Contingent Capital And Dynamic Investment And Financing Policy

This paper considers recently invented contingent capital,which includes Contingent Convertible bonds(CoCos),Write-down CoCos and debt-to-equity swaps.Under the risk-neutral pricing rule,applying economic theory,stochastic calculus for finance,real option approach and numerical calculation to develop a formal model of mathematical finance,we explore the effects of the issues of contingent capital on investment and financing decisions of a company.CoCos are new financial security after the global financial crisis of 2007/2009,in order to enhance the stability and bail-in ability of financial institutions and reduce the financial risk.Debt-for-equity swaps aim to de-leverage,decrease high debt ratio of enterprise,and reduce banks non-performing loan ratio and dissolve the risk of financial institutions.These problems are currently concerned by the government,banks and enterprises.This article tries to explore whether such contingent capital can improve the firm's total value,reduce the ruin probability and mitigate market inefficiencies such as asset substitution and agency conflicts,and examine how it impacts on corporate capital structure,investment and financing decisions.Finally,we put forward the policy suggestion of the development,implementation and risk management of contingent capital.The main contents of the paper are structured as follows:First,most of domestic banks have issued Write-down Contingent Capital Bonds(write-down CoCo bonds).Intuitively,such new contingent capital must induce a considerable adventure motivation of managers under the fixed wage and equity incentive compensation structure.To mitigate and even completely eliminate this incentive,we take contingent cash compensation as a manager's long-term incentive fee and establish a new scheme of managerial contingent compensation.We study the effect of write-down CoCo bonds issuance and managerial contingent compensation design on managers' risk-taking motivation,the value of the issuing company,the ruin probability,bankruptcy cost,and the risk premium of the common bond.Closed-form solutions of the values of the write-down CoCo bonds and managerial wealth are obtained under a risk-neutral probability measure.By numerical simulations,we find that write-down CoCo bonds increase the value of the issuing company by reducing their bankruptcy probability,but enhance the managers' adventure motivation.In contrast,the managerial contingent cash income can restrain this motive.In addition,shareholders of the issuing company can adjust the amount of contingent cash compensation or the fraction of equity to control the adventure motivation of managers and in particular,regulators are able to control the risk of the banking system by adjusting the trigger level to write down.Therefore,our analysis has theoretical and practical guiding significance for risk management problems of the issuer and regulators,and it is helpful to the current reform in the financial institution compensation of managers.Second,we examine 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 the 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 not only could not alleviate,and conversely exacerbate the investment distortion.Third,we explore the interaction between investment and financing policies in a dynamic model for a firm with existing assets-in-placeand 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 equityallocated 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.Not only CoCos financing at investment can mitigate the inefficiencies arising from asset substitution and debt overhang,but also alleviate overinvestment problem.Fourth,in order to lower corporate leverage,decrease high cost of bond,reduce banks' non-performing loan ratio and dissolve the risk of financial institutions,the debt-to-equity problem has caused wide concern for the government,companies and banks.Basing on the idea of debt renegotiations,we establish partial debt-to-equity swaps model,and examine the effects of debt-to-equity on the firm's value,bankruptcy probability,bankruptcy loss costs and capital structure,and obtain a sufficient condition that the creditors are willing to carry out debt-to-equity swaps ex post.It turned out that,compared to the bankruptcy liquidation,debt for equity swaps can improve the value of the firm from the perspective of social welfare maximization.For predetermined bankruptcy liquidation,however,only if negotiation ability between the shareholders and creditors satisfy some certain conditions,the creditors has an incentive to change the way of debt restructuring,and choose debt-to-equity swaps afterwards.By numerical simulations,we find that debt-to-equity are able to reduce the risk of bankruptcy and bankruptcy loss costs,increase the firm's value,but raise the risk premium of bond;Moreover,compared to the full debt-to-equity,the partial debt-to-equity can improve the value of the company,which optimal convertible coupon ratio increases with the assets' volatility rising.Finally,as shareholders' bargaining power rise,the optimal firm value,convertible coupon ratio and leverage decrease,and while the credit spread of bond increase.The results can provide theoretical and practical guidance for the government's debt-for-equity swap to reduce leverage,capacity and control risks.Finally,On the issue of debt-to-equity swaps,which are concerned by the government,enterprises and banks,we examine its effects on investment and financing decisions in a real options framework.We obtain the values of all the corporate securities,capital structure and static comparative analysis under partial debt-to-equity swaps model.By numerical simulations,we find that,in contrast to the bankruptcy liquidation,debt-to-equity swaps can improve the option value.And there is always the optimal combination of the debt's coupon and convertible coupon ratio to maximize the option value.Moreover,the option value is concave function for the proportion of coupon consultation,and the optimal investment level is the convex function for it.In addition,the optimal investment trigger reduce with growth rate of the cash inflow,but increase as the shareholder's bargaining ability,volatility,corporate tax rate,loss rate of bankruptcy and risk-free interest rate;Last but not least,the option value and the optimal convertible coupon ratio are an increase function of the flow's volatility,and are a decreasing function for shareholders negotiations ability,tax rate,and the risk-free interest rate.