Convertible Debt Financing Research Articles

Product Market Competition and Convertible Debt Financing

Product Market Competition and Convertible Debt Financing

Product Market Competition and Convertible Debt Financing

Product Market Competition and Convertible Debt Financing

Przesłanki emisji obligacji zamiennych z opcją call przez spółki amerykańskie i europejskie – analiza porównawcza

The aim of the article is to identify the reasons for using the call option in convertible debt financing and to find out whether these motives differ across countries. The analysis encompasses 299 issues of callable convertible bonds carried out by American and European companies from the service and manufacturing sector between 2004 and 2014. It turns out that both American and European firms are likely to use the call provision in order to avoid redeeming debt at maturity by either ensuring them a right to repay nominal value of bonds before maturity (American firms) or by forcing an early conversion on bondholders (European firms). Moreover, it seems that companies use callable hybrid debt to raise capital for financing new investment projects which may help them to increase their financial results.

Micron Technology, Inc.: Riding the Wave—Refinancing Convertible Notes

In 2013, Micron Technology (Micron), a leading provider of advanced memory solutions, was finally having a good year after several difficult years. In July, its share price rose above $14, an increase of more than 100% since the beginning of the year. In light of the recently improved performance, Ronald C. Foster, vice president of finance and CFO, was reevaluating the firm's financing policies. Micron had historically made heavy use of convertible debt financing to fund its operations and strategic goals and, as of August 31, 2013, it had close to $3 billion of outstanding convertibles. These bonds had been issued between 2007 and 2013, when Micron's share price had been below $10 and its earnings were negative. The firm's current stock price was above the conversion price on all of its outstanding convertible bonds, and in some cases even above the provisional call triggers. Should Micron's stock price continue to rise, its capital costs would increase, and potentially greater wealth would be transferred from the firm's shareholders to bondholders.Micron's investment bankers had recommended refinancing its 2014 Notes and Series A bonds (the bonds currently eligible to be called) with new convertible notes. The new notes would most likely require a higher annual coupon rate than the retired bonds, but the conversion price would be reset to around $19, a 35%-to-40% premium over its recent stock prices. Foster needed to be convinced that the costs in time and money justified refinancing the bonds.The Micron case offers students an opportunity to consider why firms might find convertible bonds an attractive form of financing. Due to its heavy use of convertibles, Micron has carefully staggered the maturities on the bond issues and chosen different settlement options to reduce dilution. Students are asked to evaluate the terms of the new converts to see if they represent a reasonable exchange of value between the issuer and investors. In addition, they are asked to compare the capital costs associated with the new convert to the retired bonds to judge how Micron's capital costs are affected by the refinancing decision. This case has been used in Darden's Corporate Financing elective as an introductory case and would work well in any course that considers various financing options. Excerpt UVA-F-1719 Rev. Jul. 27, 2015 Micron Technology, Inc.: Riding the Wave—Refinancing Convertible Notes It had been an unusually long and hot summer in Boise, Idaho, in August 2013. It had also been a hot year for Micron Technology (Micron), a leading provider of advanced memory solutions. In July, its share price rose above $ 14, an increase of more than 100% since the beginning of the year. The company announced its first quarter of positive earnings in May 2013 after seven continuous quarters of losses. In July 2013, Micron finally completed the JPY200 billion ($ 2.2 billion) acquisition of Elpida Memory, Inc., Japan's largest dynamic random-access memory (DRAM) maker, after agreeing to purchase it out of bankruptcy in May 2012. . . .

Design of convertible debt financing - some observations from the American market

A convertible bond may be an attractive financial instrument that helps to achieve the optimal capital structure of a company. In this paper, we analyze 562 issues of bonds from the American market between 2002-2013. Using regression trees analysis, we give some hints with respect to the design of convertible debt financing, which is the main goal of the paper, considering the most important characteristics of the issuers’ financial standing and the parameters of issued convertibles. Our research let us formulate a few conclusions. Firstly, we identified some relationships between a conversion premium, a conversion period and a conversion ratio applied by issuers. Secondly, it turned out that most of the issuer’s financial characteristics were not statistically significant for the issued convertibles. Finally, we found out that the share of fixed assets in the balance sheet amount seems to be one of the most important factors determining the internal structure of issued hybrid instruments, which supports the assets substitution theory.

Convertible debt and shareholder incentives

Given equity's convex payoff function, shareholders can transfer wealth from bondholders by increasing firm risk. We test the existing hypothesis that convertible debt reduces this classical agency problem of risk-shifting. First, we derive a measure of shareholders' risk incentives induced by convertible debt using a contingent claims framework. We then document that when risk-shifting incentives are high, the propensity to issue convertible (rather than straight) debt increases and the negative stock market reaction following convertible debt issue announcements is amplified. We further highlight that convertible debt is the only type of security that affects business risk durably downwards. Our conclusions support the agency theoretic rationale for convertible debt financing especially for financially distressed firms.

