Question

1) Describe an asset substitution problem and discuss why convertible bonds may mitigate the problem.

Answer 1

A situation which occurs when shareholders prompt a company to invest in assets that are riskier than what bondholders want (asset substitution). The newer, riskier investment potentially increases the return that shareholders will see from their stock, while increasing the risk that bondholders will bear due to the increased risk of bankruptcy. Asset substitution problem highlights the conflicts between stockholders and creditors

When a firm’s capital structure includes convertible debt, every project un-dertaken affects not only the distribution of the value of the firm’s assets but also thelikelihood that the debt will be converted and thereby the distribution of the firm’s leverage.Company providing bondholders with conversion rights helps mitigate the risk-shifting problem. That is, as the incentive to convert bonds to common shares increases with firm value, and as conversion dilutes the equity held by the currentshareholders, the presence of convertible debt makes risky projects with high upside potential less attractive to shareholders. It implies that convertible debt reverses the incentive for equityholders to take on more risk due to dilution effect therefore, reduces shareholders’incentive to increase firm risk.