A Theory of Corporate Financial Structure Based on the Seniority of Claims

We develop a theory of optimal capital structure based on the idea that debt and equity differ in their priority status relative to future corporate cash pants. A company with high (dispersed) debt will find it hard to raise new capital since new security-holders will have low priority relative to existing senior creditors. Conversely for a company with low debt. We show that there is an optimal debt-equity ratio and mix of senior and junior debt for a corporation whose management may undertake unprofitable as well as profitable investments. Among other things, our theory can explain the observation that profitable firms have low debt. In addition, it predicts that (long-term) debt will be high if new investment is risky and on average profitable, or if assets in place are risky an new investment is on average unprofitable.