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Intercorporate guarantees, leverage and taxes

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  • Elisa Luciano
  • Giovanna Nicodano

Abstract

This paper characterizes optimal intercorporate guarantees, under the classical trade-off between bankruptcy costs and taxation. Conditional guarantees, allowing the guarantor - or Holding company - to maintain limited liability vis-a-vis the beneficiary - or Subsidiary - maximize joint value. They indeed achieve the highest tax savings net of default costs. We provide conditions ensuring that - at the optimum - guarantees increase total debt, which bears mostly on the Subsidiary. This difference in optimal leverage between Holding company and Subsidiary explains why optimal conditional guarantees (i) generate value independently of cash flow correlation (ii) are unilateral rather than mutual, at least for moderate default costs (iii) dominate the unconditional ones, that are embedded in mergers, at least when firms have high cash-flow correlation. We also endogenize the choice of the guarantor, showing that it has higher proportional bankruptcy costs, lower tax rates and bigger size.

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Bibliographic Info

Paper provided by Collegio Carlo Alberto in its series Carlo Alberto Notebooks with number 95.

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Length: 43 pages
Date of creation: 2008
Date of revision: 2010
Handle: RePEc:cca:wpaper:95

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Related research

Keywords: debt; taxes; bankruptcy costs; limited liability; capital structure; subsidiary; groups; mergers;

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Cited by:
  1. Elisa Luciano & Clas Wihlborg, 2013. "The Organization of Bank Affiliates; A Theoretical Perspective on Risk and Efficiency," ICER Working Papers 06-2013, ICER - International Centre for Economic Research.
  2. Stefan Lutz, 2013. "Effects of taxation on European multi-nationals’ financing and profits," Documentos del Instituto Complutense de Análisis Económico 2013-04, Universidad Complutense de Madrid, Facultad de Ciencias Económicas y Empresariales.

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