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

Abstract

We argue that long-term debt has a role in controlling management's ability to finance future investments.A company 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 a company with low debt We show there is an optimal debt-equity ratio and mix of senior and junior debt if management undertakes unprofitable as well as profitable investments.We derive conditions under which equity and a single class of senior long-term debt work as well as more complex conuacts for controlling investment behavior.

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