The Cost of Financing in a Regulated Industry: Managerial Incentives and the Impact of Cash Flow Subsidies

Abstract

We document that mandatory debt accounting impacts managerial incentives and influences the use of debt covenants restricting dividends and additional borrowing in the defense industry. To examine the economic implications of mandatory debt accounting, we consider a unique accounting treatment and its resulting cash flow or debt subsidy in this industry, the Facilities Capital Cost of Money (FCCOM). We find that variables explaining debt covenants restricting dividends and additional borrowing are decidedly different for defense firms than for commercial firms. We also demonstrate that the FCCOM debt subsidy leads to lower cost of debt but an increased cost of equity capital in the defense sector.