Dynamic investment, debt structure and debt overhang

We study the impact of the optimal debt and priority structure on the intertwined corporate financing and investment decisions in a dynamic trade-off model, where the firm simultaneously uses bank and market debt for project financing. Private bank debt is renegotiable during financial distress, thus it avoids inefficient and costly bankruptcy losses should the renegotiation be successful. Our model shows: (i) Shareholders' bargaining power, renegotiation friction, growth potential, and bankruptcy costs limits bank debt capacity; (ii) The substitution effect between bank and market debt dominates in most cases; (iii) Bank debt issuance reduces the bankruptcy risk and speeds firm investment, which mitigates the debt overhand effect; (iv) Debt priority structure has a monotonic positive effect on firms' optimal capital structure, the net benefit of mixed debt financing, and firm valuation, the effect of which is much stronger for weaker shareholders, therefore, it would be optimal to place bank debt as senior for firm value maximization; (v) The benefit of mixed debt financing is significant (a firm valuation boost between 5%- 10% ) compared to either the bank debt exclusive or market debt exclusive debt structure.