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Ownership links, leverage and credit risk

Author

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  • Elisa Luciano
  • Giovanna Nicodano

Abstract

This 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.

Suggested Citation

  • Elisa Luciano & Giovanna Nicodano, 2008. "Ownership links, leverage and credit risk," Carlo Alberto Notebooks 69, Collegio Carlo Alberto, revised 2008.
  • Handle: RePEc:cca:wpaper:69
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    File URL: http://www.carloalberto.org/assets/working-papers/no.69.pdf
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    More about this item

    Keywords

    credit risk; default risk; structural models; optimal leverage; zero leverage; ownership structure; parent-subsidiary;

    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

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