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Optimal Priority Structure, Capital Structure, and Investment

Dirk Hackbarth

Boston University Questrom School of Business

David C. Mauer

University of North Carolina at Charlotte

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 Tobinā€™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: April 11, 2015

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: https://ssrn.com/abstract=1424107 or http://dx.doi.org/10.2139/ssrn.1424107

Contact Information

Dirk Hackbarth
Boston University Questrom School of Business ( email )
Department of Finance
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 North Carolina at Charlotte ( email )
9201 University City Boulevard
Charlotte, NC 28223
United States
704-687-7707 (Phone)
Feedback to SSRN

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