Debt Covenants and Capital Structure: Evidence from an Exogenous Shock to Debt Capacity
Columbia Business School
Sharon P. Katz
Columbia Business School - Accounting, Business Law & Taxation
University of Texas at Dallas
July 9, 2012
This paper empirically examines how debt covenants impact the capital structure choices of firms, by utilizing an exogenous accounting based shock to the distance to covenant violation. We find that, on average, the shock to debt capacity had a positive impact on the debt choices of all treated firms, but the response was strongest by firms that were close to violating or in violation of the affected covenants, and that were otherwise financially unconstrained. Our findings suggest that debt covenants are a key component of the capital structure trade-off that influences debt choices well before they are triggered. We proceed to examine how the additional debt affected firms' corporate financial behavior and find that it did not result in an increase in investments or cash holdings, but rather was associated with lower profitability and a lower likelihood to enter default or bankruptcy. Some firms even maintained or increased their dividend payouts.
Number of Pages in PDF File: 55
Keywords: Debt, covenants, financial constraints, leverage, investments, default
JEL Classification: G01, G30, G31, G33, M21, M41
Date posted: July 12, 2012
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