Debt and Seniority: An Analysis of the Role of Hard Claims in Constraining Management

Publication Date
Financial Markets Group Discussion Papers DP 168
Publication Authors

We develop a theory of long term debt based on the idea that debt and equity differ in their priority status relative to future corporate cash payments. A company with high (dispersed) debt will find it hard to raise new capital since new security-holders will have low priority relative to existing senior creditors. Conversely for a company with low debt. We show that there is an optimal debt-equity ratio and mix of senior and junior debt for a corporation whose management may undertake unprofitable as well as profitable investments. We also provide a preliminary analysis of the tradeoff between short-term and long-term debt. 

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