Debt Covenants and the Speed of Capital Structure Adjustment

51 Pages Posted: 30 Nov 2017

See all articles by Erik Devos

Erik Devos

University of Texas at El Paso - College of Business Administration - Department of Economics and Finance

Shofiqur Rahman

New Mexico State University

Desmond Tsang

McGill University - Desautels Faculty of Management

Date Written: April 2017

Abstract

This paper examines the impact of debt covenants on the speed of capital structure adjustment. Overall, we find that covenants lower the speed of adjustment by 10–13%, relative to the speed of adjustment of firms without covenants. The speed of adjustment is significantly lower, by 40–50%, for firms with the most intense covenant provisions. In particular, we find that capital covenants, as opposed to performance covenants, appear to be the main mechanism that lowers the speed of adjustment, delaying the speed of capital structure adjustment by 86%. We find that the speed of adjustment is reduced more for strict capital covenants than for strict performance covenants. We also show that, for firms that are cash and financially constrained, covenants impede the speed of adjustment even more. Lastly, we show that the negative relationship between covenants and the speed of adjustment is more pronounced for firms that are over-levered.

Keywords: Capital structure; Debt covenants; Speed of adjustment; Capital covenants; Performance covenants

JEL Classification: G32

Suggested Citation

Devos, Erik and Rahman, Shofiqur and Tsang, Desmond, Debt Covenants and the Speed of Capital Structure Adjustment (April 2017). Journal of Corporate Finance, Vol. 45, 2017. Available at SSRN: https://ssrn.com/abstract=3077612 or http://dx.doi.org/10.2139/ssrn.3077612

Erik Devos

University of Texas at El Paso - College of Business Administration - Department of Economics and Finance ( email )

500 W. University Ave.
El Paso, TX 79968
United States
915 747 7770 (Phone)

HOME PAGE: http://utminers/utep.edu/hdevos

Shofiqur Rahman

New Mexico State University ( email )

College of Business
Las Cruces, NM 88003
United States

Desmond Tsang (Contact Author)

McGill University - Desautels Faculty of Management ( email )

1001 Sherbrooke St. West
Montreal, Quebec H3A1G5 H3A 2M1
Canada

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