Trade‐Off Theory for Dual Holders

A dual holder simultaneously owns (private) debt and equity in the same firm. Private debt has a tax advantage, a positive cashflow, which incentivizes its use. This cashflow leads to a lower net cost of debt, which again reduces default risk as well as the cost of external debt. The usual trade‐off between tax benefits and bankruptcy costs is altered. Debt priority affects both financing and default decisions. We find that an enterprise‐value maximizing firm should issue senior, external debt and junior, private debt, rather than debt with pari‐passu priority. Our analysis further highlights that tax authorities can effectively curtail the tax‐motivated use of private debt through straightforward measures.