Growth Option, Contingent Capital and Agency Conflicts

Abstract

In this paper we attempt to clarify how contingent convertible bond (CoCo) affects expansion investment and the inefficiencies arising from debt overhang and asset substitution in a dynamic model. We show that there is a conversion ratio, i.e. the fraction of equity allocated to CoCo holders upon conversion, such that both investment distortion and debt overhang problem are eliminated. If growth option is not exercised, there is no debt overhang problem for a relatively high cash flow level, no matter what financing strategies are taken for assets in place. Generally speaking, there exists a risk-shifting incentive of shareholders. The incentive gets weaker if the conversion ratio increases. In particular, if the conversion ratio is high enough and expansion option is exercised, the inefficiency arising from asset substitution disappears.