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Subsidiary Financing: Risk-Shifting as a Commitment Device

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  • Lóránth, Gyöngyi
  • Morrison, Alan
  • Zeng, Jing

Abstract

We study how firms can design their organizational structures to overcome dynamic commitment problems when entering new markets or technologies. A manager exerts costly effort to first develop and subsequently manage an investment opportunity. Ex post, the firm underinvests in projects that generate high management rents. However, the prospect of those rents helps offset the manager’s initial project development cost, making ex ante commitment to invest optimal. Levered subsidiaries mitigate this time-consistency problem by introducing risk-shifting incentives that counteract underinvestment. Subsidiaries are most valuable for projects that are costly to develop, have moderate management costs, and yield returns uncorrelated with existing business.

Suggested Citation

  • Lóránth, Gyöngyi & Morrison, Alan & Zeng, Jing, 2025. "Subsidiary Financing: Risk-Shifting as a Commitment Device," CEPR Discussion Papers 20963, Centre for Economic Policy Research.
    • Handle: RePEc:cpr:ceprdp:20963
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    JEL classification:

    • G32 - Financial Economics - - Corporate Finance and Governance - - - Financing Policy; Financial Risk and Risk Management; Capital and Ownership Structure; Value of Firms; Goodwill
    • G34 - Financial Economics - - Corporate Finance and Governance - - - Mergers; Acquisitions; Restructuring; Corporate Governance
    • L22 - Industrial Organization - - Firm Objectives, Organization, and Behavior - - - Firm Organization and Market Structure

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