Quick Answer
Capital structure is a company's mix of debt and equity financing, and liquidation priority is the strict legal order assets get distributed in when a company fails. Debt always beats equity: secured debt, then unsecured debentures, then subordinated debt, then preferred stock, then common stock last. Higher priority generally improves bankruptcy recovery, but it does not by itself determine a security's overall risk or yield.
The exam pairs this topic with risk-return tradeoffs elsewhere in the unit: the same ladder that determines who gets paid first in bankruptcy also explains why secured bonds yield less than common stock.
What Is 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, which creates creditor relationships
- Equity financing: issuing stock to investors, which creates ownership relationships
- A company's capital structure determines the risk and return profile for each class of investor
- More debt, meaning higher leverage, means higher financial risk for all stakeholders
The key principle: higher priority generally means lower risk and lower expected return in practice, since secured debt is typically safest and lowest-yielding while common stock is typically riskiest and highest-potential. Priority itself only governs bankruptcy recovery order, not risk or yield directly; issuer credit, maturity, collateral quality, and market conditions also matter.
How Do Risk and Return Line Up Across the 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) |
Exam Tip: Gotchas
Claim priority answers a bankruptcy-recovery question, not a general risk or yield question. It does not prove a security has the lowest overall risk or yield, since issuer credit, maturity, collateral quality, market conditions, and contractual terms also matter. If a question asks which security holder has the least risk in bankruptcy specifically, the answer is secured bondholders, not preferred stockholders.
What Order Are Claims Paid in a Liquidation?
When a company is liquidated (dissolved or bankrupt), its assets are distributed in a strict legal order under the absolute priority rule. 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
Does a Real Bankruptcy Ever Deviate From This Ladder?
In actual bankruptcy proceedings under the U.S. Bankruptcy Code, certain priority unsecured claims, such as unpaid employee wages up to a statutory cap and unpaid taxes, are paid ahead of general unsecured creditors from the company's unencumbered assets. These priority claims do not, however, displace secured creditors' rights against their specific collateral.
The Series 65 does not test this nuance. Treat the simplified hierarchy above as the answer on the exam.
Exam Tip: Gotchas
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.
What Should You Check on Exam Day?
- Can you recite the five-step liquidation ladder in order without hesitating: secured debt, unsecured debentures, subordinated debt, preferred stock, common stock?
- Do you know that "senior" or "junior" attached to preferred stock only ranks it against other preferred stock, never against any class of debt?
- Can you explain why higher liquidation priority correlates with lower expected return?
- Do you know that common stockholders hold a residual claim and often receive nothing?