We develop a theory of optimal capital structure based on the idea that debt 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 mix of senior and junior debt for a corporation whose management may undertake unprofitable as well as profitable investments. Among other things, our theory can explain the observation that profitable firms have low debt. In addition, it predicts that (long-term) debt will be high if new investment is risky and on average profitable, or if assets in place are risky and new investment is on average unprofitable.
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