Time Inconsistency and Financial Covenants

51 Pages Posted: 23 Nov 2018

See all articles by Haotian Xiang

Haotian Xiang

University of Pennsylvania, The Wharton School

Date Written: November 10, 2018

Abstract

I investigate how financial covenants influence corporate behavior and firm value by allocating control rights. In a dynamic model with long-term debt, shareholders cannot commit to not expropriate creditors in the future with new debt issuances and risky investments. Creditors intervene upon violations of covenant restrictions and restructure the debt without ex ante commitment. I find that financial covenants significantly increase debt capacity, investment and ex ante firm value by disciplining shareholders. However, I show that lenders' inability to commit to a restructuring plan severely impairs contractual efficiency. My analysis suggests that a further tightening of covenants, relative to the calibrated benchmark, improves their role as a commitment device.

JEL Classification: E22, G31, G32

Suggested Citation

Xiang, Haotian, Time Inconsistency and Financial Covenants (November 10, 2018). Available at SSRN: https://ssrn.com/abstract=3274047 or http://dx.doi.org/10.2139/ssrn.3274047

Haotian Xiang (Contact Author)

University of Pennsylvania, The Wharton School ( email )

3641 Locust Walk
Philadelphia, PA 19104
United States

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