Debt Choice Determines Capital Structure in Divested Subsidiaries
When a firm spins off a subsidiary to create a stand-alone entity, it must decide how much debt to allocate to the newly formed company. This strategic decision determines the divested subsidiary's initial capital structure. The parent's choice of leverage is particularly crucial at the time of divestiture because offloading too much debt onto the new company could reduce its growth prospects or even threaten its survival.
In a study of 129 corporate spin-offs announced between 1983 and 1995, Amy Dittmar, an assistant professor at the University of Michigan Business School, reports that size, growth and collateral value are key factors that affect the parent company's decision about debt choice. This evidence indicates that firms consider the costs and benefits of leverage for the subsidiary when determining how to allocate debt.
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The subsidiary's debt level originates from debt re-assigned from the parent and debt issued for the purpose of up-streaming funds to the parent. Thus, it is possible that the parent could consider only what is best for the retained firm, but this does not appear to be the case in most spin-offs.
Dittmar's results, which appeared in the January 2004 issue of the Journal of Business, show that the leverage ratio (average debt to value) of the subsidiaries is significantly lower than that of their pre- and post-spin-off parent companies. Both the subsidiaries' and the parents' leverage ratios are higher than those in their industry, but the subsidiaries' industry-adjusted leverage ratio is still significantly lower than the parents' industry-adjusted ratio. Thus, she concludes, firms choose lower leverage ratios for their subsidiaries.
Dittmar also examines the firm characteristics that influence leverage choices. She finds that high-growth firms choose lower leverage ratios and firms with high collateral value choose higher leverage ratios. Profitability does not influence the choice of debt, because at the time the initial leverage ratio is established, there is no operating history that over time can create distortions.
"Subsidiaries have lower leverage ratios if they are small and have high growth opportunities, as measured by research and development expense to sales, because too much debt would be a burden for these firms." Dittmar says. "However, when subsidiaries are large and have high collateral value, as measured by the ratio of inventory and PP&E to assets, they have higher leverage ratios."
In both groups, the subsidiaries are significantly smaller and have lower profits than the parent companies. Furthermore, the lower-leverage subsidiaries are smaller relative to the higher-leverage subsidiaries. Other factors such as tax rates and volatility do not influence the leverage choice. However, subsidiaries have higher leverage ratios if the pre-spin-off parent firm has more debt to allocate, indicating the leverage choice is not totally free of constraints.
"This study reveals that companies do make systematic leverage choices and allocate debt based on firm characteristics," Dittmar says. "The results also suggest there is a trade-off in which firms weigh the costs and benefits of debt when they make capital-structure decisions."