Risk analysis with contractual default. Does covenant breach matter?

Emanuele Borgonovo and Stefano Gatti

European Journal of Operational Research, 2013, vol. 230, issue 2, 431-443

Abstract: Mergers and acquisitions (M&A), private equity and leveraged buyouts, securitization and project finance are characterized by the presence of contractual clauses (covenants). These covenants trigger the technical default of the borrower even in the absence of insolvency. Therefore, borrowers may default on loans even when they have sufficient available cash to repay outstanding debt. This condition is not captured by the net present value (NPV) distribution obtained through a standard Monte Carlo simulation. In this paper, we present a methodology for including the consequences of covenant breach in a Monte Carlo simulation, extending traditional risk analysis in investment planning. We introduce a conceptual framework for modeling technical and material breaches from the standpoint of both lenders and shareholders. We apply this framework to a real case study concerning the project financing of a 64-million euro biomass power plant. The simulation is carried out on the actual model developed by the financial advisor of the project and made available to the authors. Results show that both technical and material breaches have a statistically significant impact on the net present value distribution, and this impact is more relevant when leverage and cost of debt increase.

Keywords: Investment analysis; Project finance; Risk analysis; Monte Carlo simulation; Coherent risk measures; Covenants (search for similar items in EconPapers)
Date: 2013
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (7)

Downloads: (external link)
http://www.sciencedirect.com/science/article/pii/S0377221713003615
Full text for ScienceDirect subscribers only

Related works:
This item may be available elsewhere in EconPapers: Search for items with the same title.

Export reference: BibTeX RIS (EndNote, ProCite, RefMan) HTML/Text

Persistent link: https://EconPapers.repec.org/RePEc:eee:ejores:v:230:y:2013:i:2:p:431-443

DOI: 10.1016/j.ejor.2013.04.047

Access Statistics for this article

European Journal of Operational Research is currently edited by Roman Slowinski, Jesus Artalejo, Jean-Charles. Billaut, Robert Dyson and Lorenzo Peccati

More articles in European Journal of Operational Research from Elsevier
Bibliographic data for series maintained by Catherine Liu ().