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Keywords:

  • G31;
  • G32;
  • G33

Abstract

I argue that convertible debt, in contrast to its perceived role, can produce shareholders’ risk-shifting incentives. When a firm's capital structure includes convertible debt, every investment decision affects not only the distribution of the asset value but also the likelihood that the debt will be converted and thereby the distribution of the firm's leverage. This suggests that managers can engage in risk-increasing projects if a higher asset risk generates a more favorable distribution of leverage. Empirical evidence using 30 years of data supports my argument.