The effect of accounting-based debt covenants on equity valuation

John E. Core · Catherine M. Schrand

73 citations0/0 files storedJournal of Accounting and Economics

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Financial Reporting and Valuation Research Corporate Finance and Governance Auditing, Earnings Management, Governance

Abstract

We use an option pricing framework to model equity valuation when firms face costs associated with violating accounting-based debt covenants. Our model shows that the value of equity depends on two factors: the economic value of the firm and the probability that the firm violates the covenant. Consistent with the model's prediction that the `covenant' effect is greatest for firms near covenant violation, we find that responses to earnings that are less informative about future cash flows (losses and transitory earnings) are significant only for thrift institutions that are near violation of regulatory net worth covenants.

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References

1976Theory of the firm: Managerial behavior, agency costs and ownership structure 1973The Pricing of Options and Corporate Liabilities 1977Determinants of corporate borrowing 1985Positive Accounting Theory 1995Earnings, Book Values, and Dividends in Equity Valuation*1997The conservatism principle and the asymmetric timeliness of earnings1 1985Dividend Policy under Asymmetric Information 1979On financial contracting

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