Asymmetric Information and Financing with Convertibles

Abstract

We analyze the problem of dilution leading to inefficient underinvestment caused by the adverse selection problem. We assume that the market obtains information about the firm over time, but that at each date the manager possesses better information about firm prospects than does the market. We show that issuing callable convertible securities with fixed conversion prices and restrictive call provisions is optimal. Such securities make the payoff to new claimholders independent of the private information of the manager. The restrictive call provision serves as a commitment device, enabling the manager to call only when the stock price rises in the future. This benefits the new as well as the existing claim—holders so that adverse selection problem is costlessly solved without any dissipation or underinvestment. Furthermore, we show that this efficient outcome can also be implemented by issuing optimally designed floating price convertibles.