Ownership Links, Leverage and Credit Risk

41 Pages Posted: 25 Mar 2008

See all articles by Elisa Luciano

Elisa Luciano

University of Turin - Department of Statistics and Applied Mathematics

Giovanna Nicodano

University of Turin - Department ESOMAS; Collegio Carlo Alberto; CEPR; EGCI; Netspar

Date Written: March 18, 2008

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.

Keywords: credit risk, default risk, structural models, optimal leverage, zero leverage, ownership structure, parent-subsidiary

JEL Classification: G32, G33, G34

Suggested Citation

Luciano, Elisa and Nicodano, Giovanna, Ownership Links, Leverage and Credit Risk (March 18, 2008). Available at SSRN: https://ssrn.com/abstract=1107806 or http://dx.doi.org/10.2139/ssrn.1107806

Elisa Luciano (Contact Author)

University of Turin - Department of Statistics and Applied Mathematics ( email )

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Turin, I-10122
Italy
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Giovanna Nicodano

University of Turin - Department ESOMAS ( email )

Turin, 10134
Italy

HOME PAGE: http://https://www.carloalberto.org/person/giovanna-nicodano/

Collegio Carlo Alberto ( email )

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HOME PAGE: http://https://www.carloalberto.org/person/giovanna-nicodano

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United Kingdom

EGCI ( email )

c/o the Royal Academies of Belgium
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Netspar ( email )

P.O. Box 90153
Tilburg, 5000 LE
Netherlands

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