Investment Under Uncertainty, Debt and Taxes

28 Pages Posted: 24 Apr 2008  

Andrea Gamba

University of Warwick - Finance Group

Gordon Sick

University of Calgary - Haskayne School of Business

Mamen Aranda

University of Navarra - Business

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It is common practice in financial derivative valuation to use a discount factor based on the risk-less 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 risk-less 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.

Suggested Citation

Gamba, Andrea and Sick, Gordon and Aranda, Mamen, Investment Under Uncertainty, Debt and Taxes. Economic Notes, Vol. 37, Issue 1, pp. 31-58, February 2008. Available at SSRN: or

Andrea Gamba

University of Warwick - Finance Group ( email )

Scarman Road
Coventry, CV4 7AL
Great Britain
+44 (0)24 765 24 542 (Phone)
+44 (0)24 765 23 779 (Fax)

Gordon Sick

University of Calgary - Haskayne School of Business ( email )

2500 University Drive, NW
Calgary, Alberta T2N 1N4
403-220-7165 (Phone)
403-282-0095 (Fax)

Carmen Maria Aranda León

University of Navarra - Business ( email )

Edificio Bibliotecas-Este
Pamplona, 31080

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