Trade-Off Theory for Dual Holders

Abstract

A dual holder simultaneously owns (private) debt and equity in the same firm. Private debt has a tax advantage, a positive cashflow, which incentivizes its use. This cashflow leads to a lower net cost of debt, which again reduces default risk as well as the cost of external debt. The usual trade-off between tax benefits and bankruptcy costs is altered. Debt priority affects both financing and default decisions. We find that an enterprise-value maximizing firm should issue senior, external debt and junior, private debt, rather than debt with pari-passu priority. Our analysis further highlights that tax authorities can effectively curtail the tax-motivated use of private debt through straightforward measures.