Debt Contracts in the Presence of Performance Manipulation

Empirical evidence suggests that firms often manipulate reported numbers to avoid debtcovenant violations. We study how a firm's ability to manipulate reports affects the terms ofits debt contracts and the resulting investment and manipulation decisions that the firm implements.Our model generates novel empirical predictions regarding the use and the level of debtcovenant, the interest rate, the efficiency of investment decisions, and the likelihood of covenantviolations. For example, the model predicts that the optimal debt contract for firms with relativelystrong (weak) corporate governance (i.e., cost of manipulation) induces overinvestment(underinvestment). Moreover, for firms with strong (weak) corporate governance, an increase incorporate governance quality leads to tighter (looser) covenant, more (less) frequent covenantviolations and lower (higher) interest rate. Our model highlights that the interest rate, which isa common proxy for the cost of debt, neither accounts for the distortion of investment efficiencynor the expected manipulation costs arising under debt financing. We propose a measure of costof debt capital that accounts for these effects