Transitory and Permanent Cash Flow Shocks in Debt Contract Design

54 Pages Posted: 2 Nov 2021 Last revised: 26 Apr 2022

See all articles by Le Ma

Le Ma

University of Technology Sydney (UTS)

Anywhere (Siko) Sikochi

Harvard University - Business School (HBS)

Yajun Xiao

Xi'an Jiaotong-Liverpool University (XJTLU)

Date Written: April 11, 2022

Abstract

We examine how lenders design contracts when borrowers are exposed to volatile transitory or permanent cash flow shocks. We find that volatile transitory shocks are associated with fewer liquidity covenants, indicating financial flexibility that can enable firms to survive temporary shocks. The opposite is true for volatile permanent shocks, suggesting that borrowers' economic fundamentals are important credit risk factors. Subsequent tests show that borrowers exposed to volatile transitory (permanent) shocks face less (more) severe consequences after covenant violations. We also find that lenders design contracts to control for agency risk, especially when borrowers are prone to gamble by delaying default.

Keywords: cash flow shocks, debt contracting, debt covenants, likelihood of default

Suggested Citation

Ma, Le and Sikochi, Anywhere and Xiao, Yajun, Transitory and Permanent Cash Flow Shocks in Debt Contract Design (April 11, 2022). Harvard Business School Accounting & Management Unit Working Paper No. 22-026, Available at SSRN: https://ssrn.com/abstract=3952604 or http://dx.doi.org/10.2139/ssrn.3952604

Le Ma

University of Technology Sydney (UTS) ( email )

15 Broadway, Ultimo
PO Box 123
Sydney, NSW 2007
Australia

Anywhere Sikochi (Contact Author)

Harvard University - Business School (HBS) ( email )

Soldiers Field Road
Morgan 270C
Boston, MA 02163
United States

Yajun Xiao

Xi'an Jiaotong-Liverpool University (XJTLU) ( email )

111 Renai Road, SIP
JiangSu province 215123
China

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