Financing multiple investment projects - Corporate Investments Special Issue

Financial Management (Financial Management Association), Summer, 1993 by Mark J. Flannery, Joel F. Houston, Subramanyam Venkataraman

This paper investigates how a multiproject firm's choice of organization structure affects its value. We develop a framework in which agency and corporate tax considerations simultaneously influence investment incentives, then evaluate how an entrepreneur would optimally organize the operation of two positive-NPV, risky investment projects which share no scope economies. In order to finance these projects at their optimal levels, the entrepreneur must sell "outside" debt or equity claims. The entrepreneur must also choose between two alternative forms of corporate organization: separate incorporation(1) or the joint incorporation of both projects within a single firm. Under separate incorporation (SI), each project is operated by a distinct firm, whose shareholders and bondholders have claims only on one project's cash flows. In addition, each firm pays corporate taxes according to the returns on its own investment project. By contrast, when both projects are jointly incorporated (JI) into a single firm, security holders receive payoffs from the sum of the projects' cash flows, and corporate taxes are based on the sum of the projects' profits.

In choosing the type of outside claim to issue, debt has obvious tax advantages because its interest payments are made from pre-tax corporate earnings. However, when the entrepreneur's investment decisions are not contractible, debt also imposes agency costs in the form of underinvestment (Myers |21~) and/or asset substitution (Jensen and Meckling |14~, Galai and Masulis |6~, Green |9~) incentives. In efficient security markets, outside claimants will rationally price these deadweight costs, which therefore fall entirely on the firm's organizers. A prominent view of corporate capital structure is that the firm balances the agency costs of debt against its tax advantages.

This paper's principal intended contribution is to demonstrate that the agency costs of debt financing are also importantly influenced by the firm's method of incorporation. Consequently, the firm must simultaneously select a capital structure and organizational form on the basis of agency cost and tax considerations. By combining the projects into a single entity, the firm reaps coinsurance benefits: less risky cash flows mitigate the underinvestment problem. At the same time, joint incorporation creates an asset substitution problem which does not exist when projects are incorporated separately. The potential asset substitution tends to make the debt riskier and exacerbate the underinvestment problem, ceteris paribus. Another benefit of separate project incorporation is that, when project risks differ, each firm can adjust its leverage to trade off the underinvestment costs of debt against its tax benefits more precisely than when both projects are merged into a single firm.(2) Finally, Green and Talmor |10~, |11~ demonstrate that the asymmetric nature of corporate taxes also influences a firm's investment choice. Because corporate tax payments are analogous to a call option on the firm's earnings, firm owners will sometimes choose less risky investments than they would under symmetric taxation.

Our model simultaneously considers these tax effects with the effect of organizational form on the agency costs of debt, in order to determine the optimal corporate form and the optimal capital structure for a given set of investment projects. For a given set of tax and production parameters, we evaluate the maximum attainable value of equity under separate incorporation, and then compare it to the maximum attainable value under joint operation of the two projects. Our computations take full account of underinvestment, asset substitution, and taxes, and primarily investigate the impact of variations in the two projects' relative variances and the correlation between their returns.

Our analysis has several straightforward applications concerning the corporate organization of multifaceted firms. First, our results suggest how a diversified holding company should structure its public debt. For example, our model explains why manufacturers' financing subsidiaries frequently issue their own debt, rather than having the parent obtain the required financing. Second, we can evaluate the effects of mergers on the agency costs of risky debt in order to determine the types of projects that are best combined and those that are best financed separately. This enables us to interpret not only the factors influencing a firm's initial choice of organizational structure, but why a firm may choose to change its organizational structure over time through mergers or spin-offs. In other words, our analysis carries implications about the financial "life cycle" of a conglomerate firm.

The paper proceeds as follows. Section I reviews the existing literature on the financial aspects of corporate organization. Section II describes our model of the optimal means of financing risky investment opportunities under separate versus joint incorporation of two separable projects. Because of the maximization problem's complexity, we employ numerical techniques to solve it. Section III reports our numerical results, which illustrate the factors that make merged operation more valuable than separate incorporation (or vice versa). The final section summarizes and briefly discusses the implications of our analysis for financial corporate structure.