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Debt covenant is a formal agreement between two parties where the borrower is restricted with certain limits the violation of which will can lead to early repayment. These debt covenants has put to existence in order to avoid the conflicts between debenture holders and shareholders. For this benefit of covenants, many entities started adopting the hypothesis of debt covenants. The debt covenants of private debt contracts were set more rigid and tight than, those of public debt contracts (Bradely, M., & Roberts, 2015). The hypothesis was mainly based on the difference in the coordination of creditors between public and private debt, whereas in public debt number of creditors are considerably higher than that of private debt. Moreover, the private debt creditors are mainly banks and in case of public debt, the creditors are mainly non-institutional investors (Lin, May, Malatesta, & Xuan, 2013).
The main conflicts that exist between the shareholders and debenture holders mainly comprise of dividend policy, assets substitution, claim dilution and underinvestment. These conflicts affects the issue of bond as its price represents the policies of a firm. The debt issued by any firm comprises of both financial as well as structural component (Cumming, Fleming, & Liu, 2016). The debt price varies with the interest rate that exposes the financial component to financial risk and on the other hand, the structural component is exposed to business risk as it is estimated based on the assets value. The second component has no effect on the bond or debenture holder as they get fixed cash flows whereas the shareholders gets a share of residual income, which is uncertain in nature. This creates a major conflict between the two groups and this can be eliminated with the application of covenants in the debt contracts (Taylor, 2013).
Covenants, though prevents the differences between the two groups, it involves cost for both the firm and the debenture holder. This makes it costly as they put restriction on future investment and financing decision. Using covenants also involves violation cost. Thus, using covenants make both the bondholders and firm to bear different cost because of which the covenants may not be termed efficient. The difference in this costing exists between public and private debt also. The costing of public debt is lesser and thus preferred over the private debt, but the private debt is more advantageous over the public debt (Mather & Peirson, 2006).
The public debt does not considers the use of financial covenants whereas the private debt does considers it which makes the public debt less restrictive, as using financial covenants is directly proportional to the number of restrictions (Reisel, 2014). In addition, there are many other differences between the private and public debt. Private debt used interest cover covenants almost thrice as much as public debt. Private debt uses other various covenants like restricting the minimum working capital ratios, net worth, maximum turnover ratio, contingent liabilities and minimum net profit that could not be seen in public debt contracts. The limits or restriction that public debt imposes is not restrictive in nature as the leverage ratio of public debt is lower than those of private debt (Mather & Peirson, 2006). All facts coveys that public debt is in loose end due to its less restrictive nature. It is important to have restrictive covenants as they create an advantage with regard to credit analysis and in the negotiation and renegotiation of contracts.
The difference in measurement of covenants also create a huge difference between the public debt and private debt. The private date gives a more detailed and broad definition on intangible assets especially with regard to those that are required to be subtracted from the value of total assets (Callahan, Leone, Yang, & Zhang, 2014). The contacts of private debt clearly mention that it required the independent valuation of assets whereas it is not mentioned in public debt. Further, private debt applies GAAP (Generally Accepted Accounting Policies) to define the liabilities; this is not done by public debt. Private debt pay special attention in relation to the earnings as they considers the interest cover covenants (Lin, May, Malatesta, & Xuan, 2013). They put importance in measuring the profit and thus it makes the covenant more restricted. Most importantly, as per private debt the auditors are not allowed to make any adjustment in the measurement rule and definitions related to financial covenants. In public debt, the auditors do have certain powers to make changes in the rules and definitions (Kalimipalli, Huang, Nayak, & Ramchand, 2016).
To conclude it could be said that the various financial covenants used by private debt and restriction imposed by it makes it more viable than the public debt. Public debt does not take the use of financial covenants that makes it less restrictive. This makes the public debt less binding in comparison to public debt. The public debt need to put more emphasis on using financial covenants to overcome its deficiencies.
Bradely, M., & Roberts. (2015). The Stricture and pricing of coporate debt covenants. The Quarterly Journal of Finance.
Callahan, C., Leone, A., Yang, L., & Zhang, J. (2014). Accounting Quality, Debt Covenants Design, and the Cost of Debt. University of Louisville Working paper.
Cumming, D., Fleming, G., & Liu, Z. (2016). Private Debt: Volatility, Credit Risk, and Returns. Credit Risk and Returns.
Kalimipalli, M., Huang, A., Nayak, S., & Ramchand, L. (2016). Private or Public Debt? Effect of Crisis on Financial Intermediation. . In, Effect of Crisis on Financial Intermediation .
Lin, C., May, Y., Malatesta, P., & Xuan, Y. (2013). Corporate ownership structure and the choice between bank debt and public debt. Journal of Financial Economics.
Mather, P., & Peirson, G. (2006). Financial covenants in the market for public and private debt. In, Accounting & Finance (pp. 285-307).
Reisel, N. (2014). On the value of restrictive covenants: Empirical investigation of public bond issues. Journal of Corporate Finance.
Taylor, P. (2013). What do we know about the role of financial reporting in debt contracting and debt covenants? Accounting and Business Research.
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