Control Rights and Maturity: The Design of Debt, Equity, and Convertible Securities
Michigan State University - Department of Finance
New York University, Center for Law and Business, Working Paper No. 98-005
This paper investigates the design of the control rights and the maturity of securities when management has the ability to divert or manipulate the cash flows, and when it is prohibitively costly for a third party, such as a court, to verify or prove any managerial wrongdoing. By endogenizing claim structures, control rights and maturity, I derive a diverse set of optimal contracts. Debt with a maturity shorter than the life of the assets is sustainable when investors have the contingent right to liquidate the firm?s assets. Longer-term debt can be sustained by investors? right to dismiss management and take over the firm as a going-concern in the event of a default. Investors are willing to hold indefinite life equity if they are granted either the unconditional right to liquidate firm?s assets or the unconditional right to dismiss management. Finally, convertible debt can be sustained by investors? right to dismiss management and take over the firm in the event of a default and by the holder?s option to convert their debt contract to an equity contract prior to its expiration date. Consistent with empirical evidence, this model predicts that small entrepreneurial firms use short-term bank loans, convertible debt, or outside equity at their initial financing stage; as they show evidence of higher profitability, they can secure longer-term debt financing.
JEL Classification: G31, G32working papers series
Date posted: May 30, 1999
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