Convertible Bonds: Matching Financial and Real Options by David Mayers, University of California at Riverside

Journal of Applied Corporate Finance

SPRING 2000 VOLUME 13.1

CONVERTIBLE BONDS: by David Mayers, University of California at Riverside* MATCHING FINANCIAL AND REAL OPTIONS

hy do companies issue convertible bonds instead of, say, straight W bonds or common stock? The popular explanation is that convertibles provide the best of both worlds: they provide issuers with “cheap” debt in the sense that they carry lower rates than straight debt; and, if the firm performs well and the bonds convert into equity, they allow issuers to sell stock “at a premium” over the current share price. Take the case of MCI Communications Corp. In August of 1981, the company issued 20-year- convertible subordinated debentures with a 10 1/4% coupon rate (as compared to the 14 1/8% it was paying on 20-year sub bonds issued just four months earlier). The conversion price of $12.825 was set at an 18% premium over MCI’s then current price of $10.875. Eighteen months later, when the stock price had risen to $40, the issue was called, the convertible bondholders chose to become stockholders, and MCI received an infusion of equity in the midst of a major capital investment program. But, as finance professors Michael Brennan and Eduardo Schwartz pointed out in an article published in the same year as MCI’s first convertible bond issue,1 the argument that convertibles represent cheap debt and the sale of equity at a premium involves a logical sleight of hand. It compares convertibles to straight debt in one set of circumstances (when the company’s stock doesn’t rise and there is no conversion) and to common stock under another (when the stock price rises and the issue converts). What the argument fails to point out is that convertible issuers may well have been better off issuing stock in the first set of circumstances and straight debt in the second. That is, if the firm performs very well, straight debt may have preserved more value for the existing shareholders by not cutting new investors into future appreciation. And, if the

*This research received support from the Charles A. Dice Center for Research in Financial Economics at Ohio State University. I thank Steve Buser, Peter Chung, Larry Dann, Tom George, Dan Greiner, Jeff Harris, Herb Johnson, Wayne Mikkelson, Tim Opler, John Persons, Cliff Smith, René Stulz, Ralph Walkling, Jerry Warner, and especially Paul Schultz for helpful comments. I thank Arnold Cowan, Nandkumar Nayar, and Ajai Singh for graciously providing me the use of their listing of convertible bond calls. 1. Michael Brennan and Eduardo Schwartz, “The Case for Convertibles,” Chase Financial Quarterly (Fall 1981). Reprinted in Journal of Applied Corporate Finance (Summer 1988).

8 BANK OF AMERICA JOURNAL OF APPLIED CORPORATE FINANCE firm’s stock performs poorly after the new issue, then a cost-effective financing approach for companies common stock would have been better than convert- with major growth options because of the ability they ibles—not only because there is no dilution of value, offer management to match capital inflows with but because the firm may then have had the greatest expected investment outlays. In particular, as the need for equity. company’s real options move into the money and its As Brennan and Schwartz went on to say in their stock price rises to reflect that, the call provision in 1981 article, convertibles do not provide issuers with convertibles effectively gives management the op- the financing equivalent of a “free lunch.” Investors tion to call the bonds and so force conversion into are willing to accept a lower coupon rate on equity. And, besides eliminating the cash flow drain convertibles than on straight bonds only because the from servicing the debt, the new infusion of equity issuer is also granting them a valuable option on the can in turn be used to support additional debt (or company’s stock—an upside participation that can convertible) financing. dilute the value of existing stockholders’ claims. And In this article, after reviewing the theory and provided the company’s stock is fairly valued at the evidence on convertibles, I show how my own ex- time of issue, there are no obvious reasons why planation and findings are both consistent with and convertibles should be less expensive than straight extend the previous research. Like other theories— debt or equity. notably, Jeremy Stein’s “backdoor equity” hypoth- But there are some less obvious reasons why esis—my argument suggests that convertibles can be convertibles may be a value-conserving financing viewed as “deferred equity” offerings that add value strategy—reasons that depend on market “imperfec- for companies with promising future growth oppor- tions” such as transaction and information costs, and tunities (that may not be fully reflected in current managerial incentives that are not fully consistent share prices). Unlike past theories, I show how con- with maximizing stockholder wealth. Beginning vertibles are uniquely suited to the sequential financ- with the pioneering paper on agency cost theory by ing problem faced by management in funding real Jensen and Meckling in 1976,2 financial academics investment options. Although there is considerable have proposed a number of ways that convertibles empirical support for my explanation in the past can reduce the costs arising from such imperfections. research, the most persuasive evidence comes from And, in a study published in 1998 in the Journal of my recent study of the investment and financing Financial Economics (JFE), I presented yet another activity of a large sample of U.S. companies around rationale for convertibles that shows how they the time their convertible bonds are converted into reduce new issue costs and agency problems facing common stock. In brief, my study of 289 conversion- certain kinds of companies.3 Put as simply as pos- forcing calls of convertible debt over the period 1971- sible, my explanation views convertibles as the most 1990 shows significant increases in corporate invest- cost-effective way for companies with promising ment activity beginning in the year of the call and growth opportunities to finance a sequence of major continuing for the following three years. This invest- corporate investments of uncertain value and timing. ment activity is matched with increased financing Financial economists, along with a steadily increas- activity, principally new long-term debt, that is sig- ing number of corporate practitioners, refer to such nificant primarily in the year of the call. Thus, al- future investment opportunities as “real options.” though equity is being brought in “through the back Such investments are options in the sense that, door” by the conversion process, new debt is being although they may not be worth undertaking today brought in along with it. To return to our earlier (i.e., they are currently “out-of-the-money”), they example, one month after MCI forced conversion of may become so in the future. And if and when such its first ($250 million) convertible bond issue, it floated options move “into the money,” the company will its second convertible issue, this time raising almost need to have sufficient capital (or at least access to $400 million. In short, my study suggests that con- capital) to “exercise” its real options and carry out its vertibles are designed to facilitate the future financ- strategic plan. Convertible bonds are likely to prove ing of valuable real investment options.

2. See Michael C. Jensen and William H. Meckling, “Theory of the Firm: 3. See my article, “Why Firms Issue Convertible Bonds: The Matching of Managerial Behavior, Agency Costs, and Capital Structure,” Journal of Financial Financial and Real Investment Options,” Journal of Financial Economics 47 (1998), Economics (1976), pp. 305-360. pp. 83-102, from which article all tables and figures in this article are taken.

