A control theory of financial structure : outside equity control and the priority and maturity structure of debt

Abstract

Firms' financial structures typically consist of debt claims of different priority and maturity, and outside equity with control rights. The present paper develops a simple control theory of financial structure in which these features arise endogeneously to allocate control and cash flow rights among the firm's manager and its investors. While short-term debt commits the manager to liquidate the firm in low profit states, outside equity with unconditional control allows investors to seize control in states for which the manager otherwise would pursue low profit projects that yield high private benefits of control. Finally, long-term subordinated debt protects the manager from excessive shareholder involvement.