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Optimality of Spin-Offs and Allocation of Debt

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  • John, Teresa A.

Abstract

Recent empirical studies have indicated that spin-offs are value enhancing, yet the theoretical aspects of spin-off gains have not been as well explored. This paper presents a theoretical analysis of spin-offs. In the model of the firm presented, outstanding risky debt gives rise to agency costs of underinvestment, which are offset by the benefit of debt-related tax shields. The trade-off specifies the optimal leverage for a firm. Within this framework, the paper considers whether and under what circumstances firm value could be enhanced by a spin-off. It is shown that a spin-off in which parent company debt is optimally allocated between the post-spin-off firms increases value by reducing agency costs and increasing the value of tax shields when the component firm cash flows are positively correlated. The optimal allocation is characterized in terms of the parameters of the technologies of the component firms. When the component cash flows are negatively correlated, under the sufficient conditions developed, a combined firm operation dominates spin-offs. Here, the coinsurance effect on investment incentives dominates the effect of a flexible allocation of debt across technologies in a spin-off.

Suggested Citation

  • John, Teresa A., 1993. "Optimality of Spin-Offs and Allocation of Debt," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 28(01), pages 139-160, March.
    • Handle: RePEc:cup:jfinqa:v:28:y:1993:i:01:p:139-160_00
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    Cited by:

    1. Habib, Michel A. & Johnsen, D. Bruce & Naik, Narayan Y., 1997. "Spinoffs and Information," Journal of Financial Intermediation, Elsevier, vol. 6(2), pages 153-176, April.
    2. McNeil, Chris R. & Moore, William T., 2005. "Dismantling internal capital markets via spinoff: effects on capital allocation efficiency and firm valuation," Journal of Corporate Finance, Elsevier, vol. 11(1-2), pages 253-275, March.
    3. Kolasinski, Adam C., 2009. "Subsidiary debt, capital structure and internal capital markets," Journal of Financial Economics, Elsevier, vol. 94(2), pages 327-343, November.
    4. Chemmanur, Thomas J. & Yan, An, 2004. "A theory of corporate spin-offs," Journal of Financial Economics, Elsevier, vol. 72(2), pages 259-290, May.
    5. Sentis, Patrick, 2001. "Sous-investissement et suppression d’effectifs : vers une réduction des coûts d’agence," L'Actualité Economique, Société Canadienne de Science Economique, vol. 77(1), pages 5-26, mars.
    6. Johnson, Shane A & Klein, Daniel P & Thibodeaux, Verne L, 1996. "The Effects of Spin-Offs on Corporate Investment and Performance," Journal of Financial Research, Southern Finance Association;Southwestern Finance Association, vol. 19(2), pages 293-307, Summer.
    7. Luc Renneboog & Peter G. Szilagyi, 2008. "Corporate Restructuring and Bondholder Wealth," European Financial Management, European Financial Management Association, vol. 14(4), pages 792-819.
    8. Debarshi Nandy & Thomas Chemmanur, 2005. "How is Value Created in Spin-Offs? A Look Inside the Black Box," Working Papers 05-09, Center for Economic Studies, U.S. Census Bureau.
    9. Haynes, Michelle & Thompson, Steve & Wright, Mike, 2003. "The determinants of corporate divestment: evidence from a panel of UK firms," Journal of Economic Behavior & Organization, Elsevier, vol. 52(1), pages 147-166, September.
    10. Kobayashi, Mami & Osano, Hiroshi, 2012. "Nonrecourse financing and securitization," Journal of Financial Intermediation, Elsevier, vol. 21(4), pages 659-693.
    11. Altieri, Michela & Manconi, Alberto & Massa, Massimo, 2017. "Corporate Bond Guarantees and The Value of Financial Flexibility," CEPR Discussion Papers 11992, C.E.P.R. Discussion Papers.
    12. Pereira da Silva, Paulo & Vieira, Isabel & Vieira, Carlos, 2015. "M&A operations: Further evidence of informed trading in the CDS market," Journal of Multinational Financial Management, Elsevier, vol. 32, pages 116-130.
    13. Szilagyi, P.G., 2007. "Corporate governance and the agency costs of debt and outside equity," Other publications TiSEM 9520d40a-224f-43a8-9bf9-b, Tilburg University, School of Economics and Management.
    14. Dmitri Boreiko & Maurizio Murgia, 2013. "European spin-offs Origin, value creation, and long-term performance," BEMPS - Bozen Economics & Management Paper Series BEMPS05, Faculty of Economics and Management at the Free University of Bozen.

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