Time Inconsistency and Financial Covenants

52 Pages Posted: 23 Nov 2018 Last revised: 4 Aug 2019

See all articles by Haotian Xiang

Haotian Xiang

Peking University - Department of Finance

Date Written: July 6, 2019

Abstract

Financial covenants influence firm behavior by state-contingently allocating decision rights. I develop a model with long-term debt where shareholders cannot commit to not dilute creditors in the future with new debt issuances and risky investments. Creditors intervene upon covenant violations and restructure the debt without ex ante commitment. My quantitative analysis suggests that financial covenants significantly increase debt capacity, investment and firm value by disciplining shareholders. Nonetheless, I show that lenders' inability to commit to a restructuring plan severely impairs contractual efficiency. Relative to the calibrated benchmark, adopting tighter covenants generates a further gain, although its magnitude might be small.

JEL Classification: E22, G31, G32

Suggested Citation

Xiang, Haotian, Time Inconsistency and Financial Covenants (July 6, 2019). Available at SSRN: https://ssrn.com/abstract=3274047 or http://dx.doi.org/10.2139/ssrn.3274047

Haotian Xiang (Contact Author)

Peking University - Department of Finance ( email )

Beijing
China

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