The Effect of Accounting-Based Debt Covenants on Equity Valuation
Posted: 22 Sep 1997
Date Written: July 1, 1998
Abstract
We use an option pricing framework to model equity valuation when debtholders have the right to take action against a firm that violates an accounting-based covenant prior to debt maturity. The model predicts that the expected value of equity depends on two factors: the economic value of the firm and the probability that the firm violates an accounting-based covenant. Earnings innovations are one example of information that can simultaneously affect both of these factors so we focus on the role of earnings in stock valuation. First, as documented in prior literature, earnings provides a signal of the value of expected future cash flows. Second and unique to our model, earnings changes the equity option value by changing the probability that the firm violates an accounting-based covenant. Our pricing model shows that this "covenant" effect of earnings is greatest for firms near the point of violation. We test for the covenant effect of earnings using a sample of thrift institutions that are bound by regulatory net worth covenants. We document that earnings response coefficients increase as firms approach covenant violation. As more direct evidence of a covenant effect, we find that stock price responses to losses and transitory earnings (earnings that are less informative about future cash flows) are significant only for thrifts that are near covenant violation.
JEL Classification: G12, G21, M41
Suggested Citation: Suggested Citation