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American Finance Association

Debt Financing, Corporate Financial Intermediaries and Firm ValuationAuthor(s): J. R. Franks and J. J. PringleReviewed work(s):Source: The Journal of Finance, Vol. 37, No. 3 (Jun., 1982), pp. 751-761

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THE JOURNAL OF FINANCE * VOL. XXXVII, NO. 1 * JUNE 1982

Debt Financing, Corporate FinancialIntermediaries and Firm Valuation

J. R. FRANKS and J. J. PRINGLE*

ABSTRACTIn this paperwe considerthe role of financial ntermediaries n the valuation of firmsand projects.We show that security prices should reflect both used and unused debtcapacity f somecorporations an act as financial ntermediaries nd cancapture he taxbenefits of debt capacity unused by the operating irm. We also providesome reasonswhy the value of the firmmightbe increased f the financingandoperatingrisks of thefirmare separatedand financial ntermediariesssue debt ratherthan the unit operatingthe asset.

IN THIS PAPER WE consider the role of financial intermediaries in the valuation offirms and projects. We show, using familiar arbitrage arguments [13], that securityprices, and therefore shareholders' returns, should reflect both used and unuseddebt capacity if other corporations can act as financial intermediaries and cancapture the tax benefits of debt capacity unused by the operating company. Theargument has two important implications. First, the project valuation exerciseshould include any incremental tax benefits (to the extent that tax benefits doexist) arising from the debt capacity contributed by a project, irrespective ofwhether that debt capacity is taken up by the firm operating the project or bysome other firm which, acting as an intermediary, holds the shares of theoperating firm and borrows. We also provide some reasons why the value of thefirm might be increased if the financing and operating risks of the firm areseparated and financial intermediaries issue debt rather than the unit operatingthe asset. The second implication of our argument is that all the shares ofcompanies that are underlevered should be held by corporate taxpaying inter-mediaries rather than by individuals or (partially) tax-exempt funds. To theextent that this takes place, security prices will reflect (most of) the tax advantagesof debt capacity even when unexploited by the operating firm. The question ofwhy these outcomes are not widely observed in practice is explored in the finalsection.

I. The Value of Unused Debt CapacityMyers [9] properly defined debt attributable to a prospective project as theproject's contribution to the firm's debt capacity, with debt capacity defined as

*LondonBusiness School andUniversityof North Carolina t ChapelHill,respectively.We wouldlike to thank R. Hamada,S. Myers, and Yoram Landskroneror their suggestions.We are alsogratefulto the members of the UNC and LBS financeworkshops or helpfulcomments, especiallythose of R. Harris,R. Brealey,I. Cooper,C.Baden-Fuller, nd S. Hodges.751

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752 The Journal of Financethe shareholders' debt optimum. He assumed implicitly that the firm operated atthe optimal debt level where the tax benefits to shareholders from debt financingat the margin were zero, although all supramarginal debt earned the full taxshields. After undertaking each new project, the firm readjusted to the newoptimum by issuing debt in the appropriate amount. Similarly, as the project(with a finite life) was exploited through time, the reduction in the present valueof future cash flows was matched by a reduction in debt capacity and theretirement of an equivalent amount of debt. He did not, however, consider thecase of firms that do not operate at their optimal debt ratio.In this section we consider firms that are in a position to use the interest taxshield but choose to operate below their optimal debt ratios. If the project's after-tax operating cash flows and the debt issued are perpetuities, the value of aproject simplifies to the familiar Modigliani and Miller [8] equation

Vo= Al+ TcL*Ao (1)where Ao is the present value of the unlevered project, L * is the optimumproportion of Ao that can be financed by debt, andTc is the corporate tax rate.When a firm undertakes new investments potential new tax shields are created.There are three ways in which these potential tax shields can be exploited:(1) by the operating firm i issuing debt up to the new optimum;(2) by another firm acquiring firm i and issuing debt on the unlevered assets.The stock price of the firm i should, as a consequence, reflect the probabilityof acquisition and the utilization of the debt capacity (see [2]); and(3) by taxpaying corporations acting as intermediaries and buying part of theshares of the underlevered operating firm i and borrowing until the stockprice of the operating firm reflects all the tax benefits of optimal leverage.Under scenario (1) the mechanism by which tax shields are reflected in marketvalues is straightforward [Vo = Ao + TcL*Ao]. Under scenario (2) the adjustedpresent value (APV) of a perpetual project will be'

