The Impact of Profit Taxation on Capitalized Investment with Options to Delay and Divest

Arqus Quantitative Tax Research Discussion Paper No. 97

45 Pages Posted: 13 Aug 2012

See all articles by Georg Thomas Schneider

Georg Thomas Schneider

University of Graz; University of Graz

Caren Sureth-Sloane

Paderborn University; Vienna University of Economics and Business; TRR 266 Accounting for Transparency

Date Written: February 1, 2010

Abstract

In entrepreneurial decisions making uncertain future profits often are a main characteristics of real investment opportunities. If investors can react to uncertainty the degree of irreversibility and timing flexibility inherent in the available project should be integrated into the decision calculus. In this paper we investigate the interdependencies of effects from profit taxation and real options. We model an investment decision including an option to invest and an option to abandon. We show that increasing the tax rate can lead to paradoxical tax effects, i.e. may foster an investor’s willingness to invest into a capitalized investment. Instead, if we abstract from the possibility to abandon the investment object such paradoxical effect cannot be identified. Determining the after-tax value of the option to enter the investment project with and without an abandonment option we receive a critical cash flow cut-off level. We find that the value of the option to abandon depends on the tax rate and the amount of periodical cash flows. The option value can be increasing or decreasing in the tax rate. We find scenarios with paradoxical tax effects and show that the observed paradoxical effects are due to the presence of the real abandonment option itself. This finding contributes to the stream of literature that explains potential sources of paradoxical tax effects. The generated decision rules are helpful for investors facing risky investment opportunities and for discussing the economic impact of tax reforms. Furthermore, we highlight the overwhelming importance of integrating taxes in typically applied valuation approaches.

Keywords: investment decisions, real options, tax effects, timing flexibility, uncertainty

JEL Classification: H25, H21

Suggested Citation

Schneider, Georg Thomas and Schneider, Georg Thomas and Sureth-Sloane, Caren, The Impact of Profit Taxation on Capitalized Investment with Options to Delay and Divest (February 1, 2010). Arqus Quantitative Tax Research Discussion Paper No. 97, Available at SSRN: https://ssrn.com/abstract=2128272 or http://dx.doi.org/10.2139/ssrn.2128272

Georg Thomas Schneider

University of Graz ( email )

Austria

University of Graz ( email )

Universitätsstrasse 15/G1
Graz, 8010
Austria

Caren Sureth-Sloane (Contact Author)

Paderborn University ( email )

Warburger Str. 100
Paderborn, 33098
Germany

Vienna University of Economics and Business ( email )

Welthandelsplatz 1
Vienna, Wien 1020
Austria

TRR 266 Accounting for Transparency ( email )

Warburger Straße 100
Paderborn, 33098
Germany

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