Convertible debt: an effective financial instrument to control managerial opportunism

Abstract

Abstract This paper discusses the superiority of convertible debt to common debt and equity in controlling managerial opportunism. When managers have both empire‐building tendencies and fears of default, over‐investment occurs under low debt levels and under‐investment occurs under high debt levels. Convertible debt, which can adjust firms' debt levels by its convertibility, can restrict over‐investment and help firms to avoid under‐investment at the same time. In a simple setting, we show that well‐designed callable convertible debt has an important role in controlling managerial opportunistic behavior that neither common debt nor equity has.

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