Contingent Capital, Real Options, and Agency Costs

Abstract

This paper aims to clarify how contingent convertible bond (CoCo) as a debt financing instrument affects a firm's investment policy, agency cost of debt, and capital structure. We consider endogenous and exogenous conversion thresholds, respectively. Under the exogenous case, there is an explicit optimal fraction of equity allocated to CoCo holders upon conversion, such that the agency cost reaches zero. Numerical analysis demonstrates that under an endogenous conversion threshold, CoCo induces overinvestment, a higher leverage, a possible bigger agency cost, and a stronger incentive to increase risk. But if the conversion threshold is exogenously determined, almost the opposite holds true.

Contingent capital with repeated interconversion between debt‐ and equity‐like instruments

“…The optimal capital structure given by (33) is essentially derived by Song and Yang (2016). However, a previous version of the paper is the first in the literature to provide the explicit optimal capital structure (33) when CoCos are issued.…”

“…The potential issuers of CCSs/CoCos should be banks, but they could be essentially issued by any firms as argued by Flannery (2005), Song and Yang (2016) and Tan and Yang (2016). 2 Our research is related to Pennacchi, Vermaelen, and Wolff (2014), who introduce and analyze a new form of contingent capital, namely a call option enhanced reverse convertible (COERC), which has several merits but like all other instruments, they cannot adjust capital structure dynamically.…”

“…Otherwise, the firm may find it optimal to 'burn money' to push its cash flow below the trigger, see Himmelberg and Tsyplakov (2012), as pointed out in Remark 3. Moreover, the choice of ownership stake is closely related with equityholders' incentive of risk shifting and the agency costs of debt, see Song and Yang (2016).…”

An Algorithm for the Pricing and Timing of the Option to make a Two-Stage Investment with Credit Guarantees

“…Next, we determine the fraction which is actually specified by solving a Nash equilibrium. In sharp contrast to prior papers on credit guarantees, similar to a loan commitment addressed by Mauer and Sarkar ( 2005 ) and Song and Yang ( 2016 ), the guarantee costs defined by pair are contracted before investment. Intuitively and as implied by previous derivations, all the values of firm securities, investment thresholds, and default threshold are totally determined by pair .…”

“…We emphasize that in sharp contrast to prior papers on credit guarantees, the guarantee agreement is signed prior to investment. That is, similar to the loan commitment discussed by Mauer and Sarkar ( 2005 ) and Song and Yang ( 2016 ), borrowers, lenders, and insurers enter into the guarantee agreement in advance which specifies the guarantee fee rate and the fraction of equity granted to insurers. Particularly, two investment thresholds are not contracted and they are totally determined by borrowers.…”