Effects of a Debt-Earnings Covenant on Optimal Capital Structure and Firm Value

Abstract

This paper develops a capital structure model with a financial covenant that sets an upper limit on a firm’s debt-earnings ratio. Shareholders reduce their debt level or default when this ratio exceeds the upper limit. In the model, firm value, debt repayment policy, and capital structure are derived explicitly. For low levels of the limit, shareholders prefer to reduce their debt every time the ratio exceeds the limit. Then, the covenant removes the cost of debt, whereas it decreases equity value by restricting shareholders. Because of this trade-off, the covenant can improve firm value. The covenant can also improve firm value by suppressing the leverage ratchet effect and removing the restriction on future debt issuance. With the covenant, the firm can begin with high leverage to take advantage of the absence of cost of debt. The covenant tends to improve firm value for higher bankruptcy cost and volatility, and the additional debt channel can greatly improve firm value for higher growth and tax rates. These results are consistent with empirical evidence and support the optimal contracting hypothesis regarding debt covenants.

Keywords: debt covenant, capital structure, real options, agency problem

JEL Classification: G13, G32, G33