Time Inconsistency and Financial Covenants

Abstract

Financial covenants influence firm behavior by state-contingently allocating decision rights. I develop a quantitative model with long-term debt where shareholders cannot commit to not dilute existing lenders with new debt issuances. Lenders intervene on covenant violations but cannot commit either to any debt restructuring plan ex ante. Counterfactual experiments suggest that financial covenants significantly reduce default probability and increase firm value. However, the value creation is limited by lenders’ limited commitment. A hump-shaped relation between covenant tightness and firm value emerges, reflecting a balance between limited commitment on two sides. This paper was accepted by Gustavo Manso, finance. Supplemental Material: The data files and online appendices are available at https://doi.org/10.1287/mnsc.2022.4667 .