Discussion of “Optimal Debt Service: Straight vs. Convertible Debt”

Abstract

Corporate bond default plays a signifi cant role in today's business environment. According to Moody's, a leading provider of credit ratings, corporate bond issuers that it rated as of January 1, 2004, defaulted on a total of US $16 billion in 2004. Credit default not only affects the equity investors of a firm, but also the debt holders, who may loose part of their credit. Default can also have dramatic consequences for a firm's future operations. Therefore, the decision of if and when to default is important for both the firm and its stakeholders. There is a substantial body of literature on the determination of optimal default points as a strategic decision by the owners of a firm. According to this view, optimal default occurs when the continuation value of the firm, less the discounted value of all future tax-adjusted coupon payments, falls below zero. However, some studies on optimal default points are limited, since these studies usually assume a simple capital structure with only equity and straight debt. Christian Koziol extends this literature by relaxing the assumption of a simple capital structure and by allowing for convertible debt. Th e main objectives of his paper are (i) to determine optimal default and conversion strategies, when debt is convertible; and (ii) to highlight the differences between this strategy and the strategy for straight debt. Since convertible debt plays a significant role in corporate finance decisions, Koziol's approach seems to be both important and of wide interest. To analyze these problems, the author uses a widely accepted time-independent model with a perpetual bond that pays a continual coupon in the presence of both bankruptcy costs and tax deductibility. My discussion is organized as follows. In section 2, I relate Koziol's paper to previous literature and provide an intuitive explanation for the results. Section 3 discusses an application in the area of real option games.