 Debt contract is an agreement in which borrower agrees to repay funds

to a lender.

 Covenant restrict the ability of managerial and shareholder in order to

protect the debtholder.

 Debt covenants are restrictions that lender put on lending agreements to

limit the actions of the borrower.

 Firm can make business policies that reduce the debt market value,
determining a transfer of wealth from the bondholders. The wealth
transfer conflict arises when dividend of shareholders are increased or
when firm issues high priority debt.

 Covenants, therefore, limiting such behaviour, can reduce the conflict of

interest between the two parties. Conversely, covenants produce
undesirable effects, thus reducing flexibility in business policy.

 In fact, shareholders and debtholders, having different rights on the cash

flows generated by the firm, often suffer because of conflict of interest
situations. These costs that relate to the divergent behaviour of the
borrower are referred to in PAT as the agency costs of debt and, under
PAT, lenders will anticipate divergent behaviour.

 Excessive dividends
o the recipient of the funds may pay excessive dividends, leaving
few assets in the firm to service the debt.
 Claim dilution
o Alternatively, the firm may take on additional and perhaps
excessive levels of debt
o The new debtholders would then compete with the original
debtholder for repayment—that is, their respective claims will be
diluted.

 Asset substitution
o Further, the firm that has borrowed the funds may also invest in
very high-risk projects
o This strategy would also not be beneficial to the debtholders.
o The debtholders have a fixed claim (that is, they are receiving a set
rate of interest) and
o hence if the project generates high profits they will receive no
greater return, unlike the owners, who will share in the increased
value of the firm.
o If the project fails, which is more likely with a risky project, the
debtholders may receive nothing.
o The debtholders therefore do not share in any ‘upside’ (the profits),
but suffer the consequences of any significant losses (the
‘downside’).

 Underinvestment
o Underinvestment occurs when managers, of a firm elect not to
undertake projects that would generate positive net present values.
o Underinvestment is thought more likely to occur when a firm is
approaching insolvency.
 Debtholder can enter into a debt agreement with a firm with the
following requirement
o Specified level of working level
 to ensure there is enough current assets to meet all of its short
term financial obligation
 has the cash needed to pay interest and principal, since the
firm is constrained from paying excessive dividends and
manager compensation.

o Specified debt equity ratio

 to ensure that the borrower does not over-leveraged
 constrains the firm from issuing additional debt, which would
dilute the security of existing lenders

o Times interest earned ratio

 to ensure that there is enough income to pay the debt and
interest
 constrains the firm from additional borrowing.
 when earnings fall, the firm is motivated to increase earnings,
by cutting costs and/or increasing revenue.

 Covenant restrict the ability of manager and shareholder in order to

protect the debtholder

 Firm is able to borrow at a lower cost due the covenant restrictions

 Covenant reduces managers’ ability to take actions detrimental to the

debtholders. In return for those agreed constraints on the company’s
activities, which represent a protection for the debtholders, the firm thus
obtains a lower spread on the debt enough current assets to meet all of
its short-term financial obligations
 Debt restrictions benefit the borrower by reducing the cost of borrowing.
For example, if lenders are able to impose restrictions, lenders will be
willing to impose a lower interest rate for the debt to compensate.

 Covenant is a common way of limiting conflicts of interest between

shareholders and bondholders, and must be taken seriously since a
broken covenant can lead to default.

 A violation of a debt covenant signals an increase in the likelihood of

default

 the more binding covenants will provide an earlier warning of default

risk, and will thereby reduce the risk exposure of the lending party this is
because management will have less ability to circumvent restrictive
covenants