Performance-Sensitive Debt

48 Pages Posted: 26 Apr 2005 Last revised: 29 Apr 2016

See all articles by Gustavo Manso

Gustavo Manso

University of California, Berkeley - Haas School of Business

Bruno H. Strulovici

Northwestern University

Alexei Tchistyi

Cornell SC Johnson College of Business

Date Written: June 18, 2009

Abstract

This paper studies performance-sensitive debt (PSD), the class of debt obligations whose interest payments depend on some measure of the borrowers performance. We demonstrate that the existence of PSD obligations cannot be explained by the trade-off theory of capital structure, as PSD leads to earlier default and lower equity value compared to fixed-rate debt of the same market value. We show that, consistent with the pecking order theory, PSD can be used as an inexpensive screening device and find empirically that firms choosing PSD loans are more likely to improve their credit ratings than firms choosing fixed-interest loans. We also develop a method to value PSD obligations allowing for general payment profiles and obtain closed-form pricing formulas for step-up bonds and linear PSD.

Keywords: Capital Structure, Financial Innovation, Step-up bonds, Performance-Pricing Loans, Default, Efficiency, Screening

JEL Classification: G32, G12

Suggested Citation

Manso, Gustavo and Strulovici, Bruno H. and Tchistyi, Alexei, Performance-Sensitive Debt (June 18, 2009). Available at SSRN: https://ssrn.com/abstract=707142 or http://dx.doi.org/10.2139/ssrn.707142

Gustavo Manso

University of California, Berkeley - Haas School of Business ( email )

545 Student Services Building, #1900
2220 Piedmont Avenue
Berkeley, CA 94720
United States

Bruno H. Strulovici (Contact Author)

Northwestern University ( email )

2001 Sheridan Road
Evanston, IL 60208
United States

Alexei Tchistyi

Cornell SC Johnson College of Business ( email )

Ithaca, NY 14850
United States

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