N°25-70: Financial Covenants, Firm Financing, and Investment
This paper studies how financial covenants, provisions included in most loan contracts, influence firm investment. I develop a structural model incorporating covenants and find that they allow for 4.7% higher aggregate investment relative to a no-covenants baseline. While covenants are beneficial overall, the model also reveals costs faced by firms attempting to avoid covenant violations. In two applications of the model, I find that, first, the transmission of aggregate shocks to firm financing crucially depends on firms' efforts to avoid covenant violations. Second, the model shows that earnings-based covenants allow for higher investment in industries with low asset pledgeability but offer no advantage when assets can be easily pledged.