Junior Debt

Abstract

While many papers in the literature have provided a rationale for the existence of debt, such as tax benefits or signaling effects, only a few have made the distinction between senior and junior debt and analyzed the consequences of differing priority of claims for firm behavior. Perotti and Spier (1993) and Hart and Moore (1995) are two recent exceptions. Both of these papers explore the effects of the existence of both senior and junior debt on the firm’s investment decision. Perotti and Spier (1993) show that value may be extracted from senior claims through the issue of junior debt. The reason is that by retiring equity through a junior debt issue, the shareholders credibly threaten not to undertake valuable new investment unless senior debt holders concede to a reduction of their claims. Hart and Moore (1995) show that a mix of short-term and senior long-term debt might be necessary to deter management from undertaking unprofitable investment. The basic intuition, extending that of Jensen (1986), is that short-term debt forces management to disgorge free cash flows.