Taxation and Investment Decisions: A Real Options Approach

Abstract

The purpose of the paper is to analyse the impact of the tax system on the ®rm's incentives to invest and disinvest in an uncertain environment. This paper follows the real options approach, which allows us to investigate the value to a ®rm of waiting to invest and/or disinvest, when payoffs are stochastic and investments partially reversible. The implications for the magnitude and directions of the effects of tax policy are studied; also the case of tax policy uncertainty is examined. I. I n t ro d u c t i o nIn this paper we analyse the impact of the tax system on the ®rm's incentives to invest and disinvest in an uncertain environment. The paper follows the real options approach, which allows us to investigate the value to a ®rm of waiting to invest and/or disinvest, when payoffs are stochastic and investments are irreversible to some degree.Making an investment involves relinquishing an option to invest in future. An opportunity to make a real investment is a call option on a stock that consists of the capital in place, and making the investment is like exercising the option, where the cost of the investment is the strike price of the option. However, exercising the option at the instant its intrinsic value becomes positive is not optimal, because the option has a value in waiting: if uncertainty is low, the value in waiting will be little, while, if uncertainty is high, setting a high trigger may be more convenient. As a result, the optimal time to kill the option is well after the point at which expected discounted future cash¯ow equals the cost of investment.Abandoning the investment involves giving up an option to disinvest in future. In this case, disinvesting is like exercising a put option, where the resale price of capital is the strike price of the option. The optimal time to give up such an option is well before the point at which expected discounted future cash¯ow equals the cost of investment.A substantial number of papers have been developed within the real options approach. Brennan and Schwartz (1985) apply options analysis to a natural resource extraction problem. McDonald and Siegel (1986) and Dixit (1989) price option values associated with à The paper has been presented at the 1999 European Economic Association Meeting: I wish to thank the participants for their helpful comments. Many thanks especially to two anonymous referees for their insightful comments.

Optimal Investment and Financial Strategies Under Tax Rate Uncertainty

“…In order to calculate a …rm's value function with tax rate uncertainty we must …rst focus on the value function after the tax-rate change, i.e., when tax rate is 1 . Subsequently, we will deal with the value function under tax rate uncertainty, i.e., when the current tax rate is 0 .…”

“…1 As shown in Figure 1, among the 106 countries surveyed by KPMG (2009), the average of corporate statutory tax rates (All) has fallen from 31.4 to 25.9% over the 1999-2008 period. While tax cuts were less pronounced in Latin American (LAT) and Asian Paci…c (ASPAC) countries, much more dramatic tax cuts occurred in industrialized countries: in the EU, for example, the decrease was sharper (i.e., from 34.2 to 23.2%).…”

“…Böhm and Funke (2000) showed that investment is not very sensitive to the degree of tax policy uncertainty, when capital is gradually accumulated. Agliardi (2001) analyzed investment e¤ects of uncertain investment tax credits following a jump-di¤usion process. She found that tax policy uncertainty delays investment.…”

Investment Effects of Wealth Taxes Under Uncertainty and Irreversibility

“…Whereas the e¤ects of pro…t (or income) taxation under uncertainty are well known since the late 1990s (for example , Niemann 1999a, 1999b, Sureth 1999, Pennings 2000, Agliardi 2001, Panteghini 2001, 2004, Sureth 2002, Niemann and Sureth 2004, Alvarez and Koskela 2008, Schneider and Sureth 2010, Gries, Prior, and Sureth 2012, Niemann and Sureth 2013, the e¤ects of wealth taxes have not yet been investigated under conditions of uncertainty and irreversibility. This is surprising against the background of the recent …ndings on the economic implications of pro…t taxation on investments in risky projects.…”

Fiscal Policy and Stimuli to R&D Investment with Uncertainty

“…Metcalf and Hassett (1994) allowed for uncertainty in tax policy and found that the level of investment grows when there is tax uncertainty, whereas it shrinks when there is price uncertainty. Interesting too, Agliardi (2001) incorporates tax uncertainty in his model to analyze how tax policies affect a firm's incentive to invest and disinvest.…”