Time Inconsistency and Financial Covenants

41 Pages Posted: 23 Nov 2018 Last revised: 2 Aug 2022

See all articles by Haotian Xiang

Haotian Xiang

Peking University - Department of Finance

Date Written: June 7, 2022

Abstract

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

Xiang, Haotian, Time Inconsistency and Financial Covenants (June 7, 2022). 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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