Real Options and Contingent Convertibles with Regime Switching

Abstract

We consider a firm with no assets in place but an option to invest in a project. The investment is irreversible but delayable in a regime-switching economy. The firm issues equity, straight bonds (SBs) and contingent convertibles (CoCos). We provide the closed-form prices for the firm's securities and the pricing and timing of the option. Our numerical analyses discover that issuing CoCos instead of SBs induces much less agency cost of debt. The agency cost is higher in a boom economy than in recession though the difference is small. There is a unique CoCos' conversion ratio such that the agency cost arrives at the minimum value zero. The inefficiencies arising from asset substitution and debt overhang are much more significant in recession than in boom. Only if the conversion ratio is not too small, the two inefficiencies disappear during boom periods.