9 VOLUME 13 NUMBER 1 SPRING 2000 THEORETICAL ARGUMENTS FOR response is roughly a negative 2%.6 (By contrast, the CONVERTIBLES4 market response to straight debt offerings is not reliably different from zero.) The negative market Given that financial markets are reasonably reactions to announcements of new equity and efficient and that convertibles are a fair deal for convertible offerings cause the new securities to be investors and issuers alike, finance theory says that issued at a lower price than otherwise. And in those the issuance of convertibles should not increase the cases where management believes the firm is fairly value of the issuing company. In fact, there is even valued (or even undervalued) prior to the announce- reason to believe that the market’s response to the ment of the convertible offering, the negative market announcement of new convertible offerings should response effectively dilutes value of the existing be negative, on average. stockholders’ claims. In this sense, the negative market reaction represents a major cost of issuing the Convertibles and the Market’s “Information security (potentially much larger than the investment Asymmetry” Problem banker fees and other out-of-pocket costs). For example, if the stock price of a (fairly valued) firm In a 1984 paper entitled “Corporate Financing with an equity market cap of $1 billion drops by 5% and Investment Decisions When Firms Have Infor- upon the announcement of a new $500 million mation That Investors Do Not Have,” Stewart Myers common stock issue, the “information costs” associ- and Nicholas Majluf offered an explanation for why ated with the new issue amount to 3.3% of the value the announcement of a convertibles issue is gener- of the firm (or 10% of the funds raised)—possibly a ally not good news for the company’s stockholders.5 good reason not to issue common equity. A company’s managers have at least the potential to know more about their firm’s prospects than outside The Risk Insensitivity Hypothesis investors and, as representatives of the interests of existing stockholders, the managers have a stronger Up to this point, we have mentioned the incentive to issue new equity when they believe the information costs associated with issuing convert- company is overvalued. Because part of a convertibles. And such costs come on top of out-of-pocket ible issue’s value consists of an option on the flotation costs that are estimated to run around 3.8% company’s stock, the same argument holds for (of funds raised) for the median convertible issue of convertibles, although to a lesser degree. Recogniz- $75 million.7 What are the benefits of convertibles ing managers’ incentives to issue overpriced securi- that would make companies willing to incur such ties, investors respond to announcements of both costs? And what kinds of companies are likely to equity and convertible offerings by lowering their find the cost/benefit ratio for convertibles to be estimates of the issuers’ value to compensate for their most favorable? informational disadvantage. The first theoretical justification for convertibles This argument is supported by empirical studies consistent with modern finance theory was provided that show that, in the two-day period surrounding by Michael Jensen and William Meckling in their the announcement of new equity issues, a company’s much-cited 1976 paper on agency costs. Among the stock price falls by about 3%, on average. In response sources of agency problems described by Jensen and to announcements of convertibles, the average market Meckling are potential conflicts of interest between

4. This section draws heavily on Frank C. Jen, Dosoung Choi, and Seong-Hyo W. Mikkelson and M. Partch, “Valuation Effects of Security Offerings and the Lee, “Some New Evidence on Why Companies Use Convertible Bonds,” Journal Issuance Process,” Journal of Financial Economics 15 (1986); C. Smith, “Invest- of Applied Corporate Finance, Vol. 10 No. 1 (Spring 1997). ment Banking and the Capital Acquisition Process,” Journal of Financial Econom- 5. S. Myers and N. Majluf, “Corporate Financing and Investment Decisions ics 15 (1986); R. Hansen and C. Crutchley, “Corporate Earnings and Financing: An When Firms Have Information That Investors Do Not Have,” Journal of Financial Empirical Analysis,” Journal of Business 63 (1990); and E. Pilotte, “Growth Economics 13 (1984). Opportunities and Stock Price Response to New Financing,” Journal of Business 6. See L. Dann and W. Mikkelson, “Convertible Debt Issuance, Capital 65 (1992), among others. Structure Change, and Financing-Related Information,” Journal of Financial 7. See I. Lee, S. Lochhead, J. Ritter, and Q. Zhao, “The Costs of Raising Capital,” Economics 13 (1984); D. Asquith and P. Mullins, “Equity Issues and Offering The Journal of Financial Research 19 (1996), pp. 59-74. In addition to the out-of- Dilution,” Journal of Financial Economics 15 (1986); E. Eckbo, “Information pocket flotation costs, there also is evidence that convertibles, like IPOs, are Asymmetries and Valuation Effects of Corporate Debt Offerings,” Journal of underpriced, by about 1% on average. See J. Kang and Y. Lee, “The Pricing of Financial Economics 15 (1986); R. Masulis and A. Kowar, “Seasoned Equity Convertible Debt Offerings,” Journal of Financial Economics 41 (1996), pp. 231- Offerings: An Empirical Investigation,” Journal of Financial Economics 15 (1986); 248.

10 JOURNAL OF APPLIED CORPORATE FINANCE Convertibles do not provide issuers with the financing equivalent of a “free lunch.” Investors are willing to accept a lower coupon rate on convertibles than on straight bonds only because the issuer is also granting them a valuable option on the company’s stock—an upside participation that can dilute the value of existing stockholders’ claims. a company’s bondholders and its stockholders (or reducing the likelihood of financial trouble, convert- managers acting on behalf of stockholders). In ibles also reduce the probability that financially normal circumstances—that is, when operations are strapped companies will be forced to pass up profitable and the firm can comfortably meet its debt valuable investment opportunities.9 service payments and investment schedule—the interests of bondholders and shareholders are united. The Role of Convertibles in Reducing Both groups of investors benefit from managerial Information Costs decisions that increase the total value of the firm. But, in certain cases, corporate managements find them- As Brennan and Schwartz argued in their 1981 selves in the position of being able to increase paper, convertibles also are potentially useful in shareholder value at the expense of bondholders. For resolving any disagreements between managers and example, management can reduce the value of bondholders about how risky the firm’s activities are. outstanding bonds by increasing debt or adding debt As suggested above, the value of convertibles is senior to that in question. (In professional circles, relatively insensitive to changes in company risk. this is known as “event risk”; in academic terms it is Unexpected increases in company risk reduce the the claims dilution problem.) Or, in highly leveraged value of the bond portion of a convertible, but at the companies, management could also choose—as did same they increase the value of the embedded many S&L executives—to invest in ever riskier option on the company’s stock (by increasing the projects after the debt is issued (the risk-shifting or “volatility” of the stock price). And, as Brennan and asset substitution problem). Finally, a management Schwartz went on to show, it is largely because of this squeezed between falling revenues and high interest risk-neutralizing effect of convertibles that convert- payments might choose to pass up value-adding ible issuers tend to be smaller, riskier, growth firms projects such as R&D or, if things are bad enough, characterized by high earnings volatility.10 basic maintenance and safety procedures (the underinvestment problem).8 The Backdoor Equity Financing Hypothesis Debtholders, of course, are aware that such problems can arise in leveraged firms, and they The next major development in the theory came protect themselves by lowering the price they are in 1992, when Jeremy Stein published a paper in the willing to pay for the debt. For corporate manage- JFE entitled “Convertibles Bonds as Backdoor Equity ment, such lower prices translate into higher interest Financing.”11 Beginning with the recognition that payments, which in turn further raise the probability many convertible bond issuers build equity through of financial trouble. And for high-growth firms, in forced conversion of convertibles, Stein developed particular, financial trouble can mean a large loss in a model that uses information asymmetry between value from underinvestment. managers and investors, and the resulting informa- Convertibles help to control such shareholder- tion costs, to explain why growth firms in particular bondholder conflicts in two ways: First, by providing find it attractive to issue convertibles. As Stein bondholders with the right to convert their claims suggests, companies with limited capital and abun- into equity, management gives bondholders the dant growth opportunities often find themselves in assurance that they will participate in any increase in a financing bind. On the one hand, they are reluctant shareholder value that results from increasing the to use significant amounts of straight debt because risk of the company’s activities—whether by further they face high expected costs of financial distress. leveraging, or by undertaking riskier investments. Often lacking an investment-grade bond rating, the Second, by reducing current interest rates and so kinds of companies that issue convertibles are likely

