Managerial Optimism and Debt Covenants
32 Pages Posted: 7 Jan 2020 Last revised: 26 Aug 2021
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Managerial Optimism and Debt Covenants
Managerial Optimism and Debt Covenants
Date Written: August 25, 2021
Abstract
This paper studies the effects of managerial optimism on the optimal design of debt covenants. We find that managers that are more optimistic about the future success of their investment ideas provide lenders with greater control rights via tighter covenants. This is optimal for optimistic managers even though they understand that tighter covenants increase the probability of covenant violations and lead to excessive lender intervention. The broad reason for this result is that optimists wish to write contracts that repay lenders more frequently in bad states rather than in good states, and the only way to achieve this is by granting lenders more control rights. Our model generates new predictions and offers a novel explanation for the empirical evidence that covenants in debt contracts are set very tightly and are often violated.
Keywords: managerial optimism, heterogeneous priors, debt covenants, control right allocation
JEL Classification: G32, G41, D23, D86
Suggested Citation: Suggested Citation