Capital Structure under Costly Enforcement* 


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    Thanks to Mike Burkart, Darrell Duffie, Eirik G. Kristiansen, Pierre Mella-Barral, Trond Olsen, Jennifer Reinganum, Suresh Sundaresan, two anonymous referees, as well as seminar audiences at Bocconi, London School of Economics (FMG), Norges Bank (Central Bank of Norway), Norwegian School of Economics and Business, Norwegian School of Management, Stockholm School of Economics, and Tel-Aviv University for helpful comments. A previous version of the paper was circulated under the title “Strategic Defaults and Priority Violations under Costly State Verification”.


We consider financial structure and repayment behavior in a setting where cash flows are private information to the entrepreneur and the cost of enforcing repayment differs across security holders. If enforcement costs are lower for shareholders than for creditors, a mixed capital structure with debt and equity can obtain in equilibrium. Under a mixed capital structure, creditors intervene in low cash-flow states while shareholders intervene in high cash-flow states. Moreover, strategic defaults, costly bankruptcy, shareholder intervention, and violation of absolute priority occur with positive probability on the equilibrium path. Several of the predictions from our framework are consistent with evidence not readily explainable by existing theories.