Financial Covenants, Firm Financing, and Investment

62 Pages Posted: 19 Feb 2021

See all articles by Konrad Adler

Konrad Adler

University of Bonn, Institute of Finance and Statistics

Date Written: December 11, 2020

Abstract

Firms reduce investment to avoid costly violations of financial covenants, most of which are based on earnings. Empirically, I show that a 25% drop in earnings implies a 15% decrease in investment for the median listed US firm due to the reduced distance to the covenant threshold. To quantify this precautionary effect of covenants in the aggregate, I incorporate earnings covenants into a heterogeneous firm model with a financial sector. Firms in the model are uncertain about the bank’s reaction to a covenant breach and therefore reduce debt issuance and investment when approaching the covenant threshold. In the model, covenants reduce aggregate investment by 14% relative to a benchmark economy without limits on borrowing, where the precautionary effect of covenants accounts for most of the decrease.

Keywords: Financial Constraints, Covenants, Investment, Heterogeneous Firms

JEL Classification: E44, G31, G32

Suggested Citation

Adler, Konrad, Financial Covenants, Firm Financing, and Investment (December 11, 2020). Available at SSRN: https://ssrn.com/abstract=3728683 or http://dx.doi.org/10.2139/ssrn.3728683

Konrad Adler (Contact Author)

University of Bonn, Institute of Finance and Statistics

Adenauerallee 24-26
Bonn, 53113
Germany

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