Working Paper: NBER ID: w4886
Authors: Oliver Hart; John Moore
Abstract: We argue that long-term debt has a role in controlling management's ability to finance future investments. A company with high (widely-held) debt will find it hard to raise capital, since new security holders will have low priority relative to existing creditors. Conversely for a company with low debt. We show there is an optimal debt-equity ratio and mix of senior and junior debt if management undertakes unprofitable 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.
Keywords: debt; seniority; management; investment behavior; corporate finance
JEL Codes: G32; D21
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| high levels of widely-held long-term debt (F34) | management's ability to raise new capital (G32) |
| high levels of widely-held long-term debt (F34) | unprofitable investments (G11) |
| low debt (H63) | optimal debt-equity ratio (G32) |
| management's empire-building motives (L21) | new investments (G31) |
| senior long-term debt (H63) | financing of unprofitable investments (G32) |
| hard claims (non-postponable short-term debt) (G32) | managers disgorge free cash flow (G35) |
| managers disgorge free cash flow (G35) | ability to make unprofitable investments (G31) |