8. For an account of the underinvestment problem, see Stewart Myers, “The shareholders receive any payoff at all. This has also been dubbed the “debt Determinants of Corporate Borrowing,” Journal of Financial Economics (1977). overhang” problem. For a more detailed examination of these sources of shareholder/debtholder 10. In his 1991 Ph.D. dissertation at the University of Chicago, “Convertible conflict, see Clifford W. Smith and Jerold B. Warner, “On Financial Contracting: An Securities and Capital Structure Determinants,” Stuart Essig reported that convert- Analysis of Bond Covenants,” Journal of Financial Economics, 7 (1979), pp. 117- ible bond financing tends to be used by risky firms, high-tech firms, and firms with 161. a limited track record. 9. More technically, the underinvestment problem arises from the fact that, in 11. J. Stein, “Convertibles Bonds as Backdoor Equity Financing,” Journal of financially troubled firms, an outsized portion of the returns from new investments Financial Economics 32 (1992). must go to helping restore the value of the bondholders claims before the

11 VOLUME 13 NUMBER 1 SPRING 2000 to face high coupon rates on straight debt. And, even responds more favorably to announcements of if they are able to issue high-yield bonds or raise a convertible issues by companies with high post- significant amount through bank loans, a temporary issue capital expenditures and high market-to-book shortfall in cash flow could force their managers to ratios (both plausible proxies for growth opportuni- cut back on strategic investment—and tripping a ties), but low credit ratings and high (post-offering) covenant or failing to meet an interest payment could debt-equity ratios.12 And since high capital expendi- even mean relinquishing much of the value of the tures and market-to-book ratios are also reasonable firm to creditors or other outsiders. proxies for the presence of the real options I But if straight debt financing is very costly in discussed earlier, such findings also provide support these circumstances, conventional equity financing for my own theory of convertibles. could also have significant costs. For one thing, the management of some growth firms—particularly, A NEW RATIONALE those in a fairly early stage of a growth trajectory— may not feel the current stock price fairly reflects In my 1998 article in the JFE, I offered a rationale the firm’s growth opportunities, and so the issu- for convertibles that both is consistent with and ance of equity would be expected to cause exces- extends Stein’s “backdoor equity” argument.13 Stein’s sive dilution of existing stockholders’ claims. And, model addresses itself mainly to the financing prob- even if the firm is fairly valued, the information lem that growth companies face at a given point in asymmetry problem described earlier might cause time. That is, given that the firm needs financing and investors to reduce the value of the company’s cannot easily service a large amount of straight debt, shares upon announcement of the offering, thereby how does management raise a form of equity diluting value. financing that minimizes the dilution (“information In such circumstances, where both straight debt costs”) suffered by the current stockholders at the and equity appear to have significant costs, manag- time of issue? ers with a great deal of confidence in their firm’s The problem I address is somewhat different: growth prospects may choose to build equity by Given that the firm needs financing today to fund issuing convertibles and planning to use the call current activities and may also require significantly provision to force conversion when the stock price more capital in the future (depending on how rises in the future. Moreover, the stock market may things turn out in the next few years), how does actually encourage the use of convertibles in the management minimize dilution and other costs following sense: If investors are persuaded that over the expected sequence of current and future convertible issuers have promising growth pros- financings. To cite once more the case of MCI, how pects but no other viable financing options (i.e., does management minimize not just the costs asso- there is little additional debt capacity and a straight ciated with its present convertible bond issue, but equity issue has been ruled out by management as also that of the issue that is expected to follow its too dilutive), the market is likely to respond less conversion…and, if the latter issue is likely to be a negatively (or, in some cases, even positively) to the convertible, too, perhaps even the issue that is announcement of a new convertible issue. That is, expected to follow it. Thus, a key consideration in management’s choice of a convertible bond financ- my theory is the extent of both managers’ and ing may function as a “signal” to investors that investors’ uncertainty about both the value and the management is highly confident about the firm’s timing of the firm’s future investment opportuni- future, thus allowing the issuer to avoid much of the ties. As I suggested earlier, the presence of such negative information costs that attend conventional uncertainty means that today’s future investment equity announcements. And there is some interest- opportunities are really “growth options” that ing evidence to support this view. In a 1997 study may (or may not) be “exercised” at some point in published in this journal, Frank Jen, Dosoung Choi, the future—in most cases, by raising more out- and Seong-Hyo Lee showed that the stock market side capital.

12. Jen, Choi, and Lee (1997), cited above. with shares (Schultz (1993), and venture capital arrangements, where equity is 13. My explanation is also similar to recent explanations for other special provided sequentially (Sahlman (1990). financing arrangements: unit initial public offerings, where warrants are issued

12 JOURNAL OF APPLIED CORPORATE FINANCE My explanation views convertibles as the most cost-effective way for companies with promising growth opportunities to finance a sequence of major corporate investments of uncertain value and timing. Financial economists refer to such future investment opportunities as “real options.”

