Taxation, Agency Conflicts, and the Choice between Callable and Convertible Debt

Posted: 24 Jan 2012

See all articles by Chris Hennessy

Chris Hennessy

London Business School

Yuri Tserlukevich

Arizona State University (ASU)

Date Written: January 23, 2012

Abstract

We analyze debt choice in light of taxes and moral hazard. The model features an infinite sequence of nonzero-sum stochastic differential games between equity and debt. Closed-form expressions are derived for all contingent-claims. If equity can increase volatility without reducing asset drift, callable bonds with call premia are optimal. Although callable bonds induce risk shifting, call premia precommit equity to less frequent restructuring and are tax-advantaged. Convertible bonds mitigate risk shifting, but only induce hedging if assets are far from the default threshold. Convertibles are optimal only if risk shifting reduces asset drift sufficiently.

Suggested Citation

Hennessy, Christopher and Tserlukevich, Yuri, Taxation, Agency Conflicts, and the Choice between Callable and Convertible Debt (January 23, 2012). Journal of Economic Theory, Forthcoming. Available at SSRN: https://ssrn.com/abstract=1990400

Christopher Hennessy

London Business School ( email )

Sussex Place
Regent's Park
London, London NW1 4SA
United Kingdom

Yuri Tserlukevich (Contact Author)

Arizona State University (ASU) ( email )

Farmer Building 440G PO Box 872011
Tempe, AZ 85287
United States

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