Time Inconsistency and Financial Covenants

Financial covenants influence firm behavior by state-contingently allocating decision rights. I develop a quantitative model with long-term debt where shareholders cannot commit to not dilute existing lenders new issuances. Lenders intervene on covenant violations but either any restructuring plan ex ante. Counterfactual experiments suggest that financial significantly reduce default probability and increase value. However, the value creation is limited lenders’ commitment. A hump-shaped relation between tightness emerges, reflecting balance commitment two sides. This paper was accepted Gustavo Manso, finance. Supplemental Material: The data files online appendices are available at https://doi.org/10.1287/mnsc.2022.4667 .