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Optimal Debt Service: Straight vs. Convertible Debt

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  • Christian Koziol

Abstract

In this paper, we analyze the optimal default strategy of a firm when debt is convertible into equity. For this purpose, we consider a convertible consol bond in a timeindependent model in the presence of bankruptcy costs and tax deductibility. The optimal default and conversion strategy result from a game between equity and debt holders. A closed-form solution for the optimal default barrier exists if the firm pays no dividends. We show that an optimal default of convertible debt occurs earlier than a default of otherwise identical straight debt. A further comparison of the optimal default strategy with the strategy for straight debt shows that the value of convertible debt is lower when the firm follows the optimal strategy rather than the strategy for straight debt. furthermore, We find that the important difference between the default barrier for convertible debt and identical but non-convertible debt rises with the conversion ratio, the coupon, a lower tax rate, and a lower payoff rate.

Suggested Citation

  • Christian Koziol, 2006. "Optimal Debt Service: Straight vs. Convertible Debt," Schmalenbach Business Review (sbr), LMU Munich School of Management, vol. 58(2), pages 124-151, April.
    • Handle: RePEc:sbr:abstra:v:58:y:2006:i:2:p:124-151
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    Cited by:

    1. Yagi, Kyoko & Takashima, Ryuta, 2012. "The impact of convertible debt financing on investment timing," Economic Modelling, Elsevier, vol. 29(6), pages 2407-2416.

    More about this item

    Keywords

    Convertible Consol Bond; Default Strategies;

    JEL classification:

    • C72 - Mathematical and Quantitative Methods - - Game Theory and Bargaining Theory - - - Noncooperative Games
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G32 - Financial Economics - - Corporate Finance and Governance - - - Financing Policy; Financial Risk and Risk Management; Capital and Ownership Structure; Value of Firms; Goodwill

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