Signaling through Dynamic Thresholds in Financial Covenants

48 Pages Posted: 23 Jan 2012 Last revised: 19 Dec 2019

See all articles by Sudheer Chava

Sudheer Chava

Georgia Institute of Technology - Scheller College of Business

Shunlan Fang

Kent State University

Saumya Prabhat

Indian School of Business (ISB), Hyderabad

Date Written: December 17, 2018

Abstract

Among loan contracts with covenants originated during 1996-2012, 35% have financial covenant thresholds that automatically tighten following a predetermined schedule. Firms accepting dynamic covenant thresholds improve creditworthiness but are more likely to violate covenants relative to matched control firms. In the event of a covenant violation, these firms are less likely to receive a waiver, more likely to pay higher waiver fees, experience greater investment cuts, and are more likely to switch lead lenders. Overall, our findings suggest that signaling through dynamic thresholds in covenants on average is credible but costly to borrowers if they fail to deliver the performance as signaled.

Keywords: loan covenant design, consequences of signaling, creditor control, information asymmetry

JEL Classification: G14, G21, G32, G34, M41

Suggested Citation

Chava, Sudheer and Fang, Shunlan and Prabhat, Saumya, Signaling through Dynamic Thresholds in Financial Covenants (December 17, 2018). Available at SSRN: https://ssrn.com/abstract=1983456 or http://dx.doi.org/10.2139/ssrn.1983456

Sudheer Chava

Georgia Institute of Technology - Scheller College of Business ( email )

800 West Peachtree St.
Atlanta, GA 30308
United States

HOME PAGE: http://www.prism.gatech.edu/~schava6/

Shunlan Fang (Contact Author)

Kent State University ( email )

Kent, OH 44242
United States

Saumya Prabhat

Indian School of Business (ISB), Hyderabad ( email )

Hyderabad, Gachibowli 500 019
India

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