The Leverage Changing Consequences of Convertible Debt Financing

Recent evidence shows that common stockholders realize significantly negative abnormal returns upon the announcement of convertible debt financing. The leverage hypothesis predicts positive announcement date abnormal returns in reaction to leverage increasing capital structure changes. Here, the frequently made assumption that convertible debt increases financial leverage is questioned and its actual effect on leverage is estimated. It is shown that convertible bonds have a significantly large equity component. For some industrial firms this equity component is large enough to reduce financial leverage, thus reconciling observed announcement date abnormal returns with the leverage hypothesis. It is also shown that the size of the equity component is inversely related to announcement date abnormal returns. This result is consistent with the Myers and Majluf model of new financings.