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Debt covenants and renegotiation

1992; Elsevier BV; Volume: 2; Issue: 2 Linguagem: Inglês

10.1016/1042-9573(92)90005-x

1096-0473

Mitchell Berlin, Loretta J. Mester,

Auditing, Earnings Management, Governance

We analyze the value to firms of being able to renegotiate covenants in their debt contracts. Covenants control agency problems, but also reduce firms' flexibility to pursue profitable investments. Initial covenants will be more severe for renegotiable contracts, because they can be relaxed selectively when the lender believes they pose an inefficient constraint. We show firms with high ex ante credit risk find the option to renegotiate most valuable. The model is used to explain why bank loans and privately placed debt typically have harsher covenants than public debt and to predict which firms will borrow using closely held debt. Journal of Economic Literature Classification Numbers: D82, G21, G32.