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

Published online by Cambridge University Press:  06 April 2009

Sheridan Titman
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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.

Type
Research Article
Information
Journal of Financial and Quantitative Analysis , Volume 20 , Issue 1 , March 1985 , pp. 19 - 27
Copyright
Copyright © School of Business Administration, University of Washington 1985

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