Separate or joint financing? Coinsurance, risk contamination, and optimal conglomeration with bankruptcy costs

This paper analyzes the determinants of the optimal scope of incorporation in the presence of bankruptcy costs. Bankruptcy costs alone generate a non-trivial tradeoff between the benefit of coinsurance and the cost of risk contamination associated with financing projects jointly through debt. This tradeoff is characterized for projects with binary returns, depending on the distributional characteristics of returns (mean, variability, skewness, heterogeneity, correlation, and number of projects), the structure of the bankruptcy cost, and the tax advantage of debt relative to equity. Our predictions are broadly consistent with existing empirical evidence on conglomerate mergers, spin-offs, project finance, and securitization.