Why Issue Mandatory Convertibles? Theory and Empirical Evidence

54 Pages Posted: 19 Jul 2003

See all articles by Thomas J. Chemmanur

Thomas J. Chemmanur

Boston College - Carroll School of Management

Debarshi K. Nandy

Brandeis University - International Business School

An Yan

Fordham University - Gabelli School of Business

Date Written: March 2006

Abstract

Mandatory convertibles, which are equity-linked hybrid securities that automatically convert to equity on a pre-specified date, have become an increasingly popular means of raising capital in recent years (about $20 billion worth issued in 2001 alone). This paper presents the first theoretical and empirical analysis of mandatory convertibles in the literature. We consider a firm facing a financial market characterized by asymmetric information, and significant costs in the event of financial distress. The firm can raise capital either by issuing mandatory convertibles, or by issuing more conventional securities like straight debt, ordinary convertibles, or equity. We show that, in equilibrium, the firm issues straight debt or ordinary convertibles if the extent of asymmetric information facing it is large, but the probability of being in financial distress is relatively small; it issues mandatory convertibles if it faces a smaller extent of asymmetric information but a greater probability of financial distress. Our model provides a rationale for the three commonly observed features of mandatory convertibles: mandatory conversion, capped (or limited) capital appreciation, and a higher dividend yield compared to common stock. We also characterize the equilibrium design of mandatory convertibles. We test the implications of our theory regarding a firm's choice between mandatory and ordinary convertibles and find supporting evidence.

Keywords: mandatory convertibles, ordinary convertibles, financial innovation

JEL Classification: G24, G32

Suggested Citation

Chemmanur, Thomas J. and Nandy, Debarshi K. and Yan, An, Why Issue Mandatory Convertibles? Theory and Empirical Evidence (March 2006). EFA 2003 Glasgow, Available at SSRN: https://ssrn.com/abstract=417601 or http://dx.doi.org/10.2139/ssrn.417601

Thomas J. Chemmanur (Contact Author)

Boston College - Carroll School of Management ( email )

Finance Department, 436 Fulton Hall
Carroll School of Management, Boston College
Chestnut Hill, MA 02467-3808
United States
617-552-3980 (Phone)
617-552-0431 (Fax)

HOME PAGE: http://https://www2.bc.edu/thomas-chemmanur/

Debarshi K. Nandy

Brandeis University - International Business School ( email )

Mailstop 32
Waltham, MA 02454-9110
United States

An Yan

Fordham University - Gabelli School of Business ( email )

113 West 60th Street
New York, NY 10023
United States
212-636-7401 (Phone)
212-765-5573 (Fax)

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