00 T(L*-L)Ao] 2o =Ao + TcLAo Dt=1 it[ ( + r)t ](2)whereL = actual debt ratio of the project (L*-L);

Ilt = probabilityof takeoverin periodt (t = 1, 2, ** ,oo); andr = discount rate reflecting the risk of the tax shields of debt.It is assumed that the acquirer uses the spare debt capacity (and obtains the taxshields) instantaneously with acquisition. Thus today's security prices, and con-sequently the value of a project, should reflect in part the tax benefits of unuseddebt capacity, contingent on the probability of acquisition.

It is important to distinguish between an acquisition of all the shares of anunderlevered firm by a single corporation (scenario 2 above), which is usuallydescribed as a merger or takeover, and the purchase of those shares by a large' If the project s not perpetual hen the second andthird termson the righthand ideof Equation(2) aremore complex.One mustuse the adjustedpresentvalueformulasdescribedby Myers [9].


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DebtFinancing and Valuation 753number of corporationsacting as intermediaries(scenario3). First, in scenario(2), trading of the shares of the operatingfirm ceases, making for less liquidmarkets,whereastradingcontinuesin scenario(3). Laterwe shall investigate theimplicationsof tradeability.Second, a single firm's acquisitionof 100 percent ofthe sharesof the operating irmnormallywouldrequirea substantialbid premiumand involve legal expenses; the latter might be substantial if the operatingmanagementwere to resist.A. The Effect of Financial Intermediaries

We show belowthat, under certainconditions, t is unnecessary or a companyto acquirecontrol over the real assets of the underlevered irm in order to takeadvantageof its unused debt capacity (as in scenario 2). All that is necessary(scenario3 above) is for sufficient corporatetaxpayingintermediaries,actingonbehalfof the shareholdersof the unleveredfirm or new shareholders, o purchaseall the shares of the unleveredor inadequatelylevered form and to borrow onthose shares.2Interestpayments on the borrowingare netted with the interme-diary's income in order to obtain the corporatetax shields. Thus, in this case(scenario2) the value of the projectto the unlevered operatingcompanyshouldinclude the total value of the tax benefits to debt contributedby the projectirrespectiveof whetherthat debt capacity is actually used by the operatingfirm;Equation (2) thus simplifiesto Equation (1).Stiglitz[13]shows in his Theorem2 that if freeentryof financial ntermediariescanbe established costlessly,then this will ensure that a set of financialsecuritieswill be offered which maximizes the value of the firmregardlessof the debt-to-equity ratio of the operating firm. Although Stiglitz did not introduce a taxadvantageto corporateborrowing, similar arbitrageargumentcanbe appliedtothis case. In the subsequent analysiswe shall examinethe way in which such apost-tax arbitrageprocesscould function underthe U.K. and U.S. corporatetaxsystems.B. U.K. Tax System

Let us comparethe cash flows received by shareholderswhen the operatingfirmborrows,with the cash flows receivedwhen a corporatetaxpayinginterme-diary does the borrowingin lieu of the operating firm. In the U.K. such anintermediarycan be anotheroperatingfirm.Assumethat a previouslyunleveredoperating irmi borrowsan amountD thatis some fractionq of its optimal debt level D*, with q < 1.0.So D = qD*. ThenN intermediaries(n = 1, 2, ** *, N) purchaseall the shares in i and issue debttotalling (1 - q)D*. Each intermediary, or example , owns some proportionaof the stock of i, and borrowsan amount a)(1 - q)D*. Shares continue to betraded, but tradingtakes place entirely among intermediaries.Now total debtissued against i's operatingincome by firmj and N intermediariescombinedisqD* + (1 - q)D* = D*, the optimalamount (since>71a, = 1).' There is an assumptionhere that taxpayingintermediariescannot reduce taxes by furtherborrowing ecauseagencycosts, expecteddefaultcosts,andother costs of financialdistress imitdebtcapacity.


