The Optimal Mix of Bank and Market Debt: An Asset Pricing Approach∗

This paper examines the optimal mix and priority structure of bank and market debt using a tax shield-bankruptcy cost tradeoff model where the only unique feature of banks is their ability to renegotiate. Closed-form expressions are derived for the values of renegotiable bank debt, non-renegotiable market debt, equity, and levered firm values. Optimal debt structure hinges upon ex post bargaining power. Weak firms utilize bank debt exclusively. Strong firms use a mixture of bank and market debt, with bank debt senior. The model explains: (i) why small firms use bank debt exclusively; (ii) why large firms employ mixed debt financing; (iii) why bank debt is senior; and (iv) why firms shift from bank debt into a mixture of market and bank debt over their life-cycle. The optimal debt contracts entail Absolute Priority, and we provide estimates of the cost of ex post priority violations across creditor classes. JEL Codes: G13, G32, G33.