Intercorporate Guarantees, Leverage and Taxes
25 Pages Posted: 16 Mar 2012
Date Written: February 29, 2012
Abstract
This paper characterizes optimal intercorporate guarantees, under the classical trade-off between bankruptcy costs and taxation. Conditional guarantees, allowing the provider to maintain limited liability vis-à-vis the beneficiary, maximize joint value. They indeed achieve the highest tax savings net of default costs. We provide conditions ensuring that - at the optimum - guarantees increase total debt, which bears mostly on the beneficiary. This difference in optimal leverage between the provider and the beneficiary explains why optimal conditional guarantees (i) generate value independently of cash flow correlation (ii) are unilateral rather than mutual, at least for moderate default costs (iii) dominate the unconditional ones, that are embedded in mergers, at least when firms have high cash-flow correlation. We also endogenize the choice of the guarantor, showing that it has higher proportional bankruptcy costs and lower tax rates.
Keywords: debt, taxes, bankruptcy costs, limited liability, capital structure, subsidiary, groups, mergers
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