Growth option, contingent capital and agency conflicts

This paper examines how contingent convertible bonds (CoCos) outstanding impact on expansion investment under exogenous and endogenous conversion threshold. We provide a relatively formal method to price general corporate securities. We find that under an exogenous conversion threshold, there is a conversion ratio, i.e. a fraction of equity allocated to CoCos' holders upon conversion, such that underinvestment is eliminated. With a sufficiently high conversion ratio, issuing CoCos can alleviate and even eliminate the inefficiencies arising from debt overhang and asset substitution. However, under endogenous conversion, CoCos will conversely exacerbate the investment distortion, no mater how much the conversion ratios are.