A Game Options Approach to the Investment Problem with Convertible Securities Financing
22 Pages Posted: 31 Aug 2008
Date Written: August, 30 2008
We consider a firm that operates a single plant and has an expansion option to invest in a new plant with convertible debt financing. This conversion feature introduces another complication not only because of the added conversion timing problem (by the bond holder) but also because the equity holder needs to take future conversion into account when evaluating her expansion/financing decision. We have two main objectives here. The first goal is to provide a comprehensive framework and procedure for solving the problem in a mathematically tractable way. In evaluating the debt value and conversion strategy, we employ the solution method for game options. Secondly, we illustrate our solution method through a concrete example and compare it with the case of straight bond financing. In this regard, we attempt to clarify how the conversion feature influences on the equity holder's investment decisions. Throughout the paper, we study expansion options by viewing a firm's existing operation, bankruptcy threat, conversion decisions and financing decisions all together.
Keywords: Convertible bond, Investment decision, Optimal stopping, Game options
JEL Classification: D81, D92, G31, G33
Suggested Citation: Suggested Citation