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The Effect of Forward Markets on the Debt-Equity Mix of Investor Portfolios and the Optimal Capital Structure of Firms

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  • Titman, Sheridan

Abstract

This paper demonstrates that the various market imperfections that have been suggested to explain observed portfolio choices and capital structures can be circumvented if securities (e.g., options) can be traded that simulate forward contracts on stock. It is shown that if the risk-adjusted returns to bondholders exceed the returns to stockholders (to reflect personal tax differences) tax-exempt investors will prefer a combination of these synthetic forward purchases and corporate bonds to purchasing stock directly. They will not, as has been suggested, include stock in their portfolios for diversification purposes when they can alternatively purchase securities that simulate forward contracts. It is also shown that firms that can sell synthetic forward positions on their own stock can essentially guarantee that sufficient funds will be available to meet their bond obligations. This gives firms the opportunity to increase their debt levels without increasing the possibility of bankruptcy and the corresponding administrative and agency costs.

Suggested Citation

  • Titman, Sheridan, 1985. "The Effect of Forward Markets on the Debt-Equity Mix of Investor Portfolios and the Optimal Capital Structure of Firms," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 20(01), pages 19-27, March.
  • Handle: RePEc:cup:jfinqa:v:20:y:1985:i:01:p:19-27_01
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    Cited by:

    1. Donohoe, Michael P., 2015. "The economic effects of financial derivatives on corporate tax avoidance," Journal of Accounting and Economics, Elsevier, vol. 59(1), pages 1-24.

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