Debt Covenants and Capital Structure: Evidence from an Exogenous Shock to Debt Capacity

This paper empirically examines how debt covenants impact the capital structure choices of …firms, by utilizing an exogenous accounting based shock to the distance to covenant violation. We …find that, on average, the shock to debt capacity had a positive impact on the debt choices of all treated fi…rms, but the response was strongest by …firms that were close to violating or in violation of the affected covenants, and that were otherwise …financially unconstrained. Our …findings suggest that debt covenants are a key component of the capital structure trade-off that in‡fluences debt choices well before they are triggered. We proceed to examine how the additional debt affected …firms’ corporate …financial behavior and …find that it did not result in an increase in investments or cash holdings, but rather was associated with lower pro…fitability and a lower likelihood to enter default or bankruptcy. Some …firms even maintained or increased their dividend payouts.