Subsidiary Debt, Capital Structure, and Internal Capital Markets

49 Pages Posted: 19 May 2006 Last revised: 3 Mar 2010

See all articles by Adam C. Kolasinski

Adam C. Kolasinski

Texas A&M University - Department of Finance

Date Written: January 6, 2009

Abstract

A significant portion of public debt is issued by operating subsidiaries of diversified firms. Drawing on models of optimal incorporation, capital structure, and internal capital markets, I propose and test various rationales for firms to use external subsidiary debt financing. First, I find that firms are more likely to have subsidiary debt in their capital structure when their divisions vary more in operating risk. This result supports Kahn and Winton's (2006) model, in which firms use subsidiary debt to mitigate asset substitution problems. Second, I find some evidence that divisions with few growth options relative to the rest of the firm but high cash flow are more likely to have nonguaranteed subsidiary debt outstanding, implying firms use such debt to control the free cash flow problem in a manner that minimizes the underinvestment problem. Finally, I find that divisions of diversified firms are more likely to have parent-guaranteed subsidiary debt in their capital structure when their growth opportunities are better than the rest of the firm. Furthermore, having guaranteed subsidiary debt in a division's capital structure significantly reduces the effect of the division's cash flow on investment elsewhere within the firm. Together, these last two results suggest that external subsidiary debt helps protect growth divisions from the poaching problems modeled in theories of internal capital markets.

Keywords: Internal Capital Markets, Corporate Organizational Structure, Corporate Finance, Subsidiary Financing, Capital Structure

JEL Classification: G31, G32, L22, L25

Suggested Citation

Kolasinski, Adam C., Subsidiary Debt, Capital Structure, and Internal Capital Markets (January 6, 2009). Journal of Financial Economics (JFE), Vol. 94, pp. 327-343 , Available at SSRN: https://ssrn.com/abstract=903413

Adam C. Kolasinski (Contact Author)

Texas A&M University - Department of Finance ( email )

360 Wehner
College Station, TX 77843-4218
United States

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