Determinants of the Usefulness of Inside Debt in Debt Contract Design

40 Pages Posted: 7 Jul 2020

See all articles by Peter R. Demerjian

Peter R. Demerjian

University of Illinois at Chicago

Paige Harrington Patrick

University of Illinois at Chicago - Department of Accounting

Frances M. Tice

University of Colorado at Boulder - Department of Accounting

Date Written: June 2020

Abstract

Evidence shows that managers’ debt-like compensation (i.e., inside debt) aligns their incentives with lenders’, reducing the agency cost of debt. We examine how changes in the contracting environment affect the use of inside debt in debt contracting. We find evidence of reduced reliance on inside debt for debt contracting when borrowers have credit constraints, consistent with a shift in bargaining power to lenders, and when firms experience financial distress, consistent with increased agency costs when bankruptcy is more probable. We detect reduced reliance on inside debt for debt contracting during the financial crisis and during shocks to industry demand, two plausibly exogenous shocks to firms’ contracting environments. In total, the results suggest that the role of inside debt changes predictably with the contracting environment.

Suggested Citation

Demerjian, Peter R. and Patrick, Paige Harrington and Tice, Frances M., Determinants of the Usefulness of Inside Debt in Debt Contract Design (June 2020). Available at SSRN: https://ssrn.com/abstract=3625161 or http://dx.doi.org/10.2139/ssrn.3625161

Peter R. Demerjian

University of Illinois at Chicago ( email )

601 South Morgan Street
University Hall, Room 2303
Chicago, IL 60607
United States

Paige Harrington Patrick

University of Illinois at Chicago - Department of Accounting ( email )

601 South Morgan Street
University Hall, Room 2303
Chicago, IL 60607
United States

Frances M. Tice (Contact Author)

University of Colorado at Boulder - Department of Accounting ( email )

419 UCB
Boulder, CO 80309-0419
United States

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