Convertible Debt and Investment Timing

31 Pages Posted: 22 Feb 2006 Last revised: 19 Apr 2018

See all articles by Evgeny Lyandres

Evgeny Lyandres

Boston University

Alexei Zhdanov

Pennsylvania State University

Date Written: 2014

Abstract

In this paper we provide an investment-based explanation for the popularity of convertible debt. Speci fically, we demonstrate the ability of convertible debt to alleviate and potentially totally eliminate the underinvestment problem of Myers (1977). A conversion feature induces shareholders to accelerate investment. This e ffect arises from the incentive of equity holders to accelerate the issuance of new equity, used to fi nance investment, since by investing early shareholders dilute the value of convertible debt holders by reducing their proportional claims to the fi rm's cash flows.Since the underinvestment eff ect and the accelerated investment e ffect work in opposite directions, convertible debt allows to mitigate or completely eliminate the debt overhang problem. In addition, we show that by choosing the right combination of straight and convertible debt, shareholders can, for a wide range of overall debt levels, commit to the investment strategy of an all-equity firm.

Keywords: Convertible Debt, Real Options, Investment, Capital Structure

JEL Classification: G32

Suggested Citation

Lyandres, Evgeny and Zhdanov, Alexei, Convertible Debt and Investment Timing (2014). Journal of Corporate Finance, 24, 21-37, Available at SSRN: https://ssrn.com/abstract=884305 or http://dx.doi.org/10.2139/ssrn.884305

Evgeny Lyandres

Boston University ( email )

595 Commonwealth Avenue
Boston, MA 02215
United States
617-3582279 (Phone)

Alexei Zhdanov (Contact Author)

Pennsylvania State University ( email )

University Park
State College, PA 16802
United States

HOME PAGE: http://www.alexeizhdanov.com

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