Although the finance literature has rigorously analyzed many dimensions of the ''capital structure'' question, little has been written about the optimal means of issuing multiproduct firms' securities. We show in this paper that a multiproduct firm can importantly influence its total market value by choosing the most appropriate arrangement for its stock and debt issues. Consider a firm which wishes to invest in two risky projects, whose initial owners must issue external debt and/or equity to implement these projects. We determine whether multiple projects should be operated within a single firm, or in separate legal subsidiaries of a holding company. Leverage has two conflicting effects on a firm's market value: while the corporate tax advantage of debt raises firm value, outstanding debt simultaneously lowers (firm) value by distorting equityholders' investment incentives. These investment distortions can take two forms. First, equityholders in a levered firm with risky debt outstanding will fail to implement certain types of profitable investment opportunities, because part of the investment's benefit accrues to the bondholders. This is called the ''underinvestment problem.'' Second, when the firm's projects have (widely) disparate risks, leverage will induce equityholders to undertake more of the riskier project, even when the safer project promises a higher expected return. This results in a reduction in firm value and is called the ''asset substitution problem.'' We model an entrepreneur with access to two separable investment opportunities. He can either incorporate each project separately, or merge the two projects into a single firm. Our analysis suggests that: (i) Joint incorporation (JI) minimizes equityholders' underinvestment incentives because the diversified firm's cash flows make the outstanding debt relatively safe. At the same time, however, JI generally creates an asset substitution problem which lowers aggregate firm market value. (ii) Separate incorporation (SI) serves to assure bondholders that their funds will not be used to overinvest in the riskier project, but generates greater underinvestment costs because each firm's debt is generally more risky than a combination of the two cash flows would have been. We present a relatively complex analytical model of this corporate design problem, with accompanying numerical solutions. Our computations indicate that a firm's organizational form can importantly influence the deadweight costs of external financing, by affecting the levered firms' tradeoff between underinvestment and asset substitution distortions. Holding other things the same, JI is more valuable when project returns are less positively correlated and when the projects' risks are more similar to one another. By contrast, SI provides the value-maximizing means of organizing projects and selling claims on their earnings when project risks are very different and/or their return correlations are very high. Our analysis has several implications for corporate planning and firm organization. First, it expands the number of known reasons why financing choices can affect firm value. When investors suffer from limited information, they will seek debt arrangements which limit equityholders' subsequent self-interested behavior. Although this insight is widely recognized, we specifically evaluate how it applies to the optimal structure of corporate borrowing within a multiproject holding company. While the majority of holding companies issue their debt exclusively at the parent level, exceptions do occur. For example, our analysis suggests that combining manufacturing and financing activities in the same corporate shell creates significant asset substitution problems. These arise when bondholders fear that funds generated from relatively safe, financing activities will be diverted to manufacturing projects. These concerns may be mitigated through the establishment of a separate financing subsidiary. Second, our analysis provides some guidance about the type of firms (projects) which can be profitably merged or spun-off. Conglomerate mergers generally do not generate large synergies or cost savings since they combine diverse activities within a single firm. Nevertheless, combining two firms' relatively uncorrelated cash flows provides real benefits: the merged entity enjoys superior investment incentives because its outstanding debt is less risky. According to our model, however conglomerate mergers will encounter a sort of natural limit because the firm's asset substitution opportunities increase with the number and disparity of investments being undertaken. Consequently, conglomerate mergers are most likely to succeed when die combined activities have similar risk levels. A related insight applies to the dynamic nature of a conglomerate firm's optimal organization: if one project's risk rises over time, the firm may optimally choose to spin it off into a separately financed subsidiary. The converse applies if the two projects' risks converge over time. The paper's analysis could be generalized in a number of ways, but its essential point would remain: that a firm's organizational form can importantly influence its cost of capital.
