Interaction between Dynamic Financing and Investments: The Role of Priority Rules

Debt priority rules, i.e., the rules determining how different classes of debt split the firm's assets after bankruptcy, influence the firm's investment decisions. Existing debt benefits from an investment either because the investment is equity financed or because new debt issued to (partly) finance the investment has lower priority in the event of bankruptcy as is the case for the commonly used absolute priority rule (APR). This incentivizes equity holders to under invest. If debt priority rules are specified in such a way that existing debt can be exploited by issuing new debt, do equity holders have the incentive to over invest. We formulate a dynamic structural model to study the interaction of initial capital structure choice, investment policy, subsequent debt issues, and debt priority rules. We find that priority rules have a substantial impact on investment timing as well as the optimal initial leverage ratio. We quantify distortions resulting from well-known debt priority structures and introduce an efficient priority rule (EPR) that incentivizes equity holders to choose first best investment timing and financing. Additionally, we derive the firm's cost of capital associated with different priority rules.