Seniority Orders Between Inside Debts and External Debts

Posted: 13 Dec 2018 Last revised: 26 Jan 2019

See all articles by Mingcherng Deng

Mingcherng Deng

City University of New York (CUNY) - Baruch College

Lin Nan

Purdue University

Xiaoyan Wen

Texas Christian University

Date Written: November 28, 2018

Abstract

In this paper, we study the seniority orders between a firm's external debts and its inside-debt compensation to its manager, and analyze how different seniority orders influence equilibrium inside debt and external debt, as well as efficiency. We find the equilibrium inside debt varies with different seniority orders and is contingent on the borrowing amount. Specifically, if the borrowing amount is small, the equilibrium inside debt is the smallest when the external debt has the seniority and is the largest when the inside debt has the seniority. However, if the borrowing amount gets sufficiently large, the results are reversed. We also analyze how the liquidation value upon bankruptcy affects the equilibrium external debt given different seniority orders, and our analysis shows that the external debt may increase in the liquidation value.

In addition, we examine an extension with asset diversion. We find that, contrary to conventional wisdom, assigning seniority to the manager's inside-debt compensation does not mitigate the manager's asset diversion. In fact, asset diversion is more severe when the manager's inside-debt compensation has the seniority over the external debts. We further find that, in the presence of a risk-averse manager, when the threat of asset diversion is very severe while the manager is not very risk-averse, it is efficient to assign seniority to external debts, which dampens asset diversion and also limits the increase in risk premium due to asset diversion. On the other hand when asset diversion is negligible and risk aversion is the dominant concern, it is efficient to assign seniority to inside debt to protect the manager from the inherent project risk and reduce risk premium.

Keywords: seniorty order, inside debt, external debt, asset diversion

JEL Classification: J33, G18, G33

Suggested Citation

Deng, Mingcherng and Nan, Lin and Wen, Xiaoyan, Seniority Orders Between Inside Debts and External Debts (November 28, 2018). Available at SSRN: https://ssrn.com/abstract=3293161

Mingcherng Deng

City University of New York (CUNY) - Baruch College ( email )

One Bernard Baruch Way, Box B12-225
New York, NY 10010
United States

Lin Nan

Purdue University ( email )

100 S Grant St
West Lafayette, IN 47907
United States
7654960551 (Phone)

Xiaoyan Wen (Contact Author)

Texas Christian University ( email )

M.J. Neeley School of Business
TCU Box 298530
Fort Worth, TX 76129
United States

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