Strategic Debt in Vertical Relations: Evidence from Franchising

In this paper, we examine the strategic use of debt in franchise organizations. We focus on both the franchisee's and the franchisor's capital structures. The primary goal of this study is to examine whether franchisors impose limits on franchisees’ debt levels to be able to increase their own leverage. We find that the franchisor's leverage is significantly related to the maximum leverage allowed for the franchisee. As the franchisor sets an upper limit on the franchisee's debt ratio, the franchisor can raise more debt and therefore seizes tax benefits, since interest payments are tax deductible. We find that this effect is stronger in chains with larger fractions of franchised outlets.

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► This paper examines the strategic use of debt in franchisor–franchisee relations.
► We empirically test whether franchisors impose limits on franchisees’ debt levels to be able to increase their own leverage.
► We find that the franchisor's leverage is significantly related to the maximum leverage allowed for the franchisee.
► Our result implies that franchisors set an upper limit on the franchisee's debt ratio to raise more debt and to seize tax benefits.