Contingent Capital, Real Options and Agency Costs
32 Pages Posted: 6 Aug 2013 Last revised: 12 Nov 2014
Date Written: June 4, 2014
This paper aims to clarify how contingent convertible bond (CCB) as a debt financing instrument affects the firm's investment policy, agency cost of debt and capital structure. We consider two different conversion thresholds of CCB: One is endogenous and the other is exogenous. We find that under an exogenous conversion threshold, there is an explicit optimal fraction of equity allocated to CCB holders upon conversion, such that the agency cost reaches the minimum value zero. Numerical analysis demonstrates that CCB decreases bankruptcy risk and increases the issuing firm value. Under an endogenous conversion threshold, CCB gives rise to overinvestment, a higher leverage, a possible bigger agency cost and a stronger incentive to increase risk. But if the conversion threshold is exogenously determined, almost the opposite holds true.
Keywords: real options, contingent convertible bond, capital structure, agency costs
JEL Classification: G13, G32
Suggested Citation: Suggested Citation