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Conglomeration with bankruptcy costs: Separate or joint financing?

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Abstract

The paper analyzes the determinants of the optimal scope of incorporation in the presence of bankruptcy costs. Bankruptcy costs alone generate a non-trivial tradeoff between the benefit of coinsurance and the cost of risk contamination associated to joint financing corporate projects through debt. This tradeoff is characterized for projects with binary returns, depending on the distributional characteristics of returns (mean, variability, skewness, heterogeneity, correlation, and number of projects), the bankruptcy recovery rate, and the tax rate advantage of debt relative to equity. Our testable predictions are broadly consistent with existing empirical evidence on conglomerate mergers, spin-offs, project finance, and securitization.

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Bibliographic Info

Paper provided by Department of Economics and Business, Universitat Pompeu Fabra in its series Economics Working Papers with number 1191.

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Date of creation: Feb 2009
Date of revision: Jul 2010
Handle: RePEc:upf:upfgen:1191

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Web page: http://www.econ.upf.edu/

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Keywords: Bankruptcy; conglomeration; mergers; spin-offs; project finance;

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  1. Roman Inderst & Holger M. Müller, 2003. "Internal versus External Financing: An Optimal Contracting Approach," Journal of Finance, American Finance Association, vol. 58(3), pages 1033-1062, 06.
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  5. Gary B. Gorton & Nicholas S. Souleles, 2007. "Special Purpose Vehicles and Securitization," NBER Chapters, in: The Risks of Financial Institutions, pages 549-602 National Bureau of Economic Research, Inc.
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  8. Sherrill Shaffer, 1989. "Pooling intensifies joint failure risk," Working Papers 89-1, Federal Reserve Bank of Philadelphia.
  9. Altman, Edward I, 1984. " A Further Empirical Investigation of the Bankruptcy Cost Question," Journal of Finance, American Finance Association, vol. 39(4), pages 1067-89, September.
  10. Alderson, Michael J. & Betker, Brian L., 1995. "Liquidation costs and capital structure," Journal of Financial Economics, Elsevier, vol. 39(1), pages 45-69, September.
  11. Scott, James H, Jr, 1977. "On the Theory of Conglomerate Mergers," Journal of Finance, American Finance Association, vol. 32(4), pages 1235-50, September.
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  14. Warner, Jerold B, 1977. "Bankruptcy Costs: Some Evidence," Journal of Finance, American Finance Association, vol. 32(2), pages 337-47, May.
  15. Gale, Douglas & Hellwig, Martin, 1985. "Incentive-Compatible Debt Contracts: The One-Period Problem," Review of Economic Studies, Wiley Blackwell, vol. 52(4), pages 647-63, October.
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