Optimal Priority Structure, Capital Structure, and Investment

We examine the role of debt priority structure in resolving stockholder-bondholder conflicts over investment policy. In a dynamic model where the firm can issue multiple classes of debt, we show that the firm may underor overinvest in future growth options. We show that when debt priority is endogenized along with capital structure there is an interior optimal priority structure which virtually eliminates equityholders’ suboptimal investment incentives and fully exploits the debt capacity of future growth options. The optimal priority structure allocates priority to initial debt to mitigate suboptimal investment incentives and yet preserves priority for subsequent debt issues to maximize future debt capacity. A key implication of our analysis is that priority structure is a critical and heretofore unrecognized financial contracting device that helps to resolve stockholder-bondholder conflicts over investment policy. Several additional results have implications for empirical research in corporate finance.