FINANCING MULTIPLE INVESTMENT PROJECTS

Although the finance literature has rigorously analyzed many dimension s of the ''capital structure'' question, little has been written about the optimal means of issuing multiproduct firms' securities. We show in this paper that a multiproduct firm can importantly influence its t otal market value by choosing the most appropriate arrangement for its stock and debt issues. Consider a firm which wishes to invest in two risky projects, whose initial owners must issue external debt and/or e quity to implement these projects. We determine whether multiple proje cts should be operated within a single firm, or in separate legal subs idiaries of a holding company. Leverage has two conflicting effects on a firm's market value: while the corporate tax advantage of debt rais es firm value, outstanding debt simultaneously lowers (firm) value by distorting equityholders' investment incentives. These investment dist ortions can take two forms. First, equityholders in a levered firm wit h risky debt outstanding will fail to implement certain types of profi table investment opportunities, because part of the investment's benef it accrues to the bondholders. This is called the ''underinvestment pr oblem.'' Second, when the firm's projects have (widely) disparate risk s, leverage will induce equityholders to undertake more of the riskier project, even when the safer project promises a higher expected retur n. This results in a reduction in firm value and is called the ''asset substitution problem.'' We model an entrepreneur with access to two s eparable investment opportunities. He can either incorporate each proj ect separately, or merge the two projects into a single firm. Our anal ysis suggests that: (i) Joint incorporation (JI) minimizes equityholde rs' underinvestment incentives because the diversified firm's cash flo ws make the outstanding debt relatively safe. At the same time, howeve r, JI generally creates an asset substitution problem which lowers agg regate firm market value. (ii) Separate incorporation (SI) serves to a ssure bondholders that their funds will not be used to overinvest in t he riskier project, but generates greater underinvestment costs becaus e each firm's debt is generally more risky than a combination of the t wo cash flows would have been. We present a relatively complex analyti cal model of this corporate design problem, with accompanying numerica l solutions. Our computations indicate that a firm's organizational fo rm can importantly influence the deadweight costs of external financin g, by affecting the levered firms' tradeoff between underinvestment an d asset substitution distortions. Holding other things the same, JI is more valuable when project returns are less positively correlated and when the projects' risks are more similar to one another. By contrast , SI provides the value-maximizing means of organizing projects and se lling claims on their earnings when project risks are very different a nd/or their return correlations are very high. Our analysis has severa l implications for corporate planning and firm organization. First, it expands the number of known reasons why financing choices can affect firm value. When investors suffer from limited information, they will seek debt arrangements which limit equityholders' subsequent self-inte rested behavior. Although this insight is widely recognized, we specif ically evaluate how it applies to the optimal structure of corporate b orrowing within a multiproject holding company. While the majority of holding companies issue their debt exclusively at the parent level, ex ceptions do occur. For example, our analysis suggests that combining m anufacturing and financing activities in the same corporate shell crea tes significant asset substitution problems. These arise when bondhold ers fear that funds generated from relatively safe, financing activiti es will be diverted to manufacturing projects. These concerns may be m itigated through the establishment of a separate financing subsidiary. Second, our analysis provides some guidance about the type of firms ( projects) which can be profitably merged or spun-off. Conglomerate mer gers generally do not generate large synergies or cost savings since t hey combine diverse activities within a single firm. Nevertheless, com bining two firms' relatively uncorrelated cash flows provides real ben efits: the merged entity enjoys superior investment incentives because its outstanding debt is less risky. According to our model, however c onglomerate mergers will encounter a sort of natural limit because the firm's asset substitution opportunities increase with the number arid disparity of investments being undertaken. Consequently, conglomerate mergers are most likely to succeed when die combined activities have similar risk levels. A related insight applies to the dynamic nature o f a conglomerate firm's optimal organization: if one project's risk ri ses over time, the firm may optimally choose to spin it off into a sep arately financed subsidiary. The converse applies if the two projects' risks converge over time. The paper's analysis could be generalized i n a number of ways, but its essential point would remain: that a firm' s organizational form can importantly influence its cost of capital.