Convertible Bond Design and Capital Investment: The Role of Call Provisions

Abstract

If firms issue convertible securities to facilitate sequential investment, the securities should be engineered to give sufficient f lexibility to accommodate timing of follow-on investment. We examine call provisions in convertible bonds and argue that firms with investment options expected to expire sooner (later) will offer weaker (stronger) call protection. We find that issues with weak or no call protection are offered by firms that invest greater amounts soon after issuance than those issuing convertibles with strong protection. Moreover, capital expenditure levels during the 5-year period following issuance are inversely related to the length of call-protection periods.MOST CONVERTIBLE BONDS AND NOTES have call provisions, and most provisions have important qualifications or protection. Broadly speaking, convertibles may have absolute protection (not callable), hard call protection (noncallable for a specified period), provisional or soft call protection (callable if certain conditions on stock price are met), or no protection (callable anytime). In this study, we investigate the relations between the strength and length of call protection and firms' subsequent investment behavior.Our hypothesis is a natural implication of the sequential financing motive for convertible debt financing. For example, in Mayers (1998), firms finance their planned multistage investment programs with convertibles. Besides Mayers' sequential financing motive, other explanations for convertible financing include theories based on post-issuance risk shifting (Jensen and Meckling (1976), Green (1984)), heterogeneous risk assessment (Brennan and Schwartz (1988)), and asymmetric information (Stein (1992)). In a recent study, Lewis, Rogalski, and Seward (2001) offer an explanation based on equity market rationing.Stein's (1992) model has at least an implicit role for callability, but we believe Mayers' explanation has direct implications for the nature of call provisions that we examine here. He argues that convertible financing is well suited to * Korkeamaki is with Gonzaga University and Moore is with the University of South Carolina.We thank an anonymous reviewer for careful guidance from which the study has benefited greatly. We also wish to express our sincere gratitude to for helpful comments and guidance, and to Ellen Roueche for help in preparation of this manuscript. Special thanks to the editor, Rick Green, for his comments and guidance. We gratefully acknowledge valuable comments from participants at a 2002 joint seminar of the Swedish School of Economics and Business Administration and the Helsinki School of Economics. 392The Journal of Finance circumstances where a firm requires immediate financing to undertake a project that is expected to be followed by a second project at some (uncertain) time in the future.We argue that firms facing investment options that are expected to mature shortly after issuance will offer convertibles with little or no call protection, and those issues with protection features will have short pr...

Investment and financing activity following calls of convertible bonds

“…Nor are our results inconsistent with the recent findings of Korkeamaki and Moore (2004), which show that firms match the firmness of the call protection features on convertible bonds to accommodate the expected life of their investment options. Companies can be deliberate in creating the flexibility to call their convertibles, but whether forcing conversion of the bonds leads to greater investment than otherwise is a separate empirical issue.…”

“…Korkeamaki and Moore (2004) find that firms planning capital expenditures soon after convertible issuance tend to include weaker call protection in their indentures.…”

Effects of law on corporate financing practices—international evidence from convertible bond issues

“…Firms with a short expected wait should therefore offer short call protection. Korkeamaki and Moore (2004) find evidence of a connection between issuers' investment patterns following the convertible issue and call protection terms on their issues.…”

“…In Mayers' model, firms with sequential investment plans are able to minimize both overinvestment problems and refinancing costs by using convertibles. Korkeamaki and Moore (2004) extend Mayers' (1998) work by studying the implications of his model on call protection terms. If convertibles are used as vehicles to finance sequential investments, issuers want to be able to call their convertibles at the time of their next investment sequence.…”

The Motives for the Issuance of Callable Convertible Bonds by American and European Companies – a Comparative Analysis

“…Po drugie, może pozwolić jej na złagodzenie sporów agencyjnych między akcjonariuszami a zarządem na tle zbyt ekspansywnej polityki inwestycyjnej realizowanej przez kadrę menedżerską [Isagawa, 2000[Isagawa, , 2002. Po trzecie, może ułatwić menedżerom realizację projektów inwestycyjnych o niepewnej rentowności lub nieznanej dacie realizacji [Mayers, 1998[Mayers, , 2000Korkeamaki, Moore, 2004;Jung, Sullivan, 2009].…”