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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