Banking

Conglomeration With Bankruptcy Costs: Separate Or Joint Financing?

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Executive Summary

The paper analyzes the determinants of the optimal scope of incorporation in the presence of bankruptcy costs. Bankruptcy costs alone generate a non-trivial tradeoff between the benefit of coinsurance and the cost of risk contamination associated to joint financing corporate projects through debt. This tradeoff is characterized for projects with binary returns, depending on the distributional characteristics of returns (mean, variability, skewness, heterogeneity, correlation, and number of projects), the bankruptcy recovery rate, and the tax rate advantage of debt relative to equity. The testable predictions are broadly consistent with existing empirical evidence on conglomerate mergers, spin-offs, project finance, and securitization.

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