Is Convertible Debt a Substitute for Straight Debt or Common Equity?

Posted: 22 Sep 1997

See all articles by James K. Seward

James K. Seward

University of Wisconsin - Madison - Department of Finance, Investment and Banking

Craig M. Lewis

Vanderbilt University - Finance

Richard J. Rogalski

Dartmouth College - Tuck School of Business

Date Written: June 1997

Abstract

This paper examines the ability of the risk-shifting hypothesis and the backdoor-equity hypothesis to explain firms' decisions to issue convertible debt. Using a security choice model that incorporates pre-offer issue, issuer, and macroeconomic information, we document significant variation in the market reaction to new convertible debt issues depending on whether investors expect the motivation for issuance to be asset substitution or asymmetric information. Our results suggest that both motives explain the use and design of convertible debt. Some firms issue convertible debt instead of straight debt to mitigate the costs of bondholder/stockholder agency conflicts. Other issuers issue convertible debt instead of common equity to reduce the costs of adverse selection.

JEL Classification: G31, G32

Suggested Citation

Seward, James K. and Lewis, Craig M. and Rogalski, Richard J., Is Convertible Debt a Substitute for Straight Debt or Common Equity? (June 1997). Available at SSRN: https://ssrn.com/abstract=11158

James K. Seward (Contact Author)

University of Wisconsin - Madison - Department of Finance, Investment and Banking ( email )

975 University Avenue
Madison, WI 53706
United States
608-263-2738 (Phone)
608-265-4195 (Fax)

Craig M. Lewis

Vanderbilt University - Finance ( email )

401 21st Avenue South
Nashville, TN 37203
United States

Richard J. Rogalski

Dartmouth College - Tuck School of Business ( email )

Hanover, NH 03755
United States

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