Contingent capital, capital structure and investment

•We examine the interaction between investment and financing policies with CoCos in a dynamic model.•There is a conversion ratio of CoCos to eliminate inefficiencies arising from debt overhang and asset substitution.•In contrast to traditional finance theory, a firm's value might first decrease and then increase with its business risk.•Debt leverage decreases with investment option payoff factor and the average appreciation rate of the cash flow.•A write-down CoCo would cause serious inefficiencies from debt overhang and asset substitution.

We examine the interaction between investment and financing policies in a dynamic model for a firm with existing assets-in-place and a growth option, of which investment cost is financed with equity and contingent convertible bonds (CoCos). We attempt to clarify how CoCos impact on investment timing, capital structure and inefficiencies arising from debt overhang and asset substitution. We show that there is a conversion ratio (the fraction of equity allocated to CoCo holders upon conversion) to eliminate the inefficiencies. Our conclusions predict that debt leverage decreases with investment option payoff factor and the average appreciation rate of the cash flow. In contrast to traditional corporate finance theory saying that a firm's value decreases globally with business risk, our model indicates that it might first decrease and then increase with asset volatility.