The Analysis maturing at time 2); this way, the profits from the initial project can be used to help fund the second- To show how convertibles can minimize costs period investment if the prospects materialize. Alter- over a sequence of financings, my study used a natively, the firm can finance both projects sepa- “two-period model” that works essentially as fol- rately by sequentially issuing single-period straight lows. At time 0, the company has a (clearly) posi- debt (and forgoing the second issue if the investment tive-NPV investment project that requires immedi- option proves “out of the money”). The third possi- ate funding, and it also has an investment “option” bility is that the firm can issue a convertible bond that that may require funding at time 1, depending on matures at the end of the first period and must either what happens between time 0 and time 1. In be redeemed or converted into equity at that point. addition to its positive-NPV project and investment First, let’s consider the two-period straight-debt option, the company also has an abundant supply issue. The advantage of this financing arrangement of negative-NPV projects (think of them as diversi- is that the proceeds from the first-period investment fying acquisitions) that management might choose are left in the firm to help finance the second-period to take if it has excess capital and no positive-NPV project if it turns out to be profitable (and this would projects. All investment projects are assumed to also be true of an equity offering). For example, if the have a life of one period. proceeds from the first project are sufficient, the two- Given these conditions, the challenge for man- period contract provides complete financing for both agement is to devise a financing strategy at time 0 that projects up front and saves the entire second-period minimizes the costs associated with funding both the issue cost. The problem with this financing alterna- initial project and the investment option. My model tive, however—and this would be even more true of assumes that there are only two major categories of equity—is that the second-period project will be costs: (1) new issue costs and (2) overinvestment financed, regardless of whether the investment op- costs. By new issue costs I mean not only the tion turns out to be valuable or not. And because the transactions costs associated with floating a new market anticipates this behavior, the firm’s securities issue, but also the “information costs” discussed are priced at a discount to reflect investors’ uncer- above.14 Overinvestment costs can be described as tainty about management’s use of the proceeds. the reduction in value that results from companies The second financing alternative—sequential having too much capital—more than they can prof- issues of single-period straight debt—avoids this itably reinvest in their core businesses. Excess capital overinvestment problem of two-period debt (and is assumed to lead to corporate investment in equity) by forcing managers to return to the market negative-NPV projects because of the managerial to fund the second project. But this choice also has tendency to pursue size at the expense of profitabil- a problem: if the investment option proves profit- ity. In my model, investors automatically assume that able, the firm may be forced to bear heavy new issue managers will invest excess capital in negative-NPV costs, particularly if managers have a more optimistic projects. Thus, if the firm announces its intent to raise view of the new investment than the market.15 And more capital than investors think it can profitably if it turns out that the firm really needs equity to fund use, investors effectively charge a higher cost for the investment option, such new issue costs will be such capital by reducing the value of the firm’s shares even higher. in advance of the offering. The optimal solution to this sequential fi- My model also assumes that the company can nancing problem—the one that both economizes choose among three debt financing alternatives on second-period issue costs and helps control available at time 0 (an equity offering is ruled out the overinvestment problem—is to issue a con- from the start as “too expensive,” making some form vertible bond at time 0 that matures at the end of of debt the preferred choice). It can issue two-period the first period. The bond is designed such that its straight debt (that is, debt issued at time 0 and equity component is “out of the money” at issue

14. The issue (or “information”) cost function is assumed to contain fixed and 15. Short-term debt typically has issue costs that are quite low, and the reader variable components, so that issue costs exhibit economies of scale, and the may wish to solve the cost-of-issue problem by sequentially issuing short-term function is the same in each period. debt. However, the periods are assumed long term, and long-term contracts are less costly.

13 VOLUME 13 NUMBER 1 SPRING 2000 and becomes “in the money” only if and when the Extension to Debt with Warrants and Con- NPV of the investment option is revealed (to vertible Preferreds. My model of convertible investors as well as managers) to be positive. If the bonds—and to some extent those of Stein and second-period project looks sufficiently profit- Brennan and Schwarz as well—can also be applied able at time 1, the bondholders will convert their to the cases of debt with warrants and convertible bonds into equity at the bond maturity date. This preferreds. Like convertible bonds, issues of debt leaves the funds both inside the firm and trans- with warrants and convertible preferreds also in- formed into equity that can then be used to clude options that provide additional financing (by finance the second-period project. But if the allowing the firm to retain funds it would otherwise project turns out not to be profitable, the bond- pay out) if the options are exercised; if not, the holders do not exercise the conversion option; funds are returned to investors. (And it’s interesting instead they submit their bonds for redemption, to note that MCI issued both convertible preferreds thus controlling the overinvestment problem. and debt with warrants before issuing its first con- The Special Role of the Call Provision. Of vertible bonds.) Indeed, the attachment of these course, like all models, this one is clearly unreal- financing options may make sense whenever a real istic in many respects. To cite one of its most investment option exists, regardless of whether artificial assumptions, the model assumes that the debt, common, or preferred stock is the initial maturity date of the investment option occurs at choice. Thus, for any initial security type (debt, the end of the first period. But what if the equity, or preferred), it can be advantageous to add investment opportunity materializes before then? a financial option as a hedge against incurring If the stock price has appreciated sufficiently (in additional issue costs. part to reflect the emergence of the new opportunity) to make the bond in the money, then THE EVIDENCE management can use the call provision to force the bondholders to convert into equity.16 What evidence do we have to back this theory? Forcing conversion has a number of benefits Consistent with the MCI story, my own recent study in this situation. First of all, the bonds no longer found striking evidence of increased investment and have to be redeemed at the end of time 1, thus financing activity around the time convertible bonds eliminating the need to raise new capital (and the are converted. But, before reporting the results of my associated issue costs) to fund the new investment own recent study, let me briefly review some of the project. Second, since dividend yields are typically relevant findings of other studies of convertibles. much lower than convertible coupon rates, forcing The focus of past research on convertibles can conversion halts the cash flow drain on the firm be classified into the following four categories: from required interest payments and allows the (1) managers’ professed motives for issuing con- savings to be channeled into the new project. vertibles; (2) the frequency and timing of convertible Third, the resulting addition to the firm’s equity calls and conversions; (3) the kinds of companies base allows it to raise additional debt financing for that choose to issue convertibles; and (4) the stock the new project unencumbered by the outstanding market’s reaction to announcements of new convert- debt issue. As mentioned earlier, one month after ible issues. MCI forced conversion of its August 1981 10 1/4% The first academic research on convertibles convertible, the company issued a new 20-year took the form of surveys of corporate issuers. Each convertible carrying a coupon of 7 3/4%. Thus, a of the three best-known surveys, published in 1955, major advantage of convertible debt is that immedi- 1966, and 1977,17 reported that about two thirds of ate conversion reduces leverage, thus making it the responding managers believed that their stock less costly to sell additional securities when more prices would rise in the future and accordingly financing is required. viewed their convertible offerings as ways of obtain-

16. The Stein model explains the purpose of the call provision as helping to 17. C.J. Pilcher, “Raising Capital with Convertible Securities,” Michigan avoid possible financial distress. The call provision allows companies “to get equity Business Studies, 21/2 1955); Eugene Brigham, “An analysis of Convertible into their capital structures ‘through the backdoor’ in situations where . . . Debentures: Theory and Some Empirical Evidence,” Journal of Finance 21 (1966); informational asymmetries make conventional equity issues unattractive.”Stein and J.R. Hoffmeister, “Use of Convertible Debt in the Early 1970s: A Reevaluation (1992, pp. 3-4). of Corporate Motives,” Quarterly Review of Economics and Business 17 (1977).

