Intercorporate guarantees, leverage and taxes

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.