A0910
Title: The effects of a financial covenant on optimal capital structure and firm value
Authors: Michi Nishihara - Osaka University (Japan) [presenting]
Takashi Shibata - Tokyo Metropolitan University (Japan)
Abstract: A capital structure model with a financial covenant is developed 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 will reduce debt every time the ratio exceeds the limit. In this way, the covenant credibly commits the dynamic leverage policy. Then, the covenant removes the cost of debt, while it decreases equity value by forcing the repayment. By this trade-off, the covenant can improve firm value. The covenant can also improve firm value by removing the restriction on additional debt. 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 costs and volatility.
