NATIONAL BUREAU OF ECONOMIC RESEARCH
NATIONAL BUREAU OF ECONOMIC RESEARCH

A Theory of Corporate Financial Structure Based on the Seniority of Claims

Oliver Hart, John Moore

NBER Working Paper No. 3431*
Issued in September 1990
NBER Program(s):   EFG

We develop a theory of optinal capital structure based on the idea that

debt ath equity differ in their priority status relative to future corporate

cash pants. A company with high (dispersed) debt will find it hard to

raise new capital since new security-holders will have lew priority relative

to existing senior creditors. Conversely for a company with lew 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. Among other things, our theory can explain the

obserrvation that profitable firms have low debt. In addition, it predicts

that (long-term) debt will be high if new investment is risky ard on average

profitable, or if assets in place are risky an new investment is on average

unprofitable.

*Published: (New Title) Debt and Senority: An Analysis of the Role of Hard Claims in Constraining Management. American Economic Review, Vol. 85, no. 3 (June 1995): 567-585.

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