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Ownership Links, Leverage and Credit Risk

by Elisa Luciano of the UniversitÓ di Torino, and
Giovanna Nicodano of the UniversitÓ di Torino

November 2007

Abstract: This paper explores the relationship between optimal leverage and 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. 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.

JEL Classification: G32, G33, G34.

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

Previously titled: "Credit Risk and Parent-subsidiary Links"

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