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

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  • Egami, Masahiko

Abstract

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.

Suggested Citation

  • 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.
    • Handle: RePEc:eee:dyncon:v:34:y:2010:i:8:p:1456-1470
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    References listed on IDEAS

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    1. 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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    Cited by:

    1. Di Corato, Luca & Moretto, Michele & Rossini, Gianpaolo, 2017. "Financing flexibility: The case of outsourcing," Journal of Economic Dynamics and Control, Elsevier, vol. 76(C), pages 35-65.
    2. Lyandres, Evgeny & Zhdanov, Alexei, 2014. "Convertible debt and investment timing," Journal of Corporate Finance, Elsevier, vol. 24(C), pages 21-37.
    3. Yuri Kifer, 2012. "Dynkin Games and Israeli Options," Papers 1209.1791, arXiv.org.
    4. Yagi, Kyoko & Takashima, Ryuta, 2012. "The impact of convertible debt financing on investment timing," Economic Modelling, Elsevier, vol. 29(6), pages 2407-2416.
    5. Dandan Song & Zhaojun Yang, 2016. "Contingent Capital, Real Options, and Agency Costs," International Review of Finance, International Review of Finance Ltd., vol. 16(1), pages 3-40, March.
    6. Lim, Dongjae & Li, Lingfei & Linetsky, Vadim, 2012. "Evaluating callable and putable bonds: An eigenfunction expansion approach," Journal of Economic Dynamics and Control, Elsevier, vol. 36(12), pages 1888-1908.

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