High School

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Do borrowers intentionally avoid covenant violations? A reexamination of the debt covenant hypothesis.

A. Yes
B. No
C. It depends on the situation
D. Not applicable

Answer :

Final answer:

Borrowers' decisions on covenant compliance depend on specific situations, considering loan terms, credit risk, market conditions, and the broader economic environment. Lenders set interest rates reflecting the riskiness of borrowers, while at a macro level, the relationship between national debt and lending rates can affect these decisions as well. So, the correct option is c) It depends on the situation

Explanation:

Whether borrowers intentionally avoid covenant violations largely depends on the situation. Lenders and borrowers make decisions based on a number of factors, including potential interest payments, the current terms of the market, and alternative opportunities.

For example, a borrower with a history of late payments, which makes them a higher credit risk, might try to adhere strictly to covenants to maintain their borrowing ability. Conversely, if interest rates rise, a borrower might find existing loans less attractive and may be less motivated to comply with strict covenants if they believe refinancing options are limited.

Ultimately, both lenders and borrowers assess the terms of a loan against current market conditions. Lenders, on the one hand, are interested in the likelihood of timely repayment and thus set interest rates that reflect the riskiness of the borrower.

At a macroeconomic level, the relationship between national debt and lending rates may show whether high levels of debt are leading to crowding out, meaning government borrowing is displacing private investment. This could influence a borrower's decision on whether to adhere to loan covenants, especially if the economic conditions make the loan less beneficial.

So, the correct option is c) It depends on the situation

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