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

  • Oliver Hart
  • John Moore

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.

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Paper provided by Suntory and Toyota International Centres for Economics and Related Disciplines, LSE in its series STICERD - Theoretical Economics Paper Series with number /1990/217.

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Date of creation: 1990
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Handle: RePEc:cep:stitep:/1990/217
Contact details of provider: Web page: http://sticerd.lse.ac.uk/_new/publications/default.asp

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  1. Myers, Stewart C. & Majluf, Nicolás S., 1945-, 1984. "Corporate financing and investment decisions when firms have information that investors do not have," Working papers 1523-84., Massachusetts Institute of Technology (MIT), Sloan School of Management.
  2. David M. Cutler & Lawrence H. Summers, 1987. "The Costs of Conflict Resolution and Financial Distress: Evidence from the Texaco-Pennzoil Litigation," NBER Working Papers 2418, National Bureau of Economic Research, Inc.
  3. Jensen, Michael C, 1986. "Agency Costs of Free Cash Flow, Corporate Finance, and Takeovers," American Economic Review, American Economic Association, vol. 76(2), pages 323-29, May.
  4. Myers, Stewart C. & Majluf, Nicholas S., 1984. "Corporate financing and investment decisions when firms have information that investors do not have," Journal of Financial Economics, Elsevier, vol. 13(2), pages 187-221, June.
  5. Oliver Hart & John Moore, 1998. "Default And Renegotiation: A Dynamic Model Of Debt," The Quarterly Journal of Economics, MIT Press, vol. 113(1), pages 1-41, February.
  6. Miller, Merton H, 1977. "Debt and Taxes," Journal of Finance, American Finance Association, vol. 32(2), pages 261-75, May.
  7. Myers, Stewart C., 1977. "Determinants of corporate borrowing," Journal of Financial Economics, Elsevier, vol. 5(2), pages 147-175, November.
  8. Hayne E. Leland and David H. Pyle., 1976. "Informational Asymmetries, Financial Structure, and Financial Intermediation," Research Program in Finance Working Papers 41, University of California at Berkeley.
  9. Franklin Allen & Douglas Gale, . "Optimal Security Design," Rodney L. White Center for Financial Research Working Papers 26-87, Wharton School Rodney L. White Center for Financial Research.
  10. Stephen A. Ross, 1977. "The Determination of Financial Structure: The Incentive-Signalling Approach," Bell Journal of Economics, The RAND Corporation, vol. 8(1), pages 23-40, Spring.
  11. Stewart C. Myers & Nicholas S. Majluf, 1984. "Corporate Financing and Investment Decisions When Firms Have InformationThat Investors Do Not Have," NBER Working Papers 1396, National Bureau of Economic Research, Inc.
  12. Gilson, Stuart C. & John, Kose & Lang, Larry H. P., 1990. "Troubled debt restructurings*1: An empirical study of private reorganization of firms in default," Journal of Financial Economics, Elsevier, vol. 27(2), pages 315-353, October.
  13. Warner, Jerold B, 1977. "Bankruptcy Costs: Some Evidence," Journal of Finance, American Finance Association, vol. 32(2), pages 337-47, May.
  14. Jensen, Michael C. & Meckling, William H., 1976. "Theory of the firm: Managerial behavior, agency costs and ownership structure," Journal of Financial Economics, Elsevier, vol. 3(4), pages 305-360, October.
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