Uncertainty and Debt Covenants

60 Pages Posted: 25 May 2012 Last revised: 22 Apr 2017

See all articles by Peter R. Demerjian

Peter R. Demerjian

University of Washington - Michael G. Foster School of Business

Date Written: April 21, 2017

Abstract

I examine the use of financial covenants when contracting for debt under uncertainty. Uncertainty, in the context of this study, is a lack of information about future economic events and their consequences for the borrower's creditworthiness. I examine the implications of ex-ante uncertainty that is resolved by information received following loan initiation but prior to maturity. I argue that financial covenants, by transferring control rights ex-post, provide a trigger for creditor-initiated renegotiation when the borrower is revealed to be of low credit quality. Using a large sample of private loans, I predict and find that financial covenant intensity is associated with greater uncertainty. I also revisit the agency-based explanation for covenant use and find that this uncertainty explanation is robust to various controls for agency conflicts.

Keywords: debt contracting, financial covenants, agency problems, renegotiation

JEL Classification: G21, G32, M41

Suggested Citation

Demerjian, Peter R., Uncertainty and Debt Covenants (April 21, 2017). Review of Accounting Studies, Forthcoming. Available at SSRN: https://ssrn.com/abstract=2066731 or http://dx.doi.org/10.2139/ssrn.2066731

Peter R. Demerjian (Contact Author)

University of Washington - Michael G. Foster School of Business ( email )

Box 353200
Seattle, WA 98195-3200
United States

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