Growth Opportunities and the Choice of Leverage, Debt Maturity, and Covenants

Abstract

We investigate the effect of growth opportunities in a firm's investment opportunity set on its joint choice of leverage, debt maturity, and covenants. Using a database that contains detailed debt covenant information, we provide large-sample evidence of the incidence of covenants in public debt and construct firm-level indices of bondholder covenant protection. We find that covenant protection is increasing in growth opportunities, debt maturity, and leverage. We also document that the negative relation between leverage and growth opportunities is significantly attenuated by covenant protection, suggesting that covenants can mitigate the agency costs of debt for high growth firms. Copyright 2007 by The American Finance Association.

Is Operating Flexibility Harmful Under Debt?

“…Furthermore, Billett et al (2007) find that the presence of covenants significantly attenuates the negative relation between leverage and growth opportunities, consistent with our results that covenants are effective in alleviating agency costs of debt for high-growth firms.…”

“…To the extent that covenant intensity is positively related to tightness, our predictions are also very well aligned with Bradley and Roberts (2004) and Billett et al (2007), who document that firms that are smaller, have fewer tangible assets, or have greater growth opportunities face more covenants. Furthermore, Billett et al (2007) find that the presence of covenants significantly attenuates the negative relation between leverage and growth opportunities, consistent with our results that covenants are effective in alleviating agency costs of debt for high-growth firms.…”

“…Furthermore, a multi-period setting would allow studying other interesting questions pertaining to the firm's financial structure and its interplay with operations. For instance, while it is known that the choice of debt maturity may act as a substitute for covenants in other settings (Billett et al 2007), it is unclear whether that would persist for inventory-heavy firms.…”

Endividamento e decisões contábeis: a relação não linear entre dívida e qualidade dos lucros

“…Além disso, tal relação é robusta aos quatro modelos utilizados para se estimar a qualidade dos lucros. Especificamente, os coeficientes da forma quadrática da variável dívida sugerem que à medida que as empresas elevam seus níveis de endividamento, reduzem os níveis de accrual (consistente com evidências em Diamond (1991) e Billett et al (2007)), o que seria decorrente de uma tentativa de reduzir custos de financiamento. Porém, a partir de certo nível de endividamento, devido às cláusulas de covenants, os ganhos advindos da redução de custos da dívida seriam mitigados pelos riscos de não cumprir as cláusulas, surgindo incentivos ao aumento dos accruals (Sweeney, 1994;DeFond & Jiambalvo, 1994;Sun & Rath, 2008).…”

Target gearing in the UK: a triangulated approach

“…But since short-term debt increases liquidity risk, he argues that firms trade this off against the cost of problems caused by underinvestment. In a study by Billet, King and Mauer (2007), there is a evidence of an increased use of debt covenants protecting bondholders and that, despite a negative relationship between gearing and growth opportunities, an interaction variable jointly linking growth opportunities to covenant protection is positively related to gearing. They conclude that covenants are used to control conflicts of interest between bondholders and shareholders in high growth firms, and can reduce agency costs.…”