Performance Sensitive Debt - Investment and Financing Incentives
Tor Age Myklebust
Norwegian School of Economics (NHH)
June 28, 2012
NHH Dept. of Finance & Management Science Discussion Paper No. 2012/7
Performance sensitive debt (PSD) contracts link the paid coupon to a measure of firm performance. PSD contracts are widely used, especially as corporate bank loans. In a model where a firm has assets in place and the opportunity to invest in a growth option, I analyze how PSD affects equityholders' investment and financing incentives. With no pre-existing debt I show that PSD reduces a given firm's optimal leverage, indicating that in this case PSD partially solves potential future conflicts related to debt overhang. With debt in place I show that PSD financing magnifies equityholders' risk-shifting incentives, proving that in this case PSD is an inefficient financing tool. My conclusion questions the hypothesis that PSD is used to prevent asset substitution. When debt overhang creates problems of underinvestment I show that PSD financing partially resolves these inefficiencies. My conclusions are partially based on numerical analysis, but they are robust to changes in input parameters.
Number of Pages in PDF File: 27
Keywords: Performance Sensitive Debt, Growth Option, Debt Overhang, Asset Substitution, Underinvestment
JEL Classification: G30working papers series
Date posted: July 11, 2012
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