CONVERTIBLE DEBT AND INVESTMENT INCENTIVES

In this paper we examine the effect of convertible debt on the investm ent incentives facing stockholders. The effect depends critically on t he value of existing assets relative to the firm's investment requirem ents. With a restrictive dividend covenant, convertible debt mitigates the overinvestment incentive associated with risky debt but exacerbat es the underinvestment incentive at higher values of existing assets. A less-restrictive dividend covenant exacerbates overinvestment under straight debt financing but reduces the underinvestment incentive indu ced by the conversion feature. In this context, a convertible debt con tract with a less-restrictive dividend covenant maximizes firm value.