Growth Opportunities and Debt Covenants: Evidence from a Natural Experiment

Abstract

Debt covenants reduce agency cost of debt while bringing into contracting cost which increases with firms' growth opportunities. In this paper, we exploit an unexpected increase in military spending after the War of Afghanistan which led to an increase in growth opportunities for defense contractors to establish a causal relationship from growth opportunities to firms' bank loan covenants. Using a difference-in-difference strategy, we find that defense contractors have much less covenants after 2001, with the effect concentrated right after the war. Aside from significantly less general covenants, firms receive less restrictions in investment spending and become less likely to include build-ups on covenant thresholds. The effect mainly comes from more diversified firms, firms that are more opaque and firms in need of more financial flexibility. Our findings are consistent with firms relieving debt covenants to minimize contracting cost as a response to increased growth opportunities and thus support the costly contracting hypothesis by Smith and Warner (1979).