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A game options approach to the investment problem with convertible debt financing

  • Egami, Masahiko
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    We consider a firm that operates a single plant and has an expansion option to invest in a new plant with convertible debt financing. This conversion feature introduces another complication not only because of the added conversion timing problem (by the bond holder) but also because the equity holder needs to take future conversion into account when evaluating her expansion/financing decision. We have two main objectives here. We use game options techniques to analyze optimal strategies involved in this convertible debt financed expansion problem. The first goal is to provide a comprehensive framework and procedure for solving the problem in a mathematically tractable way. Secondly, we illustrate our solution method through a concrete example with economic analysis. This includes a comparison with straight bond financing and comparative statics with respect to price volatility and conversion ratio. In this regard, we attempt to clarify how the conversion feature affects the equity holder's investment decisions. Throughout the paper, we study expansion options by viewing a firm's existing operation, bankruptcy threat, conversion decisions and financing decisions all together.

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    Article provided by Elsevier in its journal Journal of Economic Dynamics and Control.

    Volume (Year): 34 (2010)
    Issue (Month): 8 (August)
    Pages: 1456-1470

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    Handle: RePEc:eee:dyncon:v:34:y:2010:i:8:p:1456-1470
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    1. Korkeamaki, Timo & Moore, William T., 2004. "Capital investment timing and convertible debt financing," International Review of Economics & Finance, Elsevier, vol. 13(1), pages 75-85.
    2. Dayanik, Savas & Karatzas, Ioannis, 2003. "On the optimal stopping problem for one-dimensional diffusions," Stochastic Processes and their Applications, Elsevier, vol. 107(2), pages 173-212, October.
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    5. Mauer, David C. & Sarkar, Sudipto, 2005. "Real options, agency conflicts, and optimal capital structure," Journal of Banking & Finance, Elsevier, vol. 29(6), pages 1405-1428, June.
    6. Childs, Paul D. & Mauer, David C. & Ott, Steven H., 2005. "Interactions of corporate financing and investment decisions: The effects of agency conflicts," Journal of Financial Economics, Elsevier, vol. 76(3), pages 667-690, June.
    7. Mello, Antonio S & Parsons, John E, 1992. " Measuring the Agency Cost of Debt," Journal of Finance, American Finance Association, vol. 47(5), pages 1887-904, December.
    8. Yuri Kifer, 2000. "Game options," Finance and Stochastics, Springer, vol. 4(4), pages 443-463.
    9. Christopher A. Hennessy, 2004. "Tobin's "Q", Debt Overhang, and Investment," Journal of Finance, American Finance Association, vol. 59(4), pages 1717-1742, 08.
    10. Gong, Pu & He, Zhiwei & Zhu, Song-Ping, 2006. "Pricing convertible bonds based on a multi-stage compound-option model," Physica A: Statistical Mechanics and its Applications, Elsevier, vol. 366(C), pages 449-462.
    11. Hennessy, Christopher A. & Tserlukevich, Yuri, 2008. "Taxation, agency conflicts, and the choice between callable and convertible debt," Journal of Economic Theory, Elsevier, vol. 143(1), pages 374-404, November.
    12. Kyoko Yagi & Ryuta Takashima & Hiroshi Takamori & Katsushige Sawaki, 2008. "Timing of Convertible Debt Financing and Investment," CARF F-Series CARF-F-131, Center for Advanced Research in Finance, Faculty of Economics, The University of Tokyo.
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