Time Inconsistency and Financial Covenants

Haotian Xiang
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Haotian Xiang: University of Pennsylvania

No 63, 2019 Meeting Papers from Society for Economic Dynamics

Abstract: I investigate how financial covenants influence corporate behavior and firm value by allocating control rights. In a dynamic model with long-term debt, shareholders cannot commit to not expropriate creditors in the future with new debt issuances and risky investments. Creditors intervene upon violations of covenant restrictions and restructure the debt without ex ante commitment. I find that financial covenants significantly increase debt capacity, investment and ex ante firm value by disciplining shareholders. However, I show that lenders' inability to commit to a restructuring plan severely impairs contractual efficiency. My analysis suggests that a further tightening of covenants, relative to the calibrated benchmark, improves their role as a commitment device.

Date: 2019
New Economics Papers: this item is included in nep-cfn
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