Interest Rates Fluctuations and the Advantage of Long-Term Debt Financing: A Note on the Effect of the Tax-Timing Option.

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 tax-timing 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. The authors' formal presentation also highlights how the tax-timing options of long-term debt may increase the debt capacity of the firm. Copyright 1992 by MIT Press.