Call Policy for Convertible Bonds and Signaling
28 Pages Posted: 18 Mar 2010
Date Written: March 16, 2010
I present a model of the firm financed with equity and callable convertible debt in the presence of tax, debt restructuring and a call period. Convertible bonds can be exchanged into equity stake upon the call if the conversion price is above the call price at the end of the notice period. Since conversion price is uncertain, firms prefer to wait and call with a premium to ensure conversion. The size of the premium depends on the firm's cost of capital. If market is not transparent, early call of convertible bond may serve as a a good signal about firm's ability to raise cash. Issuing convertible bond with "soft protection" that specifies the significant call premium as part of the contract will improve the total value of firm's marketable claims by eliminating the cost of calling.
Keywords: Convertible bonds, callable bonds, asymmetric information
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