Control Rights and Maturity: The Design of Debt, Equity, and Convertible Securities

48 Pages Posted: 7 Nov 2008

See all articles by Zsuzsanna Fluck

Zsuzsanna Fluck

Michigan State University - Department of Finance

Multiple version iconThere are 2 versions of this paper

Date Written: November 1997

Abstract

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 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. Long-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 default 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 financing.

Keywords: security design, nonverifiability of cash flows, managerial moral hazard, control rights, maturity, managerial dismissal, asset liquidation, capital structure

Suggested Citation

Fluck, Zsuzsanna, Control Rights and Maturity: The Design of Debt, Equity, and Convertible Securities (November 1997). NYU Working Paper No. FIN-98-035. Available at SSRN: https://ssrn.com/abstract=1297091

Zsuzsanna Fluck (Contact Author)

Michigan State University - Department of Finance ( email )

Eli Broad Graduate School of Management
315 Eppley Center
East Lansing, MI 48824-1122
United States
517-353-3019 (Phone)
517-432-1080 (Fax)

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