DEBT AND SENIORITY - AN ANALYSIS OF THE ROLE OF HARD CLAIMS IN CONSTRAINING MANAGEMENT

We argue that long-term debt has a role in controlling management's ab ility to finance future investments. Companies with high (widely held) debt will find it hard to mise capital, since new security-holders wi ll have low priority relative to existing creditors; conversely for co mpanies with low debt. We show that there is an optimal debt - equity ratio and mix of senior and junior debt if management undertakes unpro fitable 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 contracts for controlling investment behavior.