Ownership links, leverage and credit risk
AbstractThis paper explores the relationship between optimal leverage and credit risk under ownership links. It develops a structural model of a parent and a subsidiary, which issues debt in its own name under a guarantee by the parent. We find that zero leverage can be optimal for the guarantor, while leverage close to one can be optimal for the guaranteed company, as this optimally exploits the tax shield of debt while minimizing default costs. As far as credit risk is considered, their joint default probability is lower than that of stand alone units, despite their higher debt capacity. Higher group optimal leverage and lower default probability increase value with respect to conglomerate mergers and stand alone arrangements. Default probability, spreads and loss given default of the subsidiary are higher than for a stand alone with similar size and volatility. We also study the situation when the subsidiary is constrained to a debt equal to the optimal stand alone level. Only in this case group credit risk depends on the ownership share. Consistently with intuition, our unconstrained model rationalizes the capital structure typical of private equity; the constrained model instead is able to explain observed features of public business groups and more regulated environments.
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Bibliographic InfoPaper provided by Collegio Carlo Alberto in its series Carlo Alberto Notebooks with number 69.
Length: 42 pages
Date of creation: 2008
Date of revision: 2008
credit risk; default risk; structural models; optimal leverage; zero leverage; ownership structure; parent-subsidiary;
Find related papers by JEL classification:
- G32 - Financial Economics - - Corporate Finance and Governance - - - Financing Policy; Financial Risk and Risk Management; Capital and Ownership Structure; Value of Firms; Goodwill
- G33 - Financial Economics - - Corporate Finance and Governance - - - Bankruptcy; Liquidation
- G34 - Financial Economics - - Corporate Finance and Governance - - - Mergers; Acquisitions; Restructuring; Corporate Governance
This paper has been announced in the following NEP Reports:
- NEP-ALL-2008-02-02 (All new papers)
- NEP-CFN-2008-02-02 (Corporate Finance)
- NEP-RMG-2008-02-02 (Risk Management)
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