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Why Issue Mandatory Convertibles? Theory and Empirical Evidence

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  • An Yan
  • Debarshi Nandy
  • Thomas Chemmanur

Abstract

Abstract Mandatory convertibles, which are equity-linked hybrid securities that automatically convert to common stock on a pre-specified date, have become an increasingly popular means of raising capital in recent years (about $20 billion worth issued in 2001 alone). This paper presents the first theoretical and empirical analysis of mandatory convertibles in the literature. We consider a firm facing a financial market characterized by asymmetric information, and significant costs in the event of financial distress. The firm can raise capital either by issuing mandatory convertibles, or by issuing more conventional securities like straight debt, common stock, and ordinary convertibles. We show that, in equilibrium, the firm issues straight debt, ordinary convertibles, or equity if the extent of asymmetric information facing it is large, but the probability of being in financial distress is relatively small; it issues mandatory convertibles if it faces a smaller extent of asymmetric information but a greater probability of financial distress. Our model provides a rationale for the three commonly observed features of mandatory convertibles: mandatory conversion, capped (or limited) capital appreciation, and a higher dividend yield compared to common stock. We also characterize the equilibrium design of mandatory convertibles. Our model also has implications for the abnormal stock returns upon the announcement of mandatory convertibles and for the post-issue operating performance of mandatory convertible issuers. We test the implications of our theory using a sample of firms which have chosen to issue either mandatory convertibles or ordinary convertibles, and we also study the long-term abnormal stock performance of mandatory convertible issuers. The evidence supports the implications of our theory.

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File URL: http://repec.org/esNAWM04/up.13953.1049166695.pdf
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Bibliographic Info

Paper provided by Econometric Society in its series Econometric Society 2004 North American Winter Meetings with number 456.

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Date of creation: 11 Aug 2004
Date of revision:
Handle: RePEc:ecm:nawm04:456

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Keywords: security design; new security; mandatory convertible; asymmetric information; financial distress;

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Cited by:
  1. Lewis, Craig M. & Verwijmeren, Patrick, 2011. "Convertible security design and contract innovation," Journal of Corporate Finance, Elsevier, vol. 17(4), pages 809-831, September.
  2. von Furstenberg, George M., 2011. "Contingent capital to strengthen the private safety net for financial institutions: Cocos to the rescue?," Discussion Paper Series 2: Banking and Financial Studies 2011,01, Deutsche Bundesbank, Research Centre.

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