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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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