Loan-commitment borrowing and performance-sensitive debt

Loan-commitment borrowing and performance-sensitive debt This paper examines a firm’s investment/financing decision when it uses loan-commitment-type debt with performance-sensitivity features. This analysis is of interest because most corporate borrowing today is by means of private debt, which tends to be of the loan-commitment type as well as contain performance-sensitivity provisions. We show that, except for the case of low leverage ratio, performance-sensitive debt makes shareholders better off relative to fixed-coupon debt. In particular, when the leverage ratio is chosen optimally, performance-sensitive debt dominates fixed-coupon debt and the resulting addition to shareholder wealth can be economically significant for reasonable parameter values. Therefore, it is not surprising that performance-sensitive debt has become so popular in the private debt market. The magnitude of shareholder wealth created by using performance-sensitive debt rather than fixed-coupon debt is an increasing function of earnings growth rate and tax rate, and a decreasing function of interest rate, earnings volatility and bankruptcy cost. Therefore, performance-sensitive debt financing is more likely to be used when earnings growth rate and tax rate are high, and interest rate, earnings volatility and bankruptcy cost are low. Review of Quantitative Finance and Accounting Springer Journals

Loan-commitment borrowing and performance-sensitive debt

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Springer US
Copyright © 2015 by Springer Science+Business Media New York
Finance; Corporate Finance; Accounting/Auditing; Econometrics; Operation Research/Decision Theory
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