Financial Covenants, Firm Financing, and Investment
Type
working paper
Date Issued
2022-08-01
Author(s)
Abstract
Firms reduce investment to avoid costly violations of financial covenants, most of which are based on earnings. Empirically, I show that a 25% drop in earnings implies a 15% decrease in
investment for the median listed US firm due to the reduced distance to the covenant threshold. To quantify this precautionary effect of covenants in the aggregate, I incorporate earnings
covenants into a heterogeneous firm model with a financial sector. In the model, covenants reduce aggregate investment by 14% relative to a benchmark economy without limits on borrowing, where the precautionary effect of covenants accounts for most of the decrease.
investment for the median listed US firm due to the reduced distance to the covenant threshold. To quantify this precautionary effect of covenants in the aggregate, I incorporate earnings
covenants into a heterogeneous firm model with a financial sector. In the model, covenants reduce aggregate investment by 14% relative to a benchmark economy without limits on borrowing, where the precautionary effect of covenants accounts for most of the decrease.