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

Abstract

We analyze in a dynamic model how debt priority rules influence firms' initial capital structure choice, investment timing, and subsequent debt issues. We quantify deviations from first-best investment behavior that arise from different debt priority rules, and document surprisingly large deviations caused by well-known rules such as the absolute priority rule. We introduce a new rule, called the efficient priority rule (EPR), that gives equity holders incentives to choose first-best investment timing and financing. Under EPR, old debt has the same value and risk characteristics as if the firm had not invested and new debt had not been issued.