… e actions that benefit one group (shareholders) and are detrimental to the other. Basically, the conflict occurs because both the bondholders’ trustee and the agent behave in accordance with their own self interests. The agency problem considered here is encountered by the corporate management in selecting among mutually exclusive investment projects. This happens because straight bonds create an incentive for equity holders to force the agents to adopt high risk projects, since high risk projects with negative NPV reduce the value of the firm and transfer wealth from bondholders to shareholders. On the other hand, creditors (bondholders’ trustee) have an incentive to force the firm into low risk activities in order to preserve their wealth.
As Jensen and Smith noted “the value of the stockholders’ equity rises and the value of the bondholders’ claim is reduced when the firm substitutes high-risk for low-risk projects.” However, because convertible bonds have an equity component, less expropriation of wealth can occur when convertible debt is issued instead of straight debt. Moreover, since convertible debt contains an option feature, its value increases with risk. In other words convertible debt can mitigate agency costs and the risk shifting problem that derives. As Ross et.
al. states one implication is that convertible bonds have less restrictive debt covenants than straight bonds. iv) A good financing strategy Firms desire equity capital and convertibles are an expedient way of selling common stock. In addition, firms desire more debt and by adding the convertible feature in a straight bond gives them the opportunity to borrow in lower interest costs. The use of a conversion privilege as a ‘sweetener’ to obtain lower interest rates on debt is well known in financial markets.
Purchasers feel that the conversion privilege is worth at least as much as the difference in interest on a straight bond and interest on a convertible. Brigham (1966) tried to determine which of the above two reasons was predominant in firm’s decisions to issue convertibles. He sent questionnaires to 22 firms. Of these, 73 percent indicated that they were interested in obtaining equity, and the remaining 27 percent stated that they were simply interested in ‘sweetening’ a debt issue.
Each one of the respondents indicated that they had financing alternatives at reasonable costs. They stated that they could have issued common stock at prices ranging from 2 to 5 percent below the market price and the straight debt alternative would have increased interest costs only to 1 percent. They were in no way forced to use convertibles. Thus, it may be concluded that the firms were in a position to take advantage of the best financing strategy package available. That is using convertible debt.
v) Backdoor Equity / Delayed Equity Firms use convertible debt for many reasons but an important reason is as a way of avoiding adverse-selection problems – caused by asymmetric information. The situation is that management has investment opportunities that they believe to be highly profitable, in contrast with the market that is either is not aware of these opportunities or it is more pessimistic concerning the profitability of the projects. The price of the firm’s stock will reflect the opinion of the market and not of management. If the firm has reached its capacity for long-term secured debt and the flow of internal funds is not sufficient to support the proposed projects, then the management would prefer to issue new shares of common stock. But the price of the new shares will reflect the market’s more pessimistic view and the present shareholders will not receive the full benefits of the investment. This is an appropriate scenario for management to make a delayed equity issue.
That is, issue convertible bonds with a conversion price approximating the value of the stock if the market agreed with management on the value of the investments. If the investment opportunities turn out as well as management expected the market price of the stock will go up and the bonds can be called (forced) and converted. Thus, management will be able to issue delayed (backdoor) equity and the present shareholders receive the benefit of the profitable investment. Stein (1992) argues that good firms (that are more likely to have success) will issue debt, bad firms will issue equity, and medium firms will issue convertibles. He also mentions that firms with high costs of bankruptcy (example higher R&D), and firms with higher than industry average debt ratios are more likely to issue convertibles if they expect good times ahead and can force conversion. By issuing convertibles now with a call provision, firms can issue equity (by forcing conversion) which will allow the firm to raise more debt if they need it in the future.
In general, when the success of a project is unknown, convertible bonds allow firms to raise new debt in the future if successful, if not successful, then controls free cash flow problem rather than allowing further investments in it. vi) Other reasons The interest is tax deductible. Because convertible bonds are a form of debt the coupon payment can be regarded as a cost of the business and can therefore be used to reduce taxable profit. Self liquidating. When the share price reaches a level at which conversion is worthwhile the bonds will normally be exchanged for shares so the company does not have to find cash to pay off the loan principal – it simply issues more shares.
This has obvious cash flow benefits. However the disadvantage is that the other equity holders may experience a reduction in earnings per share (equity dilution). Fewer restrictive covenants. The company has greater operating and financial flexibility than they would with a secured debenture. Investors accept that a convertible is a hybrid between debt and equity finance and do not tend to ask for high-level security, impose strong operating restrictions on managerial action or insist on strict financial ratio boundaries. Ending, Mayers, D.
(1998) proposes that corporations use callable, convertible bonds to lower the issuance costs of sequential financing. Sequential financing helps control over-investment incentives, that can arise if financing is provided prior to an investment option’s maturity, but incurs additional issue costs. A convertible bond’s conversion option reduces these costs while helping to control the over-investment incentive. 4. Conclusion Principles of basic financial theory are in direct conflict with the reasons given by managers to issue convertible debt. Some see convertibles as cheap debt; others view them as a way to raise equity at a favourable cost and with less dilution.
While convertibles are not a cheap form of financing, they can lower the cost of capital and thus increase the value of the firm. Straight debt and equity represent the opposite ends of the spectrum of fixed payment obligations incurred by a firm. Convertible debt on the other hand permits a trade off between the fixed payment obligation and the equity component. Issuing convertibles is a more flexible source of finance. Therefore, firms have the opportunity to use convertible debt in various situations and for various reasons. 5.
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