OPTIMALITY OF SPIN-OFFS AND ALLOCATION OF DEBT

Recent empirical studies have indicated that spin-offs are value enhan cing, yet the theoretical aspects of spin-off gains have not been as w ell explored. This paper presents a theoretical analysis of spin-offs. In the model of the firm presented, outstanding risky debt gives rise to agency costs of underinvestment, which are offset by the benefit o f debt-related tax shields. The trade-off specifies the optimal levera ge for a firm. Within this framework, the paper considers whether and under what circumstances firm value could be enhanced by a spin-off. I t is shown that a spin-off in which parent company debt is optimally a llocated between the post-spin-off firms increases value by reducing a gency costs and increasing the value of tax shields when the component firm cash flows are positively correlated. The optimal allocation is characterized in terms of the parameters of the technologies of the co mponent firms. When the component cash flows are negatively correlated , under the sufficient conditions developed, a combined firm operation dominates spin-offs. Here, the coinsurance effect on investment incen tives dominates the effect of a flexible allocation of debt across tec hnologies in a spin-off.