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Investment under Uncertainty, Debt and Taxes


  • The authors gratefully acknowledge the financial support of TransAlta Research Visiting Scholar Program, Faculty of Management, University of Calgary, the financial support of the University of Navarra and the financial support of University of Verona. We thank the referee for providing valuable suggestions. Alex Triantis, Steve Heston, Martino Grasselli, Paolo Panteghini and the participants at the International Conference of Finance, Hammamet 2003, at the 7th Real Options Conference, Washington (DC) 2003, at the Northern Finance Association conference, Quebec City 2003, at the Conference on Quantitative Methods in Finance, Sydney 2003, the seminar at the University of Maryland, April 2004, and the UBC Summer Finance Conference in Tofino, July 2004 for their insightful comments. Any remaining errors are our own.

Corresponding author: Andrea Gamba


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.