Investment under uncertainty, debt and taxes
Gamba, Andrea, Sick, Gordon A. and Aranda León, Carmen. (2008) Investment under uncertainty, debt and taxes. Economic Notes, Vol.37 (No.1). pp. 31-58. ISSN 0391-5026Full text not available from this repository.
Official URL: http://dx.doi.org/10.1111/j.1468-0300.2008.00193.x
It is common practice in financial derivative valuation to use a discount factor based on the riskless debt rate. But, to what extent is this discount factor appropriate for cash flows emerging in capital budgeting? To answer this question, we introduce a framework for real asset valuation that considers both personal and corporate taxation. We first discuss broad circumstances under which personal taxes do not affect valuation. We show that the appropriate discount rate for equity-financed flows in a risk-neutral setting is an equity rate that differs from the riskless debt rate by a tax wedge due to the presence of personal taxation. We extend this result to the valuation of the interest tax shield for exogenous debt policy with default risk. Interest tax shields, which accrue at a net rate corresponding to the difference between the corporate tax rate and a tax rate related to the personal tax rates, can have either positive or negative values. We also provide an illustrative real options application of our valuation approach to the case of an option to delay investment in a project, showing that the application of Black and Scholes formula may be incorrect in presence of personal taxes.
|Item Type:||Journal Article|
|Subjects:||H Social Sciences > HG Finance|
|Divisions:||Faculty of Social Sciences > Warwick Business School > Finance Group
Faculty of Social Sciences > Warwick Business School
|Journal or Publication Title:||Economic Notes|
|Publisher:||Wiley-Blackwell Publishing Ltd.|
|Number of Pages:||28|
|Page Range:||pp. 31-58|
|Status:||Not Peer Reviewed|
|Access rights to Published version:||Restricted or Subscription Access|
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