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Capital Structure and Debt Priority


  • Sami Attaoui,

  • Patrice Poncet

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    • Sami Attaoui is an Associate Professor of Finance in the Economics and Finance Department, at the Rouen Business School in Mont Saint Aignan, France. Patrice Poncet is a Distinguished Professor of Finance in the Finance Department at ESSEC Business School in Cergy-Pontoise, France.

  • We are grateful to Raghu Rau (Editor) for his insightful comments and to an anonymous referee for very useful comments and suggestions that have substantially improved the overall quality of the paper. We also thank Sridhar Arcot, Florina Silaghi, and participants at the EUROFIDAI—AFFI 9th International Paris Finance Conference for their discussions. We are solely responsible for any remaining errors.


We study a defaultable firm's debt priority structure in a simple structural model where the firm issues senior and junior bonds and is subject to both liquidity and solvency risks. Assuming that the absolute priority rule prevails and that liquidation is immediate upon default, we determine the firm's interior optimal priority structure along with its optimal capital structure. We also obtain closed-form solutions for the market values of the firm's debt and equity. We find that the magnitude of the spread differential between junior and senior bond yields is positively, but not linearly related to the total debt level and the riskiness of assets. Finally, we provide an in-depth analysis of probabilities of default and the term structure of credit spreads.