Loan-commitment borrowing and performance-sensitive debt

Sudipto Sarkar () and Chuanqian Zhang ()
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Sudipto Sarkar: McMaster University
Chuanqian Zhang: William Paterson University

Review of Quantitative Finance and Accounting, 2016, vol. 47, issue 4, No 4, 973-986

Abstract: Abstract This paper examines a firm’s investment/financing decision when it uses loan-commitment-type debt with performance-sensitivity features. This analysis is of interest because most corporate borrowing today is by means of private debt, which tends to be of the loan-commitment type as well as contain performance-sensitivity provisions. We show that, except for the case of low leverage ratio, performance-sensitive debt makes shareholders better off relative to fixed-coupon debt. In particular, when the leverage ratio is chosen optimally, performance-sensitive debt dominates fixed-coupon debt and the resulting addition to shareholder wealth can be economically significant for reasonable parameter values. Therefore, it is not surprising that performance-sensitive debt has become so popular in the private debt market. The magnitude of shareholder wealth created by using performance-sensitive debt rather than fixed-coupon debt is an increasing function of earnings growth rate and tax rate, and a decreasing function of interest rate, earnings volatility and bankruptcy cost. Therefore, performance-sensitive debt financing is more likely to be used when earnings growth rate and tax rate are high, and interest rate, earnings volatility and bankruptcy cost are low.

Keywords: Private corporate debt; Loan commitment; Performance-sensitive debt (search for similar items in EconPapers)
JEL-codes: G3 (search for similar items in EconPapers)
Date: 2016
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Citations: View citations in EconPapers (3)

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DOI: 10.1007/s11156-015-0527-z

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