Taxation, agency conflicts, and the choice between callable and convertible debt

Christopher A. Hennessy, Yuri Tserlukevich

Research output: Contribution to journalArticlepeer-review

19 Scopus citations


We analyze debt choice in light of taxes and moral hazard. The model features an infinite sequence of nonzero-sum stochastic differential games between equity and debt. Closed-form expressions are derived for all contingent-claims. If equity can increase volatility without reducing asset drift, callable bonds with call premia are optimal. Although callable bonds induce risk shifting, call premia precommit equity to less frequent restructuring and are tax-advantaged. Convertible bonds mitigate risk shifting, but only induce hedging if assets are far from the default threshold. Convertibles are optimal only if risk shifting reduces asset drift sufficiently.

Original languageEnglish (US)
Pages (from-to)374-404
Number of pages31
JournalJournal of Economic Theory
Issue number1
StatePublished - Nov 1 2008
Externally publishedYes


  • Agency
  • Capital structure
  • Stochastic differential games

ASJC Scopus subject areas

  • Economics and Econometrics


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