Essays on debt covenants

One of the major uses of accounting information is in mitigating the conflict of interest problems which arise because of the different incentives of debt-holders and equity-holders. These incentive problems frequently lead to the inclusion of contractual debt covenants within lending agreements. The optimal use and form of such covenants is therefore of interest to both academics and practitioners. This dissertation expands on existing theory by considering two important aspects of debt covenants which have often been ignored. The first chapter of the dissertation considers the role played by the use of multiple covenants within the same debt contract. I develop a model that highlights the tradeoffs and interdependencies among different covenants in a multi-dimensional contract, and the effect of specific covenants on controlling over and under-investment problems caused by the different incentives faced by lenders and shareholders. A second chapter of the dissertation recognizes that debt covenants are written using numbers produced by the firm's accounting system, and develops a theory of how expected future accounting changes may affect the optimal debt contract in the presence of renegotiation. In particular the dissertation establishes how the effect of changes in accounting rules can play a role in determining when renegotiation occurs.