Dynamic Capital Structure and the Contingent Capital Option

Abstract

The financial crisis has emphasized the difficulties for financial companies to raise funds through conventional assets. In this environment, hybrid securities are becoming popular. In this paper we study the optimal capital structure of a company issuing a particular type of hybrid security: perpetual contingent capital, i.e., debt to be converted in equity under some conditions. A two period model with endogenous bankruptcy for a company with equity, straight debt and contingent capital is analyzed. We investigate the instrument under dif- ferent conversion rules: exogenous or optimally chosen by equity holders. We show that contingent capital reduces the spread of straight debt and expected bankruptcy costs but is also quite expensive (high spreads). A trigger imposed by the regulatory authority may induce a little use of contingent capital with an increase of bankruptcy costs.