Asymmetric Information and Financing with Convertibles

Rodney L. White Center for Financial Research Working Paper No. 05-03

30 Pages Posted: 21 Jul 2003

See all articles by Archishman Chakraborty

Archishman Chakraborty

York University - Schulich School of Business

Bilge Yilmaz

University of Pennsylvania - Finance Department

Abstract

We analyze the problem of dilution leading to inefficient underinvestment caused by the adverse selection problem. We assume that the market obtains information about the firm over time, but that at each date the manger possesses better information about firm prospects than does the market. We show that issuing callable convertible securities with fixed conversion prices and restrictive call provisions is optimal. Such securities make the payoff to new claimholders independent of the private information of the manager. The restrictive call provision serves as a commitment device, enabling the manager to call only when the stock prices rises in the future. This benefits the new as well as the existing claim-holders so that the adverse selection problem is costlessly solved without any dissipation or underinvestment. Furthermore, we show that this efficient outcome can also be implemented by issuing optimally designed floating price convertibles.

Suggested Citation

Chakraborty, Archishman and Yilmaz, Bilge, Asymmetric Information and Financing with Convertibles. Rodney L. White Center for Financial Research Working Paper No. 05-03, Available at SSRN: https://ssrn.com/abstract=408240 or http://dx.doi.org/10.2139/ssrn.408240

Archishman Chakraborty

York University - Schulich School of Business ( email )

4700 Keele Street
Toronto, Ontario M3J 1P3
Canada

HOME PAGE: http://www.yorku.ca/archish/

Bilge Yilmaz (Contact Author)

University of Pennsylvania - Finance Department ( email )

The Wharton School
3620 Locust Walk
Philadelphia, PA 19104
United States
215-898-1163 (Phone)
215-898-6200 (Fax)

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