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Financial contracts, opportunism, and disclosure management

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Abstract

This article shows that if all variables that determine a firm's future cash flows are not contractible, it can be ex ante optimal to design a financial contract that admits debtholders waiving debt covenants on a discretionary basis and firms investing opportunistically subsequent to contracting. Further, as the contractible variable becomes less informative, the contract attaches greater significance to it. Finally, uncertainty in the magnitude of reporting latitude induces aggressive reporting by the firm to avoid violating the covenant or to enhance the chances of a waiver. The debtholders respond by sometimes not allowing the firm to implement mutually beneficial projects.

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Authors and Affiliations

  1. Kellogg Graduate School of Management, Northwestern University, 60208, Evanston, IL, USA

    Sri S. Sridhar

  2. Kellogg Graduate School of Management, Northwestern University, 60208, Evanston, IL, USA

    Robert P. Magee

Authors
  1. Sri S. Sridhar
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  2. Robert P. Magee
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Sridhar, S.S., Magee, R.P. Financial contracts, opportunism, and disclosure management. Rev Acc Stud 1, 225–258 (1996). https://doi.org/10.1007/BF00555373

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  • DOI: https://doi.org/10.1007/BF00555373

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