14 JOURNAL OF APPLIED CORPORATE FINANCE The association of convertibles with volatility, intangible assets, and high R&D and market-to-book ratios is consistent with convertible issuers having significant growth opportunities, as well as considerable uncertainty about the value and timing of those opportunities.

ing deferred equity financing. Management’s belief itself neither supports nor contradicts my explana- that the convertible feature will be exercised because tion. But, as also mentioned earlier, the 1997 study the stock price will rise is, of course, consistent with by Jen, Choi, and Lee found considerable variation my argument that convertible issuers have future in the market’s response to convertible offerings. investment “options” that will require funding if they The market reaction was significantly less negative turn out to be profitable. to announcements of convertibles by companies And management’s expectations appear to be with high market-to-book ratios and high (post- borne out by the subsequent experience of convert- offering) capital expenditures. These are the kinds of ible issuers. For, as shown in a 1991 study by Paul companies that fit my thesis—firms with significant Asquith, roughly two-thirds of all convertible bonds investment options that may pan out and require issued (and not subsequently redeemed in a merger) future funding, but may not. are eventually converted.18 Moreover, a 1991 study by Asquith and David Mullins showed that essen- New Evidence on After-Issue Investment and tially all companies call their convertibles if the Financing Activity conversion value exceeds the call price and if there are cash savings from the conversion (that is, if the In my 1998 study of convertibles, I tested my after-tax interest payments on the debt exceed the sequential financing hypothesis by comparing the dividends on the new equity).19 The fact that such a post-issue investment and financing activity of con- large fraction of convertible bonds is ultimately vertible issuers with that of their industry competi- converted is consistent with my view of convertibles tors. I began by compiling a sample of all (436) calls as part of an anticipated financing sequence. of convertible bonds by NYSE or AMEX companies Among studies of the kinds of companies that during the period 1968-1990. After combining mul- issue convertibles, Stuart Essig’s 1991 Ph.D. disser- tiple calls by the same companies within the same tation showed that convertible issuers tend to have year (there were 35 such cases) and deleting cases higher-than-average R&D-to-sales ratios, market-to- without Cusip numbers (5) or call announcement book ratios, and long-term debt-to-equity ratios dates (2), the sample fell to 394. Finally, I was forced (when the convertible issue is counted as debt).20 to drop an additional 105 cases because some firms They also tend to have more volatile cash flows than are not listed in Standard and Poor’s Industrial issuers of straight debt. At the same time, convertible Compustat data files—my source of information issuers have lower ratios of tangible assets (prop- about the company’s investment and financing. The erty, plant and equipment, and inventories) to total final sample contains 289 events that occur during assets. The association of convertibles with volatil- the period 1971 to 1990. ity, intangible assets, and high R&D and market-to- Table 1 lists the (two-digit) industrial classifica- book ratios is consistent with convertible issuers tion codes of the companies making the 289 calls. As having significant future growth opportunities, as the table shows, convertible issuers are not confined well as considerable uncertainty about the value and to just a few industries, but nor are they randomly timing of those opportunities. The higher leverage distributed among all sectors. For example, both the ratios also are consistent with my argument since oil and gas extraction and computer equipment higher leverage means larger potential cash flow industries have large concentrations of companies savings from calling the bonds and replacing them calling their convertibles. The firms in such indus- with equity when additional financing is required tries would seem to fit the profile of companies with for new investment. large ongoing financing requirements combined As noted earlier, the stock market reaction to with significant investment options. announcements of convertible bonds is significantly Table 2 contains summary statistics comparing negative, on average, though less negative than in the sample firms with their industry medians at the the case of equity issues. Such a finding in and of close of the year prior to the call. Like the findings

18. Paul Asquith, “Convertible Debt: A Dynamic Test of Call Policy,” Working 20. Stuart Essig, “Convertible Securities and Capital Structure Determinants,” paper, Sloan School of Management (1991). Ph.D. dissertation (Graduate School of Business, University of Chicago, 1991). 19. Paul Asquith and David Mullins, Jr., “Convertible Debt: Corporate Call Policy and Voluntary Conversion, Journal of Finance 46 (1991), 1273-1289.

15 VOLUME 13 NUMBER 1 SPRING 2000 TABLE 1 DISTRIBUTION OF TWO-DIGIT INDUSTRY AFFILIATION OF 289 FIRMS CALLING CONVERTIBLE BONDS DURING THE PERIOD 1971 THROUGH 1990

Two-Digit Two-Digit Code Industry No. Code Industry No.

01 Agriculture Production-Crops 1 48 Communications 7 10 Metal Mining 1 49 Electric, Gas, Sanitary Serv. 7 13 Oil and Gas Extraction 18 50 Durable Goods-Wholesale 7 15 Operative Builders (Bldg. Const.) 2 51 Nondurable Goods-Wholesale 7 16 Heavy Construction-Not Bldg. Const. 2 52 Bldg. Matl., Hardwr., Garden-Retl. 6 20 Food and Kindred Products 5 53 General Merchandise Stores 9 21 Tobacco Products 1 54 Food Stores 4 22 Textile Mill Products 2 56 Apparel and Accessory Stores 1 23 Apparel & Other Finished Pds., 2 57 Cmp. and Cmp. Software Stores 1 24 Lumber and Wood Pds. - Ex. Furn. 2 58 Eating Places 4 25 Wood-Hshld. Furniture 1 59 Miscellaneous Retail 3 26 Paper and Allied Products 5 60 Depository Institutions 9 27 Printing, Publishing & Allied Products 2 61 Nondepository Credit Instn. 4 28 Chemicals & Allied Products 12 62 Security Brokers and Dealers 6 29 Petroleum Refining 10 63 Insurance Carriers 3 30 Rubber & Misc. Plastics Products 2 65 Real Estate 5 32 Abrasives, Asbestos, Misc. Minrls. 1 67 Real Estate Investment Trust 5 33 Primary Metal Industries 6 70 Hotels, Other Lodging Places 1 34 Fabr. Metal 9 73 Business Services 12 35 Indl., Comml. Machy., Computer Eq. 21 75 Auto Rent and Lease 3 36 Electr., Oth. Elec. Eq., Ex. Cmp. 12 78 Motion Pic., Videotape Prodtn. 2 37 Transportation Equipment 16 79 Misc. Amusement & Rec. Services 3 38 Meas. Instr.; Photo. Gds.; Watches 16 80 Hospitals 5 39 Misc. Manufacturing Industries 3 82 Educational Services 1 40 Railroad Transportation 2 83 Social Services 1 44 Water Transportation 1 87 Engineering Services 1 45 Transportation by Air 17 Total 289

