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Loan-commitment borrowing and performance-sensitive debt

Author

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  • Sudipto Sarkar

    (McMaster University)

  • Chuanqian Zhang

    (William Paterson University)

Abstract

This paper examines a firm’s investment/financing decision when it uses loan-commitment-type debt with performance-sensitivity features. This analysis is of interest because most corporate borrowing today is by means of private debt, which tends to be of the loan-commitment type as well as contain performance-sensitivity provisions. We show that, except for the case of low leverage ratio, performance-sensitive debt makes shareholders better off relative to fixed-coupon debt. In particular, when the leverage ratio is chosen optimally, performance-sensitive debt dominates fixed-coupon debt and the resulting addition to shareholder wealth can be economically significant for reasonable parameter values. Therefore, it is not surprising that performance-sensitive debt has become so popular in the private debt market. The magnitude of shareholder wealth created by using performance-sensitive debt rather than fixed-coupon debt is an increasing function of earnings growth rate and tax rate, and a decreasing function of interest rate, earnings volatility and bankruptcy cost. Therefore, performance-sensitive debt financing is more likely to be used when earnings growth rate and tax rate are high, and interest rate, earnings volatility and bankruptcy cost are low.

Suggested Citation

  • Sudipto Sarkar & Chuanqian Zhang, 2016. "Loan-commitment borrowing and performance-sensitive debt," Review of Quantitative Finance and Accounting, Springer, vol. 47(4), pages 973-986, November.
    • Handle: RePEc:kap:rqfnac:v:47:y:2016:i:4:d:10.1007_s11156-015-0527-z
    DOI: 10.1007/s11156-015-0527-z
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    Cited by:

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    More about this item

    Keywords

    Private corporate debt; Loan commitment; Performance-sensitive debt;
    All these keywords.

    JEL classification:

    • G3 - Financial Economics - - Corporate Finance and Governance

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