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754 The Journal of FinanceA number of conditions must be maintained for such an arbitrage process totake place. First, we have assumed that N intermediaries purchase all the sharesof the underlevered firm. Thus, we have implied a clientele effect whereby onlyintermediaries paying corporate taxes will hold the shares of underlevered com-

panies. To see this, consider the situation where XN a n< 1 (the remainder isheld by private investors). Assuming that the debt capacity of the financial claimis equal to the debt capacity of the real assets, only the proportion XN an (1-q)D* could be raised on the stock, which must be less than the unused debtcapacity (1 - q)D*.In the arbitrage process, we have assumed that the intermediary j has pur-chased a proportion a' of i's stock and issued debt of aCY(1 - q)D*, on whichinterest of a (1 - q)rD * is paid. Two conditions will enable firm j to capture thetax shields previously foregone by i: (1) if firm j is paying corporate taxes onother income Y and Y -? a(1 - q)rD*; (2) if dividends and capital gains fromfirm i to an intermediary j are not taxable to j. In the U.K. dividends received bycorporations are not taxed, but realized capital gains are subject to a 30 percenttax.In order for the equilibrium to be reached, there must be sufficient corporateintermediaries with adequate taxpaying capacity to absorb the interest tax shieldsarising from the unused debt capacity of companies; otherwise security priceswill not reflect all the tax benefits of the optimal debt capacity and the interme-diaries will obtain economic rents from the transaction. It is useful to note thatthe intermediary role of taxpaying corporations is very much analogous to therole they play in financial leasing transactions when user companies are inpermanent or temorary nontaxpaying positions and therefore are unable to obtainthe tax benefits available on capital investment. Here, taxpaying companies(acting as lessors) purchase assets and obtain the tax shields from depreciationand the investment tax credit, which are partially or wholly passed back to theuser firm operating the asset via lower lease payments. The exact proportion ofthe tax benefits obtained by the intermediary depends upon the balance betweenthe supply of taxable capacity available to the leasing industry and the demandfor it by temporary or permanently nontaxpaying entities.C. United States Tax System

An important difference (for this analysis) between the U.K. tax laws and thoseof the U.S. involves treatment of earnings and dividends of subsidiary firms.Under current U.S. law, if firmj owns 80 percent or more of i's stock, the twofirms must combine their incomes and pay taxes as a single entity. They may, attheir option, file a consolidated return, although this has no effect on the amountof the tax. If j owns less than 80 percent, the two firms are taxed as separateentities. With less than 80 percent ownership, if i pays dividends to j, somefraction (currently 15 percent) is taxed as income to j, with the other 85 percentexcluded from the tax computation.Let tijrepresent the fraction of i's dividend that is taxable to j (currently 15percent, as noted above). If tijwere zero, the situation would be identical to that


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Debt Financing and Valuation 755of the UK. Corporations, acting as intermediaries, could recapture all the taxbenefits of debt capacity unused by i, providing all earnings were distributed.Where tij> 0 the situation is different. Suppose, as before, i has issued debt Dequal to some fraction q of its optimal debt ratio D *, with q < 1.0. So D = qD*.Thus i is foregoing annual tax savings of (1 - q)rD *T. Firm j buys a proportionof a( of i's stock and issues debt of a (1 - q)D *, thereby reducing its annual taxliability by a5(1 - q)rD*T and recapturing a proportion of the subsidy foregoneby i. Offsetting this saving is additional tax paid by j on the dividends of i and thetaxes on realized capital gains.3 If securities are sold by corporations within oneyear of purchase, only 15 percent of the gain is taxed. Under these conditionscapital gains and dividends would be taxed at the same rate, T,, in the hands ofthe corporate intermediary, and the annual tax savings T would be

T = a(1 - q)rD*c- aXi(1 -Tc)tiTc (3)where X(1- Tc) is the amount of after-tax earnings. If

