Capital Structure and Liquidation Priority
Capital Structure
Capital structure refers to the mix of debt and equity a company uses to finance its operations.
- Debt financing - borrowing money through bonds or loans (creates creditor relationships)
- Equity financing - issuing stock to investors (creates ownership relationships)
- A company's capital structure determines the risk and return profile for each class of investor
- More debt (higher leverage) = higher financial risk for all stakeholders
The Key Principle: Higher priority = lower risk = lower expected return. Secured debt is safest but offers the lowest yield; common stock is riskiest but offers the highest potential return.
Risk-Return Relationship Across Capital Structure
| Security | Risk Level | Expected Return | Liquidation Priority |
|---|---|---|---|
| Secured bonds | Lowest | Lowest yield | Highest (paid first) |
| Unsecured bonds (debentures) | Low-moderate | Moderate yield | Second |
| Subordinated debentures | Moderate | Higher yield | Third |
| Preferred stock | Moderate-high | Stated dividend rate | Fourth |
| Common stock | Highest | Highest potential (dividends + appreciation) | Lowest (paid last) |
Liquidation Priority (Absolute Priority Rule)
When a company is liquidated (dissolved/bankrupt), its assets are distributed in a strict legal order. Creditors (debt holders) are ALWAYS paid before equity holders (stockholders).
| Priority | Claim Type | Description |
|---|---|---|
| 1 (Highest) | Secured debt | Bonds/loans backed by specific collateral (e.g., mortgage bonds) |
| 2 | Unsecured debt (debentures) | Bonds with no collateral backing; rely on issuer's general creditworthiness |
| 3 | Subordinated debt | Debentures that contractually rank below other unsecured debt |
| 4 | Preferred stock | Equity with priority over common stock for dividends and liquidation proceeds |
| 5 (Lowest) | Common stock | Last claim on assets; receives whatever remains after all other claims are satisfied |
Key exam points:
- Bondholders vs. stockholders - bondholders (creditors) have a senior claim to stockholders (owners); this is the most commonly tested distinction
- Preferred vs. common stock - preferred stockholders receive their stated liquidation preference before common stockholders receive anything
- Residual claim - common stockholders have a residual claim, meaning they receive what is left (if anything) after all creditors and preferred stockholders are paid
- In practice, common stockholders often receive nothing in a corporate liquidation
Critical Rule: Debt always comes before equity, regardless of adjectives.
- A "junior subordinated debenture" still beats a "senior prior lien preferred stock"
- The word "senior" in "senior preferred" just means it beats other preferred classes
Exam Tip: Gotchas
- The exam tests the inverse relationship between liquidation priority and expected return. Secured bondholders get paid first but accept lower yields. Common stockholders get paid last but have unlimited upside potential. If a question asks "which security holder has the LEAST risk in bankruptcy," the answer is secured bondholders, not preferred stockholders.
- Preferred stock is equity, not debt. Despite the word "preferred," preferred stockholders are paid AFTER all creditors (including subordinated debenture holders). The exam may try to trick you into placing preferred stock above unsecured bonds; it does not belong there.