Costs Of Financial Distress, Delayed Calls Of Convertible Bonds, And The Role Of Investment Banks

Dwight Jaffee and Andrei Shleifer

No 2558, NBER Working Papers from National Bureau of Economic Research, Inc

Abstract: In a frictionless market with perfect information, a shareholder-wealth- maximizing firm should force conversion of its convertible bond issue into stock as soon as the bond comes in-the-money. Firms however appear to systematically delay forced conversion, sometimes for years, beyond this time. We show that the observed delays can be plausibly explained in terms of costs to shareholders of a failed conversion and the ensuing financial distress. Firms delay the forced conversion to avoid the self-fulfilling outcome that bondholders expect the conversion to fail, tender their bonds for cash, and the stock price falls to account for the costs of financial distress, in which case tendering for cash is in fact optimal. Unlike other explanations of delayed forced conversion, we can explain the common use of investment banks to underwrite these transactions, since the banks can eliminate the self-fulfilling bad outcome.

Date: 1988-04
Note: ME
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Published as "Costs of Financial Distress, Delayed Calls of Convertible Bonds, and the Role of Investment Banks" Journal of Business: Merton Miller Conference, January, 1990.

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Journal Article: Costs of Financial Distress, Delayed Calls of Convertible Bonds, and the Role of Investment Banks (1990)
Working Paper: Costs of Financial Distress, Delayed Calls of Convertible Bonds, and the Role of Investment Banks (1990)
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