Debt and Seniority: An Analysis of the Role of Hard Claims in Constraining Management.

The authors argue that long-term debt has a role in controlling management's ability to finance future investments. Companies with high (widely held) debt will find it hard to raise capital, since new security-holders will have low priority relative to existing creditors; conversely for companies with low debt. The authors show that there is an optimal debt-equity ratio and mix of senior and junior debt if management undertakes unprofitable as well as profitable investments. They derive conditions under which equity and a single class of senior long-term debt work as well as more complex contracts for controlling investment behavior. Copyright 1995 by American Economic Association.