Capital Structure and Debt Priority

Posted: 13 Oct 2011 Last revised: 14 May 2012

Sami Attaoui

NEOMA Business School

Patrice Poncet

ESSEC Business School; Universite Paris I Pantheon Sorbonne

Date Written: September 2, 2011

Abstract

We study a defaultable firm's debt priority structure in a simple structural model where the firm issues senior and junior bonds and is subject to both liquidity and solvency risks. Assuming that the absolute priority rule prevails and that liquidation is immediate upon default, we determine the firm's interior optimal priority structure along with its optimal capital structure. We also obtain closed-form solutions for the market values of the firm's debt and equity. We next assess the magnitude of the spread differential between junior and senior bond yields, which is positively but not linearly related to the total debt level and the riskiness of assets. We finally provide an in-depth analysis of probabilities of default and the term structure of credit spreads.

Keywords: Capital structure, Debt priority structure, Liquidation, Default probability, Credit spread

JEL Classification: G13, G32, G33

Suggested Citation

Attaoui, Sami and Poncet, Patrice, Capital Structure and Debt Priority (September 2, 2011). Paris December 2011 Finance Meeting EUROFIDAI - AFFI. Available at SSRN: https://ssrn.com/abstract=1943508 or http://dx.doi.org/10.2139/ssrn.1943508

Sami Attaoui (Contact Author)

NEOMA Business School ( email )

Boulevard André Siegfried - BP 215
Mont Saint Aignan, 76825
France

Patrice Poncet

ESSEC Business School ( email )

Avenue Bernard Hirsch
BP 105 Cergy Cedex, 95021
France
33 1 3443 3000 (Phone)
33 1 3443 3001 (Fax)

Universite Paris I Pantheon Sorbonne ( email )

Finance Department, UFR 06
17 rue de la Sorbonne
75005 Paris
France
33 1 40 46 2783 (Phone)
33 1 40 46 33 66 (Fax)

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