Contingent Capital, Capital Structure and Investment
36 Pages Posted: 15 Feb 2015 Last revised: 16 Feb 2015
Date Written: February 15, 2015
We examine the interaction between investment and financing policies in a dynamic model for a firm with existing assets-in-place and a growth option, of which investment cost is financed with equity and contingent convertible bond (CoCo). We attempt to clarify how CoCo impacts on investment timing, capital structure and the inefficiencies arising from debt overhang and asset substitution. We show that the inefficiencies disappear if CoCo's conversion ratio is sufficiently high. Our conclusions predict two empirical phenomenons: The debt leverage of a firm decreases with the growth rate of growth option or the cash flow average appreciation rate, as reported by Fama and French (2002), and it is close to the empirical data, 0.33, as far as US corporations are concerned. In contrast to traditional corporate finance theory, our model indicates that the firm value before expansion investment first decreases and then increases with asset volatility, instead of decreasing globally with business risk. We highlight that a CoCo with a full principal write-down feature would cause serious inefficiencies from debt overhang and asset substitution.
Keywords: Growth option, Contingent capital, Capital structure, Debt overhang
JEL Classification: G13, G31, G32, G33
Suggested Citation: Suggested Citation