Discussion Papers,
Norwegian School of Economics, Department of Business and Management Science

Abstract: Performance sensitive debt (PSD) contracts link the paid coupon to a measure of firm performance. PSD contracts are widely used, especially as corporate bank loans. In a model where a firm has assets in place and the opportunity to invest in a growth option, I analyze how PSD affects equityholders' investment and financing incentives. With no pre-existing debt I show that PSD reduces a given firm's optimal leverage, indicating that in this case PSD partially solves potential future conflicts related to debt overhang. With debt in place I show that PSD financing magnifies equityholders' risk-shifting incentives, proving that in this case PSD is an inefficient financing tool. My conclusion questions the hypothesis that PSD is used to prevent asset substitution. When debt overhang creates problems of underinvestment I show that PSD financing partially resolves these inefficiencies. My conclusions are partially based on numerical analysis, but they are robust to changes in input parameters.

Keywords: Performance Sensitive Debt; Growth Option; Debt Overhang; Asset Substitution; Underinvestment

JEL-codes: G30

26 pages, June 28, 2012

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