(1 - q)rD* > tijXi( -Tc) (4)then T > 0. From Equation [3] it is apparent that having N intermediaries do theborrowing instead of i, results in a net tax penalty of Xi (1l- Tc ))tijTc, reducingearnings to shareholders by that amount.In the U.S., from a tax point of view it is best for firm i to do the borrowingdirectly. However, if i does not fully utilize its debt capacity, a large fraction ofthe tax benefit attributable to the unused debt capacity can be recaptured byintermediaries.4 The double taxation of the dividends of i might be reduced bylimiting i's dividend payout and deferring the realization of the capital gain for asufficient period of time.The arbitrage arguments presented above for the U.K. and U.S. require somefurther comment and qualification. The opportunity for such arbitrage to takeplace is sufficient to cause stock prices to reflect the tax benefits of unused debtcapacity provided the market expects the debt to be actually issued. The valueplaced on that expectation will depend on the probability that the marketattaches to the eventual issuance of the debt. The intermediary must havesufficient other taxable income to provide the tax shelter for the interest chargeson the debt issued. Finally, the intermediary can finance the purchase of thesecurities in one of two ways: either from a combination of the tax shields createdby the arbitrage process and the dividends received from the operating company,or from funds received by the intermediary from the existing shareholders of theunlevered company. In the second case the shareholders of i are in effect sellingtheir shares and leverage positions to the corporate intermediary in exchange forthe latter's shares.

3Given this double taxation of dividends and capital gains on quoted securities held by acorporation, there is a negative net present value to such holdings. Clearly, there must be advantageswhich explain these holdings and offset the extra taxes. However, these remain obscure like thosewhich explain why firms pay out dividends and incur greater taxes for some of their shareholders.

4 The double taxation of dividends and capital gains would provide a small incentive to acquire thefirm outright; however, the required bid premium and other transaction costs would almost certainlyexceed the taxes saved.


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756 The Journal of FinanceIf intermediariesare able to operatein the mannerwe have described,most ofthe tax advantagesof debt should be reflected in security prices regardlessofwhether the debt capacity is fully utilizedby the operatingfirm.5Furthermore,we have also suggestedthat the projectvaluationexerciseshouldalso includethe

tax benefits of debt irrespective of whether the debt capacity is used by theoperating irm;similarly,pricing,wage,andother decisions willbe affectedby taxbenefits received by shareholdersrather than by only those benefits that passthroughthe hands of the operatingfirm [4]. In evaluatinga prospectiveinvest-ment, the operatingfirm'smanagementshould "lookthrough" he intermediary,treatingthe intermediary's hareholdersas its own.6

II. The Advantages of Separating Operating and Financial RisksOur analysis thus far has assumed that the debt capacity of a firm or project isthe same irrespectiveof whether the operatingfirm or a financial intermediarydoes the borrowing.We now discuss some reasons why intermediaries mayprovideadvantages.A. Monitoring Costs and Liquidity

Whena lender is offered tradeablefinancialclaims as securityfor a loan, thereare two advantagescomparedwith the security of real assets.7The first is thatcontinuousunbiased prices are set in the market place. As a consequencethelender has no need to estimate the valuation of the real assets, and thereforethere is no need to monitor the actions of the managersand incur the resultingcosts.The second advantageof tradeable financial claims (otherthan the operatingfirm'sown shares) as security for a loan is that of liquidity. If the value of theborrower's ecurity falls below a certain level, a new call for funds is made, or,failing that, the securities are sold by the bank to realize the loan. Such a

