Optimal Debt Mix and Priority Structure: The Role of Bargaining Power∗

This paper examines the optimal priority structure and mix of bank and bond market debt within a continuous-time asset pricing framework. Closed-form expressions are derived for the values of renegotiable bank debt, non-renegotiable bond market debt, equity, and levered firm values. We show that the optimal debt structure hinges upon the ex post division of bargaining power between the firm and bank. The optimal debt structure for firms that are weak vis-à-vis the bank entails financing exclusively with bank debt. Strong firms find it optimal to issue a mix of bank and bond market debt, with the bank senior in the priority structure. The model explains: (i) why it is optimal for small firms to avoid public debt markets, (ii) why large firms employ mixed debt financing (iii) why banks are senior in the priority structure, and (iv) why firms shift from bank debt into a mixture of bond market and bank debt over their life-cycle. These predictions are generated within a tax shield-bankruptcy cost tradeoff model in which the only unique feature of banks is their ability to renegotiate. JEL Codes: G13, G32, G33.