Abstract
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.
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Notes
A small fraction of PSD has the opposite feature, i.e., coupon falls when firm performance declines, in order to reduce the firm’s default risk; see Manso et al. (2010) for details.
As mentioned in Sect. 2.1, when θ = 0 our PSD becomes equivalent to the traditional fixed-coupon debt.
All derivations are available from authors on request.
Mauer and Sarkar (2005) use r = 5 % and convenience yield δ = 2 %. Since the convenience yield is given by δ = r−μ, the implied growth rate is μ = 3 %.
The investment cost is higher than that in Mauer and Sarkar (2005) because our model has no fixed operating cost.
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Sarkar, S., Zhang, C. Loan-commitment borrowing and performance-sensitive debt. Rev Quant Finan Acc 47, 973–986 (2016). https://doi.org/10.1007/s11156-015-0527-z
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DOI: https://doi.org/10.1007/s11156-015-0527-z