How Effectively Can Debt Covenants Alleviate Financial Agency Problems?

58 Pages Posted: 7 Jul 2012 Last revised: 26 Dec 2019

See all articles by Andrea Gamba

Andrea Gamba

University of Warwick - Finance Group

Alexander J. Triantis

Johns Hopkins University - Carey Business School; University of Maryland - Robert H. Smith School of Business

Date Written: February 10, 2014

Abstract

We examine the effectiveness of debt covenants in alleviating financial agency problems. Distortions in both investment and financing policies with long--term debt are captured in a structural dynamic model where both policies are endogenously determined by shareholders. The combined and compounding effect of these distortions is shown to be large. We impose covenants that restrict the level of debt, or control the use of proceeds from asset sales or debt issuance, and analyze how, and how much, they mitigate financial agency costs. We investigate the direct and indirect impact of covenants on financing and investment policies, including at the point where covenants are violated, providing alternative interpretations of recent empirical evidence. We conclude that the presence and enforcement of debt covenants significantly alters dynamic financing and investment policies, not only at the point of covenant violations, and thus should be an important element of structural models.

Keywords: Dynamic corporate finance, Debt covenants

JEL Classification: G32, G33, G34, D86

Suggested Citation

Gamba, Andrea and Triantis, Alexander J., How Effectively Can Debt Covenants Alleviate Financial Agency Problems? (February 10, 2014). WBS Finance Group Research Paper No. 186, Available at SSRN: https://ssrn.com/abstract=2101645 or http://dx.doi.org/10.2139/ssrn.2101645

Andrea Gamba (Contact Author)

University of Warwick - Finance Group ( email )

Scarman Road
Coventry, CV4 7AL
Great Britain
+44 (0)24 765 24 542 (Phone)
+44 (0)24 765 23 779 (Fax)

Alexander J. Triantis

Johns Hopkins University - Carey Business School ( email )

100 International Drive
Baltimore, MD 21202
United States

University of Maryland - Robert H. Smith School of Business ( email )

Department of Finance
College Park, MD 20742-1815
United States
301-405-2246 (Phone)
301-314-9157 (Fax)

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