'The extent of the tax advantage o the use of debt is an open questionat this point (see Miller[7]). There may be, however,other nontax motives for using debt. One explanationmight be thatfunds raised (by operating irms)via financial ntermediaries re cheaperthan fundsraisedvia thepublicmarkets because of lower informationprocessingcosts (see [6]). The financial ntermediaryacts as agentfor both lenderandborrowerand can acquireandprocessinformationat less expensethan can largenumbersof investors acting individually.This is simplythe standardexplanationofthe economic role of financial ntermediaries.Since many types of intermediariesdeal primarily ndebt contracts,many firms (especiallythose that are small or little known)might find debt anattractivesourceof funds evenif therewere no subsidydue to deductibilityof interest.The argumenthere rests on a reductionof aggregate nformationprocessingcosts throughoutthe economythatimprovessocialwelfare; here is no subsidyof one group by another.Also, the firm will face a lesscomplete financialmarket if it is unable to borrow; his is especially important consideringthedifferent ransactioncosts arising romdifferent inancial nstruments.6 If the unlevered irmsubsequentlyraisesdebt, then the firmactingas an intermediarywill haveto unravel ts leverageposition.This maycreatesome moralhazard or the lender ssuingdebtto theintermediary,ince the intermediarymaynot unravel ts debt position.Anycovenantswouldhavetobe in terms ofaggregatedbalancesheets ormarketvaluesof the intermediary nd the operating irm.

7There is one potentialdisadvantage-the lendercannotcontrolor influence he operatingpolicyof the firmdirectly.


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Debt Financing and Valuation 757realizationcantake placevirtually nstantaneously; herefore,such a loan is closeto riskless.The same is not true when the agreement is tied to the value of theoperating irm'sshares, foreven if the operating irm permitsthe bank a covenantrelated to the traded price of the securities, the lender is in no sense completelyimmunized rom a loss since it must sell real assets to redeemthe loan. The lenderhas a claim only on the real assets of the firm.Time may be requiredto realizethose assets (realasset markets are frequently mperfectand inactive),andthereremains the uncertaintyas to the future priceof the asset until the sale is made.B. Moral Hazard

Assumethat a sufficiently arge number of financial ntermediariesown sharesin a particularunlevered operating company, so that no single financial inter-mediary is able to influence the investment policy of the operatingfirm. Also,assume such financial firms are unable to act in consort to influence thoseinvestment decisions. Under these conditions we can argue that certain moralhazardproblemsdescribedby Myers [10] as pertaining o the lending decision ofthe operatingfirmare reduced.Myers shows why firms will be unable to borrowon futureinvestment oppor-tunities, i.e., growth opportunities.He argues that if the net present values ofsuch opportunitiesare unique to the managementof the firm, a moral hazardproblem arises if the value of the assets is less than the value of the debt.Shareholderswill have less incentive to exploit profitable nvestment opportuni-ties if part or all of the net presentvalue accruesto the lender. The lender canrecover the net present value only if shareholdersrequiremanagement o exploitthe projects8or if the projectscan be sold to other partiesat priceswhich reflectsuch positive net presentvalue. The moralhazardproblemprovidesan explana-tion of why banks are reluctant to lend on such growth opportunities.Myers'argumentseems to applyjust as well to loans on assets in placewhere the presentvalue of the investment in place is uniqueto the managementof the company.Itis for this reason that banks will frequently base their loan decisions on thepresent value of the assets in alternative uses. The values in alternative usesprovidethe banks with protectionfrom moral hazard problems.The separationoffinancingand operatingrisksthrough inancial ntermediarieswill reduce suchmoralhazardproblems.However,the intermediarymayhave anincentive to induce the operatingfirm'smanagementto pass up good projectsifthe intermediaryrisked default for purely capital structurereasons.There areseveral reasonswhy the corporate ntermediarywould have serious difficultyinenforcing changes in the operating firm's investment program. First, not allintermediariesmay be in default simultaneously; herefore,the operatingfirmcould not reject profitableopportunitiesand act unambiguouslyn favor of all itsshareholders.This will be so where the intermediarieshold differentassets, andwhere the assets' returns are varyingly and imperfectly correlated with thereturns of the operatingfirm. Thus, a decline in the latter's shares will have a

8 Shareholdersmay have no incentive to exploitthe projectbut managementmay have such anincentive.The failureby managemento adhere o contractualobligationswill affect the valueplacedon their servicesby the market.


