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Performance Sensitive Debt - Investment and Financing Incentives

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  • Myklebust, Tor Åge

    ()
    (Dept. of Finance and Management Science, Norwegian School of Economics and Business Administration)

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    Abstract

    Performance sensitive debt (PSD) contracts link the paid coupon to a measure of firm performance. PSD contracts are widely used, especially as corporate bank loans. In a model where a firm has assets in place and the opportunity to invest in a growth option, I analyze how PSD affects equityholders' investment and financing incentives. With no pre-existing debt I show that PSD reduces a given firm's optimal leverage, indicating that in this case PSD partially solves potential future conflicts related to debt overhang. With debt in place I show that PSD financing magnifies equityholders' risk-shifting incentives, proving that in this case PSD is an inefficient financing tool. My conclusion questions the hypothesis that PSD is used to prevent asset substitution. When debt overhang creates problems of underinvestment I show that PSD financing partially resolves these inefficiencies. My conclusions are partially based on numerical analysis, but they are robust to changes in input parameters.

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    Bibliographic Info

    Paper provided by Department of Business and Management Science, Norwegian School of Economics in its series Discussion Papers with number 2012/7.

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    Length: 26 pages
    Date of creation: 28 Jun 2012
    Date of revision:
    Handle: RePEc:hhs:nhhfms:2012_007

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    Web page: http://www.nhh.no/en/research-faculty/department-of-business-and-management-science.aspx
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    Related research

    Keywords: Performance Sensitive Debt; Growth Option; Debt Overhang; Asset Substitution; Underinvestment;

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    10. Tsyplakov, Sergey, 2008. "Investment frictions and leverage dynamics," Journal of Financial Economics, Elsevier, vol. 89(3), pages 423-443, September.
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    12. Gustavo Manso & Bruno Strulovici & Alexei Tchistyi, 2010. "Performance-Sensitive Debt," Review of Financial Studies, Society for Financial Studies, vol. 23(5), pages 1819-1854.
    13. Asquith, Paul & Beatty, Anne & Weber, Joseph, 2005. "Performance pricing in bank debt contracts," Journal of Accounting and Economics, Elsevier, vol. 40(1-3), pages 101-128, December.
    14. Roberts, Michael R. & Sufi, Amir, 2009. "Renegotiation of financial contracts: Evidence from private credit agreements," Journal of Financial Economics, Elsevier, vol. 93(2), pages 159-184, August.
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