Convertible Debt and Investment Incentives
DOI:
https://doi.org/10.1016/1057-0810(95)90030-6Abstract
In this paper we examine the effect of convertible debt on the investment incentives facing stockholders. The effect depends critically on the value of existing assets relative to the firm’s investment requirements. With a restrictive dividend covenant, convertible debt mitigates the overinvestment incentive associated with risky debt but exacerbates the underinvestment incentive at higher values of existing assets. A less-restrictive dividend covenant exacerbates overinvestment under straight debt financing but reduces the underin- vestment incentive induced by the conversion feature. In this context, a convertible debt contract with a less-restrictive dividend covenant maximized firm value. The Journal of Financial Research, Spring 1994, XVII(l): 15-29. (Reprinted with permission of The Journal of Financial Research.)
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