EURO 2024 Copenhagen
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2146. The effects of a financial covenant on optimal capital structure and firm value

Invited abstract in session TA-59: Learning and pricing, stream Pricing and Revenue Management.

Tuesday, 8:30-10:00
Room: S08 (building: 101)

Authors (first author is the speaker)

1. Michi Nishihara
Graduate School of Economics, Osaka University
2. Takashi Shibata
Graduate School of Management, Tokyo Metropolitan University
3. Benoit Chevalier-Roignant
emlyon business school

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 will reduce debt or default when the 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 debt every time the ratio exceeds the limit. Then, the covenant removes cost of debt, while it decreases equity value by restricting shareholders. By 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 no 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

Status: accepted


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