Determinants of the Usefulness of Inside Debt in Debt Contract Design

39 Pages Posted: 7 Jul 2020 Last revised: 25 Feb 2022

See all articles by Peter R. Demerjian

Peter R. Demerjian

School of Accountancy, J. Mack Robinson College of Business, Georgia State University; 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 1, 2020

Abstract

We provide evidence on how borrowers’ credit constraints and distress risk affect the weight creditors place on inside debt when designing debt contract terms, focusing on the inclusion and strictness of covenants and the cost of debt. We find evidence that creditors place less weight on inside debt 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. Our evidence is stronger for the cost of debt than for covenant inclusion or strictness. We augment our results by leveraging two plausibly exogenous shocks to firms’ credit constraints and distress risk: the Global Financial Crisis and industry-level shocks to demand. Consistent with our primary tests, we detect reduced weight on inside debt for debt contracting during these events.

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 1, 2020). Available at SSRN: https://ssrn.com/abstract=3625161 or http://dx.doi.org/10.2139/ssrn.3625161

Peter R. Demerjian

School of Accountancy, J. Mack Robinson College of Business, Georgia State University ( email )

GA
United States

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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