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Performance-Sensitive Debt

Gustavo Manso1; Bruno Strulovici2; Alexei Tchistyi3

1 Massachusetts Institute of Technology · 2 Northwestern University · 3 University of California, Berkeley

Review of Financial Studies 2010 open access

This article studies performance-sensitive debt (PSD), the class of debt obligations whose interest payments depend on some measure of the borrower’s performance. We demonstrate that the existence of PSD obligations cannot be explained by the trade-off theory of capital structure, as PSD leads to earlier default and lower equity value compared to fixed-rate debt of the same market value. We show that, consistent with the pecking-order theory, PSD can be used as an inexpensive screening device, and we find empirically that firms choosing PSD loans are more likely to improve their credit ratings than firms choosing fixed-interest loans. We also develop a method to value PSD obligations allowing for general payment profiles and obtain closed-form pricing formulas for step-up bonds and linear PSD.

DOI
10.1093/rfs/hhq005
Volume
23 (5)
Pages
1819-1854
Language
en
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