Abstract: We consider a dynamic asymmetric information model where firms face multiple investment
opportunities and their capital structure is endogenous at all times. We identify a new economic
force, short-term debt overhang, which leads firms to issue short-term debt and subsequently
underinvest in growth options. This force, which arises at the optimal mechanism and is timeconsistent, generates several new testable predictions. Strikingly, we find that greater retained
earnings, or cash, can reduce the investment in positive net present value projects by firms with
intermediate credit ratings, and that these firms are the most likely to issue short-term debt.
Abstract: This paper studies the extent to which financial covenants are an important consideration for firm decisions outside of violation events. Applying textual analysis to earnings call transcripts, I construct a novel measure of covenant concerns by distinguishing between discussions of covenants that relate to the future as opposed to the past or present. The measure predicts future violations, and covaries intuitively with earnings and leverage. Covenant concerns are associated with significant reductions in investment and financing activity. These responses persist even after controlling for standard measures of investment opportunities and are economically large relative to the effects of actual violations.
Discussant: Robert Hills, Pennsylvania State University
