The Choice of Call Provision Terms: Evidence of the Existence of Agency Costs of Debt

Abstract

ABSTRACT An examination of the provisions of bond issues reveals that most bonds prohibit firms from calling the issue during the initial years, after which time the bond can be called at the option of the firm. A substantial number of firms, however, also reserve the right to call the issue during this initial period for purposes other than refinancing at a lower coupon rate. The additional flexibility which accompanies the option of early redemption can be used to reduce the agency costs of debt associated with future investment opportunities, informational asymmetry, and the risk incentive problem. Using a sample of newly issued bonds, statistical tests are performed to show that there are, in fact, differences between firms which do and do not reserve the right of early redemption. This paper shows that these differences provide empirical evidence which is consistent with the hypothesis that firms use the option of early redemption to reduce agency costs.