Interaction between Dynamic Financing and Investments: The Role of Priority Rules
40 Pages Posted: 10 Mar 2016
Date Written: March 8, 2016
We analyze in a dynamic model how debt priority rules influence firms' initial capital structure choice, investment timing, and subsequent debt issues. We quantify deviations from first-best investment behavior that arise from different debt priority rules, and document surprisingly large deviations caused by well-known rules such as the absolute priority rule. We introduce a new rule, called the efficient priority rule (EPR), that gives equity holders incentives to choose first-best investment timing and financing. Under EPR, old debt has the same value and risk characteristics as if the firm had not invested and new debt had not been issued.
Keywords: Dynamic capital structure, taxes and optimal debt structure, structural model, credit risk, priority rule, investment and financing decisions
JEL Classification: G32
Suggested Citation: Suggested Citation