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Surveys show that managers base their motives for the use of convertible debt on factors that are irrational according to the theoretical literature. This theoretical literature in turn offers a number of rational motives. These motives are based on the resolution of the problems of informational asymmetry and agency costs, on tax motivations and managerial entrenchment arguments. Most of the rational motives have been investigated in the cross-sectional studies, which offer general support to at least some of them.
However, the survey studies find very little to no support for the rational motives. This might be due to either the sensitivity of the surveys to the question contents, to the use of weak proxies in the cross- sectional studies, or a combination of these.
In our view, future research in this field should aim for an approach that combines the use of survey data and cross-sectional analysis. We believe that such an approach may bridge the gap between theory and practice. Loncarski uvt. V5A 1S6, tel. Companies can use equity in the form of internally generated funds or issue new shares of common stock. Alternatively, they can use debt in the form of bank loans or issue bonds. The use of hybrid securities represents yet another possibility.
The most well-known hybrid securities are so- called convertible bonds which, at the option of the holder, can be exchanged into shares of common stock of the issuing company. An example of a convertible bond issue is the bond issue by General Motors Corporation in These bonds pay an annual coupon of 6. Furthermore, on their maturity date, the holder of the bond has the option to choose between receiving the nominal value in cash or converting the bond into 21 shares of the General Motors Corporation stock.
On the other hand they resemble equity, because part of the price that is paid for them is for the option to exchange the bonds into shares. The money paid for the option does not have to be paid back by the company, irrespective of future developments of the stock price. An interesting question is what motivates companies to issue a hybrid security like a convertible bond instead of issuing straight debt or equity.
The argument that equity can be attracted at a higher price than the stock price at the issuance date of the convertibles is based on the fact that the conversion price is generally higher than the current stock price. The conversion price is the price for which the holders of the convertible bonds can buy stocks. The second argument that convertibles offer a possibility to attract debt at a low interest rate is based on the fact that the coupon rate on the convertibles is lower than the coupon rate a company would have to pay on ordinary debt.
In the General Motors example, the company pays a coupon of 6. However, both these claims are refuted by academics who argue that the conversion price should not be compared to the current stock price, and hence reject the first argument. They also reject the second argument, explaining that the lower coupon interest on convertible bonds is caused by the 4 The data on these convertible bonds is taken from the SDC database on new issues.
The conversion ratio is the number of shares that is acquired when the bonds are converted. In this example it is Since an option is a right and not an obligation, this option has a value, which is paid for by the holder of the convertible by accepting a lower interest rate. Academic theories in corporate finance concerning the question why companies issue convertible debt are generally based on agency and asymmetric information models.
However, surveys among managers responsible for the decision to issue convertibles generally show very little support for these theories. The objective of this paper is to review the different viewpoints and to see where theory and practice agree, and where the large disagreement lies. Before going into the question why companies issue convertible bonds, it is useful to give a short overview of the market for these financial instruments.
The size of the market for convertible debt varies between the countries considerably, with the U. The U. However, there is an increased popularity of convertible debt between and in terms of the number of convertible bond issues, which can again be observed in As shown in Table 3, the largest issue sizes, measured in mean and median values, are in the Western European markets, while the smallest are in South Korea and Australia.
The largest variations, measured with the coefficient of variation, are in the German and South Korean market, while the smallest can be observed in Taiwan 6. This is due to missing information on issue sizes for some of the issuers in the SDC database. This question is very relevant in practice, because convertible bonds are not only frequently used by large exchange-listed companies, but also by young companies that use venture capital.
By answering the question why companies issue convertible bonds we can also shed more light on the question why companies issue other hybrid financial instruments.
These hybrids include convertible preferred stock and warrant-bond loans among others. Convertible preferred stock is preferred stock with an option for the holder to convert it into common stock. A warrant-bond loan is a loan with warrants attached. The most important difference between warrant- bonds and convertible bonds is that the warrants in a warrant-bond loan can be detached from the bonds after the issuance.
