The paper applies contingent claims analysis in a real option investment model in order to investigate taxation's influence on investor's decisions under uncertainty. The results show the distortion from realistic-type tax systems, allow to identify a tax-induced paradox in option valuation for specific settings and acknowledge the property of investment neutrality of well-known 'ideal' tax systems in the context of different degrees of irreversibility. Furthermore, it is clarified that the idea of risk-neutral valuation cannot be adopted by the real option approach in general. Copyright Verein fü Socialpolitik and Blackwell Publishers Ltd 2002.

In this paper we use a real option model for assessing uncertain investment projects and we show that—due to a flexibility premium—taxes asymmetrically affect the option value of projects that differ in their riskiness. Hence, this may generate distortions. We analytically identify a set of neutral tax rates (a tax regime) that preserve the post‐tax investment threshold if taxes change, and determine normal and paradoxical settings for investments. Unlike other tax paradoxes neither depreciation rules nor loss offset restrictions cause these paradoxical reactions. Taxes affect each project individually, depending on the project risks involved. This implies that, for a variety of uncertain projects, taxes cannot be neutral on aggregate.

Investment decisions are often characterized by uncertainty, irreversibility, and timing flexibility. We use a binomial model to investigate the interdependencies of effects from profit taxation and both an option to delay and an option to abandon on investment decisions. We show that increasing the tax rate can lead to paradoxical tax effects, i.e. it may foster an investor's willingness to invest. By contrast, if we abstract from the abandonment option, such paradoxical effects cannot be identified. Hence, we show that paradoxical tax effects can be caused by an abandonment option. Our results are helpful for investors facing risky investment opportunities and for improving typical valuation approaches.

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Minimum tax, Business strategy, Investment decisions, Tax neutrality, Wealth tax, H25, H21,