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Costs of Financial Distress, Delayed Calls of Convertible Bonds, and the Role of Investment Banks

  • Jaffee, Dwight
  • Shleifer, Andrei

In a frictionless market with perfect information, a shareholder-wealth- maximizing firm should force conversion of its convertible bond issue into stock as soon as the bond comes in-the-money. Firms however appear to systematically delay forced conversion, sometimes for years, beyond this time. We show that the observed delays can be plausibly explained in terms of costs to shareholders of a failed conversion and the ensuing financial distress. Firms delay the forced conversion to avoid the self-fulfilling outcome that bondholders expect the conversion to fail, tender their bonds for cash, and the stock price falls to account for the costs of financial distress, in which case tendering for cash is in fact optimal. Unlike other explanations of delayed forced conversion, we can explain the common use of investment banks to underwrite these transactions, since the banks can eliminate the self-fulfilling bad outcome.

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File URL: http://dash.harvard.edu/bitstream/handle/1/3606238/Shleifer_CostsFinancial.pdf
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Paper provided by Harvard University Department of Economics in its series Scholarly Articles with number 3606238.

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Date of creation: 1990
Date of revision:
Publication status: Published in Journal of Business -Chicago-
Handle: RePEc:hrv:faseco:3606238
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  1. Mikkelson, Wayne H., 1981. "Convertible calls and security returns," Journal of Financial Economics, Elsevier, vol. 9(3), pages 237-264, September.
  2. Dann, Larry Y. & Mikkelson, Wayne H., 1984. "Convertible debt issuance, capital structure change and financing-related information : Some new evidence," Journal of Financial Economics, Elsevier, vol. 13(2), pages 157-186, June.
  3. Shleifer, Andrei, 1986. " Do Demand Curves for Stocks Slope Down?," Journal of Finance, American Finance Association, vol. 41(3), pages 579-90, July.
  4. Harris, Milton & Raviv, Artur, 1985. " A Sequential Signalling Model of Convertible Debt Call Policy," Journal of Finance, American Finance Association, vol. 40(5), pages 1263-81, December.
  5. Kyle, Albert S, 1985. "Continuous Auctions and Insider Trading," Econometrica, Econometric Society, vol. 53(6), pages 1315-35, November.
  6. Brennan, M J & Schwartz, Eduardo S, 1977. "Convertible Bonds: Valuation and Optimal Strategies for Call and Conversion," Journal of Finance, American Finance Association, vol. 32(5), pages 1699-1715, December.
  7. Warner, Jerold B, 1977. "Bankruptcy Costs: Some Evidence," Journal of Finance, American Finance Association, vol. 32(2), pages 337-47, May.
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