Abstract
This paper investigates the optimal contract between a principal and an agent that manages a business group and diverts funds among its projects. The optimal contract can be implemented by limited liability financial securities and results in a capital structure that provides risk sharing among the group firms. The paper provides explanations for the cross-holding of equity between firms in business groups, the contagion between the asset prices of such firms, and shows that a tax on intercorporate dividends may render the organization of such groups infeasible and lead to the creation of conglomerates.
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