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758 The Journal of Financevaryingimpact on the probabilityof default of each intermediary.Also, if eachintermediaryholdsotherassets (whichareimperfectlycorrelatedwiththe returnsof the operatingfirm),there will be a reduction n the probabilityof defaultas aresult of the co-insuranceeffect;in effect, there will be fewer defaultscomparedwith the situationwherethe debtwas held directlyby the operating irm.Second,the managersof the operatingcompanymay have some disincentive to rejectprofitableprojectsbecause of the consequentcosts that they incur. Such costsare not difficult to find, since, if the managersthreaten to pass up profitableprojects n order o inducebanksto be more lenient with respectto intermediaries,they may increasethe probabilityof their own operatingcompanies'default,andimpairtheir own personalincome streams (including heir reputations).C. Asymmetry of Risks between Shareholders and Managers

If financial risks affect the value of the manager'sand employees' benefitsstream,andsuch individuals ncurhigherrisksfrom a givenbenefitsstreamthanshareholders,then more projectsmay be rejected that are profitableto share-holdersbut which are expectedto diminishthe wealth of managersand employ-ees. The asymmetryof risks between shareholdersand managersmay prevailbecausethe managersarepoorlydiversifiedandthereforethey have not obtainedthe benefits of risk reduction.Moralhazard problemsand the concentrationofmanymanagers'wealthin the formof humancapitalmay preventits tradeabilityandas a resultpreventadequatediversification.Thus, the risksof debt financingmay be greater for managersthan for shareholdersand lead to a rejection ofprojects that will increase shareholders'wealth. If debt can be employed infinancial intermediaries,then shareholders may obtain the benefits of debtfinancingbut not the penaltiesof a lower level of investment.It may be arguedthat the managerscan alwayssell those projectswhichhavea positive net present value if they do not wish to undertakethem. However,unless the net presentvaluehas arisenfroma windfallgain,we mightreasonablyexpect part of the supernormalprofits to be unique to the skills of the specificmanagement.It might also be arguedthat specificcompensationplans could bedevelopedto providemanagerswith the incentive to maximizeshareholderwealthor that a competitive manageriallabor market might encourge managers topursueshareholder nterests (see Heckerman [3], Jensen and Meckling [5], andFama [1]).D. Financial Distress

When an operatingfirmuses debt, the onset of financialdistressmay put thefirm'smanagementat a disadvantagen negotiatingwithsuppliersandcustomers.The credibilityof the firm'sguaranteeto performagainst contracts,to deliverfuture goods and services, etc., may be reduced. Opportunitycosts may beincurreddue simply to the diversion of management time from operating tofinancingmatters. Also, creditorsmay impose unwise constraintson the firm'soperationsand commercialstrategy.Separating he operatingandfinancingrisksby havingdebt issuedby financial


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Debt Financing and Valuation 759intermediariescouldavoid some of these problemsand their attendantcosts.9Solong as the commercialoperations of the firm remain economically viable (i.e.,having a positive net present value), insulating them from disputes amongsuppliers of fundsshouldprovideadvantages.One such advantagemay arise (inMiller'sworld of debt andtaxes) when a firm is in financialdistress. Forexample,a firmmay wish to raisean issue of equity in order to obtain the value of unusedtax benefits;the new equity couldbe invested in corporatebondsand the interestincomewould be offsetagainstthe unusedtax benefits.Thus,shareholderswouldbe able to hold corporatebonds,tax free, via the firm.However,if the firm haddebt outstanding,the new equity would reducethe bondholders'risks of defaultand provide them with windfallgains, at the expense of existing equity holders.Such wealth transfersmight explainthe puzzle ofwhy firmswhich are in financialdistress (and have risky debt outstanding) are unwilling to resort to new equityissues.E. Holding Companies as Financial Intermediaries

