The Role of Covenants and the Firm's Financing Choice : A theoretical model in order to increase the efficency of public and private debt contracts

In the aftermath of the recent financial crisis, the introduction of particular clauses in the debt contracts may represent an useful instrument to enhance their efficiency. Covenants are agreements that give the creditors more guarantees about the reliability of their loan: when they are breached, they allow the lenders to take certain actions, as the early repayment of the loan or the change of the debt's terms, in order to protect them against a potential borrower's default. Covenants are therefore useful for creditors' protection but they also restrict the business policies of borrowers. These clauses may be included both in public and in private debt. The goal of this work is to provide a theoretical model that analyses the impact of a covenant on both types of debt. In order to guarantee the efficiency of the instrument, there are some necessary conditions to satisfy, otherwise it does not collect the desired result. To define the conditions for the covenant efficiency, we proceed by steps, analyzing firstly the financing decision of a firm without the covenant and then examining how a covenant either on the public or on the private debt, can impact on the firm's choice.