We will not go into the choice that companies can make between different hybrid financial instruments. A related topic that will shortly be mentioned is that of the call policy of convertible bonds. Convertible bonds are usually callable, which means that the company has a right to call the bonds, and to repay the investor before maturity or conversion. Ingersoll demonstrates that the optimal moment to call a convertible is when the conversion value equals the call price.
The conversion value is the value of the common stock to be received in the conversion exchange. However, in an empirical study he finds that in practice the calls show a delay. On average the conversion value of the bonds is This finding of Ingersoll has led to a large amount of academic papers on the question why convertible bonds are called late. Given that this is only a side issue in the decision to issue convertible bonds, we will not discuss this topic further.
The paper is structured as follows. In Section 2 we review the theoretical arguments for the issuance of convertible debt. Section 3 is dedicated to a review of empirical evidence, based on different types of empirical studies: event studies, cross-sectional analyses and surveys.
Section 4 concludes the paper. Why do investors then in terms of underlying equity valuation of the company react differently to the issue announcements of different types of securities 7? Modigliani and Miller build their model based on the assumptions of perfect capital markets 8 and those of perfectly informed agents who trade securities, who share similar information symmetric knowledge and are of equal atomic size. Their model, although shown not to hold in reality, provides the cornerstone of the capital structure research framework.
Perhaps the most crucial assumption is the one about symmetric information and perfect knowledge of the agents. This assumption has inspired numerous later strains of literature.
We can describe such a setting with the notion of an asymmetric information framework. In such a setting efficient transmission of funds contracts between parties is impaired and can, in the worst case, lead to a complete market collapse see Akerlof The main reasons are adverse selection and agency problems. The agency problem is a result of ex-post possible opportunistic behavior of an agent, once the contract has been made, but the actions of the agent are unverifiable and contracts do not cover all possible contingencies.
In a financing arrangement contract between a firm agent and an investor principal all these issues play crucial roles and the severity of the adverse selection and the agency problem affects the efficiency of a firm's financing.
The worse the adverse selection and agency problems are, the less efficient the financing channel will be, since a first best solution cannot be achieved. A first best solution is the outcome under no adverse selection and agency problems. Put differently, the financing will become more expensive for the firms, because principals cannot differentiate between the agents properly, since bad types can mimic good types. This drives out some positive net present value investment opportunities Myers and Majluf and creates a social dead weight loss, since a first best solution is not implemented.
Good type agents thus try to send signals to the principals about their true types in order to differentiate themselves and overcome this issue. In such setting the capital structure, or the way a firm finances itself, is considered to be a signaling device Heinkel , but above all the security types that compose the capital structure are considered to be a signaling mechanism Myers and Majluf Producing a signal has to be costly in order to be perceived as credible.
In other words, only the agents that can afford to produce the signal good types will do so, while bad types will not mimic them, as 7 For the empirical evidence on wealth effects associated with announcements of different securities see Section 3.
Otherwise, the signal can be sent by anyone and types cannot be correctly inferred. For example, a bad type firm will not issue debt, since that increases the probability of the financial distress much more than for a good type firm. In that respect, a capital structure or a degree of leverage can serve as a credible signal of the firm type. Similar is the case of different types of security issues, where there is an equity issue on one end of the spectrum and a straight debt issue on the other.
The paradox of both security types is their incompatibility. Namely, equity ownership induces risk taking, due to limited liability. The most an investor can lose are the funds invested, while the upper potential for gains is unlimited 9. Debt ownership on the other hand induces risk aversion, since the most debtholders can gain is the principal and a fixed return. Debtholders are not compensated for additional risk being undertaken by the firm and are therefore faced with a concave payoff function.
In the case where the realized cash flow of the firm is greater than the principal, debtholders receive only the principal and do not participate on any gains above that value.
Convertible bonds as backdoor equity financing
Skip to search form Skip to main content You are currently offline. Some features of the site may not work correctly. DOI: Stein Published Economics. This paper argues that corporations may use convertible bonds as an indirect albeit possibly risky method for getting equity into their capital structures in situations where adverse selection problems make a conventional stock issue unattractive. Unlike other theories of convertible bond issuance, the model of this paper highlights: 1 the importance of call provisions on convertibles; and 2 the significance of costs of financial distress to the Information content of a convertible issue.