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Taxation, agency conflicts, and the choice between callable and convertible debt

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  • Hennessy, Christopher A.
  • Tserlukevich, Yuri
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    Abstract

    We analyze debt choice in light of taxes and moral hazard. The model features an infinite sequence of nonzero-sum stochastic differential games between equity and debt. Closed-form expressions are derived for all contingent-claims. If equity can increase volatility without reducing asset drift, callable bonds with call premia are optimal. Although callable bonds induce risk shifting, call premia precommit equity to less frequent restructuring and are tax-advantaged. Convertible bonds mitigate risk shifting, but only induce hedging if assets are far from the default threshold. Convertibles are optimal only if risk shifting reduces asset drift sufficiently.

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    Bibliographic Info

    Article provided by Elsevier in its journal Journal of Economic Theory.

    Volume (Year): 143 (2008)
    Issue (Month): 1 (November)
    Pages: 374-404

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    Handle: RePEc:eee:jetheo:v:143:y:2008:i:1:p:374-404

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    Web page: http://www.elsevier.com/locate/inca/622869

    Related research

    Keywords: Capital structure Agency Stochastic differential games;

    References

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    Cited by:
    1. Kuersten, Wolfgang & Linde, Rainer, 2011. "Corporate hedging versus risk-shifting in financially constrained firms: The time-horizon matters!," Journal of Corporate Finance, Elsevier, vol. 17(3), pages 502-525, June.
    2. Egami, Masahiko, 2010. "A game options approach to the investment problem with convertible debt financing," Journal of Economic Dynamics and Control, Elsevier, vol. 34(8), pages 1456-1470, August.

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