Interest Rates Fluctuations and the Advantage of Long-Term Debt Financing: A Note on the Effect of the Tax-Timing Option |
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| Authors: | Ivan E. Brick Oded Palmon |
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| Affiliation: | Rutgers–The State University of New Jersey, Newark, NJ 07102.;Rutgers—The State University of New Jersey, New Brunswick, NJ 08903. We greatly appreciate the comments from an anonymous referee, Douglas Emery, C. F. Lee, Avri Ravid, and participants of seminars at Fordham University and Rutgers University. We are especially indebted to David Mauer for his comments and suggestions. Any remaining errors are our responsibility. This paper has been partially funded by the New Jersey Center for Research in Financial Services and the Coordinating Council for Business Studies at Rutgers University. |
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| Abstract: | When interest rates fluctuate, issuing long-term debt may implicitly generate a valuable tax-timing option. The holder of long-term debt has an optimal-trading taxtiming option to immediately realize capital losses if an increase in interest rates lowers the price of the bond below the original issue price. In contrast, if interest rates decrease and the bond price is greater than the original issue price, the holder would prefer to defer the realization of capital gains. This tax-timing option confers an advantage for issuing long-term debt. Our formal presentation also highlights how the tax-timing options of long-term debt may increase the debt capacity of the firm. |
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