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Optimal Priority Structure, Capital Structure, and Investment

Dirk Hackbarth

Boston University School of Management

David C. Mauer

University of Iowa

August 30, 2011

Review of Financial Studies, Forthcoming

We study the interaction between financing and investment decisions in a dynamic model where the firm has multiple debt issues and equityholders choose the timing of investment. Jointly optimal capital and priority structures can virtually eliminate investment distortions, because debt priority serves as a dynamically optimal contract. Examining the relative efficiency of priority rules observed in practice, we develop several predictions about how firms adjust their priority structure in response to changes in leverage, credit conditions, and firm fundamentals. Notably, large, financially unconstrained firms with few growth opportunities prefer senior debt, while small, financially constrained firms, with or without growth opportunities, prefer junior debt. Moreover, lower rated firms are predicted to spread priority across debt classes. Lastly, our analysis also has a number of important implications for empirical capital structure research, including the relations between market leverage, book leverage, and credit spreads and Tobin’s Q, the influence of firm fundamentals on the agency cost of debt, and the conservative debt policy puzzle.

Number of Pages in PDF File: 69

Keywords: Priority Structure, Financial Contracting, Investment Policy, Real Options

JEL Classification: G13, G31, G32, G33

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Date posted: June 29, 2009 ; Last revised: February 14, 2012

Suggested Citation

Hackbarth, Dirk and Mauer, David C., Optimal Priority Structure, Capital Structure, and Investment (August 30, 2011). Review of Financial Studies, Forthcoming. Available at SSRN: http://ssrn.com/abstract=1424107 or http://dx.doi.org/10.2139/ssrn.1424107

Contact Information

Dirk Hackbarth
Boston University School of Management ( email )
595 Commonwealth Avenue
Boston, MA 02215
United States
(617) 358-4206 (Phone)
(617) 353-6667 (Fax)
HOME PAGE: http://people.bu.edu/dhackbar/
David C. Mauer (Contact Author)
University of Iowa ( email )
Iowa City, IA 52242-1000
United States
319-335-0944 (Phone)
Feedback to SSRN

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References:  51
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