TABLE 2 SUMMARY STATISTICS COMPARING CHARACTERISTICS OF FIRMS CALLING CONVERTIBLE BONDS DURING THE PERIOD 1971 THROUGH 1990 WITH MATCHING INDUSTRY MEDIANS

Calling Firms Matching Industry Two-sample Test p-values Mean/Median N Mean/Median N t-test Wilcoxon

Leverage (LTD/Equity) 0.94/0.47 286 0.53/0.30 248 0.0001 0.0012 Convertible Debt/Total Debt 0.30/0.23 263 0.01/0.00 238 0.0001 0.0001 Total Convertible/Total Debt & Preferred 0.31/0.24 261 0.01/0.00 238 0.0001 0.0001 Market/Book of Equity 2.12/1.60 289 1.64/1.40 250 0.0090 0.0002 R&D/Sales 0.03/0.02 119 0.04/0.01 224 0.1842 0.0986 Tangible/Total Assets 0.97/0.99 228 0.99/1.00 250 0.0001 0.0001 reported in Essig’s 1991 study (cited earlier), my R&D to sales, and lower tangible to total assets than sample of convertible-calling companies had higher the median values in their industries. Moreover, for leverage ratios, higher market-to-book ratios, more these sample firms, convertible bonds were an

16 JOURNAL OF APPLIED CORPORATE FINANCE Companies that call their convertibles show somewhat higher levels of capital expenditures than their industry competitors in the years leading up to the call, but sharply higher levels in the years following the call. By far the largest changes in capital expenditures are reported in the year of the call and the year immediately following.

FIGURE 1 50 FREQUENCY DISTRIBUTION OF TIME TO CALL (NUMBER OF YEARS 40 BETWEEN ISSUE AND CALL) FOR 286 CALLED CONVERTIBLE BONDS, 1971-1990 30

20 Frequency

0 15913172125 Time to Call (Years) important part of the capital structure, representing call together with the stated uses of funds, it seems on average 30% of total debt.21 highly plausible that most convertible issuers were The next issue my study addressed was the considering the possible need to fund future invest- amount of time that elapses between the issuance ment options when raising capital for current activities. and call of convertibles. Figure 1 presents a fre- Post-Call Investment Activity. Having looked at quency distribution of the number of years between corporate statements of intent and the timing of issue and call (time to call) for the 286 called convert- convertible calls, the next step in my study was to ible bonds that are identified in Moody’s Industrial examine both actual investment and further financ- Manual. Although the original maturities of the called ing activity around the time of the convertible bond convertible bonds ranged from 10 to 35 years, with calls. For each of the 289 companies in my sample, a median of 25 years, the time period between issue I collected annual data from Standard & Poor’s and call was relatively short. The mean and median Industrial Compustat files on capital expenditures (a time to call were 6.8 and 5 years, and the mode was category which represents the funds used for addi- 3 years. (MCI’s 1981 convertible had a maturity of 20 tions to the company’s property, plant, and equip- years and was called in 18 months.) ment, but excludes amounts arising from acquired I also examined the stated uses of funds re- companies). My data collection began five years ported in Moody’s (by 279 issuers) at the time of before the convertible call (year -5) and ended four issue. Although the most common is to repay other years after the year of the call (year +4). For each of indebtedness (cited by 162 of the 279 issuers), most the 10 years (year 0 counts as the year of the call) and issuers mention other uses. And, in the majority of for all 289 companies, I calculated (1) the level of cases where debt repayment is cited, there is another capital expenditures as a percentage of total assets use that can be interpreted as providing funding for and (2) (for nine of the ten years) the change in corporate investment. For example, 95 issuers men- capital expenditures as a percentage of total assets tioned a desire to fund increases in working capital from the prior year. Then I performed the same (including accounts receivable), 38 cited funding for calculations for a control sample of companies in the acquisitions, and 74 mentioned various forms of same four-digit industrial classification. investment, a category that includes “exploration,” As shown in Table 3 (see columns 2 and 3), “expansion,” “capital expenditure,” and “new equip- companies that call their convertibles show some- ment.” Thus, considering the relatively short time-to- what higher levels of capital expenditures than their

21. These companies also tended to be among the larger firms in their greatest proportion of convertible securities. This fact is also consistent with the industries; however, I think that the more useful comparison is that between sequential-financing hypothesis since issue costs are more important for smaller convertible issuers and issuers of straight bonds in the same industry. Other studies issues, and issue size should be correlated with firm size. (e.g., Essig (1991)) have shown that across industries small firms tend to have the

17 VOLUME 13 NUMBER 1 SPRING 2000 TABLE 3 MEAN AND MEDIAN CAPITAL EXPENDITURES AND CHANGES IN CAPITAL EXPENDITURES (LEVELS AND CHANGES SCALED BY TOTAL ASSETS FOR YEAR –1) FOR YEARS RELATIVE TO THE CALL OF CONVERTIBLE DEBT BY 289 FIRMS DURING THE PERIOD 1971 THROUGH 1990*

Capital Expenditures/Total Assets (%) Changes in Capital Expenditures/Total Assets (%) Conversion Industry Conversion Industry Sample Match Sample Match Two-sample Test p-values Year Mean/Median Mean/Median N(Sample) N(Match) Mean/Median Mean/Median t-test Wilcoxon (1) (2) (3) (4) (5) (6) (7) (8) (9)

-5 5.0/3.7 4.7/4.0 227 228 -4 5.8/4.2 5.1/4.5 241 233 1.0a/0.5a 0.4a/0.4a 0.0967 0.2106 -3 6.8/5.8 5.7/4.8 245 241 0.8a/0.4a 0.5a/0.4a 0.4285 0.6412 -2 7.6/6.4 6.6/5.7 264 253 0.8a/0.7a 0.8a/0.6b 0.9377 0.9618 -1 9.2/7.1 7.8/6.2 276 268 1.3a/0.6a 0.8a/0.4a 0.1720 0.4009 0 13.4/8.8 9.5/7.2 273 268 3.4 /1.3 1.5 /0.5 0.0023 0.0019 1 18.3/11.6 11.5/8.1 261 268 5.0c/1.8a 1.6 /0.5 0.0001 0.0001 2 18.8/12.4 12.7/9.5 252 268 1.0b/0.9 0.3a/0.2 0.5132 0.0274 3 20.5/12.5 13.4/9.6 238 257 1.8c/0.9 –0.1b/0.2 0.0929 0.0138 4 23.2/12.2 14.6/9.7 224 249 1.3b/0.5b 0.7/0.2 0.5033 0.5719

