Debt Covenants and Capital Structure: Evidence from an Exogenous Shock to Debt Capacity

Western Finance Association 2012 Annual Meeting

55 Pages Posted: 31 Aug 2011 Last revised: 12 Jul 2012

See all articles by Moshe Cohen

Moshe Cohen

Columbia Business School

Sharon P. Katz

INSEAD

Gil Sadka

University of Texas at Dallas

Date Written: July 9, 2012

Abstract

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.

Keywords: Debt, covenants, financial constraints, leverage, investments, default

JEL Classification: G01, G30, G31, G33, M21, M41

Suggested Citation

Cohen, Moshe and Katz, Sharon P. and Sadka, Gil, Debt Covenants and Capital Structure: Evidence from an Exogenous Shock to Debt Capacity (July 9, 2012). Western Finance Association 2012 Annual Meeting. Available at SSRN: https://ssrn.com/abstract=1919715 or http://dx.doi.org/10.2139/ssrn.1919715

Moshe Cohen

Columbia Business School ( email )

3022 Broadway
New York, NY 10027
United States
(212) 854-1486 (Phone)

Sharon P. Katz (Contact Author)

INSEAD ( email )

Boulevard de Constance
CEDEP No. 11
F-7705 Fontainebleau Cedex, 77305
France

Gil Sadka

University of Texas at Dallas ( email )

2601 North Floyd Road
Richardson, TX 75083
United States

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