Financing decisions: The case of convertible bonds

Research studying firms' motivations to issue convertible bonds remains far from complete. This paper aims to provide further understanding of firms' motives behind issuing convertible bonds. We propose a theoretical model that explains issuers' choice between convertibles and equity when raising a required amount of capital by comparing the cash flow streams of both alternatives in order to maximize the firm's value for the current shareholders. We derive a closed form solution of our theoretical model both in absence and presence of default risk. Our model suggests that issuing convertible bonds is preferred to a direct stock issuance if the expected return of convertible bonds is lower than the expected return of common stocks. Empirical findings confirm our theoretical predictions.