Effects of an interest coverage ratio covenant on optimal capital structure and firm value

This paper develops a capital structure model with a financial covenant that imposes a lower limit on a firm's interest coverage ratio. Shareholders reduce their debt level or default whenever this ratio falls below the limit. In the model, firm value, debt repayment policy, and capital structure are derived explicitly. For low levels of the limit, shareholders prefer to reduce their debt every time the ratio reaches the limit. In other words, the covenant acts as early pressure on shareholders and eliminate their incentives to default. Then, it decreases the cost of debt but also lowers equity value by constraining shareholders. Because of this trade-off, the covenant can improve firm value. With the covenant, the firm can begin with high leverage to take advantage of the decreased cost of debt. The covenant tends to improve firm value for higher bankruptcy cost and volatility because these conditions lead to high expected default costs without a covenant. It can also improve firm value for higher growth and tax rates by easing the restriction on future debt issuance. These results are consistent with empirical evidence and support the optimal contracting hypothesis for covenants.