Performance Sensitive Debt - Investment and Financing Incentives
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.
|Date of creation:||28 Jun 2012|
|Contact details of provider:|| Postal: NHH, Department of Business and Management Science, Helleveien 30, N-5045 Bergen, Norway|
Phone: +47 55 95 92 93
Fax: +47 55 95 96 50
Web page: http://www.nhh.no/en/research-faculty/department-of-business-and-management-science.aspx
More information through EDIRC
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
- Sheridan Titman & Sergey Tsyplakov, 2004.
"A dynamic model of optimal capital structure,"
2004 Meeting Papers
592a, Society for Economic Dynamics.
- Tsyplakov, Sergey, 2008. "Investment frictions and leverage dynamics," Journal of Financial Economics, Elsevier, vol. 89(3), pages 423-443, September.
- 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.
- Merton, Robert C., 1973.
"On the pricing of corporate debt: the risk structure of interest rates,"
684-73., Massachusetts Institute of Technology (MIT), Sloan School of Management.
- Merton, Robert C, 1974. "On the Pricing of Corporate Debt: The Risk Structure of Interest Rates," Journal of Finance, American Finance Association, vol. 29(2), pages 449-470, May.
- Christopher A. Hennessy & Toni M. Whited, 2005.
Journal of Finance,
American Finance Association, vol. 60(3), pages 1129-1165, 06.
- Gustavo Manso & Bruno Strulovici & Alexei Tchistyi, 2010. "Performance-Sensitive Debt," Review of Financial Studies, Society for Financial Studies, vol. 23(5), pages 1819-1854.
- Dirk Hackbarth & Christopher A. Hennessy & Hayne E. Leland, 2007. "Can the Trade-off Theory Explain Debt Structure?," Review of Financial Studies, Society for Financial Studies, vol. 20(5), pages 1389-1428, 2007 04.
- 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.
- Myers, Stewart C., 1977. "Determinants of corporate borrowing," Journal of Financial Economics, Elsevier, vol. 5(2), pages 147-175, November.
- Dirk Hackbarth & David C. Mauer, 2012. "Optimal Priority Structure, Capital Structure, and Investment," Review of Financial Studies, Society for Financial Studies, vol. 25(3), pages 747-796.
- Houweling, P. & Mentink, A.A. & Vorst, A.C.F., 2003.
"Valuing Euro rating-triggered step-up telecom bonds,"
Econometric Institute Research Papers
EI 2003-50, Erasmus University Rotterdam, Erasmus School of Economics (ESE), Econometric Institute.
- Patrick Houweling & Albert Mentink & Ton Vorst, 2003. "Valuing Euro Rating-Triggered Step-Up Telecom Bonds," Tinbergen Institute Discussion Papers 03-028/2, Tinbergen Institute.
- Mello, Antonio S & Parsons, John E, 1992. " Measuring the Agency Cost of Debt," Journal of Finance, American Finance Association, vol. 47(5), pages 1887-1904, December.
- Mauer, David C & Triantis, Alexander J, 1994. " Interactions of Corporate Financing and Investment Decisions: A Dynamic Framework," Journal of Finance, American Finance Association, vol. 49(4), pages 1253-1277, September.
- Lando, David & Mortensen, Allan, 2004. "On the Pricing of Step-Up Bonds in the European Telecom Sector," Working Papers 2004-9, Copenhagen Business School, Department of Finance.
- Bhanot, Karan & Mello, Antonio S., 2006. "Should corporate debt include a rating trigger?," Journal of Financial Economics, Elsevier, vol. 79(1), pages 69-98, January.
When requesting a correction, please mention this item's handle: RePEc:hhs:nhhfms:2012_007. See general information about how to correct material in RePEc.
For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: (Stein Fossen)
If references are entirely missing, you can add them using this form.