Subsidiary debt, capital structure and internal capital markets

This study investigates external subsidiary debt financing and its implications for internal capital markets. I find that firms tend to finance business segments with subsidiary debt when those segments have better investment opportunities than the rest of the firm. Such debt tends to be parent-guaranteed. I also find that having such debt outstanding significantly reduces the effect of a segment’s cash flow on the capital expenditures of other segments, but not vice versa. These findings suggest that firms use subsidiary debt to protect their stronger segments from the underfunding or “poaching ” problems modeled in theories of internal capital markets. In addition, I find evidence that firms use subsidiary debt for reasons related to traditional capital structure concerns, namely debt overhang, risk-shifting, information asymmetry, and transactions costs