Private benefits of control, contingent capital and investment timing

Abstract

By establishing a real options model, this paper investigates, for the first time, how the controlling shareholder’s private benefits of control affect the endogenous default threshold, investment policy, and risk-shifting incentive under contingent convertible bonds financing. The results indicate three key findings. First, the default threshold rises with the controlling shareholder's equity ratio, conversion ratio, and the magnitude of investor protection. Second, contingent convertible bonds can mitigate overinvestment. Specifically, the controlling shareholder’s incentive to overinvest declines as investor protection strengthens, but increases with the controlling shareholder's equity ratio. There exists an optimal conversion ratio related to the private benefits of control that effectively eliminates inefficient investment. Finally, the controlling shareholder’s risk-shifting incentive increases slightly with stronger investor protection, while the effect of the controlling shareholder's equity ratio on such incentives depends on the firm’s current cash flow level.