*Tests reported in columns 6 and 7 (and indicated by the letters a, b, and c as described below) are paired mean and median tests comparing year-zero changes with the changes in other years. Thus, for example, the 3.4 mean value reported in column 6, year 0 is significantly different from the other mean values of that column in all years. The tests reported in columns 8 and 9 are the indicated two-sample tests comparing the sample and matching mean changes and distributions of changes for each year. Thus, for example, both the means and distributions differ in years 0 and 1 between the conversion sample (column 6) and the industry matches (column 7). a. indicates significance at the 0.01 level. b. indicates significance at the 0.05 level. c. indicates significance at the 0.10 level. industry competitors in the years leading up to the capital expenditures, and their rates of growth, are call, but sharply higher levels in the years following significantly higher for the companies that force the call. Moreover, as can be seen most clearly in conversion of their convertibles. column 6, by far the largest changes in capital Financing activity. Using the same Compustat expenditures are reported in the year of the call source for the same sample of 289 firms, I next (3.4%) and the year immediately following (5.0%). calculated the amount of funds received from (1) the (MCI’s increases in capital expenditures were 40.9% sale of common and preferred stock, (2) the issu- and 25.8% in the year of and the year following the ance of long-term debt, and (3) total sources—each call of its first convertible issue in 1983.) As shown as a percentage of total assets—over the same ten- in column 7, the industry-matched control firms also year period. As shown in Table 4, long-term debt, show their largest increases in years 0 and 1 (al- common and preferred stock, and total funding though the increases were only 1.5% and 1.6%). sources all experience significant increases during (And, to return to the MCI example, the capital the year of the call. For example, as shown in Panel spending of other telecommunications firms changed A, the average increase in long-term debt for con- by –1.1% and 0.6% in 1983 and 1984.) Increased vertible-calling firms was 6.66% of total assets (as investment by competitors is not surprising since the compared to less than 1% for the industry matched profitability of investment options for firms within sample). And, as shown in Panel B, the increase in industries should be correlated. That is, when one oil common and preferred stock in year 0 also is about company decides to undertake a major expansion, 6%, which reflects mainly the conversion of the the same factors are likely to drive other oil compa- called convertibles into stock.22 But then in year 1, nies to do the same. But even so, both the levels of the percentage of equity drops sharply (by about

22. I inferred this from the following procedure: Using the fractions of means from Table 3, I estimate that shares added through conversions on average outstanding shares into which the bonds are convertible (about 14%), as reported represent 5.5% of assets. See A.K. Singh, A.R. Cowan, and N. Nayar, “Underwritten in Singh, Cowan, and Nayar (1991), and the equity capitalization and total asset Calls of Convertible Bonds,” Journal of Financial Economics 29 (1991), 173-196.

18 JOURNAL OF APPLIED CORPORATE FINANCE Long-term debt, common and preferred stock, and total funding sources all experience significant increases during the year of the call. Debt is clearly the preferred instrument for financing after convertible bond calls.

TABLE 4 MEAN AND MEDIAN ISSUANCES OF LONG-TERM DEBT, COMMON AND PREFERRED, AND TOTAL SOURCES OF FUNDS (LEVELS AND CHANGES SCALED BY TOTAL ASSETS FOR YEAR -1) FOR YEARS RELATIVE TO THE CALL OF CONVERTIBLE DEBT BY 289 FIRMS DURING THE PERIOD 1971 THROUGH 1990*

Financing Activity Level/Total Assets (%) Changes in Financing Activity/Total Assets (%) Conversion Industry Conversion Industry Sample Match Sample Match Two-sample Test p-values Year Mean/Median Mean/Median N(Sample) N(Match) Mean/Median Mean/Median t-test Wilcoxon (1) (2) (3) (4) (5) (6) (7) (8) (9)

PANEL A: ISSUANCES OF LONG-TERM DEBT -5 4.4/2.6 3.6/1.3 195 224 -4 5.0/2.8 3.9/1.6 205 229 0.8a/0.0a 0.7 /0.0 0.8398 0.3640 -3 7.5/4.9 3.4/1.8 214 233 2.7b/0.5 –0.3c/0.0 0.0003 0.0012c -2 7.9/5.6 3.2/1.9 220 241 0.5a/0.0a –0.2a/0.0 0.4828 0.5194b -1 8.9/5.0 4.3/2.3 230 253 1.3b/0.8a 0.4 /0.0 0.3020 0.1939c 0 15.5/9.0 4.9/2.3 243 268 6.6 /1.6 0.9 /0.0 0.0001 0.0004 1 21.0/8.6 7.2/3.0 229 268 5.4 /0.0 1.9c/0.0 0.1410 0.2694 2 18.1/8.5 6.7/2.6 225 268 –2.3a/0.0a –1.5b/0.0 0.7622 0.6488c 3 20.9/7.6 9.0/2.8 219 257 2.3b/0.0a 0.6 /0.0 0.4578 0.9114 4 22.4/9.1 9.6/3.2 207 250 0.2b/0.0 1.1 /0.0 0.7038 0.7552 PANEL B: ISSUANCES OF COMMON AND PREFERRED -5 0.9/0.1 0.3/0.0 200 224 -4 1.4/0.1 0.6/0.0 212 229 0.4a/0.0a 0.2 /0.0 0.5335 0.3864 -3 1.7/0.2 0.6/0.0 219 233 0.3a/0.0a 0.0c/0.0 a 0.4362 0.0072 -2 1.8/0.2 0.6/0.0 227 241 0.0a/0.0a 0.1 /0.0 0.7142 0.2078 -1 2.4/0.5 0.7/0.0 238 253 0.6a/0.0a 0.0b/0.0 a 0.2119 0.0071 0 9.4/5.4 0.9/0.1 250 268 6.7 /3.5 0.2 /0.0 0.0001 0.0001 1 5.4/0.5 0.6/0.1 239 268 –4.0a/–2.4a –0.3b/0.0a 0.0002 0.0001 2 3.5/0.2 0.6/0.1 232 268 –1.8a/0.0 –0.2 /0.0 a 0.1662 0.0037 3 4.1/0.3 0.9/0.0 220 257 0.7a/0.0a 0.1 /0.0 0.5740 0.8634 4 3.8/0.2 0.7/0.0 206 250 –0.6a/0.0 0.0 /0.0 b 0.6038 0.3575 PANEL C: TOTAL SOURCES OF FUNDS -5 13.1/11.2 14.1/11.6 210 224 -4 15.4/12.7 16.0/12.6 219 228 2.4a/1.3a 2.2b/1.7a 0.8455 0.5159 -3 19.4/15.4 16.3/14.4 219 231 4.2a/3.1a 1.8b/1.7a 0.0180 0.0127 -2 22.8/18.5 18.3/17.2 212 236 4.0a/3.3a 1.8b/2.2a 0.0748 0.0773 -1 27.4/21.9 21.9/19.9 208 240 4.7a/2.8a 2.3 /2.8c 0.1112 0.7692 0 43.0/34.3 29.1/22.6 212 252 16.1 /12.4 7.3 /3.0 0.0043 0.0001 1 47.6/33.4 31.0/24.4 185 244 3.3a/–1.4a 4.3 /1.8c 0.7505 0.0012 2 48.1/36.7 32.9/26.1 169 221 1.8a/2.2a 0.4a/1.9a 0.6850 0.5429 3 52.9/36.9 38.7/29.4 150 200 5.0a/0.8a 3.8 /2.9 0.7025 0.2585 4 60.2/38.9 40.5/32.8 129 186 7.4 /2.8a 4.0 /2.2 0.4198 0.7757

