The Leverage Changing Consequences of Convertible Debt Financing

Abstract

Dann and Mikkelson (1984) report that the common stockholders of firms issuing convertible debt realize significantly negative returns upon the announcement of such financing. They further state that this observation is not consistent with the leverage hypothesis nor with the new financing models of Myers and Majluf (1984) and Miller and Rock (1982). This study also documents negative returns to the stockholders of convertible debt issuing firms on the announcement date. However, Dann and Mikkelson's assumption that the issuance of convertible debt increases financial leverage is questioned. A new convertible bond valuation model is proposed which valuates a convertible bond as the sum of its market perceived equity and straight debt components. Convertible bond rates of return are regressed on common stock and straight debt rates of return to demonstrate that convertible bonds have a large and significant equity component; often large enough to cause leverage decreasing changes to the issuing firm's capital structure. Furthermore, the perceived change in leverage is shown to be significant in explaining the announcement period excess returns realized by the stockholders of convertible issuing firms. In this way, negative announcement period excess returns are shown to be consistent with the leverage hypothesis. In addition, the results support the new financing model developed by Myers and Majluf.

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