Time Inconsistency and Financial Covenants
52 Pages Posted: 23 Nov 2018 Last revised: 4 Aug 2019
Date Written: July 6, 2019
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: Suggested Citation