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Do Debt Covenants Unnecessarily Constrain Leverage? Evidence from SFAS 160

48 Pages Posted: 12 Jul 2012 Last revised: 19 Aug 2017

Moshe Cohen

Columbia Business School

Sharon P. Katz

Columbia Business School - Accounting, Business Law & Taxation

Sunay Mutlu

Kennesaw State University - Michael J. Coles College of Business

Gil Sadka

University of Texas at Dallas

Date Written: August 6, 2017

Abstract

We use an exogenous, accounting-based shock to debt covenants (SFAS 160) to explore whether such covenants unnecessarily restrict leverage. Incomplete contract theory suggests that covenants are set too tightly to aid future renegotiations. Therefore, we argue that covenants constrain leverage for borrowers that are close to violation, even when the borrower is financially healthy. We find that the shock that relaxed covenant tightness led to increased debt levels in firms that had been close to violation. This increase in debt among covenant-constrained firms was driven by financially healthy firms, suggesting the covenants were repressing debt levels. We also find an increase in the investment sensitivity to Q in covenant-constrained firms after the shock, suggesting the additional debt was used in sound investment decisions. Overall, our evidence suggests that covenant-based monitoring restricts financially-healthy firms’ ability to access external funds for profitable investments.

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 Mutlu, Sunay and Sadka, Gil, Do Debt Covenants Unnecessarily Constrain Leverage? Evidence from SFAS 160 (August 6, 2017). Available at SSRN: https://ssrn.com/abstract=2102878 or http://dx.doi.org/10.2139/ssrn.2102878

Moshe Cohen

Columbia Business School ( email )

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

Sharon P. Katz (Contact Author)

Columbia Business School - Accounting, Business Law & Taxation ( email )

3022 Broadway
New York, NY 10027
United States

Sunay Mutlu

Kennesaw State University - Michael J. Coles College of Business ( email )

1000 Chastain Road
Kennesaw, GA 30144
United States

Gil Sadka

University of Texas at Dallas ( email )

2601 North Floyd Road
Richardson, TX 75083
United States

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