A question arises as to whether it is possible to obtain all or any of the aboveadvantageswhen the shares of the operatingcompany are owned by a singleintermediary,and where the investmentand financing risks are separatedvia aholdingcompanystructure. In the case of monitoringcosts and moralhazard itis difficult to see how the holding companystructure can provideany benefits.The operating company's stock is not traded, and the management of theoperatingcompanywouldbe too close to the managementof the holdingcompanyto avoid moralhazardproblems.Of course,if the holding companyheld only amajor interest in the operatingcompanyand the remainderof the shares weretraded, then some of the advantages of reduced monitoringcosts and moralhazard could be obtained. This situation is not very different from the "N"intermediariescase except that one intermediaryhas a dominating nterest.In the case of asymmetryof risks and the costs of financialdistress,the singleintermediaryor holdingcompany concept should obtainthe relatedadvantages.The holding company structure will permit creditors,customers,suppliers,andmanagersall the more clearlyto distinguish the causes of financialdistress, andto determinewhen distress arises fromoperatingas opposed to financingconsid-erations.Clearly,suchgainswill ariseonlyif informationalmperfectionsare suchthat the parties involved find it sufficientlydifficult or costly to distinguishthesources of financialdistress.

III. ConclusionWe have shown in this paperthat if there is a corporatetax advantageto debt,the value of an operating irm'ssharesmayreflect its optimaldebt level regardless

'Any reduction n costs will obviouslydependuponwhat kind of intermediarys used. Costs aremost likely to be reducedwhen the intermediarys purelya financialconcern such as an insurancecompany,where assets and liabilities can be valuedat small cost, and where the costs of financialdistressmaybe lower than in otheroperating irms.


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760 The Journal of Financeof how much debt it actuallyuses. Ourarbitragearguments ollow from those ofStiglitz. The implication for capital budgeting is that the project valuationexercise should include all the tax benefits of the debt capacity contributedbythe project,irrespectiveof the amountactuallyborrowedby the firm operatingthe asset (subjectto the tax leakage causedby the double taxationof dividendsin the U.S.). The implicationis that intermediarieswill purchasethe shares inthe inadequately levered firm and borrow in order to obtain the unused taxbenefits. The role played by intermediaries n capturingunused debt capacityprovidesan alternativeto mergingas a way of obtainingunused debt capacity.As a consequence, he sharesofunderleveredcompanieswillbe held by corporatetaxpaying ntermediaries.We have also providedreasonswhy a financialintermediarymay actuallybeable to borrow more on the financial claims of the operating firm than theoperatingfirm can borrowon the real assets. The tradeabilityof the financialclaims may reduceagencycosts and increaseliquidity.Furthermore, he separa-tion of the financingand operatingrisksmay reducemoral hazardproblemsandthe costs of financial distress.Finally,a holdingcompanymay be able to obtainsome of these advantageswhile eliminatingsome of the difficultiesof havingtheoperatingfirm look to severalsources (i.e., severalintermediaries) or financing.This argumentmay provide a financialrationalefor the past popularityof theholdingcompanyorganizational tructure.Our final observation s an empiricalone. Ouranalysissuggeststhat borrowingis best done by financialintermediariesrather than directly by operatingfirms,whereasin practicewe observe that operatingfirms do borrow.Some might findthis fact to be supportiveof Miller'sargument[7] on the groundsthat it is taxbenefits which motivate our argument n Part I of this paper.If operatingfirmsdo borrow, hen perhapsthose tax advantagesare smallerthan they appear, ustas Millerargues.However,this proposition s not totally persuasivesincewe havefoundnontaxadvantageswhich would recommenddebt financingby intermedi-aries rather than by the operating firm. A second reason for borrowingbyoperating irmsmaybe that capitalstructure s used by suchfirms as a signallingdevice wherethere is informationasymmetry(see Ross [12]andRendleman [11].The use of financial ntermediaries n the role we have prescribedwoulddepriveoperatingmanagementof such signallingdevices.A thirdpossiblereasonmay bethat the managersof operatingcompaniespreferto see the advantagesof debtfinancingreflectedin their own firms'income account,ratherthan throughtheincome account of a corporate intermediary,since their compensationis fre-quently related to earnings rather than to stock returns. Finding a suitableexplanation s made more difficultby the fact that we do not have a comprehen-sive model of the capitalstructuredecisionof the firm.10

? There may also be constraints on the supply of intermediaries who may be able, or willing, toperform the intermediary function. For example, banks are prohibited by law from owning commonstock. Taxpaying industrial companies may not find the intermediary role compatible with theirexisting activities.


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Debt Financing and Valuation 761REFERENCES

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