Does CEO-Specific Performance Impact Corporate Decisions? Evidence from Convertible Debt Issues

A firm’s convertible debt issues are not only determined by the fundamentals of the firm such as past stock performance, but also related to whether this performance is realized during the tenure of current CEO who decides the issues. I define the performance that the current CEO achieves in the firm ever since the CEO comes to the helm as CEO-specific performance. Higher CEO-specific performance leads to (1) a higher probability of convertible issues, and (2) a less negative abnormal stock return in response to the convertible issue announcements, controlling for other firm characteristics. These evidences show that CEO-specific performance serves as a credible information signal to influence the adverse selection costs between the firm and outside investors in convertible debt financing.

Convertible Debt and Shareholder Incentives

Given equity’s convex payoff function, shareholders can transfer wealth from bondholders by increasing firm risk. We test the existing hypothesis that convertible debt reduces this classical agency problem of risk-shifting. First, we derive a measure of shareholders’ risk incentives induced by convertible debt using a contingent claims framework. We then document that when risk-shifting incentives are high, the propensity to issue convertible (rather than straight) debt increases and the negative stock market reaction following convertible debt issue announcements is amplified. We further highlight that convertible debt is the only type of security that affects business risk durably downwards. Our conclusions support the agency theoretic rationale for convertible debt financing especially for financially distressed firms.

The impact of convertible debt financing on investment timing

We develop a model to examine the timing of investment decisions in relation to the issuance of convertible debt by firms. Our model shows that when the demand shock has higher volatility, the firm finances the investment cost with high-coupon convertible debt. We find that default occurs earlier for firms that finance with convertible debt rather than with straight debt. We also find that firms with high-growth prospection, high volatility, and low capital costs that issue convertible debt tend to defer investments. Furthermore, we examine the investment decisions in which the convertible debt includes a call provision. We show that firms that use callable convertible debt invest earlier than those that use non-callable convertible debt by using suboptimal coupon payments. The opportunity from the forced conversion increases as the volatility increases. These results are consistent with recent empirical evidence.

The Impact of Convertible Debt Financing on Investment Timing

We develop a model to examine the timing of investment decisions in relation to the issuance of convertible debt by firms. Our model shows that when the demand shock has higher volatility, the firm finances the investment cost with high-coupon convertible debt. We find that default occurs earlier for firms that finance with convertible debt rather than with straight debt. We also find that firms with high-growth prospection, high volatility, and low capital costs that issue convertible debt tend to defer investments. Furthermore, we examine the investment decisions in which the convertible debt includes a call provision. We show that firms that use callable convertible debt invest earlier than those that use non-callable convertible debt by using suboptimal coupon payments. The opportunity from the forced conversion increases as the volatility increases. These results are consistent with recent empirical evidence.

A game options approach to the investment problem with convertible debt financing

We consider a firm that operates a single plant and has an expansion option to invest in a new plant with convertible debt financing. This conversion feature introduces another complication not only because of the added conversion timing problem (by the bond holder) but also because the equity holder needs to take future conversion into account when evaluating her expansion/financing decision. We have two main objectives here. We use game options techniques to analyze optimal strategies involved in this convertible debt financed expansion problem. The first goal is to provide a comprehensive framework and procedure for solving the problem in a mathematically tractable way. Secondly, we illustrate our solution method through a concrete example with economic analysis. This includes a comparison with straight bond financing and comparative statics with respect to price volatility and conversion ratio. In this regard, we attempt to clarify how the conversion feature affects the equity holder's investment decisions. Throughout the paper, we study expansion options by viewing a firm's existing operation, bankruptcy threat, conversion decisions and financing decisions all together.

A Game Options Approach to the Investment Problem with Convertible Securities Financing

We consider a firm that operates a single plant and has an expansion option to invest in a new plant with convertible debt financing. This conversion feature introduces another complication not only because of the added conversion timing problem (by the bond holder) but also because the equity holder needs to take future conversion into account when evaluating her expansion/financing decision. We have two main objectives here. The first goal is to provide a comprehensive framework and procedure for solving the problem in a mathematically tractable way. In evaluating the debt value and conversion strategy, we employ the solution method for game options. Secondly, we illustrate our solution method through a concrete example and compare it with the case of straight bond financing. In this regard, we attempt to clarify how the conversion feature influences on the equity holder's investment decisions. Throughout the paper, we study expansion options by viewing a firm's existing operation, bankruptcy threat, conversion decisions and financing decisions all together.

