Time Inconsistency and Financial Covenants
41 Pages Posted: 23 Nov 2018 Last revised: 2 Aug 2022
Date Written: June 7, 2022
Financial covenants influence firm behavior by state-contingently allocating decision rights. I develop a quantitative model with long-term debt where shareholders cannot commit to not dilute existing lenders with new debt issuances. Lenders intervene upon covenant violations but cannot commit either to any debt restructuring plan ex ante. Counterfactual experiments suggest that financial covenants significantly reduce default probability and increase firm value. However, the value creation is limited by lenders' limited commitment. A hump-shaped relation between covenant tightness and firm value emerges, reflecting a balance between limited commitment on two sides.
Keywords: covenants, debt dilution, investment, contingent control
JEL Classification: E22, G31, G32
Suggested Citation: Suggested Citation