Thus the owners equity represents only about 46 12 260

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Unformatted text preview: s of Carr Company’s $12 worth of equity have control over $260 worth of assets (company X’s $100 worth and company Y’s $160 worth). Thus the owners’ equity represents only about 4.6% ($12 $260) of the total assets controlled. From the discussions of ratio analysis, leverage, and capital structure in Chapters 2 and 12, you should recognize that this is quite a high degree of leverage. If an individual stockholder or even another holding company owns $3 of Carr Company’s stock, which is assumed to be sufficient for its control, it will in actuality control the whole $260 of assets. The investment itself in this case would represent only 1.15% ($3 $260) of the assets controlled. pyramiding An arrangement among holding companies wherein one holding company controls other holding companies, thereby causing an even greater magnification of earnings and losses. The high leverage obtained through a holding company arrangement greatly magnifies earnings and losses for the holding company. Quite often, a pyramiding of holding companies occurs when one holding company controls other holding companies, thereby causing an even greater magnification of earnings and losses. The greater the leverage, the greater the risk involved. The risk–return tradeoff is a key consideration in the holding company decision. Another commonly cited advantage of holding companies is the risk protection resulting from the fact that the failure of one of the companies (such as Y in the preceding example) does not result in the failure of the entire holding company. Because each subsidiary is a separate corporation, the failure of one company should cost the holding company, at maximum, no more than its investment in that subsidiary. Other advantages include the following: (1) Certain state tax benefits may be realized by each subsidiary in its state of incorporation. (2) Lawsuits or legal actions against a subsidiary do not threaten the remaining companies. (3) It is generally easy to gain control of a firm, because stockholder or management approval is not generally necessary. Disadvantages of Holding Companies A major disadvantage of holding companies is the increased risk resulting from the leverage effect. When general economic conditions are unfavorable, a loss by one subsidiary may be magnified. For example, if subsidiary company X in Table 17.8 experiences a loss, its inability to pay dividends to Carr Company could result in Carr Company’s inability to meet its scheduled payments. Another disadvantage is double taxation. Before paying dividends, a subsidiary must pay federal and state taxes on its earnings. Although a 70 percent tax exclusion is allowed on dividends received by one corporation from another, the remaining 30 percent received is taxable. (In the event that the holding company owns between 20 and 80 percent of the stock in a subsidiary, the exclusion is 80 percent; if it owns more than 80 percent of the stock in the subsidiary, 100 percent of the dividends are excluded.) If a subsidiary...
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This document was uploaded on 01/19/2014.

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