[We study the interaction between financing and investment decisions in a dynamic model, where the firm has multiple debt issues and equityholders choose the timing of investment. Jointly optimal capital and priority structures can virtually eliminate investment distortions because debt priority serves as a dynamically optimal contract. Examining the relative efficiency of priority rules observed in practice, we develop several predictions about how firms adjust their priority structure in response to changes in leverage, credit conditions, and firm fundamentals. Notably, financially unconstrained firms with few growth opportunities prefer senior debt, while financially constrained firms, with or without growth opportunities, prefer junior debt. Moreover, lower-rated firms are predicted to spread priority across debt classes. Finally, our analysis has a number of important implications for empirical capital structure research, including the relations between market leverage, book leverage, and credit spreads and Tobin's Q, the influence of firm fundamentals on the agency cost of debt, and the conservative debt policy puzzle.]

[It is well established that value stocks outperform glamour stocks, yet considerable debate exists about whether the return differential reflects compensation for risk or mispricing. Under mispricing explanations, prices of glamour (value) firms reflect systematically optimistic (pessimistic) expectations; thus, the value/glamour effect should be concentrated (absent) among firms with (without) ex ante identifiable expectation errors. Classifying firms based upon whether expectations implied by current pricing multiples are congruent with the strength of their fundamentals, we document that value/glamour returns and ex post revisions to market expectations are predictably concentrated (absent) among firms with ex ante biased (unbiased) market expectations.]

[We provide evidence that creditors play an active role in the governance of corporations well outside of payment default states. By examining the Securities and Exchange Commission's filings of all U. S. nonfinancial firms from 1996 through 2008, we document that, in any given year, between 10% and 20% of firms report being in violation of a financial covenant in a credit agreement. We show that violations are followed immediately by a decline in acquisitions and capital expenditures, a sharp reduction in leverage and shareholder payouts, and an increase in CEO turnover. The changes in the investment and financing behavior of violating firms coincide with amended credit agreements that contain stronger restrictions on firm decision-making; changes in the management of violating firms suggest that creditors also exert informal influence on corporate governance. Finally, we show that firm operating and stock price performance improve post-violation. We conclude that actions taken by creditors increase the value of the average violating firm.]

[We investigate the relation between firms' weighted average cost of capital and internal financial resources, using mandatory pension contributions as a proxy for internal financial resources. Rauh (2006) documents a negative association between mandatory pension contributions and capital .expenditures. We find that an increase in mandatory pension contributions increases the cost of capital, but only for firms facing greater external financing constraints. Our results suggest that firms' cost of capital is an intervening variable that can explain Rauh's finding that mandatory pension contributions (i.e., internal financing constraints) result in foregone investment. Overall, we provide evidence consistent with recent studies (Rauh 2006; Almeida and Campello 2007) that conclude that financial market frictions affect real economic activity and, in particular, corporate investment.]

It is well established that value stocks outperform glamour stocks, yet considerable debate exists about whether the return differential reflects compensation for risk or mispricing. Under mispricing explanations, prices of glamour (value) firms reflect systematically optimistic (pessimistic) expectations; thus, the value/glamour effect should be concentrated (absent) among firms with (without) ex ante identifiable expectation errors. Classifying firms based upon whether expectations implied by current pricing multiples are congruent with the strength of their fundamentals, we document that value/glamour returns and ex post revisions to market expectations are predictably concentrated (absent) among firms with ex ante biased (unbiased) market expectations.

We provide evidence that creditors play an active role in the governance of corporations well outside of payment default states. By examining the Securities and Exchange Commission's filings of all U.S. nonfinancial firms from 1996 through 2008, we document that, in any given year, between 10% and 20% of firms report being in violation of a financial covenant in a credit agreement. We show that violations are followed immediately by a decline in acquisitions and capital expenditures, a sharp reduction in leverage and shareholder payouts, and an increase in CEO turnover. The changes in the investment and financing behavior of violating firms coincide with amended credit agreements that contain stronger restrictions on firm decision-making; changes in the management of violating firms suggest that creditors also exert informal influence on corporate governance. Finally, we show that firm operating and stock price performance improve post-violation. We conclude that actions taken by creditors increase the value of the average violating firm. The Author 2012. Published by Oxford University Press on behalf of The Society for Financial Studies. All rights reserved. For Permissions, please e-mail: [email protected]., Oxford University Press.

We study the interaction between financing and investment decisions in a dynamic model, where the firm has multiple debt issues and equityholders choose the timing of investment. Jointly optimal capital and priority structures can virtually eliminate investment distortions because debt priority serves as a dynamically optimal contract. Examining the relative efficiency of priority rules observed in practice, we develop several predictions about how firms adjust their priority structure in response to changes in leverage, credit conditions, and firm fundamentals. Notably, financially unconstrained firms with few growth opportunities prefer senior debt, while financially constrained firms, with or without growth opportunities, prefer junior debt. Moreover, lower-rated firms are predicted to spread priority across debt classes. Finally, our analysis has a number of important implications for empirical capital structure research, including the relations between market leverage, book leverage, and credit spreads and Tobin's Q, the influence of firm fundamentals on the agency cost of debt, and the conservative debt policy puzzle.

We investigate the relation between firms' weighted average cost of capital and internal financial resources, using mandatory pension contributions as a proxy for internal financial resources. Rauh (2006) documents a negative association between mandatory pension contributions and capital expenditures. We find that an increase in mandatory pension contributions increases the cost of capital, but only for firms facing greater external financing constraints. Our results suggest that firms' cost of capital is an intervening variable that can explain Rauh's finding that mandatory pension contributions (i.e., internal financing constraints) result in foregone investment. Overall, we provide evidence consistent with recent studies (Rauh 2006; Almeida and Campello 2007) that conclude that financial market frictions affect real economic activity and, in particular, corporate investment. The Author 2011. Published by Oxford University Press on behalf of The Society for Financial Studies. All rights reserved. For Permissions, please e-mail: [email protected]., Oxford University Press.