19 VOLUME 13 NUMBER 1 SPRING 2000 FIGURE 2 0.7 MEAN CAPITAL EXPENDITURES AND NEW Common and Preferred 0.6 FINANCING (SCALED BY Long-term Debt ASSETS IN YEAR –1) FOR Capital Expenditures YEARS RELATIVE TO THE 0.5 CALL OF CONVERTIBLE Total Sources DEBT BY 289 FIRMS, 1971-1990 0.4

0.3

0.2 Dollars/Assets (Year –1) Dollars/Assets (Year 0.1

0.0 –5 –4 –3 –2 –1 0 1 2 3 4 Years Relative to Convertible Call

4%)—and the reason for this sudden drop will total debt rather than long-term debt in measuring shortly become clear. the leverage ratio.) This rapid increase in leverage In the final part of my study, I also collected data ratios after the call explains the sharp drop in from Investment Dealer’s Digest (which reports all common and preferred in year 1. issues of public securities by corporations) on the In summary, Figure 2 illustrates the changes in financing activity of a somewhat larger sample of 365 both capital expenditures and funding sources of the convertible-calling companies around the time of 289 companies over the 10-year period surrounding the call. Of the 365 firms, 110 obtained new financing their conversions. As shown in the figure, both the during the year prior to the call, while 144 raised new level of investment and total sources of outside capital the year after the call, a significant increase of funding experience notable increases in the year of 31%. Moreover, of the 144 firms with new post-call the call and the year after. Nevertheless, equity financings, 86 issued only debt, 28 only equity, and funding, after rising sharply in the year of conver- seven only preferred—while 23 issued some combi- sion, declines sharply in the next two years as nation of debt and either preferred or equity. Thus, companies follow with new debt (or convertible) debt is clearly the preferred instrument for financing issues. after convertible bond calls.23 Another way to capture the relative importance CONCLUSION of debt in post-call financing is to examine leverage ratios (LTD/Equity), which reflect private as well as In the “new economy,” a rapidly growing public debt. As a result of conversion, there are proportion of corporate value appears to derive not significant reductions in leverage ratios by the end from the profits generated by companies’ current of year 0, the mean and median leverage ratios are activities, but from their real investment options that 0.63 and 0.36, as compared with 0.94 and 0.47 at the may prove worth pursuing, but may not. For com- end of the preceding year. But at the end of year 1, panies whose value consists in large part of real the mean and median leverage ratios have risen options (and Internet and biotech stocks are likely to significantly to 0.81 and 0.39. Moreover, by the end fall into this category), convertible bonds may offer of year 2, mean and median leverage are 1.00 and the ideal financing match (as long as the coupon rate 0.43, which are indistinguishable from their values at can be kept low enough) because of the matching year end -1. (And the same result is obtained using financial option that they provide.

23. Further, these estimates of the relative number of firms with new debt financings are likely biased down by the omission of private financings by the Digest.

20 JOURNAL OF APPLIED CORPORATE FINANCE For companies whose value consists in large part of real options (and Internet and biotech stocks are likely to fall into this category), convertible bonds may offer the ideal financing match because of the matching financial option they provide.

In this paper, I propose that corporations use the stock price is “in the money,” effectively en- convertible debt as a key element in a financing ables managers to force conversion of the bonds strategy that aims not only to fund current activities, into equity. As option pricing theory suggests, the but to enable them to “exercise” their real options by value of this call option increases directly with giving them access to low-cost capital should the increases in uncertainty about both the eventual options turn out to be valuable. In this sense, value and the maturity date of the real option. If convertibles can be seen as the most cost-effective and when the investment opportunity does materi- solution to a sequential financing problem—that is, alize, exercise of the call feature gives the firm an how to fund not only today’s activities, but also infusion of new equity that enables it to carry out tomorrow’s opportunities. According to my analysis, its new investment and financing plan unencum- the sequential financing approach is designed to bered by the debt issue. control an overinvestment incentive that can arise if Because my analysis suggests the convertible financing is provided before an investment option’s feature is the key to solving a sequential-financing maturity (i.e., before an investment opportunity problem, my study examines the investment and materializes). The key considerations in my analysis financing activities of 289 companies around the are new issue costs (which include the “information time their convertible bonds are called and con- costs” associated with selling underpriced securities) verted. Such companies made significant increases and the degree of uncertainty about the profitability in capital expenditures (as compared to those by an of the firm’s real investment options. The higher the industry-matched control group) starting in the year new issue costs, and the greater the degree of of the call and extending through three years after. uncertainty about the size and timing of the firm’s These companies also showed increased financing future capital requirements, the more effective are activity following the call, mainly new long-term convertibles both in controlling the overinvestment debt that is issued in the year of the call. These new problem and minimizing costs associated with rais- issues of debt, which are often themselves convert- ing capital in the future. ible into equity, suggest that financing the exercise As my analysis also shows, the critical feature of real investment options is an important consider- of convertibles is the call provision that, provided ation in the design of convertible bonds.

DAVID MAYERS holds the Philip L. Boyd Chair in Finance at the A. Gary Anderson Graduate School of Management at the University of California, Riverside.

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