Investor protection and convertible debt design

An important issue that firms consider when designing convertible debt is to specify security features such as conversion ratio, maturity date and call period. Following Lewis et al. [Lewis, M., Rogalski, R., Seward, J., 2003. Industry conditions, growth opportunities and market reactions to convertible debt financing decisions. Journal of Banking and Finance 27, 153–181], we employ a single measure that simultaneously considers all of these features: the expected probability (measured at issue date) that the convertible will be converted to equity at maturity. We find that firms in countries with stronger shareholder rights issue convertible debt with a higher expected probability of converting to equity. The positive association between the expected probability of conversion and shareholder rights is less pronounced in firms for which ownership structures create potentially high managerial agency costs. Specifically, in countries with stronger shareholder rights, firms with higher separation of control rights and cash flow rights tend to issue convertibles with lower probability of conversion. Furthermore, we find that large non-management block ownership strengthens the likelihood of issuing convertible debt with higher probability of conversion in countries with stronger shareholder rights. In contrast, firms in countries with stronger creditor rights issue convertibles with lower probability of conversion. We also document that the negative association between creditor rights and probability of conversion is more pronounced in firms with higher separation of control rights and cash flow rights.

Capital investment timing and convertible debt financing

We provide preliminary evidence that firms time capital investment decisions in a manner consistent with prescriptions from the real options literature. A prominent model of investment timing implies that firms with high-expected growth, high volatility, and low capital costs should defer investment longest. We examine capital expenditure patterns for a sample of 719 firms following issuance of convertible bonds because of the hypothesized role of these instruments in sequential investment. The findings are consistent with predictions: i.e., firms exhibiting high-growth prospects, high volatility, and low capital costs tend to defer subsequent investment longer.

Why firms use convertibles: A further test of the sequential-financing hypothesis

The sequential-financing hypothesis advanced by Mayers [J. Financ. Econ. 47 (1998) 83] suggests that convertibles are more valuable for issuing firms with focused activities. The hypothesis also suggests that firms may design their convertibles so that there are sufficient internal funds for future investment expenditures so as to avoid the costs of accessing capital markets. This paper provides direct evidence for these two predictions. We find that the stock market responds more favorably to the announcements of convertible offerings by focused firms than to those by diversified firms. This finding holds even after controlling for other potential explanatory variables. We also find that the issuing firms' net new financing is not significantly different from zero over the life of the convertible debt. Thus, our results provide further support for the sequential-financing hypothesis that convertible debt financing is motivated by a desire to minimize security issue costs and agency costs of overinvestment for firms with promising growth opportunities to finance a sequence of potential investment options.

Industry conditions, growth opportunities and market reactions to convertible debt financing decisions

Firms that issue convertible debt have high debt- and equity-related costs of external finance. Existing theories of convertible debt finance differ primarily in their identification of the specific causes of the debt- and equity-related costs of external finance. To assess the theoretical issuance motives separately, we propose a simple framework that characterizes how issuers should design convertible debt to efficiently mitigate specific debt- and equity-related costs of external finance. We provide evidence from 588 security offer announcements that supports the hypotheses that: (1) convertible debt can be designed to mitigate different combinations of debt- and equity-related costs of external finance and (2) share price reactions depend on the security design decisions. The results also illustrate that the relations between firm value, financial leverage, investment opportunities, and the rate of future growth are more complex among convertible debt issuers than situations where firms issue standard financial securities.

Industry update

Industry update

Stage Financing and the Role of Convertible Debt

Venture capital financing is characterized by extensive use of convertible debt and stage financing. We show why convertible debt is better than a simple mixture of debt and equity in stage financing situations. When the venture capitalist retains the option to abandon the project, the entrepreneur has an incentive to engage in window dressing or short-termism, i.e. to bias positively the short term performance of the project in order to reduce the probability that the project will be liquidated. With a straight debt-equity contract, the entrepreneur will always engage in signal manipulation. With a convertible debt contract, such behavior reduces the likelihood of liquidation, but increases the probability that the venture capitalist will convert debt into equity, reducing the entrepreneur's profits. Therefore, with an appropriately designed convertible debt contract, the entrepreneur will not engage in short termistic signal manipulation.

The information content of a convertible debt offer announcement

We develop a model of convertible debt financing that combines issue and call decisions into a common framework. The model suggests a role for refinancing costs in a manager's efforts to signal firm productivity to investors by an appropriate choice of debt issue terms. A cross section of convertible debt offers can be divided into two groups: a high conversion ratio group and a low conversion ratio group. The model predicts that high conversion ratios are negatively correlated with offer announcement stock returns and low conversion ratios are uncorrelated with offer announcement stock returns. The model is tested on a sample of 124 convertible debt offer announcements. Test results support model accuracy.

EQUITY VALUATION EFFECTS OF WARRANT‐DEBT FINANCING

AbstractStock price reactions to warrant‐debt unit financing announcements are examined and a significant two‐day average abnormal return of −1.32 percent is found. The negative average abnormal return is similar to that observed for convertible debt financing announcements in previous research. Warrant‐debt financing decisions result in large increases in capitalization; on average, issuers' long‐term debt increases by 84 percent, and common shares outstanding increase by 18 percent assuming full exercise of the warrants.