable debt. First. the issuing firm is able to capitalize on a security holding while delaying the recognition of capital gains. Any accrued capital gains are not taxed until the conversion feature is exercised. Second, the issuing firm is able to hold the convert firm's stock in escrow, collecting tax-preferred dividend income (due to the corporate dividend tax exclusion) until the conversion feature is exercised. The latter tax advantage only applies to holdings purchased prior to October 1984. It is likely that exchangeable debt was originally conceived to capitalize on specific features of the tax code. However, these tax motivations do not appear to be potential sources of value to firms issuing exchangeable debt for three reasons. First, there is no abnormal price response to the issuing firm on the announcement of an exchangeable debt issue. Second, there is no evidence that the price response of issuing firms is cross-sectionally related to estimates of the tax benefits associated with issuing exchangeable debt. Third, the tax motivations are not unique to exchangeable debt. Capital gains taxation can be avoided by delaying the sale of the stock. Tax-preferred dividend income can be captured by issuing debt to purchase stock. Finally, this paper documents that the median underwriting cost of issuing exchangeable debt (1.56%) is less than the median underwriting cost of a secondary offering (4.7%). This evidence, in combination with the less pronounced valuation effects relative to secondary offerings or block sales, provides some justification for the use of exchangeable debt as a divestment strategy. Aside from this evidence, I conclude that exchangeable debentures are a neutral mutation of previously existing divestment strategies and represent an unconvincing attempt to capitalize on specific characteristics of the tax code.
