Costs of Financial Distress, Delayed Calls of Convertible Bonds, and the Role of Investment Banks

29 Pages Posted: 6 Apr 2007 Last revised: 30 Dec 2022

See all articles by Andrei Shleifer

Andrei Shleifer

Harvard University - Department of Economics; National Bureau of Economic Research (NBER); European Corporate Governance Institute (ECGI)

Dwight M. Jaffee

University of California, Berkeley - Finance Group; National Bureau of Economic Research (NBER)

Date Written: April 1988

Abstract

In a frictionless market with perfect information, a shareholder-wealth- maximizing firm should force conversion of its convertible bond issue into stock as soon as the bond comes in-the-money. Firms however appear to systematically delay forced conversion, sometimes for years, beyond this time. We show that the observed delays can be plausibly explained in terms of costs to shareholders of a failed conversion and the ensuing financial distress. Firms delay the forced conversion to avoid the self-fulfilling outcome that bondholders expect the conversion to fail, tender their bonds for cash, and the stock price falls to account for the costs of financial distress, in which case tendering for cash is in fact optimal. Unlike other explanations of delayed forced conversion, we can explain the common use of investment banks to underwrite these transactions, since the banks can eliminate the self-fulfilling bad outcome.

Suggested Citation

Shleifer, Andrei and Jaffee, Dwight M., Costs of Financial Distress, Delayed Calls of Convertible Bonds, and the Role of Investment Banks (April 1988). NBER Working Paper No. w2558, Available at SSRN: https://ssrn.com/abstract=978754

Andrei Shleifer

Harvard University - Department of Economics ( email )

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Dwight M. Jaffee (Contact Author)

University of California, Berkeley - Finance Group ( email )

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