Convertible Debt and Investment Timing

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 effect 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 effect and the accelerated investment effect 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